Using Crowdfunding to Raise Capital for Your Franchise Business

New crowdfunding regulations now allow franchisors and franchisees to sell securities through a less rigorous process than a full securities filing but risks must be considered. Conferring with experienced legal counsel before choosing this path is recommended.

By Samuel G. Wieczorek

Approximately a year and a half ago, final crowdfunding regulations went into effect and since then, the number of companies raising capital by crowdfunded offerings has been on the rise. Companies in the franchise industry may be able to use crowdfunding to raise capital, although certain guidelines must still be followed.

Regulations

As they stand, the new crowdfunding regulations let anyone, regardless of income or net worth, invest in securities-based crowdfunding transactions, and issuers are not limited to offering securities only to “accredited investors” (i.e., investors who have certain minimum amounts of net worth or income). Although the regulations are meant to reduce the regulatory burden on issuers, they must still comply with certain disclosure and other regulatory requirements. These disclosure obligations involve filing a document with the U.S. Securities and Exchange Commission known as Form C, which requires background information on the issuer’s directors, officers, and principal shareholders, the issuer’s business plan, the issuer’s plans for using the funds raised by the crowdfunded offering, and financial statements. This document must also be provided to prospective investors.

Potential Costs and Downsides

With careful planning, a crowdfunded securities offering may work well for franchisees who are looking for a new way to raise capital. However, before starting, franchisees should consider the potential downsides, the most obvious of which is the expense associated with complying with the crowdfunding regulations. These expenses include the cost of preparing a compliant disclosure document, preparing the appropriate financial statements (which must be audited in some cases), and engaging a broker-dealer or funding portal to oversee the offering. Franchisees will most likely need to hire an attorney with experience in both crowdfunding and franchise law.

As with all public offerings of securities, franchisees need to consider the possibility of liability for material misstatements and omissions in their offering documents. If a registration statement contains an untrue statement or omits important information, an aggrieved investor can recover the difference between the purchase price and the price at which he is able to dispose of the security. This difference can be taken from several individuals associated with the issuer such as principal officers and board members.

Limited Use for Franchisors

A crowdfunded securities offering by a franchisor could also make sense in the right circumstances. However, because an issuer of securities is permitted to only raise a maximum of $1 million in a 12-month period, this may be an insufficient amount of capital to make a crowdfunded offering worthwhile for larger franchisors.

On the plus side, much of the information required in Form C for a crowdfunded offering overlaps with information that must be disclosed in a franchisor’s FDD. As such, the burden of assembling this information may be less onerous than for a franchisee who wishes to raise capital via crowdfunding.

However, franchisors should bear in mind that there is not perfect overlap between the information required by the FDD and Form C, and that Form C, in some cases, requires more information be disclosed than the FDD. For example, while a franchisor must disclose its parent in its FDD, Form C requires the disclosure of all principal shareholders (each person who is the beneficial owner of 20 percent or more of outstanding voting equity securities). Form C also requires disclosure of the material terms of all indebtedness, including the identity of the creditor, outstanding amount, interest rate, maturity date, and other material terms. Some franchisors may be unwilling to disclose this information in a public document.

Franchisor Considerations in Consenting to Franchisee Crowdfunded Offerings

Assuming a franchisee wishes to raise capital through a crowdfunded securities offering, it will almost certainly need to obtain the consent of its franchisor based on the “restriction on transfer” provisions of the franchisee’s franchise agreement. In contemplating whether to grant its consent, the franchisor should consider several risks.

Secondary liability risk: There is a broad universe of potential defendants in a claim for violation of the crowdfunding regulations. For this reason, the franchisor needs to take a careful approach so that it does not directly participate in the franchisee’s preparation of its registration statement. Determine ahead of time whether the acceptance or approval of the franchisee’s documents would subject it to liability.

The brand or system risk: Because crowdfunding assumes a “crowd” of investors in the franchisee’s business, there will be a much larger pool of people looking to point the finger should the investment not pan out as expected. In other words, will the negative publicity generated by individuals who have lost their investment in the franchisee’s securities be worth the risk to the goodwill of the franchise system overall?

The disclosure risk:  As noted above, crowdfunding requires disclosure of information that isn’t required in the franchisor’s FDD. Unless the franchisee incorporates a mechanism to secure confidentiality agreements from its crowd investors and to weed out competitors who might be part of the crowd, the franchisee may be disclosing proprietary information to owners who are not bound by confidentiality obligations and competitors who would benefit from the information. Also keep in mind that most states have laws to protect and give rights to minority shareholders, and those laws are not superseded by the crowdfunding regulations.

Tips for Crowdfunding

If a franchisee or franchisor decides to raise capital through a crowdfunded offering, it should consider a few critical factors. First, because investors can rescind their purchase of crowdfunded securities within 48 hours before the offering deadline, consider an oversubscription to help ensure the issuer meets its subscription goal.

Second, issuers should be aware of the restriction on their ability to advertise the terms of the offering, because advertisements of a crowdfunded offering are carefully regulated. Finally, issuers must be sure to comply with restrictions on compensation to promoters of the securities being issued.

Unlimited Possibilities

The long-awaited crowdfunding regulations have opened up possibilities for franchised businesses to sell securities to unaccredited investors through a less rigorous process than a full securities filing. It may be a good option for both franchisees and franchisors who wish to raise capital. However, franchisors and franchisees looking to stick their toes in the crowdfunding pool must consider the risks to the franchise system, how this fundraising option fits within the construct of the system, and the need to confer with experienced legal counsel before doing so.

Samuel G. Wieczorek is an attorney with Cheng Cohen LLC, a premier full service boutique law firm.