Legal Bulletins

The first major governance dispute arising from a successful crowdfunded company offers a roadmap for founders hoping to avoid becoming the next cautionary tale.

Introduction

For more than a decade, the conversation surrounding Regulation Crowdfunding ("Reg CF") has focused on a single objective: helping entrepreneurs raise capital from the crowd. Founders have learned how to prepare Form C disclosures, market their offerings within the confines of the securities laws, and convert passionate supporters into investors.

Yet remarkably little attention has been devoted to what happens after the campaign ends.

That omission is understandable. Most startups never reach the point where governance becomes more difficult than fundraising. But for those that do, success often creates challenges that no offering memorandum anticipated.

No company better illustrates that reality than The Chosen.

What began as a crowdfunded television series has evolved into a global entertainment franchise with hundreds of millions of viewers, 
theatrical releases, merchandising, international licensing, and strategic relationships with some of the world's largest media companies. Internal financial materials produced in pending litigation describe a business projecting hundreds of millions of dollars in future revenue and an expanding portfolio of entertainment assets extending well beyond the television series that first captured audiences.

Today, however, The Chosen stands for something else.

It has become the subject of one of the first significant corporate governance disputes involving a company that successfully transitioned from community-funded startup to sophisticated media enterprise.

The litigation is still in its earliest stages, and the Delaware Court of Chancery will ultimately determine whether the challenged transactions complied with Delaware law. Regardless of the outcome, however, the case already offers valuable lessons for every founder considering a Regulation Crowdfunding offering. Those lessons have surprisingly little to do with crowdfunding itself. They have everything to do with governing success.

A Brief Primer on Regulation Crowdfunding

Congress enacted Regulation Crowdfunding ("Reg CF") as part of the Jumpstart Our Business Startups ("JOBS") Act of 2012 to make it easier for startups and small businesses to raise capital from everyday investors. Before the JOBS Act, most private investment opportunities were effectively limited to venture capital firms, institutional investors, and wealthy individuals who met the Securities and Exchange Commission's definition of an "accredited investor."
Reg CF changed that landscape.

For the first time, ordinary individuals could invest relatively small amounts in private companies through SEC-registered online funding portals and broker-dealers. In doing so, Congress sought to democratize capital formation by allowing entrepreneurs to raise money from the very communities that believed in their products, missions, or ideas.

Today, an eligible U.S. company may raise up to $5 million during any rolling 12-month period through a Reg CF offering. Unlike many other private offering exemptions, Reg CF permits participation by both accredited and non-accredited investors, although the amount an individual may invest during any 12-month period is subject to strict SEC investment limits designed to protect retail investors.

In exchange for this broader access to capital, issuers must comply with a number of important regulatory requirements. Among other things, companies must:

• Conduct the offering exclusively through an SEC-registered funding portal or broker-dealer; 
• File a Form C with the SEC containing prescribed disclosures regarding the company's business, management, capitalization, risk factors, use of proceeds, and financial condition; 
• Provide financial statements meeting the level of review or audit required by the size of the offering; 
• Make ongoing annual reports available to investors until the reporting obligation is terminated; and 
• Comply with restrictions on advertising and communications designed to promote fair and transparent capital formation. 

Although Reg CF is sometimes described as "crowdfunding," it is fundamentally a securities offering. Investors are not simply making donations or pre-ordering products. They are purchasing securities and, depending on the structure of the offering, may become shareholders or holders of other economic interests with legally enforceable rights.

The Rise of a Crowdfunding Success Story

Before becoming a global franchise, The Chosen represented everything advocates of equity crowdfunding hoped the model could 
become.

Rather than relying exclusively on traditional Hollywood financing, the project attracted financial support from an extraordinary community of early believers who shared the creators' vision. Those supporters accepted substantial risk at a time when the commercial viability of the project remained uncertain.

Against considerable odds, that gamble succeeded.

According to company materials included among the complaint's exhibits, The Chosen has grown into an integrated entertainment business with multiple revenue streams, including television production, theatrical releases, merchandising, licensing, music, live experiences, publishing, studio operations, and international distribution. Company projections referenced in those materials describe approximately $225 million in projected fiscal year 2025 revenue and nearly $590 million in contracted revenue through fiscal year 2029.

Those same materials describe:

•  More than 250 million global viewers;
• Seven contracted seasons;
• More than $200 million raised from supporters;
• Over $135 million in lifetime merchandise sales; and
• Strategic distribution relationships with leading streaming platforms.

In many respects, The Chosen became the poster child for what community financing could accomplish.

Ironically, that success appears to have created the very governance challenges now before the Delaware Court of Chancery.

The Litigation

According to the Verified Class Action Complaint, the defendants implemented a reverse stock split that allegedly eliminated approximately 16,000 minority shareholders by cashing them out at $3.75 per share. The plaintiff alleges that this transaction unfairly undervalued the company and deprived early investors of the opportunity to participate in the next stage of the company's growth. The defendants dispute those allegations.

The complaint further alleges that, by the time of the transaction, management possessed financial projections and strategic information suggesting that the company's value substantially exceeded the price paid to minority shareholders. Among the exhibits attached to the complaint are internal presentations prepared with Goldman Sachs discussing projected revenues, business expansion, and strategic initiatives.

Whether those allegations prove accurate remains to be seen.

More importantly for founders, however, the case raises a broader question:

How should boards of directors navigate the transition from founder-led startup to institutionally financed growth company when thousands of retail investors remain on the capitalization table?

That question extends far beyond The Chosen.

The Legal Framework

The dispute centers on a corporate transaction that is both common and frequently misunderstood: the reverse stock split.

A reverse stock split does not inherently increase or decrease a company's value. Rather, it changes how ownership is divided among shareholders. A company may conduct such a transaction for many legitimate reasons, including simplifying its capitalization table, preparing for institutional investment, or reducing administrative burdens associated with maintaining thousands of small shareholder accounts.

Complications arise, however, when the transaction eliminates minority shareholders through mandatory cash payments.

Under Delaware law, directors owe fiduciary duties of care and loyalty to the corporation and its stockholders. When a transaction disproportionately benefits controlling shareholders or insiders, Delaware courts may examine not only whether the price paid was fair, but also whether the process used to reach that price satisfied the demanding "entire fairness" standard.

Entire fairness consists of two complementary inquiries:

• Fair dealing — Was the process fair?
• Fair price — Was the consideration paid objectively fair?

Neither inquiry exists in isolation. An impeccable valuation process cannot justify an unfair price. Likewise, a fair price may still invite judicial scrutiny if the process was tainted by conflicts of interest, inadequate disclosures, or procedural irregularities.

For founders, this distinction is critical.

Corporate governance is not judged solely by outcomes.

It is judged by process.

Applying the Law to the Allegations

Without prejudging the merits, the allegations in The Chosen illustrate several recurring governance issues that sophisticated boards routinely encounter.

If management possessed materially different financial projections than those reflected in the transaction valuation, the Court may examine whether those projections should have informed the cash-out price.

If insiders stood to benefit differently than minority shareholders, the Court may scrutinize the procedural safeguards employed by the board.

If independent directors, special committees, or outside valuation advisors participated in the process, those facts may likewise become significant.

Ultimately, the litigation is unlikely to turn on whether reverse stock splits are lawful.

They unquestionably are.

Instead, the dispute is likely to focus on whether this particular transaction satisfied Delaware's exacting fiduciary standards under the specific facts presented.

Ten Lessons Every Regulation Crowdfunding Issuer Should Learn

This, in my view, is where the litigation becomes most valuable—not as a predictor of liability, but as a governance roadmap.

Plan for Success Before You Raise Capital

Every founder spends months preparing for the offering. Far fewer spend equal time planning for the company they hope to become. Your approach to governance should anticipate success, not merely survival.

Retail Investors Are Shareholders

Crowdfunding investors are not customers. They are owners. Treat them accordingly.

Design Your Capital Structure for Growth

If your company ultimately has 5,000 or even 10,000 shareholders, what mechanisms exist to facilitate future financing, liquidity events, or 
recapitalizations? Answer those questions before the offering launches.

Document the Process

When significant corporate decisions arise, contemporaneous board minutes, valuation analyses, and independent advice often become just as important as the ultimate decision itself.

Separate Conflicts Before They Arise

Independent directors, special committees, and outside financial advisors are not merely governance formalities; they help protect both the company and its directors.

Transparency Creates Trust

Investors are generally more accepting of difficult decisions when they understand why those decisions were made. Communication is often the cheapest form of risk management.

Valuation Matters

If shareholders are being forced to surrender ownership, boards should expect their valuation methodology to receive close judicial scrutiny.

Institutional Capital Changes Governance

The governance practices appropriate for a startup may not remain appropriate for a sophisticated operating company. Boards should evolve accordingly.

Litigation Often Focuses on Process

Delaware courts routinely ask not only whether directors reached the correct conclusion, but whether they reached it the right way. Process matters.

Success Magnifies Fiduciary Duties

Growth does not diminish directors' obligations. It increases them. 
 

Counsel's Take

The Chosen litigation should not discourage founders from pursuing Regulation Crowdfunding. On the contrary, it demonstrates what is possible when a community rallies behind a compelling vision. However, it also reminds us that success carries responsibilities.

Every founder dreams of building the next The Chosen. Few spend enough time preparing for the governance challenges that accompany extraordinary success.

The best time to think about recapitalizations, shareholder liquidity, board independence, valuation procedures, and investor communications is not after your company becomes a global franchise. It is before your first share is ever sold.

For more information about crowdfunding or corporate governance, please contact our Securities or Business Law teams.

Julian A. Haffner
410-576-4021 • jhaffner@gfrlaw.com