The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

On July 11, 2016, the Wall Street Journal reported that the Securities and tesla logoExchange Commission is investigating whether Tesla Motors Inc. violated the securities laws, apparently by not disclosing timely a fatal crash involving a Tesla Model S. Tesla’s handling of the incident from a disclosure standpoint raises interesting issues involving materiality and risk factors.

It seems the SEC is examining whether Tesla should have disclosed information regarding the fatal crash in offering documents relating to the sale of approximately $2.8 billion of Tesla common stock, nearly $600 million of which were sold by Tesla CEO, Elon Musk.

tesla crashHere are the facts. On May 7, 2016, a Model S Tesla featuring Tesla’s autonomous driving technology “Autopilot” collided with a tractor trailer that had turned in front of it, killing the driver of the Model S.  Ironically, the driver, Joshua Brown, regularly posted videos of his rides in the car, and he was clearly a big fan of Autopilot. On May 10, Tesla filed its first quarter 10-Q without any reference to the crash.  Eight days later, Tesla filed a preliminary prospectus with the SEC to sell up to 10,697,674 shares of common stock without mentioning the crash.  Two days after that, Tesla filed a prospectus supplement disclosing the pricing of the offering (up to $2 billion of stock, approximately $1.4 billion by Tesla and nearly $600 million by Musk), and again with no disclosure regarding the crash.  On June 29, Tesla learned the National Highway Traffic Safety Administration would conduct a preliminary evaluation of the crash, which Tesla addressed in a blog post after the markets closed the following day.

As to Tesla’s blog post, one thing that caught my attention was the part that states that Tesla informed the NHTSA about the accident “immediately after it occurred”. Yet the accident took place on May 7 and Tesla didn’t notify the NHTSA until May 16, a full nine days later.  In Tesla’s defense, it claimed that the extent of the wreckage made remote data analysis impossible, and it had to dispatch its internal investigators to the scene of the accident which slowed down the process.

As a general rule, SEC reporting companies must disclose categories of information specifically mandated by regulation as well as any information that’s material to investors. But there is no clearly defined standard for whether the May 7 accident was “material” enough to require disclosure. Instead, general standards regarding materiality have been established in SEC rules, judicial decisions and administrative guidance.  As a general proposition, information is deemed material if “there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision”.  For a fact to be material, there must be a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

So is the crash material to Tesla investors? If so, the failure to disclose it would be deemed to be a material omission. One place to look for evidence of materiality is the stock market. In this case, the reaction of the stock market tesla stockseems to indicate that the crash is not material.  The day the news broke about the NHTSA investigation (June 29), the stock closed at $210.19, up from 201.79 the day before.  It rose to $212.29 on the first day after Tesla blogged about the crash (July 1), and it closed at $234.79 on July 29, the last trading day before this blog post.  In fact, the only noticeable drop in price after the crash date of May 7 occurred on June 22, when Tesla shares cratered (down $22.95 from the previous close of $219.61) in reaction to Tesla’s bid for Solar City.

The history of auto fatalities may be another reason the crash itself should not be deemed to be material. In 2015, there were an estimated 38,000 auto fatalities in the United States. Nearly 1.3 million people die in road crashes each year worldwide, an average of 3,287 deaths per day.  In its June 30 blog post, Tesla asserted that the May 7 crash was the first fatality in the 130 million miles driven with Autopilot.  By comparison, Tesla asserted that there is a fatality every 94 million miles for all American vehicles and one every 60 million miles worldwide, which Tesla asserts proves it has a “better-than-human” driving capability.  Companies do disclose safety recalls and product liability suits when they trigger significant financial charges, but not fatal crashes.  Perhaps the reason may be that fatal car crashes in and of themselves are not perceived to have a material adverse effect on a company.

But perhaps an argument in favor of materiality here is that Tesla had been aggressively promoting its Autopilot technology, which it bills as the most tesla autopilotadvanced self-driving system on the road. Investors have been drawn to Tesla shares in large part on the conviction that the company is on the cutting edge of technology, particularly with Autopilot, and may be poised to leap ahead of more traditional car manufacturers. A fatal crash, however, could lead to a change in perception of autonomous vehicles in general, and Autopilot in particular, on the part of both the public and the insurance industry. But even assuming as much, it appears that Tesla did not determine that the car was actually on Autopilot at the time of the crash until after it filed its 10-Q and offering prospectus.

One of the stranger aspects of this story is the email and tweet battle that broke fortuneout between Musk and Fortune Magazine. Fortune editor Alan Murray tweeted “[s]eems pretty material to me,” with a link to the magazine’s online article in which Musk is quoted saying in an email that the matter was “not material” to Tesla shareholders. Musk then retorted to Murray on Twitter: “Yes, it was material to you — BS article increased your advertising revenue. Just wasn’t material to [Tesla], as shown by market.”  Murray then predicted that the materiality issue would be resolved in a lawsuit, implicitly inviting shareholders to sue (sort of like Trump inviting the Russians to find Hillary Clinton’s deleted emails).

Another interesting aspect to all this is Tesla’s risk factor disclosure. Tesla’s 10-Q filed on May 10 for the quarter ended March 31 contained a risk factor entitled “We may become subject to product liability claims, which could harm our financial condition and liquidity if we are not able to successfully defend or insure against such claims”, in which it stated that a successful liability claim associated with its technology, including the Autopilot feature, could harm the company’s financial condition, “could generate substantial negative publicity about [its] products and business and would have material adverse effect on [its] brand, business, prospects and operating results” (emphasis added).  Seems like Tesla is careful to draw a distinction between an isolated crash and a products liability claim.  Also, in its June 30 blog post, Tesla referred to the foregoing risk factor as “boilerplate”, something Tesla may regret saying as the SEC has a long history of discouraging intensely boilerplate disclosures.  And finally, the part of that risk factor that really jumped off the page at me was that “We self-insure against the risk of product liability claims, meaning that any product liability claims will have to be paid from company funds, not by insurance.”  My hunch is that self-insurance is not very common in the industry, and it will be interesting to see whether Tesla revisits its insurance approach in the aftermath of all of the post-crash scrutiny.

On July 5, the House of Representatives passed a watered down version of the Fix Crowdfunding Act (the “FCA”) that was initially introduced in March.  The bill seeks to amend Title III of the JOBS Act by expressly permitting “crowdfunding vehicles” and broadening the SEC registration exclusion, but leaves out three important reforms that were part of the original version of the FCA introduced in March and about which I blogged about here. The House bill is part of the innovation initiativeInnovation Initiative which was jointly launched by Majority Leader Kevin McCarthy and Chief Deputy Whip Patrick McHenry.  The bill was passed by the House with overwhelming bipartisan support, so it’s likely to be passed quickly by the Senate.  This post summarizes what was left in the bill from the original and what was dropped from it.

What’s In: Special Purpose Vehicles and the Section 12(g) Registration Exclusion

Special Purpose Vehicles

Title III of the JOBS Act excludes from crowdfunding eligibility any issuer that is an “investment company”, as defined in the Investment Company Act, or is exempt from investment company regulation by virtue of being owned by not more than 100 persons. Several accredited investor-only matchmaking portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in which investors invest into a special purpose vehicle (“SPV”), which in turn makes the investment into the issuer as one shareholder. Because Title III did not permit issuers to sell shares through SPVs, many growth-oriented startups may be dissuaded from engaging in Title III crowdfunding offerings if they expect to raise venture capital in the future, as VC funds don’t like congested cap tables.

The FCA would create a new class of permitted crowdfunding issuer called a “crowdfunding vehicle”, which is an entity that satisfies all of the following requirements:

  • purpose (as set forth in its organizational documents) limited to acquiring, holding and disposing crowdfunded securities;
  • issues only one class of securities;
  • no transaction-based compensation received by the entity or any associated person;
  • it and company whose securities it holds are co-issuers;
  • both it and company whose securities it holds are current in ongoing Regulation Crowdfunding disclosure obligations; and
  • advised by investment adviser registered under Investment Advisers Act of 1940

Section 12(g) Registration Exclusion

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) of the Securities Exchange Act that triggers registration with the SEC, which subjects the company to periodic reporting obligations (e.g., 10-Ks, 10-Qs, etc.). It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC provided that shareholders that purchased crowdfunded shares would be excluded from the shareholder calculation under Section 12(g), but conditioned the exclusion on, among other things, the issuer having total assets of no more than $25 million.

The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The original version of the FCA would have removed from the 12(g) exclusion the condition that an issuer not have $25 million or more in assets.

The version of the FCA passed by the House removes the $25 million asset condition but replaces it with two other conditions: that the issuer have a public float of less than $75 million and annual revenues of less than $50 million as of the most recently completed fiscal year.

What’s Out: Issuer Cap, Intermediary Liability and Testing the Waters

The House version of the FCA unfortunately dropped a few of the reforms that were contained in the original version introduced in March, apparently the price paid for securing votes of opponents of the FCA.

Issuer Cap                                                                                    

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The original version of the FCA would have increased the issuer cap from $1 million to $5 million in any rolling 12 month period. This was scrapped from the House version.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. Title III also exposes an intermediary (i.e., funding portal or broker-dealer) to possible liability if an issuer made material inaccuracies or omissions in its disclosures on the crowdfunding site. It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The original version of the FCA would have clarified that an intermediary will not be considered an issuer for liability purposes unless it knowingly made a material misstatement or omission or knowingly engaged in any fraudulent act. Presumably then, as proposed, a plaintiff would have had the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time. The House version dropped this relief for intermediaries.

Testing the Waters

Securities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC, out of concern that unscrupulous companies could prime the market before any disclosure became publicly available.

The original version of the FCA would have allowed Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest is highlighted to potential investors in the information filed with the SEC. This too was left out of the version approved by the House.

Although it was disappointing to see the foregoing three reforms dropped from the eventual House bill, half a loaf is better than no loaf. Perhaps the dollar cap, intermediary liability and testing the waters could be revisited at some point down the road.

Ever since the Federal securities laws were enacted in 1933, all offers and sales of securities in the United States had to either be registered with the SEC or satisfy an exemption from registration. The commonly used private offering exemption, however, prohibited any act of general solicitation. The JOBS Act of 2012 JOBS Act signingcreated a new variation to the private offering exemption under Rule 506 of Regulation D that permits online offers and other acts of general solicitation, but issuers selling under this new Rule 506(c) may sell only to accredited investors and must use reasonable methods to verify investor status.

Starting today, companies will be permitted to offer and sell securities online to anyone, not just accredited investors, without SEC registration. This is pursuant to Title III of the JOBS Act and the final crowdfunding rules promulgated by the SEC called Regulation Crowdfunding.  The potential for Title III Crowdfundingequity crowdfunding is enormous and potentially disruptive.  It is believed that approximately 93% of the U.S. population consists of non-accredited investors who have an estimated $30 trillion stashed away in investment accounts.  If only one percent of that amount got redirected to equity crowdfunding, the resulting $300 billion dollars invested would be ten times larger than the VC industry.  Hence the potential.

The reality, however, is not as encouraging. In the interest of investor protection, Congress in JOBS Act Title III and the SEC in Regulation Crowdfunding created a heavily regulated and expensive regime that many fear will severely limit the prospects of equity crowdfunding.  The rules include a $1 million issuer cap, strict dollar limits on investors, disclosure requirements and funding portal liability, registration and gatekeeper obligations.

wefunderSEC registration for funding portals began on January 29. But as of last week, only five portals had completed the registration process: Wefunder Portal LLC, SI Portal LLC dba Seedinvest.com, CFS LLC dba seedinvestCrowdFundingSTAR.com, NextSeed US LLC and StartEngine Capital LLC.  Over 30 others are apparently awaiting approval.  Of the two best known and most successful non-equity crowdfunding portals, only Indiegogo has declared an intention to get in the Title III funding portal business; Kickstarter has so far declined.

The likely reason for the apparent lackluster funding portal activity so far is the restrictive regulatory regime referred to above, the burden of which falls disproportionately on funding portals. None of this should be a surprise.  Several key aspects of the crowdfunding rules were contentiously debated at the Congressional level and later during SEC rulemaking.  Opponents asserted that retail equity crowdfunding is an invitation for massive fraud against those who can least afford it and so believe Title III is a mistake.  Proponents advocated against several of the more restrictive rules but conceded on these points in order to get Title III passed.  And because the legislation itself was so prescriptive and granular, there was only room for marginal improvement in the final SEC rules relative to those proposed in the initial release.

Regrettably, there’s painful precedent for securities exemptions so restrictive that no one used them.  Regulation A allowed for a mini-public offering through a streamlined filing with the SEC.  But issuers were capped at $5 million and were forced to go through merit review in each state where they offered the securities.  The result:  hardly anyone used Reg A.  In recognition of this, Title IV of the JOBS Act reformed Reg A by increasing the cap to $50 million and, more importantly, preempting state blue sky review for so-called Tier II offerings which must satisfy investor protection requirements.

In an effort to prevent Title III from a fate similar to pre-reform Reg A, legislation has been introduced in Congress to increase the issuer cap, allow for special purpose vehicles, remove the $25 million asset cap on the exemption from the 500 shareholder SEC registration trigger and allow issuers to test the waters. See my previous blog post here on the proposed Fix Crowdfunding Act.

It may seem somewhat premature to advocate for reform when the rules have barely gone live. But given the time necessary for the legislative process to run its course, and inasmuch as the indications are already fairly clear that both issuers and funding portals remain skeptical about Title III crowdfunding, it makes sense to begin the process now of introducing necessary common sense reform of Title III.

Beginning on May 16, issuers for the first time will be able to offer and sell securities online to anyone, not just accredited investors, withoutTitle III Crowdfunding registering with the SEC. The potential here is breathtaking.  Some $30 trillion dollars are said to be stashed away in long-term investment accounts of non-accredited investors; if only 1% of that gets allocated to crowdfunding, the resulting $300 billion would be ten times bigger than the VC industry.   But the onerous rules baked into JOBS Act Title III and the SEC’s Regulation Crowdfunding (the statutory and regulatory basis, respectively, for public equity crowdfunding), leave many wondering if Title III crowdfunding will prove to be an unattractive alternative to other existing exemptions and become a largely underutilized capital raising pathway – a giant missed opportunity.

Patrick_McHenry_OfficialBut help may be on the way. Congressman Patrick McHenry recently introduced new legislation to address certain defects in Title III.  The Fix Crowdfunding Act (H.R. 4855)  would seek to improve the utility of Title III crowdfunding by raising the issuer dollar limit, simplifying the Section 12(g)(6) exemption, clarifying portal liability, permitting special purpose entities to engage in Title III offerings and allowing issuers to “test the waters”.  The House Financial Services Committee’s Subcommittee on Capital Markets recently held hearings on the Fix Crowdfunding Act labeled “The JOBS Act at Four: Examining Its Impact and Proposals to Further Enhance Capital Formation”, with witnesses such as Kevin Laws (Chief Operating Officer of AngelList) and The Honorable Paul S. Atkins (Chief Executive Officer of Patomak Global Partners) testifying.  Congress should pass this proposed legislation, and the sooner the better.

Here’s a summary of the proposed legislation, identifying the defect in the original Title III and the proposed fix.

Issuer Cap                                                                                     

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The new legislation would increase the issuer cap from $1 million to $5 million in any rolling 12 month period.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. By comparison, a plaintiff in a Rule 506 offering must allege not just a material misstatement or omission but that the issuer either knew or should have known if it made a reasonable inquiry.  Title III defines “issuer” to include “any person who offers or sells the security in such offering.”  In its final rules release, the SEC considered but refused to clarify that intermediaries were not issuers for purposes of the liability provision.  As it currently stands, Title III exposes intermediaries (i.e., funding portals and broker-dealer platforms) to possible liability if issuers commit material inaccuracies or omissions in their disclosures on crowdfunding sites.  It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The Fix Crowdfunding Act would make clear that an intermediary will not be considered an issuer for liability purposes unless it knowingly makes any material misstatements or omissions or knowingly engages in any fraudulent act. Presumably then, as proposed, a plaintiff would have the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time.

Section 12(g) Registration Exemption

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) that triggers Exchange Act registration. It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC exempted crowdfunded shares from the shareholder calculation under Section 12(g), but conditioned the exemption on, among other things, the issuer having total assets of no more than $25 million.  The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The new legislation would remove from the 12(g) exemption the condition that an issuer not have $25 million or more in assets.

Special Purpose Vehicles

Several portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in SPVwhich investors invest into an SPV which in turn makes the investment into the company as one shareholder. Because of the SPV exclusion, many growth-oriented startups might avoid Title III crowdfunding if they expect to raise venture capital in the future, as VC firms don’t like congested cap tables.

The proposed legislation would make “any issuer that holds, for the purpose of making an offering pursuant to [Title III], the securities of not more than one issuer eligible to offer securities pursuant to [Title III]” eligible for Title III offerings.

Testing the Waters

testing the watersSecurities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC.  The concern is that allowing issuers to do so would enable unscrupulous companies to prime the market before any disclosure became publicly available. Without the protection of public disclosure, issuers may be able to use selective disclosures or overly enthusiastic language to generate investor interest.

The Fix Crowdfunding Act would specifically allow Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest are highlighted to potential investors in the information filed with the SEC.

Seed stage investment deals, i.e., those in a range of approximately $100,000 on the low end and around $1.3 million on the high end, are structured either as straight equity or as convertible loans. If straight equity, the company typically issues to the investor shares of preferred stock usually designated as Series Seed which includes a package of enhanced rights but usually stripped down from seed investingthose typically associated with Series A shares.  Alternatively, the investor could invest in the form of a loan that converts into the security issued in the next equity round, usually at some discount to the next round’s price.

This post will focus on convertible note deal term trends based on the 2016 Venture Capital Report recently released by the helpful folks at Wilmer Hale. The convertible note data in the Report was compiled from over 100 deals handled by the firm from 2013 through 2015 for companies and investors in the U.S.

Conversion Discount

Seed investors often negotiate for a discount from the price per share in the next equity round to reward the seed investor for investing at an earlier, riskier stage. discount89% of convertible loan deals covered by the Report in 2015 had discounts, a significant increase from the 66% that had them in 2013.  Sometimes parties negotiate for an ascending discount in which the discount increases as the period between seed and next round increases.  The Report doesn’t provide any information on time periods between seed and next round, or on the percentage of deals that had a sliding discount.  The range of discounts was between 10% and 50%, with 74% of discounted deals having a discount of 20% or less and 26% having discounts of more than 20%.

Conversion Caps

A major advantage of convertible loans is that they allow the parties to defer negotiation of probably the most difficult business issue until the next round: valuation. But that advantage also poses a risk to the seed investor, namely that at the time of conversion at the next round the company’s pre-money valuation will be much higher and thus much more expensive for the seed round investor. caps A discount offers protection against valuation inflation, but only relative to what the next round investors are paying.  An added measure of protection is a cap on the next round valuation applicable to the seed investor’s conversion rate.  For example, imagine a $1 million convertible loan with no discount, no cap, and the company subsequently raises $5 million in a Series A round at a pre-money valuation of $20 million with a per share price of $1.  The note would convert into one million shares ($1 million loan (leaving aside interest for simplicity) divided by $1/share).  But if the note had a $5 million cap, the shares would convert at the rate of, not $1 per share, but $0.50 per share, so that the seed investor would receive two million shares ($1,000,000/$0.50) rather than one million.  I’ve previously blogged here about why valuation caps are loved by angels, tolerated by VCs and hated by entrepreneurs.

Although still popular, valuation caps seem to be trending down somewhat. The Report indicates that only 55% of convertible loan deals contained caps in 2015, nearly a 20% drop from the 74% that featured them the year before.

Conversion on Maturity

The truth about seed round convertible promissory notes is that they are promises that no one intends to be kept. At least the repayment part.  They are intended to be converted into equity.  But what happens if a qualified next round doesn’t occur prior to the maturity date of the note?  Very often, the note will provide that the outstanding principal and interest will convert on a given date, either automatically or at the option of the holder, at a set price or a price determined by a formula or procedure.  According to the Report, 60% of deals in 2015 had some kind of conversion at maturity.  Of those, 89% were at the investor’s option (up from 80% in 2013) and 11% were mandatory (down from 20% in 2013).  In addition, 32% of the 2015 deals that converted upon maturity convert into common stock, substantially unchanged from 2013 but a dramatic decline from the 54% of the conversion-at-maturity deals in 2015 that convert into common.  68% of the 2015 convert-at-maturity deals convert into preferred, also substantially unchanged from 2013, but a sharp increase from the 46% of the 2014 deals that convert into preferred.

Sale of the Company

Upon a sale of the company prior to maturity and prior to a next-round conversion, the outstanding principal and interest may convert into common or preferred stock, either automatically or at the option of the debt holder. In 2015, 74% of the convertible deals covered in the Report had some kind of conversion on a sale of the company, up from 66% in 2014.  Of those, the conversion-on-sale feature was overwhelmingly at the option of the holder (91%, up from 86% in 2014; 9% were mandatory).  Of these deals, they were pretty evenly split in 2015 between those converting into common and those converting into preferred.  In 2014, on the other hand, the conversion-on-sale provisions tended to favor conversions into common (60%) rather than preferred (40%).

Conversion Premiums on Sale of the Company

Seed investors sometimes negotiate for the right to be paid a multiple of principal and interest upon a sale of the company, similar to a liquidation preference associated with preferred stock. Roughly one half of the deals in the Report had company sale premiums.  The premiums ranged from 1.5x (i.e., 1.5 times the outstanding principal and interest) on the low end to 4x on the upper end, an increase from the upper range of 3x in 2014, although the median multiple was steady throughout 2013-2015 at 2x.

Secured Notes

Convertible note investors sometimes negotiate for the note to be secured by some or all of the company’s assets. If the note is not repaid or converted at maturity, the investor could look to the pledged assets to satisfy the loan.  Investors in 2015 were not as successful as they were in 2013 in getting their notes secured.  Only 15% of the convertible notes covered by the Report in 2015 were secured (85% unsecured), down from 25% in 2013 (75% unsecured in 2013).

Conclusion

The foregoing data on conversion discounts, caps, conversion at maturity, sale-of-company conversions and premiums and security suggests that the convertible note deal term pendulum may have started to swing back in favor of investors in 2015. Deal terms in the categories of conversion discounts, conversion at maturity, sale-of-company conversions and sale-of-company premiums were more favorable to investors in 2015.  Terms were more favorable to companies in 2015 with respect to caps and note security.  Given recent developments regarding cooling valuations and a stalled technology IPO market, it will be interesting to see whether the pendulum for convertible deal terms will move more significantly in favor of investors in 2016.

 

Lane Becker, Former CEO of Get Satisfaction
Lane Becker, Former CEO of Get Satisfaction

The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”.  Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded.  Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself.  In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.

Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything.  The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.

I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack.  For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference.  The founder is giddy about the $60 million pre-money valuation and takes the deal.  The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference.  Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)).  Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.

Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50,000, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).

In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation?  What incentive does the common stock holding management team have to stick it out?  Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with.  By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup.  Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.

That mechanism is a bonus or carve-out plan that provides for a payout to carveouteligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds.  A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments.  The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.

Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.

One of the key investor protections of Regulation Crowdfunding under JOBS Act Title III is theyou've got funding requirement that offerings must be conducted exclusively through a single platform operated by a registered broker-dealer or a new type of SEC registrant, a funding portal. Although SEC registration for funding portals began January 29, 2016, intermediaries (funding portals and broker-dealers) may not engage in crowdfunding activities until May 16, 2016, the date that Regulation Crowdfunding goes live. It remains to be seen how popular Title III crowdfunding will prove to be given its burdensome rules relative to other available exemptions, but the potential is enormous both for issuers and for the brand new type of financial intermediary it created, the funding portal.

SEC logoThe SEC spent three years trying to reconcile the enormous capital markets potential of the “crowd” with the investor protection concerns voiced by equity crowdfunding’s critics. The SEC believes that requiring an issuer to use only one intermediary to conduct an offering helps foster the creation of a crowd, by facilitating information sharing and avoiding dilution or dispersement of the crowd, and helps minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering usingcrowd 2 more than one intermediary would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit. But to mitigate fraud risk concerns, the SEC has also imposed a heavy gatekeeping burden on intermediaries, particularly funding portals.

This blog post will focus on the rules governing funding portals, and will summarize the permitted “safe harbor” activities and compliance rules unique to funding portals, as well as certain requirements common to both types of Regulation Crowdfunding intermediaries (broker-dealers and funding portals).

Unique Funding Portal Requirements

Registration. Funding portals are required to register with the SEC on Form Funding Portal, a stripped-down version of Form BD, the registration form for broker-dealers.  For example, unlike broker-dealer registration, funding portals will not be required to post a fidelity bond to register as a funding portal.  As required under the JOBS Act, SEC registered funding portals are exempt from broker-dealer registration.  The text of the Form currently appears only in the final rules release on pages 623-664 (inclusive of Schedules A-D and general instructions).[i]

All registered funding portals are also required to become members of the Financial Industry Regulatory Authority, or FINRA.  FINRA funding portal registration information can be found here.

A funding portal’s SEC registration becomes effective on the later of: (1) 30 calendar days after the date that the registration is filed with the SEC; or (2) the date the funding portal is approved for FINRA membership.

Form Funding Portal must be filed electronically on EDGAR, although as of this writing the Form has not startenginebeen assigned a submission type or even been listed on the EDGAR forms index. To gain access to EDGAR for the electronic filing of Form Funding Portal, a funding portal will first need to obtain an EDGAR access code and a central index key, or CIK, by submitting a Form ID with the SEC. When a funding portal’s registration becomes effective, the information on Form Funding Portal becomes publicly available except for certain personally identifiable information.  As of this writing, there are no Form Funding Portals shown to have been filed on EDGAR, although at least one portal, StartEngine Capital LLC, put out a press release that it did so on January 29.

Permitted Activities – Safe Harbor. Unlike registered broker-dealers, funding portals are prohibited from giving investment advice, soliciting offers, paying success fees to persons for solicitations or handling investor funds or securities.  To help funding portals navigate these prohibitions while trying to function as effective intermediaries, the rules provide a safe harbor for the following activities:

  • Curating Offerings. A funding portal may use broad discretion to determine whether and under what circumstances to allow an issuer to offer and sell securities through its platform, subject to the prohibition on providing investment advice or recommendations and provided it complies with all other provisions of Regulation Crowdfunding. The SEC believes this kind of discretion is important for the protection of investors, as well as to the viability of the funding portal industry and the crowdfunding market.
  • Highlighting Issuers and Offerings. A funding portal is permitted to highlight particular issuers or offerings on its platform based on objective criteria where the criteria are reasonably designed to highlight a broad selection of issuers offering securities through the platform, are applied consistently to all issuers and offerings and are clearly displayed on the platform. The permissible criteria include type of securities offered (e.g., common stock, preferred stock or debt securities), geographic location of the issuer, industry or business segment of the issuer, number or amount of investment commitments made, progress in meeting the target offering amount and minimum or maximum investment amount.
  • Providing Search Functions. A funding portal may provide search functions on its platform that investors could use to search, sort or categorize available offerings according to objective criteria, and that would allow investors to sort through offerings based on a combination of different criteria, such as by the percentage of the target offering amount that has been met, geographic proximity to the investor and number of days remaining before the closing date of an offering. However, search criteria may not include the advisability of investing in the issuer or its offering, or an assessment of any characteristic of the issuer, its business plan, its management or risks associated with an investment.
  • Providing Communication Channels. A funding portal may provide communication channels by which investors can communicate with one another and with representatives of the issuer through the funding portal’s platform about offerings conducted through the platform, but neither the funding portal nor its associated persons or employees may participate in these communications, other than to establish guidelines about communications and to remove abusive or potentially fraudulent communications. The communication channels must be made available to the general public and must restrict the posting of comments to those who have accounts on the funding portal’s platform. The funding portal must require each person posting comments to disclose clearly with each posting whether he is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or will receive any compensation for promoting an issuer.
  • Advising Issuers. A funding portal may advise an issuer about the structure or content of the issuer’s offering, including preparing offering documentation. For example, a funding portal may provide pre-drafted templates or forms for an issuer to use in its offering, and advice about the types of securities the issuer can offer, the terms of those securities and the procedures and regulations associated with crowdfunding.  Without these services, the SEC believes that crowdfunding as a method to raise capital might not be viable.
  • Paying for Referrals. A funding portal may compensate a third party for referring a person to the funding portal if the third party does not provide the funding portal with personally identifiable information about any investor, and the compensation, other than that paid to a registered broker-dealer, is not a transaction based success fee. The SEC believes the prohibition on success fees will help to minimize the incentive for high-pressure sales tactics and other abusive practices in this area.
  • Compensation Arrangements with Registered Broker-Dealers. A funding portal may pay compensation to a registered broker-dealer for services, including for referring a person to the funding portal, in connection with the offer or sale of securities, provided that the services are provided pursuant to a written agreement between the funding portal and the registered broker-dealer, the compensation is permitted under Regulation Crowdfunding and the compensation complies with FINRA rules.
  • Advertising. A funding portal may advertise its existence and identify one or more issuers or offerings available on its portal on the basis of objective criteria, so long as the criteria are reasonably designed to identify a broad selection of issuers offering securities through the platform and are applied consistently to all potential issuers and offerings, and the funding portal does not receive special or additional compensation for identifying the issuer or offering in this manner. However, a funding portal may not base its decision as to which issuers to include in its advertisements on whether it has a financial interest in the issuer, and any advertising may not directly or indirectly favor issuers in which the funding portal has invested or will invest.
  • Denying Access to Platform. A funding portal may deny access to its platform to an issuer if the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.
  • Accepting Investor Commitments.  A funding portal may, on behalf of an issuer, accept investment commitments from investors but may not actually handle the funds.
  • Directing Transmission of Funds. A funding portal may direct investors where to transmit funds and may direct a qualified third party to release proceeds of an offering to the issuer upon completion of the offering or to return investor proceeds when an investment commitment or offering is cancelled. Interestingly, the SEC chose not to impose requirements that would prohibit variations of a contingency offering, such as minimum-maximum offerings, that would establish a fixed deadline for transmission of funds as compared to the proposed requirement to transmit funds “promptly” or that would require funding portals to maintain a certain amount of net capital.

            Compliance.  A funding portal must have written policies and procedures reasonably designed to achieve compliance with the federal securities laws and regulations relating to its business as a funding portal.  In addition, funding portals must follow the same privacy rules as those applicable to brokers.  Finally, funding portals are required to preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years.

Rules Governing Crowdfunding Intermediaries Generally

The following rules apply to all Regulation Crowdfunding intermediaries, i.e., funding portals and broker-dealers:

  • Receiving Financial Interests in Issuers. The intermediary entity (but not its directors, officers or partners) is permitted to receive a financial interest in an issuer using its services, provided that the financial interest is compensation for the services provided to the issuer in connection with the offering and the financial interest consists of the same security as being offered to investors in the offering. This was as an accommodation in the final rules that will better enable issuers to pay intermediary upfront fees (through stock) and also have the added benefit of aligning the interests of issuer, intermediary and investors.
  • Measures to Reduce Risk of Fraud. There are several measures that intermediaries are required to take that are designed to reduce the risk of fraud in crowdfunding transactions. An intermediary is required to have a reasonable basis for believing that the issuers on its platform comply with Regulation Crowdfunding and have established means to keep accurate records of the holders of the securities, and may reasonably rely on representations of the issuer unless the intermediary has reason to question the reliability of those representations.   An intermediary must deny access if it has a reasonable basis for believing that an issuer, or any of its officers, directors or any 20% owner is subject to a disqualification under Regulation Crowdfunding.
  • Accounts and Electronic Delivery. Intermediaries may not accept an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained from the investor consent to electronic delivery of materials.
  • Educational Materials. Intermediaries must deliver certain educational materials to investors, including information on process for purchase of securities, types of securities that may be offered on the intermediary’s platform, risks associated with each type of security, restrictions on resale, types of information that an issuer is required to provide in annual reports, frequency of the delivery of that information, limits on amounts investors may invest and limitations on an investor’s right to cancel an investment commitment.
  • Promoters. Intermediaries must inform investors, at the time of account opening, that promoters must clearly disclose in all communications on the platform the receipt of promotion compensation and the fact that he is engaging in promotional activities on behalf of the issuer.
  • Compensation Disclosure. At the time of opening an account, intermediaries must clearly disclose the manner in which they will be compensated in connection with Regulation Crowdfunding offerings.
  • Issuer Information. Intermediaries must make available to the SEC and investors, not later than 21 days prior to the first day on which securities are sold to any investor, any information provided by the issuer pursuant to Regulation Crowdfunding, and that such information be publicly available on the platform for a minimum of 21 days before any securities are sold in the offering, during which time the intermediary may accept investment commitments, and remain publicly available on the platform until the offering is completed or cancelled.
  • Investor Qualification. Before accepting an investment commitment, an intermediary must have a reasonable basis for believing that the investor satisfies the investment limits under Regulation Crowdfunding. An intermediary may rely on an investor’s representations concerning annual income, net worth and the amount of the investor’s other investments in Regulation Crowdfunding offerings through other intermediaries unless the intermediary has a reasonable basis to question the reliability of the representation. Intermediaries must also confirm that an investor has reviewed the intermediary’s educational materials, understands that the entire amount of his investment may be lost and is in a financial condition to bear the loss of the investment and has completed a questionnaire demonstrating an understanding of the risks of any potential investment.
  • Communication Channels. Intermediaries must provide on their platforms channels through which investors can communicate with one another and with representatives of the issuer about offerings, to make the channels publicly available, permit only those persons who have opened accounts to post comments and require any person posting a comment in the channels to disclose whether he is a founder or employee of an issuer engaging in promotional activities on behalf of the issuer or otherwise compensated to promote the issuer’s offering. Funding portals are prohibited from participating in communications in these channels.
  • Transaction Confirmations. At or before the completion of a transaction, an intermediary must send to each investor a notification disclosing date of transaction, type of security, identity, price and number of securities purchased by the investor, certain specified terms of the security and source, form and amount of any remuneration to be received by the intermediary in connection with the transaction.
  • Completion of Offerings, Cancellations and Reconfirmations. Intermediaries must give investors the right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. If an issuer reaches the target prior to deadline, it could close the offering provided the offering has been open for a minimum of 21 days, the intermediary provided notice about the new offering deadline at least five business days prior to the new offering deadline and investors are given the opportunity to reconsider and cancel their investment commitment until 48 hours prior to the new offering deadline. Finally, if there was a material change to the offering terms or to the information provided by the issuer, the intermediary would be required to give or send to any investors who have made investment commitments notice of the material change, stating that the investor’s investment commitment will be cancelled unless the investor reconfirms his or her commitment within five business days of receipt of the notice.

[i] Although funding portal registration went live on January 29, 2016, Form Funding Portal does not yet appear on the SEC’s website and a Google search came up empty.

Buried in the recently enacted Highway Bill, officially the Fixing America’s Fast ActSurface Transportation Act or FAST Act, is a new exemption for the resale of securities.  The new resale exemption appears in the form of a new Section 4(a)(7) of the Securities Act of 1933 and essentially codifies the so-exit strategy 2called 4(a)(1-1/2) exemption.  New Section 4(a)(7) will provide securityholders seeking to resell their securities without registration greater certainty and another viable alternative exit pathway, particularly from privately held companies.   Inasmuch as no Securities and Exchange Commission rulemaking is required, the new exemption is effective right now.

Background

The requirement that each sale of securities be either registered with the Securities and Exchange Commission or satisfy an exemption from registration applies as well to any resale of securities by security holders. Rule 144 is a common exemption for the resale of restricted securities (and of any securities by holders who are affiliates of the issuer, i.e., control securities).  Another exemption used by reselling shareholders is the so-called 4(a)(1-1/2) exemption, an unofficial, unwritten exemption conceived by securities lawyers which over time has become accepted practice.  It’s called the 4(a)(1-1/2) exemption because it contains elements of both Section 4(a)(1) of the Securities Act, which exempts from registration transactions by any person other than an issuer, underwriter or dealer, and Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer not involving any public offering.

The New Section 4(a)(7) Resale Exemption

New Section 4(a)(7) essentially codifies “Section 4(a)(1-1/2)” by exempting from the registration requirements of Section 5 of the Securities Act resales of restricted securities that satisfy the following requirements:

  • securities sold only to accredited investors
  • no general solicitation
  • if the issuer is not a reporting company, the seller and prospective buyer are able to obtain from the issuer certain reasonably current information about the issuer, including the number of shares outstanding, information about the officers and directors, any persons registered as a broker, dealer or agent that will receive any commission for the transaction; recent balance sheet and profit and loss statements; and if the seller is a control person of the issuer, a statement regarding the nature of the affiliation and a certification by the seller that it has no reasonable grounds to believe that the issuer is in violation of the securities laws
  • seller is not a direct or indirect subsidiary of the issuer
  • neither the seller nor any person being paid in connection with the sale is a bad actor, as described in Regulation D
  • the issuer is not a blank check, blind pool or shell company; and
  • the class of securities has been outstanding for at least 90 days prior to the transaction.

New Section 4(a)(7) will provide greater legal certainty to shareholders seeking to resell shares than currently provided in the so-called Section 4(a)(1-1/2) exemption, which was never formally legislated or codified through SEC rulemaking.

New Section 4(a)(7) will also present a viable alternative to Rule 144, the traditional safe harbor for the resale of restricted and control securities, in relation to which Section 4(a)(7) has both advantages and disadvantages.

As to the advantages, sellers under Section 4(a)(7) may sell an unlimited number of shares, unlike affiliates in Rule 144 transactions who are capped in any rolling three month period to the greater of one percent of the outstanding shares or the average weekly trading volume over the preceding four week period. Section 4(a)(7) sellers need not satisfy any holding period, unlike Rule 144 sellers who must hold the shares for either six months in the case of reporting issuers or one year in the case of non-reporting issuers.  A Section 4(a)(7) exemption need not be reported in an SEC filing, unlike Rule 144 sales by affiliates.  Finally, the FAST Act made explicitly clear that shares sold in a Section 4(a)(7) transaction are deemed “covered securities” for purposes of the National Securities Markets Improvement Act of 1996, meaning that state regulation is preempted and these transactions are not subject to state review.

On the other hand, there are certain disadvantages relative to Rule 144. Shares sold in a Section 4(a)(7) transaction are deemed to be restricted securities in the hands of the purchaser, who would then need to find his own exemption on a subsequent resale, as opposed to shares sold under Rule 144 which become unrestricted.  Furthermore, Section 4(a)(7) shares may only be sold to accredited investors, whereas shares sold under Rule 144 may be sold to anyone.

Finally, it will be interesting to see what practices emerge with respect to the information that must be obtained from a non-reporting issuer, including whether issuers will insist on signed confidentiality agreements as a condition to disclosing the required information.

It’s official: the new Regulation Crowdfunding rules will become effective on May 16, 2016.  The SEC’s crowdfunding-keyboardfinal rules release of October 31, 2015 provided that, with certain exceptions, the new rules will go into effect 180 days after they are published in the Federal Register.  We just learned that the rules were published in the Federal Register on November 16, and that, accordingly, they will become effective on May 16, 2016.

So mark your calendars.  May 16, 2016 will be the first day that companies will be able to file Form C, the offering statement mandated by the SEC for Regulation Crowdfunding offerings.  But because of the requirement that disclosure be made publicly available on the intermediary’s platform for a minimum of 21 days before any securities are sold in an offering, however, the first Regulation Crowdfunding closings will not take place until at least June 6, 2016.

An important exception to the May 16, 2016 effective date relates to registration of funding portals, the relevant effective date for which remains January 29, 2016.  That means that funding portals, one of the two types of intermediaries (the other being registered broker-dealers) that will be permitted to operate funding portalsonline platforms for securities transactions under Regulation Crowdfunding, could begin filing their registration form, called Form Funding Portal, on January 29, 2016.  The reason for the staggered effective dates is to provide a level playing field between broker-dealers, who would already be registered and possess built-in infrastructure, and “funding portals”, the newly designated category of intermediary that will need to register with the SEC as funding portals and develop infrastructure.  I’ll be blogging about what the new Regulation Crowdfunding means for funding portals in my next post.

You can find my initial reaction to the new Regulation Crowdfunding rules here.