Are you an officer or director of a private company? Use of equity crowdfunding will expose you to significant liabilities.

The JOBS Act poses several new risks for officers and directors of equity crowdfunded companies:

1. The Act specifically calls out personal liability should any written or oral communication in the offering or sale of crowdfunding equity turn out to contain a material misrepresentation or omission—whether or not it is intentional.
2. Each of the hundreds of people expected to participate in an equity crowdfunding could be a potential lawsuit. Defending lawsuits is expensive in both time and money.
3. The SEC has narrowly-defined parameters for companies who can seek equity crowdfunding. Expect the SEC to closely police crowdfunding activities and vigorously pursue violators.
4. Inadvertent violation of the strict crowdfunding rules could lead the SEC to reclassify all the crowdfunding equity holders as regular security holders. This could push the company over the threshold for maximum number of private company shareholders and force the company to go public. Given the expense of a public company, most startups would go out of business.

Rising Costs of D&O Insurance

Private company D&O insurance policies generally have been much cheaper than public company insurance. Shareholders sue private companies less often than public companies, and for smaller amounts. When a company goes public, D&O insurance costs rise substantially.

Still, lawsuits against private companies have been on the rise, and higher insurance premiums have followed. The JOBS Act is likely to accelerate this trend, and the resulting increase in D&O insurance premiums likely will impact all our startup companies.

Private company D&O insurance companies contain exclusions for being a public company. The language in these exclusions varies widely among insurers. Some are written so broadly that they would omit coverage for equity crowdfunded companies. If you are doing any sort of equity-based fund raising, read your D&O exclusions carefully. 

At last week’s 2012 GSB Healthcare Innovation Summit at Stanford University, Big Data was the opening theme. Todd Park, Health and Human Services CIO launched the Summit with a talk about breaking open silos of data for access by entrepreneurs.

In the healthcare arena, the Health Data Initiative seeks to replicate the success of weather data provided by the National Oceanic and Atmospheric Administration (NOAA). When NOAA made weather data public and accessible, an entire industry was spawned (e.g., The Weather Channel, weather websites, weather mobile apps, and more). A rising tide of organizations is making data accessible for third party analysis, and this movement is exemplified by http://bluebuttondata.org.

What is Big Data? It is comprised of data sets that are too big for commonly-used software to capture, access, analyze and manage quickly. Sizes currently range from dozens of terabytes to several petabytes. Because the information held in the data is changing constantly, it’s a dynamic, ever-moving target.

The challenges in accessing Big Data are substantial. The US healthcare system generates mountains of data every year, but mostly in inaccessible forms such as books and pdf files. The data are not “liquid” (standardized and machine-readable). The push for electronic medical records will help substantially, but we’re still in the early stages.

Even with liquid data, regulations for healthcare privacy and HIPPA can be daunting. Our healthcare system has been built on sharing data with the smallest circle of “need to know” people. Providing ready access to third parties won’t be easy. Historically, healthcare companies have protected any data they collected as valuable intellectual property not to be shared with others.

The US healthcare domain has four distinct pools of data, with little overlap in ownership or accessibility.

1. Pharmaceutical R&D data – clinical trials and high throughput screening libraries
2. Hospital clinical data – electronic medical records
3. Insurer claims and cost data – care utilization and costs
4. Consumer data about patient behavior – retail purchase history, captured exercise data, emerging digital health sector

The low hanging fruit in Big Data may be new business models based on online consumer platforms and communities. Examples include PatientsLikeMe.com for shared patient experiences. Because it is opt-in and data is provided by consumers, HIPAA and other regulations do not apply. More difficult but equally ripe with opportunities are medical cost transparency, comparative effectiveness research, clinical decision support, and remote patient monitoring,

The proliferation of digital healthcare data, from the wired consumer to clinical records to claims information, is fertile ground that is ripe with startup opportunities. The prospects for new business models and Big Data entrepreneurs have never been better. 

Pebble Technology receives $6.9 million—20 days remain! Headlines from Bloomberg, CNN, ABC, and others have been shouting out about the record amount pledged through crowdfunding at Kickstarter. Pebble has become a poster child for the crowdfunding movement.

Who are Kickstarter and Pebble Technology? Kickstarter is a highly successful crowdfunding website for products and projects, where people pay companies for rewards and discounts. The overhead cost is 5% to Kickstarter plus another 3-5% to Amazon Payments, which handles the money.

Pebble Technology is a three-year old startup company that offers a wearable gadget—a smartwatch that brings some of the functionality of a smartphone to a wristwatch. The standout features are its screen and ability to connect wirelessly to an iPhone. The iPhone connection is the real difference maker. Both the Pebble and its competitors can connect to Android phones via Bluetooth.

Kickstarter pledges for Pebbles watches range from $1 to $10,000 or more. People who pledge large amounts will receive 100 Pebbles in about four months. Prior to Pebbles, the top 10 Kickstarter campaigns produced from ~$500K to more than $3 million. Pledges for the average project was less than $10,000 and the most common pledge is $25. Still, the success of Kickstarter and others has been a key driver for the equity crowdfunding provisions in the JOBS Act of 2012.

Many Venture Capitalists have supported crowdfunding and would like to use Kickstarter for their portfolio companies. Who wouldn’t? It is non-dilutive, fast, and low effort.

Non-Equity vs Equity Crowdfunding

To date, all crowdfunding has been for projects not equity. These non-equity payments are outside the purview of the Security and Exchange Commission (SEC). The new JOBS Act enables the use of crowdfunding to sell equity to the general public (unaccredited investors). Equity crowfunding will be subject to SEC oversight, and the legislation contains several “legal land mines” and restrictions, such as early disclosures, personal liability, and a $1 million cap, among others. (See prior post: Will Crowdfunding replace Angel Funding?).

Will Angels/VCs ignore the legal risks and invest in companies with shareholders from equity crowdfunding? The startup financing world is a market-driven environment, and when a frenzy of buying occurs (throwing money at companies irrespective of terms), thoughtful consideration of details often goes out the window. The devil is in those details, which may come back to bite those investors in a big way during the ensuing years.

What About Mentoring?

Post-investment Angel participation can make the difference for a successful outcome. Involved Angels provide mentoring/coaching, strategic consultation, and monitoring of financial information. Angels also are a key source for making connections. Rookie or seasoned veteran, entrepreneurs benefit from guidance and/or perspectives that an Angel who has “been there and done that” can provide.

In the crowdfunding model, investors are uninvolved and distanced from the company. Is this better for entrepreneurs? The answer is no, according to data from the Kaufman Foundation. When Angel investors participate in a company after making an investment, returns nearly triple. At HealthTech Capital, one of our core philosophies is to be involved and mentor companies for success—both for us and the entrepreneur. 

The short answer is NO.

The new JOBS Act of 2012 contains radical new provisions for “crowdfunding”—a new practice to raise funds through the sale of equity to the general public (unaccredited investors). Rightfully worried about fraud, Congress included several investor protections. These provisions, however, make crowdfunding an unattractive option for most Silicon Valley startups. Here are a few of the major issues:

• Detailed public disclosures. For young companies in stealth mode, the requirement to make detailed public disclosures is a “deal killer.”

• Invitation to sue. The JOBS Act explicitly states that crowdfunding investors may sue the startup company for material misstatements or omissions. It does not matter if a mistake is unintentional.
• Personal guarantees. The Company CEO must personally guarantee the accuracy of company financial statements.
• Conflicting regulations. Combining crowdfunding with Angel or VC funding may be impossible.
• $1 million maximum. This is the total amount a company can raise by crowdfunding. It is the rare startup that achieves an exit on this amount of funding.

Given that most startups will fail, these requirements create fertile ground for lawsuits against CEOs and possible judgments against their personal assets. Why would an experienced CEO with a track record of success ever want to do this?

Even if it becomes possible to mix crowdfunding and Angel/VC funding, in most cases this will be a non-starter. Professional investors will be reluctant to fund a company with the overhanging liabilities of a messy cap table with perhaps hundreds of unsophisticated tiny investors.

Crowdfunding may find a niche with companies that never need Angel or Venture funding. Examples include “the dorm room CEO” who has few assets, as well as restaurants, consulting businesses, and other non-venture fundable businesses. None of the current crowdfunding success stories involve the sale of equity.

When the SEC writes the rules implementing crowdfunding, additional devils will be found in the details. These rules are due by the end of 2012. But the SEC already is more than a year behind on other rules. Don’t hold your breath…. 

On April 17, 2011, David Ford will be at the HealthTech Capital Dinner Meeting.  We’ll follow our typical format of a social gathering followed by two company presentations. Then, David will cap the evening with a keynote interactive discussion: The Once and Future Landscape for HealthTech Companies.

David is one of the leading experts