Issues with Alaska Equity Crowdfunding

In previous articles, I went over the very basics of what intrastate equity crowdfunding is and why you might choose to use it to finance your business. Today, I want to discuss some issues with crowdfunding that make it harder to use in Alaska than it needs to be, and give some direction on how to overcome a few of them.

It Is Not Yet Clear How-to, And The Process Is Fiddly

Equity crowdfunding is new. Very new. Interstate crowdfunding (which is Federally regulated) has only been legal for a few years. Intrastate crowdfunding in Alaska has been legal since 2017. That means there is very little track record to work off of. That means no one is very clear on the process - what must you do, what can you do, what should you do, and what must you avoid to have a successful crowdfunding round? Tough to say.

It is already getting better, bit by bit. There are professionals (myself included) who are interested enough to learn more about the process. The regulators are definitely digging in and learning, as well. And most importantly, we have brave early movers. One company, Baranof Brewing Company, has moved forward so far with a (moderately successful) crowdfunding campaign, and the Division of Banking and Securities is really pushing to educate entrepreneurs and professionals in order to promote more uptake. But the reality is that the process is new to everyone, and the learning process can be tricky. Baranof Brewing, for instance, was unable to get guidance up front on a lot of issues and misjudged what the response might look like. That made the whole process more painful, and meant it did not line up perfectly with their expectations. Consider: the limited liability company (LLC) is about 40 years old, having emerged and developed in the 1970s.¹ But there are still attorneys and accountants, let alone entrepreneurs, who do not understand the flexibility of this form of entity and routinely set them up in ways that later cause problems.

Couple this with the fact that securities mistakes can be extremely costly to fix down the road. Everyone who has worked on startup financing likely has a tale to tell of a startup that had to spend a stack of money during their second or third round of financing to fix mistakes made in an earlier round. VCs frequently request some kind of assurance before investing that there is not a latent securities law violation waiting in the wings to absorb their investment. That means that, prior to closing the VC round, the entrepreneur must invest in cleaning things up (usually by hiring a raft of professionals to come up with a rescission document and work with regulators to get it approved). So getting an early stage crowdfunding round right is very important.

There are already some fixes to this in the works. The State is trying hard to improve the process and communication about it. The Division has created educational materials, including helping to explain things like the importance of transparency and how to put together a decent prospectus (even providing a template!). But more needs to be done, starting with more people learning by doing.

Lack Of Awareness

If the State does everything in its power to encourage entrepreneurs to make use of crowdfunding, the laws are good, the regulations are easy to use, the forms are in place, and the professionals all know their role and can efficiently advise clients, the whole process could still fail. That's because, at heart, crowdfunding depends on one thing: crowds. Right now, the crowds are not aware of crowdfunding opportunities, or even the possibility that crowdfunding opportunities might arise. In practice, this means each entrepreneur must individually promote their crowdfunding opportunity, which adds frustration and expense to the process.

Alaska's crowdfunding rules permit the entrepreneur to advertise. In fact, this right to solicit investment generally, not just among a group of highly-selected individuals, is part of what makes crowdfunding more useful than some other kinds of equity formation exemptions. But advertising the crowdfunding opportunity is like advertising anything else: it costs money to get people's attention. Most entrepreneurs want to spend their energy and money promoting their business, not flogging for investment. And considering the low level of investment that each crowdfund investor brings to the table, it seems cheaper, easier, and more efficient to solicit a small number of high-equity investors than to solicit a huge number of folks from all walks of life, each of whom may have questions and concerns about the funding opportunity that have to be addressed.

This issue is particularly aggrieving because other forms of crowdfunding are so well-known. Many startups are raising funds through non-equity crowdfunding. For instance, a number of businesses have successfully launched by effectively pre-selling products via Kickstarter or other crowd platforms that are well-established and widely subscribed. Why go through the time and expense of promoting a crowdfunded equity sale that is limited to Alaskans when funds can be raised with better guidance and exposure on a national stage without giving up any equity in the company?

There are a few good answers to this question. For instance, pre-sales on Kickstarter lead to some goodwill, but not the same kind of community investment in your company's success that an equity crowdfunding round can bring. And some products and services simply cannot be sold through Kickstarter. I am convinced that this is a major reason that craft breweries and wineries are early adopters and frequent users of equity crowdfunding: they benefit from the local involvement in their business, and the rules for selling their product across state lines are complex to navigate. But even if there are good reasons to equity crowdfund, the fact that it is unfamiliar to the Alaskan masses decreases its appeal.

There is a mechanism in the law to deal with this by permitting a web service to emerge that hosts Alaskan equity crowdfunding projects. But the restrictions on that web service mean that it will probably be a labor of love for whomever sets it up: it is unlikely ever to be profitable to the operator.

Escrow Requirements

Alaska requires that the proceeds of the crowdfunding round be kept in an account and not released until the target amount has been raised. Huh?!

It works like this: when an entrepreneur decides to crowdfund to, say, build a new building she first decides how much she is trying to raise. Say she decides she needs to raise $450k. Then she starts advertising and offering the crowd equity in exchange for investment. Say shares are selling for $10 apiece, with a minimum investment of 10 shares and a maximum of 1,000. She will need at least 45, and likely 100+ investors to buy-in. If she only gets 10 investors representing $25k, she cannot move forward with her new building plan - the investment the crowd thought it was making it will not be able to make. In that circumstance, the $25k will be released back to the investors.

Alaska's crowdfunding law says that this money must be kept in "escrow." That requires an escrow provider. But Alaska's banks and other financial institutions have proved absolutely unwilling to write escrows for this purpose, because there are so many scary ambiguities as to what it will mean. This means we have to find a way to get an "escrow".

This is a stupid issue to hang up an investment possibility. I have asked the State Division of Banking and Securities to strongly suggest to Alaskan community and chartered banks to get past their reticence. I also believe the Division could resolve this through regulation, by interpreting "escrow" to include trust accounts (which is how the situation is resolved in Oregon). In Washington, the state authority has compiled a list of community banks and charter banks that will offer escrow services.

Conclusion

Crowdfunding is new, and there are issues with its implementation. The most significant issues are all related to the fact that the mechanism is unknown, and there is a lot of education and kink-working to be done. But these issues can be resolved with more study and development.

^{1. Actually, things are a little more complicated than that. The LLC emerged in scholarship in the 1970s, but only two states adopted LLC statutes prior to 1990 because the IRS gave unfavorable tax treatment to them (making them pointless) until 1988. A lot of LLC law is based around nervousness over whether the IRS will revert to its old treatment. Being as that now seems very unlikely, many LLC acts are starting to evolve. But the point in the text remains: they have been used for over 30 years and are still unfamiliar, so no surprise that the 2-year-old Alaska crowdfunding provisions feel strange and new.}