This is the third in a 3-part series about the use of crowdfunding in health and biotech start-ups. We started with the story of a tech start-up which set records for funding through a Kickstarter campaign, triggering the interest of entrepreneurs in capital- intensive industries. Part 2 discussed the JOBS Act and the government’s attempt to overcome regulatory hurdles facing companies which want to use crowdfunding to raise equity investment capital. Part 3 addresses some Potential Dangers inherent in the system of crowdfunding being devised. We hope you find the series educational and invite you to contact the authors with questions.
PART III: First, the JOBS Act requires the SEC to issue complex implementing rules prior to crowdfunding becoming a reality. For any startup seeking funding through a crowdfunding source, the rules proposed by the SEC under the Act demand detailed disclosures regarding the company. The company must also describe exactly how the securities it is offering are being valued. Additionally, the Act requires ongoing, annual financial reports from the company after any successful crowdfunding campaign. These facts alone may scare off some entrepreneurs.
Startups will have to wait to see exactly how the JOBS Act is implemented and interpreted. But many entrepreneurs may be hesitant to disclose details on how their companies are being run. One of the benefits of being a small, privately held company is that competitors may not understand exactly how a company operates or what financial state it is in. With the disclosure requirements of crowdfunding, a company may need to disclose detailed information to hundreds or thousands of individuals with little control over what happens to that information after it is disclosed.
Second, health and biotechnology startups usually depend heavily on their intellectual property—especially patents. Using crowdfunding campaigns to raise capital creates concerns over patent rights in two main areas. First, the very disclosure required by the JOBS Act could potentially create prior art bars under US and foreign patent laws. Generally, prior art is anything that is available to the public before a patent application’s effective filing date and is relevant to whether an invention is truly “new.” Prior art commonly takes the form of journal articles or other patents. The US already had fairly strict prior art rules in place. But the US patent system recently went through a major revision, the America Invents Act (AIA). While the AIA altered many aspects of the US patent system, it made a few prior art bars even more onerous than they were before. Now if an invention is “described in a printed publication, or in public use, on sale, or otherwise available to the public before the effective filing date” of a patent application, the invention may be barred from being patented (see 35 U.S.C. § 102(a) (2012)). There are a series of exceptions in the US that create 1-year grace periods for the inventor in certain situations. But many foreign patent systems have strict novelty rules, which means that their prior art considerations do not have any exceptions or 1-year grace periods. Entrepreneurs need to be very careful about disclosing information through a crowdfunding campaign that they later may want to patent. The very disclosures allowing companies to get the capital to launch their product may end up being used as prior art to prevent the companies from obtaining patents at a later date.
Health and biotechnology companies utilizing crowdfunding platforms where an interest in certain aspects of their company is being sold and patents are essential to their business need to be exceedingly careful about what agreements they reach with both investors and the crowdfunding platform itself concerning any patent licenses. The specifics will likely vary between crowdfunding platforms, and the specific rules of Title III of the JOBS Act must be implemented by the SEC before the true intellectual property implications can be appreciated. However, it is important for entrepreneurs to realize the potential dangers of granting licenses to their intellectual property through the use of any future crowdfunding platforms.
Finally, entrepreneurs need to realize fully the implications of using crowdfunding platforms created under the JOBS Act. Entrepreneurs are selling a small interest in their company to hundreds or thousands of individual investors. While this may be an excellent way to raise capital for a startup, it also dilutes entrepreneurs’ ownership position over the company and effectively creates hundreds or thousands of business partners that may have varying expectations with regards to what input they should have on the running of the business. This issue is not a new problem for entrepreneurs, and it is certainly not limited to equity-based crowdfunding. Any entrepreneur who takes on angel investor funds or venture capital funds will need agreements with their investors over how much of the company the entrepreneur is selling and what level of involvement is appropriate for the investors.
But crowdfunding creates a new situation where hundreds or thousands of people are investing in a company at its founding. The rules created by the SEC implementing aspects of the JOBS Act and the terms and conditions of crowdfunding platforms will influence exactly how this issue plays out. But entrepreneurs need to ensure they understand exactly what they are agreeing to when they use an equity-based crowdfunding campaign to generate capital.
None of these concerns should be taken as general criticism or a lack of faith in crowdfunding, though. Crowdfunding is creating an incredible new channel for companies to raise capital and for startups to enter new markets rapidly. Using a crowdfunding campaign can be an excellent decision for a startup. Entrepreneurs simply need to ensure that they understand the potential drawbacks and unique issues they may face by using future equity-based crowdfunding campaigns.