When investing in a startup one component of due diligence that many won’t even think to consider is legal due diligence. Such questions could include, “does this company actually exist?,” or “are any of the key stakeholders in the business bad actors?”
In regards to legal compliance RegCF platforms like Wefunder and StartEngine do work to prevent scams and things of that nature but it’s not quite as simple as that. Even companies acting in good faith can make mistakes in regards to their legal structure.
This is why having a company like CrowdCheck in the space, which works to crackdown on these issues by conducting legal due diligence on companies raising capital is so important. We sat down with Sara Hanks, Founder & CEO of CrowdCheck to discuss how she and her team are working to bring compliance to the online private markets.
She also discussed how you can protect yourself as an investor by conducting legal due diligence. Protect yourself, and read on!
Sara, can you tell us a little about yourself and why you enjoy working in this emerging space?
Sara: I spent a couple of decades as a partner in one of the world’s largest law firms, mostly working on multibillion dollar IPOs and private placements for non-US companies. I did a lot of work with the first companies from emerging markets to access the international markets, so I have a high tolerance for chaos.
I left there to go to work on Capitol Hill in the financial crisis. I never went back to international capital markets work, because by the time I left I was solving the same problems every day. I like new challenges. I solved a Rubik’s Cube once and never saw the point of doing it again. Online capital formation has new and different problems for me to solve.
Can you talk more about the services CrowdCheck provides?
Sara: We now provide a wide range of legal, compliance, diligence and disclosure services for online securities offerings, both for issuers and online platforms. We started off purely as a due diligence shop, trying to address the question “why would people make investments in unknown small companies online if no-one has checked the company out for them?”
We offered a number of different due diligence reports doing just that and that is still an important part of our business. But over the years we added other services that issuers or platforms requested, including Bad Actor checks, state notice filings for Reg A, Reg D and Reg CF, issuer-dealer filings and the drafting of compliant disclosure. Because we can also add the specialized services of our affiliated law firm, CrowdCheck Law, we can also offer complete legal and compliance services for all these types of offerings, and we now have the market-leading practice for Reg A filings, with our 40th Reg A offering just qualified this week.
When people are analyzing a startup for investment, from a legal perspective what are some key legal items to look for?
Sara: Start with the absolute basics. Does this company actually exist? That is, is it still in good standing in the state it is organized in? Has it created the securities it is offering by making the appropriate filings and passing the required board resolutions? Then make sure the company has the permits or permissions needed to conduct its business.
Then you can get into issues like whether the company has complied with the requirements of the exemption from registration it is supposed to be relying on. If it fails to meet any of the conditions of an exemption, it could be that the entire offering violates securities law and there is a right of rescission (that is, the company has to give the investors their money back with interest). Most startups couldn’t survive that!
What are typically the red flags you look for in startups as it relates to legal compliance?
Sara: Well, obviously we check that the conditions of the exemption (Reg CF, Reg A, Reg D, etc) are met. And the corporate requirements I just mentioned. But over the years we’ve developed some interesting data points to check that can be very telling. Checking who owns a company’s intellectual property, for example.
You’d be amazed at the number of founders who get a patent, say, in their own name, and don’t assign it to the company even though the company’s business plan depends on the patent. And it’s not unusual for a founder to own a company’s URL. All is fine until the founders have a falling out and the person who just stormed out the door is the person who has the GoDaddy account!
Other frequent points of failure are failure to set up a bank account in the company’s name and companies identifying team members who aren’t actually involved, especially in advisor roles. We check everyone who’s name-checked. And that includes CPAs. We’ve had companies claim that the person signing reports on their financial statements were CPAs, when they weren’t. Or even forging a genuine CPA’s name!
What are the key issues you see from startups raising capital as it relates to compliance and how do we improve this?
Sara: Startups have to understand that they are taking money from the public in exchange for securities, and that they owe those investors accurate and convincing information if anyone’s going to give them money. They have to understand that even though they think they have the best idea ever and that it’s worth millions, they have to work for that money.
We also need to do a better job in getting companies to be more organized when they start their capital-raising. The thing about crowdfunding is that it’s meant that the level of regulatory complexity that most companies didn’t encounter until they got to an IPO is now facing them at an earlier stage in the companies’ lives. While you are still taking money from friendly angels or VCs it doesn’t matter so much that you failed to pay Delaware franchise taxes last year. When you are taking money from strangers over the internet, that kind of thing can be fatal.
Investors may be aware of the fact that owners in companies raising capital via RegCF that have 20%+ ownership need to have a background check. Can you talk more about this and why it is important?
Sara: One of the conditions of Reg CF is that there are no disqualified “Bad Actors” among the company’s officers, directors or major shareholders. These are basically people who have violated securities laws or committed financial fraud.
Over the years, in the Reg D market especially, the same bad guys would show up again and again promoting scams, and Congress and the SEC thought it important to just keep these people out of the online offering world altogether.
In order to be able to rely on Reg CF, the funding portal or intermediary has an obligation to run a background check on the people behind the company. That’s one of the services we provide. Funny, the things that come up in those checks! We never realized how many people who later go on to found a start-up were dealing weed! (That’s not a disqualifying act, by the way.)
To date have there been any scams in the RegCF or RegA+ investment markets and how do we continue to maintai n it as a safe space to invest?
Sara: Strangely, no scandals yet, but many scams. I’ve seen several offerings for perpetual motion machines or other offerings to build things that are technologically impossible. We’ve seen offerings of securities that do not exist and offerings by companies that no longer exist.
We have seen some classic “lie, and run away with the money” frauds that may be addressed by the regulators at some point and we have seen a lot of misleading statements all over the place.
However, what is important here is the role played by the teams at the Reg CF funding portals. These are mostly younger people, frequently with no specialized financial training, and some of them are doing a fantastic job at spotting issues and heading off attempted frauds before they can try to take people’s money.
Reg A is presenting the opportunity for some very specialized scams. We’ve identified at least a dozen Reg A filings that take advantage of moribund companies that used to be quoted on OTC, and are being used by a financial institution to pump unregistered securities into the market in a way that guarantees profits to the financial institution.
What are some key regulatory changes that you think would help to grow the online private market investment landscape safely?
Sara: I’d like to see statutory changes to permit the use of special purpose vehicles in Reg CF offerings. This would have a number of advantages, including addressing the “messy cap table” issue that some VCs identify.
I’d like to see a greater ability for Reg CF funding portals to select issuers, or rather to “deselect” issuers that they know have no chance of raising money and who just waste their time. I’d like to see preemption of state securities laws relating to secondary trading of private securities, to increase liquidity.
For startups or individuals interested in more legal due diligence where can they contact you?
Sara: Sara@CrowdCheck.com. I’m always happy to talk.