Crowdfunding Financial Statements Disclosure Challenges

Have you ever gone camping with someone who has only read about the outdoors, but has never really camped before? How about sailing?

Book learning is fine, but nature presents many unexpected challenges. You either quickly adapt or you suffer. You don't always have the ideal equipment. And the instruction books often leave out small, but important details. There is no substitute for hands on experience that helps to improvise solutions.

Let's discuss how this applies to financial statements, when small and midsize businesses try to raise capital.

Accounting fees are often a major expense of any offering, which we discuss in detail in Chapter 21.

In part, accounting fees depend on the size and complexity of the business that is trying to raise capital. But the cost of financial statements also depends on whether investors or securities regulations:

• Require more than one year be covered by the financial statements.
• Permit cash or tax based financial statements.
• Require GAAP-compliant accrual based financial statements with footnotes.
• Require financial statements to be audited or reviewed by independent accountants.
• Require independence and other credentials for the audit firm that the business's normal accounting firm does not meet.

Let's discuss how these variables affect small and midsize businesses when they try to raise capital.

Securities regulators often take the instruction manual approach to raising capital. They assume you always have infinite time and money available. Rules about financial statements disclosures are a good example.

Securities regulations seem to start with the assumption that all businesses create GAAP-compliant financial statements and retain an independent accounting firm to audit the financial statements. That assumption simply does not reflect the reality of how many small and midsize businesses actually operate. Many small and midsize businesses:

• Use cash financial statements for tax purposes and do not normally produce accrual based GAAP-compliant financial statements.
• Do not retain an outside accounting firm or they use the accounting firm only for tax work.
• Rely on outside accountants to produce financial statements when they are needed, which undermines auditor independence.
• Do not maintain financial records that are sufficiently detailed to be audited if an audit is required.
• Leave nonessential projects and expenses until the last minute, which means that obtaining financial statements often delays offerings.
• Need to raise capital to meet payroll and other immediate needs.

For these reasons, accounting fees can differ greatly from one transaction to another and requiring audited GAAP-compliant financial statements can often both substantially increase transaction expenses and delay offerings.

Financial statements costs

Let's discuss cost first. The SEC estimated in the Final Crowdfunding Release that audited financial statements are likely to cost in the range of $2,500 to $30,000 and reviewed financial statements are likely to cost in the range of $1,500 to $18,000.¹ The SEC caveats this by saying that audits should be easier and less expensive for small businesses because the business being audited is less complicated than it is for bigger companies.

The SEC's prediction about lower costs for small businesses ignores the fact that many smaller accounting firms are reluctant to conduct audits for businesses, if the accountants know the business will use the financial statements in securities offerings— especially if the financial statements will be filed with the SEC. They fear liability risks. SEC regulations may even prohibit using financial statements prepared by a small accounting firm that does not meet SEC standards. Accounting firms that are willing and able to provide audit services for offerings often price liability risks into the prices they charge.

We discuss accounting fees and other transaction expenses in greater detail in Chapter 21.

Do investors always need financial statements to make informed investment decisions?

Some people might say that, if a business has trouble giving investors audited GAAP-compliant financial statements, the business should not be selling securities to investors. There is some merit to that sentiment, if you think investors should only be allowed to invest in established businesses that operate by a business school textbook. However, it ignores the purpose of new securities rules to make it easier for small and midsize businesses to raise capital.

But we do not always have to choose between protecting investors and helping businesses raise capital. Financial statements are just tools. Sometimes financial statements are essential tools for investors, but financial statements have their strengths and weaknesses. They are not a universal tool that produces good investment decisions in all situations.

Financial statements measure past economic performance. A balance sheet tells you some things about a business's assets and liabilities at a specific date.

The SEC requires brokers and investment advisers to tell investors that past performance is not a guaranty of future performance.

That is because investors usually make their investment decisions based on what they expect future financial performance will be. Sometimes the past financial performance that is reflected in financial statements is a good predictor of future financial performance. Sometimes it is not.

For example, a business that loses money every year it exists may be sold for a huge profit based on value that financial statements cannot measure:

• Intellectual property or other assets that are not reflected on a balance sheet may create substantial future value.
• Or the business may have low revenue, because it lacked marketing money, which the capital raised in the offering is likely to change.
• Or the business's long-term relationship building with a big potential customer is about to substantially increase revenue. Balance sheets do not value relationships.

All these examples illustrate that financial statements sometime have limited usefulness in determining current value and predicting future financial performance and future value. Many investors have an investment strategy that seeks to identify situations where future financial performance and value is likely to diverge sharply from the past financial performance that financial statements measure.

With this in mind, we will discuss financial statements requirements with a view toward determining:

• When do securities laws require businesses to provide any financial statements to investors?
• What types of the financial statements must businesses provide to investors to comply with securities laws?
• Can businesses that raise capital provide other types of disclosures to investors as a substitute for expensive financial statements?

We will start our analysis with a quick review of accounting industry standards and what the various exemptions from registration that we discussed in Part II specifically say about financial statements.

By Jim Verdonik. Jim Verdonik began practicing securities law with a large New York City law firm where he primarily represented investment bankers and venture capital funds in transactions with technology and science based businesses. Since relocating to Research Triangle, NC, he has counseled both companies and investors about securities, business and technology commercialization issues. Excerpted from Crowdfunding: A Legal Guide to Investment & Platform Regulation, 2016 ed., available for purchase on ThomsonReuters.com. This practical guide offers readers comprehensive and straightforward information so that they can make strategic decisions with regard to raising capital. The guide answers questions on a wide range of current and future crowdfunding issues.

^{1. Crowdfunding SEC Release No. 33-9974 (October 30, 2015) (80 Fed. Reg. 71,387) at fn 1395.↵}