Testing The Waters

Founders considering running a community round should understand what Testing The Waters means, and how it might apply to their raise.

If you’re considering running a community round, you might hear the phrase “Testing The Waters” (TTW). It’s worth understanding this concept, and evaluating whether you want to leverage it for your raise.

And if you’re an investor / potential investor in a community round, if the company goes the TTW route, it will impact their financial disclosure requirements at different points in the round, and will slightly affect the investment process.

What is Testing The Waters?

Community rounds allow startups to do two cool things when raising capital. Firstly, they can raise capital from unaccredited investors, as well as accredited investors. And secondly, they can publicly promote the offering (e.g. on social media, on a podcast, in an email blast, etc.). Both of these things are made possible because community rounds are conducted through an SEC exemption called Regulation Crowdfunding. Whereas most startups have historically raised capital through Regulation D 506(b) – which is limited to accredited investors only, and private solicitation only.

So where does Testing The Waters fit in? Testing The Waters allows startups raising capital through Regulation Crowdfunding (Reg CF) to quickly and easily assess investor demand, before (or in parallel to) undertaking the financial and compliance requirements of a Reg CF community round.

As one example, if you’re raising more than $1.235M through Reg CF, you need CPA-audited GAAP financials (if you’re raising between $124K and $1.235M you need a CPA review. And if you’re raising less than $124K, you can submit self-reported financials). An audit usually takes a few weeks to pull together, and can be quite a significant cost. Testing The Waters allows founders to gauge whether there is likely to be more than $1.235M of investor demand. And so they can decide whether to commit to the CPA audit with more data.

When companies are communicating about a potential upcoming community round in TTW, they are not technically collecting investments, but rather “reservations” to invest. If they do decide to proceed with a community round, they will need to file a Form C with the SEC, and at that point their TTW reservations can be confirmed / transitioned to investments. Legally, companies can not receive a disbursal from Wefunder until 21 days after the Form C is filed – at which point, the company moves from Testing The Waters to whatever-the-thing-is-called-when-they-have-filed-the-Form-C-and-are-no-longer-testing-the-waters. My naming proposal is In The Waters. But most of my colleagues say that sounds dumb. But they’re not editing this blog. So for the rest of the blog, In The Waters it is!

Testing The Waters wasn’t legally allowed for Regulation Crowdfunding raises before March 2021. But as part of the improvements to the Reg CF rules that the SEC rolled out at that time, Testing The Waters was made possible (along with $5M maximum raise amounts, Special Purpose Vehicles, increased investor limits, etc.).

Why Test The Waters?

There are three main reasons a startup might want to “start” their community round in TTW. Firstly, to gather more data to assess investor demand. Secondly, to parallel process. And thirdly, to move quickly. To take each in turn…

(1) Gathering more data to assess investor demand. Sometimes founders are very confident that they will be able to raise their target amount, and so this benefit of TTW is less relevant to them. But many founders would like to gather more data before deciding how much capital to shoot for, or even whether to run a community round at all. TTW allows founders to assess investor demand, and perhaps how best to frame the pitch to investors, before engaging a CPA or paying a lawyer to draft an investment contract (if they’re using a custom contract, vs. one of the standard Wefunder template contracts — which are free to use).

(2) Parallel processing. Even if founders know they want to do a community round, TTW might benefit them by allowing them to raise capital more quickly. Imagine your financials are a little messy and complex – a CPA audit might take a couple of months to complete. And maybe the marketing / promotion of your raise to investors will take two months to execute on. If you do things in series, then it would take you two months to get your audit done and file your Form C. And only then could you start the two-month process of pitching investors. But with TTW, you can start pitching investors immediately, and in parallel to getting the audit done. i.e. You can conclude the raise in two months (audit and fundraising in parallel), vs. four months (audit and fundraising in series).

(3) Moving quickly. Let’s say you have an event coming up next week (a tradeshow, a demo day, a big product launch, etc.), and you want to have your Wefunder page live ahead of the event. It might be tough / impossible for you to get your CPA financials reviewed / audited, and your Form C filed, in time. But I have spun up a decent-looking Wefunder page in 15 minutes (click a button to upload your pitch deck, you don’t need a video, etc.). So launching in TTW can sometimes allow founders to quickly capitalize on immediate opportunities.

So why wouldn’t I do it?

There’s only one reason (I think?) to not do TTW, and instead jump straight to the Form C filing. Because you are only collecting “reservations” to invest in TTW, there is an extra step for investors to “confirm” their investments after you file your Form C. There is usually some small drop-off in investor conversion at this point (e.g. 10%). (Although you never know the counter-factual – maybe these investors who drop would not have invested anyway, in which case there isn’t actually a drop in investor conversion as a result of TTW).

On the Wefunder team, we’ve seen the drop in investor conversion from TTW reservations to confirmed investments vary based on a number of factors – with the most obvious driver being the amount of time between when the investor made their TTW reservation, and when they receive the notification to confirm their investment. In the case of Substack, where the time between TTW launch and Form C filing was very short, the conversion from TTW reservations to investments was very high. For some companies on Wefunder, the Form C wasn’t filed for many months after the TTW launch – which usually significantly reduced percentage conversion.

So should I do it?

It depends on the circumstances.

If you’re trying to assess whether there might be investor demand, and whether you even want to commit to a community round, you could do TTW to gather more data.

If you would love to get your hands on the money as soon as possible, then you should do TTW, and parallel process the financials and the Form C filing, with starting to reach out to investors and secure reservations.

If you have a demo day coming up tomorrow, and you’d love to be able to direct everyone in the audience to a page where they can learn more, subscribe, and reserve an investment, then you should definitely leverage TTW.

Usually, the only reason not to launch in TTW is if you’re not in a rush, and you’re fine to take your time. In that instance, you may as well wait until after you’ve filed your Form C to communicate with potential investors – because then they only need to engage a single time, vs. two engagements in the TTW route (making the reservation, and then confirming the investment after the Form C is filed).

On the Wefunder team, one of our roles is to help founders evaluate the right TTW strategy for their specific situation.

How to Test The Waters?

There are two main approaches to TTW – a lighter touch approach, and a more committed approach.

In the lighter touch approach, founders might float the idea of a community round on social media, or by email. Imagine a Typeform survey with a few questions to gauge investor interest. Investors don’t get out their credit cards. This approach usually works best for founders that are more exploring the idea of a community round. In our Wefunder fundraising guide, we outline how a founder might execute on a light touch TTW campaign here.

In the more committed approach, founders set up a Wefunder page, which looks similar to a regular Wefunder page, post Form C filing. It’s slightly more of a time commitment usually, and more of a “signal” that you’re committing to run a community round. The key difference of this approach is that investors are actually funding their reservations (Wefunder holds it in an escrow account). This gives founders a lot more confidence that the money is “real” (it’s easy to say “Sure I’ll invest $25K!” in a Typeform survey!). And this explains why the percentage conversion from TTW reservations to Post-Form-C investments on Wefunder is so high.

Whichever approach you take, one important thing for founders to know is that – if you are publicly communicating about your upcoming (or potential) community round in TTW, the SEC requires you to use some standard legal disclosures in your communications. (See this FAQ for more details).

Most of the most explosive community rounds have launched in TTW first, and filed their Form C later. Mercury, Replit and Substack being three of the best examples.