Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if "market" terms emerge.
Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if “market” terms emerge.

While it remains to be seen how and to what extent crowdfunding will take off, here are a few things to keep in mind as you start thinking about possible deal terms on your first crowdfunding operation. I should note that ultimately, I anticipate that entrepreneurs will gravitate toward terms suggested by the most popular funding portals, and that these terms will become the market standard. Nonetheless, you’ll still have to come up with the economic and control terms of the deal yourself, and I hope this article helps you think critically about such terms as you do.

  • Valuation – Valuation is a function of the amount being raised and the percentage of the company being purchased. Current practices involve a negotiation between the investors and the entrepreneur, whereas crowdfunding will let the entrepreneur set the terms. In Venture Deals, Brad Feld and Jason Mendelson warn of setting your valuation too high due to the risk of not achieving a higher valuation at the time of your next round, causing dilution of your original supporters. While crowdfunding investors might not have the same anti-dilution protections as VC investors, there still might be risks from a subsequent down round due to the investors’ expectations going unmet. The takeaway here is to be reasonable in your valuation and have a solid plan on how you’re going to use your funds to build and create value in the business.
  • Number of Shares – Angel investing in seed rounds typically acquire between 20%-35% of the company—any more than that could hurt your ability to raise future rounds. Of course, with new types of companies entering the mix, common practices may not hold. Consider having your CFO use a <a href=””>pro forma cap table</a> to run through a few hypothetical future financing scenarios, and let where you hope to end up inform where you might start.
  • Protective Provisions – Freedman and Nutting anticipate a future in which funding portals may opt to allow investors to pool their funds into a single entity that could serve as an agent of the “CF class” and possibly negotiate a board seat. Until that becomes a reality in the U.S., you can expect investors to pay special attention to the veto rights they are given.In negotiated transactions, investors almost always have the right to vote when an issuer (1) alters the rights of the issued shares, (2) changes the authorized shares of common or preferred stock, (3) creates a new class of shares having rights, preferences or privileges senior to the issued shares, and (4) wants to merge or be acquired. I can’t imagine many investors signing up to invest without (1)–(3), but we’ll have to see how investors respond in a system in which the terms are set by entrepreneurs.Note that Section 4A(b)(1)(H) requires “a description of how the exercise of the rights held by the principal shareholders of the issuer could negatively impact the purchasers of the securities being offered,” so failing to treat your investors fairly will likely negatively impact the economic terms of your offering.
  • Drag-Along/Tag-Along Rights – Drag-along rights ensure that if you want to sell the company, you can compel other shareholders to sell their shares on the same terms. Tag-along rights provide corresponding rights for investors and ensure that they have the option to sell their shares on the same terms if you sell the company.Drag-alongs tend to be more controversial when they are being requested by investors in a new round, in which case they could force an entrepreneur to sell her company even if she didn’t want to. When being imposed on crowdfunded investors, they simply allow you to capture the full value of your equity in the event of a sale. You’ll almost certainly want them given the large number of shareholders inherent in crowdfunding transactions. It’s tough to think of a reason why you wouldn’t want to offer investors tag-along rights—which is likely why both drag-alongs and tag-alongs appear in the suggested term sheet on UK crowdfunding site Seedrs.

Of course, no deal is the same, and you should always work with an attorney experienced in this field when creating a financial offering.

Part 1 of this series is here and Part 2 of this series is here.