How to maintain corporate governance in equity crowdfunding

Doing equity crowdfunding means selling shares in the company, thus opening up the company's share capital to the entry of new shareholders. For this reason, many entrepreneurs are concerned that equity crowdfunding may pose risks to company governance. In this article we will dispel this concern by exploring ways in which companies can avoid losing corporate governance in equity crowdfunding and smoothly maintain control over their business.

The issue of governance in equity crowdfunding

Equity crowdfunding involves the issuance of company shares or units to outside investors, who by participating in the crowdfunding campaign on the hosting portal can acquire an ownership stake in the company, proportional to the capital increase made and the size of the investment. Equity investors then become true partners in the company. Most of them are not insiders either in the financial field or in the company's target industry, so it would not be appropriate for them to have the power to make strategic and operational decisions. Small, unsophisticated investors do not have the experience or tools to actively influence the day-to-day decisions of the company.

If share capital dilution is substantial, the original shareholders may find themselves in the position of owning a minority of the ownership shares. This can result in loss of control by the founders or managers of the company, but only if appropriate measures are not taken to protect governance, which are the practice in equity crowdfunding. Knowing such measures is a basic prerequisite for doing equity crowdfunding safely and profitably for the company.

The differentiation of shares

The key to maintaining corporate governance in equity crowdfunding is to manage the opening of the company's capital stock strategically.

The main way to do this is to differentiate the shares sold in equity crowdfunding:

• Category A shares with voting rights at the shareholders' meeting
• Category B shares, without voting rights

Category A shares may be very few and reserved for those who invest a large amount of capital and/or those with professional skills useful to the company: they represent an incentive that can be used to attract specific categories of investors and should be defined in detail.

Category B shares will account for almost all of the shares sold in equity crowdfunding: investors become equity partners and acquire property rights, but do not participate in governance decisions, which remain reserved for the founders or shareholders with voting shares. In this way, a high percentage of the company can be divested while still keeping voting rights in the hands of the original founders or shareholders.

Within the Italian legal system this procedure is only allowed as part of an equity crowdfunding transaction, which therefore represents an opportunity with unique characteristics for companies to increase their share capital.

Each company can define the amount and type of shares it prefers, according to its own needs, as long as they are stipulated in the company's bylaws and fall within the scope of the law. For example, by law, non-voting shareholders cannot represent more than 50 percent of the capital, and the associated property rights cannot be unrelated to profit results.

Other methods of managing the opening of capital stock

Other corporate governance safeguards also exist that can be used when doing equity crowdfunding. Like the types of shares, they too must be defined in the articles of incorporation.

Governance Clauses: specific limits can be included in the terms of the offer presented to potential investors to protect the rights of the founders and their decision-making power. For example, clauses can be included that require the founders' approval for strategic decisions, the sale of large shares in the company, the issuance of new shares, or other. This practice allows founders to have a kind of “veto” over key decisions that may affect the direction of the company.

One of the best-known formulations of these clauses is the right to drag along: a clause whereby the majority shareholders of the company can also sell the shares of the minority shareholders, on the same economic terms as their own, without asking for consent. This right is called bring along when it is partial, that is, when it is stipulated that the minority shareholder is obliged to sell his shares only if the third-party buyer himself requests it.

Such clauses are useful to prevent small investors from having blocking power or causing decision-making gridlock, but keeping their participation in line with the project's shared values: partners from an equity crowdfunding campaign should still have an advisory role or be involved even marginally in the life of the company, in line with promises made during the capital raising.

For example, companies can strengthen governance by including clauses that limit voting rights on technical and financial issues, allowing investors to intervene only on long-term strategic issues or stated social goals. This is especially important for those crowdfunding campaigns that leverage improvements for society, the environment, or certain categories of people that the company plans to achieve through the development of its product or service. 

Limits to representation on the board of directors: establishing a maximum number of board members who can be elected by investors is another way to maintain control by the company's founders or managers.

Planning for dilution and evaluating the use of SAFE/SFP: Before launching a crowdfunding campaign, it is crucial to accurately calculate the level of equity dilution to ensure that founders retain a significant share of ownership. Another option to avoid immediate dilution is the use of financial instruments such as Participatory Financial Instruments (derived from the U.S. Simple Agreement for Future Equity), which allow investors to convert their shares into equity at a future valuation, keeping control in the hands of the founders until a contractually determined time. This mode of equity-type capital raising is less intrusive to the founders and allows them to manage governance and the opening of equity gradually and with a precise roadmap. SFPs can also be placed with a crowdfunding campaign on an authorized platform.

The main objective of these restrictions is to balance the need for transparency and participation with the efficiency of corporate governance. Advice from legal experts specializing in crowdfunding is crucial to ensure that the terms and conditions of the offering protect the interests of the original shareholders while respecting the rights of crowd investors. 

With these arrangements, companies can take advantage of the benefits of equity crowdfunding while minimizing the risks of losing corporate governance. 

Equity crowdfunding, governance and transparency

What has been said so far must go hand in hand with compliance with the transparency rules that the European ECSP Regulation reaffirmed to protect crowd investors.

Companies and crowdfunding platforms are required to provide clear information on the terms of the investment and the nature of the stake, how conflicts of interest are managed, governance clauses, governance control structures, and how the company and shareholders communicate.

To maintain a good relationship with members and build a community of crowd investors who will also be able to support the company in subsequent transactions, it is important to build an open and transparent communication channel and provide regular reports on the company's activities.