On July 10, 2019, the Securities and Exchange Commission declared Blockstack PBC’s offering statement “qualified”, thus allowing Blockstack to commence the distribution and sale of its Stacks Tokens under Regulation A. This is the first offering of digital tokens to be qualified by the Commission under Regulation A, a significant milestone for the blockchain industry which raised billions of dollars in 2016-2018 in unregistered non-exempt initial coin offerings before the Commission threw down the gauntlet in the form of lawsuits and enforcement actions alleging illegal unregistered offerings, most recently against Kik Interactive Inc.  Yet given recent Regulation A headwinds, it’s unclear to what extent other blockchain developers will follow Blockstack’s lead and look to raise capital under Regulation A.

State of Regulation A

Regulation A was reformed under the JOBS Act of 2012 to allow issuers to raise up to $50 million in any rolling 12-month period with scaled down disclosure relative to full-blown registration, freedom to test-the-waters and no qualification at the state level. Referred to as a mini-IPO, Regulation A also provides a streamlined pathway to Securities Exchange Act registration (for those issuers choosing to be SEC reporting companies) and for listing on a national securities exchange. Shares issued in a Regulation A offering are unrestricted; they can be freely resold without a holding period or other restriction.

Issuers’ and securities professionals’ hopes were high that Regulation A could be a viable alternative to registered public offerings or other existing exemptions. Initial signs were encouraging. Since Regulation A went live in 2016, over 100 transactions have been consummated averaging $10 million per deal, including ten issuers that got listed on Nasdaq or the NYSE.

Unfortunately, however, Regulation A has experienced some hiccups lately. The shares of the ten listed Regulation A issuers have fared poorly, and the Commission recently approved Nasdaq’s proposed rule to require Regulation A funded companies seeking Nasdaq listing to have a minimum two year operating history. One Regulation A issuer, Longfin Corp., terminated operations less than one year after closing its Regulation A offering and is now the subject of a fraud lawsuit by the Commission.

Blockstack Offering of Stacks Tokens

Blockstack is developing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications. Blockstack is offering up to $40 million of its Stacks Tokens, consisting of a combination of full-priced tokens to “qualified purchasers” as defined in Regulation A, discounted tokens to holders of certain purchase vouchers and non-cash consideration tokens under Blockstack’s “app mining” program in exchange for the development of well-reviewed applications on its decentralized application network.  Blockstack previously raised over $50 million in VC rounds and under Rule 506(c); among those investing were big-time early stage investors Union Square Ventures, Y Combinator, Lux Capital and Naval Ravikant.

The Evolving Token

In a June 2018 speech, SEC Division of Corporate Finance Director William Hinman broke new ground when he stated that a digital asset originally sold in a securities offering could later be sold in a manner that does not constitute an offering of a security when there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created. I blogged about the speech here.

Consistent with the guidance from Hinman’s speech and with the Commission’s recent guidance in its “Framework for ‘Investment Contract’ Analysis of Digital Assets”, Blockstack asserts its Stacks Token is a security now but may not be so in the future. In its offering statement, Blockstack states that, for the foreseeable future, it anticipates treating the Stacks Token as a security based on its view that the token is an “investment contract” under the application of the Howey test to digital assets: an investment of money, in a common enterprise, with a reasonable expectation of earning a profit, through the efforts of others. With investment of money in a common enterprise and a reasonable expectation of earning a profit assumed, the real issue is whether that profit expectation is through the efforts of others.

Under the Framework and the Howey Test, a profit expectation is considered to be through the efforts of others if the network is still being developed and the token is not fully functional, because the success of the network is considered to be dependent on the efforts of management. Once the network is sufficiently decentralized, that success can no longer be said to be dependent on the efforts of management. Blockstack maintains that, currently, it employs all core developers of the Blockstack network. But as the network becomes increasingly decentralized, core developers other than those employed by Blockstack may become primarily responsible for the development and future success of the network. Blockstack also maintains it may transfer governance and control of the Blockstack network to other parties, such as network users and developers.

Whether Stacks Tokens lose their status as investment contracts will ultimately depend on whether purchasers of the tokens no longer expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack no longer retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants.  Arguably, purchasers will no longer have that expectation and Blockstack will no longer have that power when the network becomes truly decentralized, at which point Blockstack asserts the Stacks Tokens will no longer constitute a security.

Precedent Setting?

Blockstack’s Regulation A journey has been an expensive and long one, purportedly costing it $2 million over the ten months of engaging in the process. Blockstack’s co-founder Muneeb Ali joked about what he calls Blockstack’s “$2 million donation to the crypto industry”, but he also made these interesting comments on his blog about the precedent setting potential of the offering:

“[the offering could] set a precedent for others in the industry…Recently, U.S. markets have been closed to crypto projects given regulatory uncertainty, and we believe in opening the U.S. markets to innovation in this area. We’ve been working with securities lawyers to create a legal framework that can enable blockchain protocols to comply with SEC regulations…Following a regulated path and proactively working with the regulators was a decision we made with the understanding that it’ll require a lot of work and time…This can potentially set a precedent for others in the industry, not just for public offerings, but also as a path to launch new public blockchains and establish a path to bootstrapping decentralized ecosystems.”

Whether Blockstack’s Regulation A offering will indeed set a capital raising precedent for others in the blockchain industry remains to be seen, and will depend on several factors including whether Regulation A can rehabilitate its brand and whether Blockstack’s “$2 million contribution to the crypto industry”, presumably through multiple versions of its offering circular and responses to voluminous SEC comment letters, will have created a practical, workable model from which others can follow Blockstack’s lead in a more cost-effective manner.

Non-accredited investors are estimated to constitute approximately 92% of the U.S. population. Yet restrictive rules governing exempt offerings have significantly limited their freedom to invest in private offerings and prevented or discouraged issuers from selling them privately offered securities. But in a recently issued concept release, the Securities and Exchange Commission has signaled a willingness to approach the issue in a much more creative way, suggesting the possibility of expanded opportunities for companies to include non-accredited investors in exempt offerings without unduly compromising their protection.

The SEC’s June 18, 2019 concept release seeks public comment on ways to simplify, harmonize and improve exempt offerings by removing some of the existing complexity, thereby promoting capital formation without unduly compromising investor protections and expanding opportunities for investors. In its press release issued the same day, SEC Chairman Jay Clayton noted that “input from startups, entrepreneurs and investors who have first-hand experience with [the SEC’s] exempt offering framework will be key to its efforts to analyze and improve the complex system we have today.”

Significant changes over the past few years to the rules governing exempt offerings (most notably through the Jumpstart Our Business Startups Act of 2012, the Fixing America’s Surface Transportation Act of 2015 and the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018) have resulted in a complex framework of differing requirements and conditions, which may be difficult for issuers to navigate, particularly startups and emerging companies with more limited resources.

Interestingly, the amount raised in exempt offerings has been trending higher in both absolute terms and relative to registered offerings, and now is twice the amount raised in registered public offerings. The concept release estimates that in 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion raised through exempt offerings.

Given the dominance of exempt offerings, the focus of the release is to seek input on whether the current regulatory framework provides adequate access to capital for a variety of issuers, particularly smaller issuers, and adequate access to investment opportunities for non-accredited investors while maintaining investor protections. Non-accredited investors’ primary investment opportunities have historically been in registered markets because of the restrictions on their participation in private offerings. Non-accredited investors have not had the same level of access to investment opportunities in exempt markets as an accredited investor would, and the upward trend in exempt offerings only exacerbates the problem.

Consequently, the SEC is seeking comment on whether it would be consistent with capital formation and investor protection for it to consider steps to make a broader range of investment opportunities available to non-accredited investors. In particular, the SEC is seeking comment on the following specific questions (among others):

Accredited Investor Definition. To be considered an accredited investor, an entity would need to fall under one of the designated categories of financial institutions, have more than $5 million in assets or have only accredited investor owners, while an individual must pass either a net worth or income test. The SEC is seeking comment on:

  • Whether the $5 million asset test for entities should be replaced with a $5 million investments test that includes all entities rather than specifically enumerated types of entities?
  • Whether individuals should be allowed to qualify based on other measures of sophistication, such as minimum amount of investments, certain professional credentials, experience investing in exempt offerings, knowledgeable employees of private funds for investments in their employer’s funds, individuals who pass an accredited investor examination?
  • Currently, a natural person just above the income or net worth thresholds would be able to invest without limits, but a person just below the thresholds cannot invest at all as an accredited investor. Should that be changed?

Rule 506 of Regulation D. Currently, Rule 506(b) allows sales to up to 35 non-accredited investors (and an unlimited number of accredited investors), but the exemption from the specific, mandated disclosure obligations of Regulation D for offerings sold only to accredited investors serves as a significant incentive to exclude non-accredited investors.   Accordingly the SEC seeks comment on:

  • Whether it is important to continue to allow non-accredited investors to participate in Rule 506(b) offerings, and if so are the information requirements having an impact on the willingness of issuers to allow non-accredited investors to participate?
  • Whether the SEC should consider eliminating or scaling the information requirements depending on the characteristics of the non-accredited investors participating in the offering, such as if all non-accredited investors are advised by a financial professional or a purchaser representative?
  • Whether information requirements should vary if non-accredited investors can only invest a limited amount or if they invest alongside a lead accredited investor on the same terms as the lead investor?
  • Should non-accredited investors be allowed to purchase securities in an offering that involves general solicitation? If so, what types of investor protection conditions should apply? For example, only if: (i) such non-accredited investors had a pre-existing substantive relationship with the issuer or were not made aware of the offering through the general solicitation; (ii) the offering is done through a registered intermediary; or (iii) a minimum percentage of the offering is sold to institutional accredited investors that have experience in exempt offerings and the terms of the securities are the same as those sold to the non-accredited investors?

Regulation A. In a Tier 2 offering by an issuer of securities that are not going to be listed on a national securities exchange upon qualification, non-accredited individual investors are limited in how much they can invest to no more than 10% of the greater of their annual income or net worth, alone or together with a spouse and excluding the value of their primary residence and any loans secured by the residence (up to the value of the residence). The SEC seeks comment on:

  • Whether the individual investment limits for non-accredited investors in Tier 2 offerings should be changed or eliminated?
  • If the investment limits are changed, what limits would be appropriate?

Responses to the foregoing or any other requests for comment set forth in the concept release may be submitted to the SEC here prior to the deadline of September 24, 2019.

The Securities and Exchange Commission filed a complaint last week against the founder of venture-backed mobile payments startup Jumio, Inc., charging him with causing the company to prepare false and misleading financial statements that inflated the company’s earnings and gross margins and with defrauding secondary market purchasers of his shares. The founder, Daniel Mattes, agreed to pay more than $16 million in disgorgement and prejudgment interest plus a $640,000 penalty and to be barred from being an officer or director of a publicly traded company in the United States.

Jumio, Inc. was founded to make mobile phone purchases easier and more secure through its customer identity and credit card verification technology.  The company had two lines of business: a processing business which connected merchants to payment processors in exchange for a commission paid by the processors equal to 10% of their processing fee, and a product business which licensed its ID and credit card verification technology to merchants.

Mattes appears to have engaged in separate fraudulent schemes for each of the two lines of business. As to the processing business fraud, the complaint alleges that Mattes prepared Jumio’s financials for 2013 and 2014 which overstated revenue and profitability by recording as revenue the entire amount of processing fees collected by payment processors, rather than the 10% actually paid to Jumio.

The product business fraud involved a roundtrip contract with no economic substance and improper recognition of subscription revenue. The roundtrip transaction consisted of an agreement Mattes entered into on Jumio’s behalf with a software developer under which the software developer would ostensibly pay Jumio $710,000 per quarter for credit card verification scans that the developer could resell to third parties, and Jumio would ostensibly pay the developer $800,000 per quarter for software development services. The complaint alleges that Mattes caused Jumio to recognize as revenue the $710,000 from that contract in the first quarter of 2013. Mattes apparently wasn’t careful enough in concealing this deception; the complaint asserts that he wrote to an employee not to get excited over the transaction because “it’s more a deal to get our numbers straight for the upcoming round”, evidently a reference to Jumio’s Series C offering. Although both parties ceased making payments to each other after the first quarter of 2013, Mattes had Jumio continue to record the stated revenue from that contract throughout 2013 and 2014.

The second type of product business related fraud involved recognizing as revenue at the commencement of certain subscription agreements the entire amount of subscription fees due under such agreements before services were performed, and even when it became obvious a subscriber wouldn’t pay, in clear violation of revenue recognition rules. Under Generally Accepted Accounting Principles, Jumio should have only recognized the revenue over the period of the subscription as the revenue was earned, and should not have recognized revenue from deals where collectability was not reasonably assured. Mattes’ accounting also violating SEC staff policy on revenue recognition. SEC Staff Accounting Bulletin No. 101 – Revenue Recognition in Financial Statements provides that revenue generally is realized or realizable and earned only when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the seller’s price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured.

The misstatements Mattes made in Jumio’s financial statements were material. The complaint states that Jumio’s 2013 financials represented that Jumio’s gross revenue was $101 million, when it was actually only $9.5 million; that its gross margin was $23 million, when it was actually only $9.2 million; and that its net profit was $1.3 million, when in fact it had a net loss of $10 million.

Mattes also deceived the board regarding his intentions, according to the complaint. In early 2014, Mattes set up a program to allow employees to sell shares through a broker in the secondary markets. Mattes himself had previously sold large blocks of shares to institutional investors and was under a contractual obligation to provide notice to the board (and presumably receive board consent) before selling any of his own shares. Mattes was evidently informed by a director that the board would not authorize further sales by him, apparently out of concern that he have sufficient skin in the game and be properly incentivized. When the board authorized the employee share selling program, Mattes represented to the board that he would be excluded. Nevertheless, Mattes in fact did sell his own shares through the program without notifying the board. The complaint further asserts that Mattes had been warned by company counsel that he needed board approval for the sales, and that he falsely represented to counsel that he received informal approval with ratification to follow.

Mattes’ profit from the alleged fraud was considerable, securing a profit of over $14 million from the sale of his own shares to secondary market investors through the employee selling program. His involvement in the fraud, according to the complaint, was direct. He prepared the false financials, caused them to be provided to the broker and personally discussed them with investors. He also misrepresented to at least one investor that he was not selling his own shares. When the investor noticed that funds were being wired to Mattes, Mattes falsely claimed that he was only acting as an intermediary for legal reasons on behalf of employee sellers. He was even quoted as saying to the investor that he didn’t want to sell a single share because of “lots of great stuff coming up” and that “[he]’d be stupid to sell at this point.”

In late 2014, Jumio hired a CFO, who quit after just a few days on the job. He told Jumio’s board that revenue numbers were inaccurate, referencing the roundtrip transaction in particular. The board then hired outside accountants to assess Jumio’s books, leading to a restatement of its 2013 and 2014 financial statements. But even after Mattes knew that the financial statements would need to be restated, he continued selling his stock in the secondary market.

Mattes resigned from Jumio in mid-2015 after an internal investigation. Jumio filed for Chapter 11 bankruptcy in 2016 and the shares that Mattes had sold to the secondary market purchasers became worthless. Ironically, Mattes founded Jumio in 2010 to decrease fraud (in mobile purchases). Certainly, primary culpability for the wrongdoing here lies with Mattes. But to minimize the risk of internal management fraud and avoid Jumio’s fate, companies should exercise good corporate governance and sound internal controls which appeared to be somewhat lacking at Jumio before it was too late. Among other safeguards, there should be some independent review of financial statements such as an audit committee composed of non-management directors and/or an independent accounting firm. Counsel also has an important gatekeeper role to play and should exercise diligence in protecting the interests of the company when uncovering evidence of possible fraud.

 

 

Lyft, Inc. last week completed its highly anticipated initial public offering, raising over $2.3 billion at a valuation of approximately $25 billion, and turning its co-founders Logan Green and John Zimmer into near billionaires on paper. But that’s not the only reason they’re smiling. Despite owning only 7% of the outstanding pre-IPO shares, Green and Zimmer will control nearly 50% of the voting power by virtue of their Class B shares having 20 votes per share and the Class A shares having just one vote per share.

Nothing that unusual so far. In three of the last four years, over one-third of the technology companies that went public featured dual-class shares, including Snap, Roku, Dropbox and Spotify. Snap went to an extreme by selling to the public shares with no voting rights at all, as did Alphabet, Under Armour and Blue Apron. I previously blogged here about Snap’s IPO of no-vote shares.

What makes Lyft’s dual class structure somewhat unusual is that it lacks a fairly typical sunset provision that would be triggered when the founders’ combined ownership falls below some threshold (often 10%) of the overall shares outstanding. In Lyft’s case, the founders’ combined ownership was already below 10% prior to the IPO.  Lyft’s dual structure also has much larger disproportionality: 20 votes for every one vote held by all other stockholders, rather than the more standard 10:1. The Lyft structure will only terminate (by Class B shares converting into Class A shares) upon (I) a two-thirds vote of the Class B, (ii) the co-founders’ Class B shares representing less than 20% of the Class B outstanding, or (iii) the death or total disability of the last to die or become disabled of the co-founders.

Lyft readily concedes that its dual class structure poses a risk to investors. The first risk factor under the caption “Risks Related to Ownership of Our Class A Common Stock” in Lyft’s final offering prospectus states: “The dual class structure of our common stock has the effect of concentrating voting power with our Co-Founders, which will limit your ability to influence the outcome of important transactions, including a change in control.” It acknowledges that founders Logan and Zimmer will be able to control the vote on matters submitted to stockholders for approval, including the election of directors, amendments to the certificate of incorporation and any merger, consolidation, sale of all or substantially all assets or other major corporate transactions.

There’s an interesting debate surrounding dual class share structures, with valid arguments both for and against. Opponents assert founders shouldn’t have it both ways — access to capital markets without relinquishing control. Also, management that’s less accountable to public stockholders may pursue strategies that produce lower returns and lower value over time. Defenders contend the structure allows founders to make decisions that are in the best long term interests of the company without undue pressure from short-termist investors. Unless founders are able to control the vote through disproportionate voting shares, they may succumb to the pressure of producing quarterly results and may forego certain actions whose benefits may only accrue over the longer term like research and development and restructurings. Another argument in favor is that it neutralizes politically motivated vote initiatives such as “say on pay” or climate-change disclosures.

The New York Stock Exchange historically denied listing of companies with dual-class voting, primarily because of a general commitment to corporate democracy and accountability. But reacting to pressure from corporate boards at the height of the takeover battles of the 1980s and competition from other exchanges, the NYSE reversed course and today permits companies to go public with dual class structures.

Some opponents have advocated an outright ban on dual class structures or lobbied exchanges to refuse to list companies that have them. But the impact on IPOs must be carefully considered. Growth startups have been shying away from going public over the last 15-20 years for a variety of reasons, including regulatory burden, availability of late stage private funding and decimalization. Another reason is activist stockholder short termism, and founders may be even more reluctant to go public without the protection afforded by dual class shares, particular since other traditional defense mechanisms have fallen out of favor, including staggered boards and shareholder rights plans.

The Wall Street Journal Editorial Board, recognizing there are merits and risks associated with a dual class structure, argues that prospective Lyft investors who oppose it should simply not invest, or invest elsewhere; Uber’s IPO is rumored to be happening later this year.

A fair question to ask is whether dual-class structures, once adopted, should last forever. Research in this area indicates that the benefits of a dual-class structure for any given company decline over time, that the costs of letting management essentially entrench itself eventually outweigh the benefits of shielding the company from short-term investors.  Last year, the SEC reviewed the stock market performance of companies with dual-class structures, comparing those that had time-based sunset provisions with those that allow them to last in perpetuity. It found that within two years of an IPO, companies with sunset provisions significantly outperformed those without them. Because of this and similar research conclusions, the Council of Institutional Investors has advocated in favor of time-based sunsets requiring multi-class structures with unequal voting rights to collapse to one-share, one-vote within a reasonable, specified period of not more than seven years after IPO.

Mandatory sunsets sound logical. After a certain number of years following an IPO, a company’s business model should have reached maturity such that it no longer needs protection from short termists in order to make long term changes. But here one size probably does not fit all. Companies often pivot differently in reaction to market trends and technological developments, and there’s no way to predict when companies will reach maturity. The better approach might be to give stockholders holding one vote/share stock the opportunity to vote after some period of time following an IPO as to whether or not to discontinue the dual class structure. Such a vote would ensure that founders aren’t insulated forever and would allow stockholders to determine when their company has matured to the point where the dual class structure is no longer needed or justified.

2018 was a historically good year for venture capital in the United States in terms of dollars invested by VC funds in U.S. companies, dollars raised by VC funds and dollar value of exits by VC-backed companies, according to the Venture Monitor for Q4 2018 published by PitchBook and the National Venture Capital Association. VC funds invested over $130 billion in over 8,000 portfolio companies in the U.S., limited partners committed $56 billion to 256 new American VC funds and 864 venture-backed exits exceeded a combined value of $120 billion. Here’s a slightly deeper dive into some of the numbers:

  • Record Year for VC Investments: The $130 billion invested by VC funds in U.S. companies marked the first time annual capital investment surpassed the $100 billion watermark set at the height of the dot-com boom in 2000.
  • Historical Year for VC Fund Capital Commitments: The $55.5 billion committed to new fund formations in 2018 was the highest amount of capital that PitchBook has ever recorded and the fifth consecutive year that at least $34 billion was raised by VC funds in the U.S.
  • Bigger but Fewer Funds: The median new venture fund raised $82 million, nearly triple what it was in 2014. The number of new funds, however, was below a 2016 peak.
  • Beginners’ Luck: Even first-time fund managers kicked butt, raising over $5 billion, the highest figure recorded in over ten years.
  • Early Stage Deals Surge: Early stage (Series A or B) value and count reached decade highs.  Early stage median deal sizes were also higher in 2018, creating a perception that Series A is the new Series B.
  • But Number of Angel & Seed Deals Tanked: Although angel and seed median deal sizes increased (as was the case with the rest of VC), the number of angel and seed deals dropped by roughly half since its 2015 high.
  • Valuations Soaring: Median pre-money valuations more than doubled since 2013 for Series A, B, C, and D+ rounds, with the median of the latter seeing a three-fold increase.
  • Latest Stage Valuations Remain Fastest Growing.  Median pre-money valuation of companies in Series D deals or higher shot up to $325 million, an increase of approximately 30% over 2017.
  • Bigger Exits, including IPOs: Total exit value surpassed $120 billion for the first time since 2012. The 85 IPOs were the most since 2014 and represented more than 50% of exit value for the second straight year.
  • Usual Suspects Continue Regional Dominance: No shocker, California, Massachusetts and New York continued to dominate VC investment activity, with companies in those states attracting 79% of total U.S. capital invested, although only 53 percent of completed U.S. deals.

With VC funds stockpiling massive amounts of dry powder as a result of five consecutive years of $34+ billion capital commitment hauls, VCs should be well positioned to invest in startups for the next few years, even if there’s a downturn in the VC market.

 

 

Real estate developers should seriously consider equity crowdfunding to fund development projects for two major reasons, one of which has little or nothing to do with money. The first reason is that new securities offering legislation enacted in 2012 creates new legal capital raising pathways which allow developers for the first time to use the internet to find investors, and also to raise money from non-accredited investors. The second reason is that a crowdfunding campaign can be a potent weapon in overcoming political and neighborhood opposition to a development project.

Pre-2012 Impediments to Capital Formation

Before 2012, real estate developers seeking to finance projects from private investors were faced with three major legal impediments. First, they could only accept investment from accredited investors[1], a legal designation for institutions with assets of at least $5 million or individuals meeting either an income test ($200,000 in each of the last two years, or $300,000 combined with one’s spouse) or a net worth test ($1 million without including one’s primary residence). This meant that real estate entrepreneurs were excluded from roughly 93% of the U.S. population that did not qualify as accredited investors and the $30 trillion that is estimated to be socked away in their savings accounts. Second, as if the first wasn’t limiting enough, the accredited investor had to be someone with whom the developer had a preexisting relationship. And not just any relationship; it had to be of the sort that would enable the developer to assess whether the investment was appropriate for the investor. And third, and perhaps most limiting, the developer was prohibited from engaging in any general solicitation or advertising: no ads, no mass mailings, no e-blasts and, most notably, no internet.

JOBS Act of 2012: Three Crowdfunding Alternatives

In 2012, Congress passed and President Obama signed into law the Jumpstart Our Business Startup Act, better known as the JOBS Act, a major piece of rare bipartisan legislation intended to make it easier for entrepreneurs to raise capital. In the U.S., any offering of securities must either be registered with the SEC (enormously expensive and time consuming, and triggers ongoing SEC reporting and other regulatory burdens as an SEC reporting company), or satisfy the requirements of an exemption from registration. Among other capital markets reforms, the JOBS Act created three crowdfunding exemptions from registration, divided into Titles II, III and IV, each with its own dollar limitations and other myriad rules.

Accredited Investor Crowdfunding

Title II of the JOBS Act and the SEC’s related Rule 506(c) provide for what many refer to as “accredited investor crowdfunding”. It allows developers to use the internet and other methods of general solicitation and advertising to raise an unlimited amount of capital, but with two strings attached. One, sales of securities may only be made to accredited investors. And two, the issuer must use reasonable methods to verify accredited investor status. The requirement to reasonably verify status means the old check-the-box on the one-page investor questionnaire doesn’t fly here; one would need to dig deeper and request such evidence as brokerage statements or tax returns (which investors are loathe to produce) or lawyer or accountant certifications (good luck getting those). Despite the advantage of being allowed to use the internet to reach accredited investors, however, only four percent of the capital raised in Regulation D offerings since Rule 506(c) went live in September 2013 was raised in offerings conducted pursuant to Rule 506(c), according to the SEC. It stands to reason that the culprit is the enhanced verification requirement, which is now the target for reform among capital markets reform advocates.

Non-Accredited Investor Crowdfunding

Under Title III of the JOBS Act and the SEC’s Regulation Crowdfunding, an issuer may offer and sell securities over the internet to anyone, not just accredited investors, without registering with the SEC. There are many limitations and restrictions, foremost of which is that an issuer may raise no more than $1,070,000 per year using this method. Investors in Title III deals are also capped based on their income and net worth. Issuers must sell through a third-party funding portal (only one), and there are disclosure and SEC filing requirements. Title III was the section of the JOBS Act that received the most buzz, largely because of the disruptive nature of allowing companies to raise capital from non-accredited investors, using the internet and without registering with the SEC and giving ordinary people the chance to invest in startups and other private investment opportunities they were previously shut out of, but also because of the controversy it created among those who believed that this new opportunity would be a recipe for massive fraud. To date, thankfully, there’s been virtually no fraud reported in Title III deals.

Mini-Public Offering

The third crowdfunding exemption allows companies to raise up to $50 million from the general public in a mini-public offering over the internet under Title IV of the JOBS Act and Regulation A+ promulgated by the SEC thereunder.  A Regulation A+ offering is similar to a traditional registered public offering except that the disclosure statement is scaled down and the whole process far less expensive and time consuming. Regulation A+ has several distinct advantages: It generally preempts the states, meaning that issuers need only go through a review process at the Federal level with the SEC (the predecessor rule required issuers to get clearance from each state in which investors were solicited). Shares sold in a Regulation A+ offering are freely tradable and may be resold right away. And issuers may “test the waters” and gauge investor interest before committing to launch an offering. For these and other reasons, real estate developers and funds have been the most active users of Regulation A+.

Real Estate Crowdfunding

Real estate crowdfunding has rapidly grown into a multi-billion-dollar industry since the passage of the JOBS Act in 2012. It is leveling the real estate investment playing field, providing access both for ordinary individuals to an asset class they were previously shut out of, and for real estate entrepreneurs to a universe of previously forbidden but low hanging investor fruit, particularly in the form of people living in the communities where projects are being proposed for development. Through equity crowdfunding, high quality real estate investment opportunities are no longer offered strictly on a “who-you-know” basis. It replaces the hand-to-hand combat of raising capital in the old school, country club network way. What used to be multiple phone calls one investor at a time, is now a tweet that potentially reaches millions of people. With equity crowdfunding, a real estate entrepreneur can post a deal on a single portal and reach thousands of potential investors at once with the portal handling the subscription process and fund transfers electronically. Another positive aspect of real estate crowdfunding is that it has the potential to attract funding to emerging neighborhoods where traditional funding sources rarely go. Furthermore, most crowdfunding portals pool investors into a single purpose entity that acts as the investor of record, so that the pooled investors are only treated as one owner on the issuer’s cap table for accounting and corporate governance purposes.

Real estate funding portals come in two general varieties: those that act as matchmaking sites between real estate entrepreneurs seeking funding and investors seeking real estate investment opportunities, and others operated by real estate firms offering investment opportunities in their proprietary deals.

Regulation A+ has proven to be an enormously popular capital raising pathway for diversified REIT-like real property investment vehicles because of the ability to raise up to $50 million from the general public (not just accredit investors) in a streamlined mini-public offering process and then invest those proceeds in several projects. Like conventional real estate funds, these investment vehicles generally conduct their capital raises prior to identifying specific projects. Other real estate professionals using crowdfunding are using the Rule 506(c) model, allowing them to raise an unlimited amount over the internet albeit only from accredited investors. Under this model, the real estate entrepreneur typically first identifies a project and then offers the investment to prospective investors under offering materials that describe the particular project.

Some real estate institutions have taken the crowdfunding plunge and launched crowdfunding platforms of their own, with Arbor Realty Trust/AMAC claiming to be the first institution to do so with its ArborCrowd platform. ArborCrowd markets one deal at a time and writes a check upfront, which allows a property’s sponsor to close quickly on its acquisition. ArborCrowd then offers interests in the investment vehicle through its platform to accredited investors under Rule 506(c), with minimum individual investments of $25,000. I checked on SEC’s EDGAR site and saw that ArborCrowd has done seven deals thus far, aptly named ArborCrowd Investment I-VII, respectively, which average approximately $3 million each.

Real estate funding portals come in two general varieties: those that act as matchmaking sites between real estate entrepreneurs seeking funding and investors seeking real estate investment opportunities, and others operated by real estate firms offering investment opportunities in their own proprietary deals.  There are currently over 100 real estate crowdfunding platforms; some of the more established include Fundrise, RealtyMogul, CrowdStreet, Patch of Land and RealCrowd.

In My Backyard

And now we get to the more intriguing use of equity crowdfunding by real estate entrepreneurs: giving community residents skin in the game and incentivizing them to support a local development project.  Most major development projects are likely to be challenged by the not-in-my-backyard phenomenon, and such opposition can derail, delay or increase project costs dramatically. Whether the project is affordable housing, a power plant or a sewage treatment facility, the developer can expect opposition from a vocal NIMBY minority, irrespective of how much the proposed project is needed by the community at large.  An equity crowdfunding campaign could be a powerful tool to convert opponents and mobilize pro-project allies. One approach could be for sponsors to allocate some percentage, e.g., 10%, of a crowdfunding offering for investors residing within some given mile radius of the project. Another approach might be to conduct simultaneous offerings, one under Title III within the $1,070,000 cap with the hope of attracting local residents to invest, and a larger parallel offering to accredited investors under Rule 506(c).

Conclusion

Real estate crowdfunding is still in its nascent stages. But as awareness grows, smart reforms are implemented to improve the rules and the market matures, I believe real estate developers will embrace equity crowdfunding as both a way to fund projects that are neglected by traditional funding sources and as a strategic tool to enlist community support and overcome opposition.

 

[1] Technically, the most popular private offering method (Rule 506(b) of Regulation D) actually allows investment from up to 35 non-accredited investors (and an unlimited number of accredited investors). But nearly all such offerings have historically been made only to accredited investors because doing so makes the specific disclosure requirements in the Rule inapplicable.

On December 19, 2018, the Securities and Exchange Commission issued final rules to permit reporting companies under the Securities Exchange Act to offer securities under Regulation A (affectionately referred to often as Regulation A+), as mandated by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.  The rule amendments also provide that so long as an issuer is current in its Exchange Act reporting, its periodic Regulation A reporting obligation will be deemed to be met. I previously blogged here about the SEC’s statutory mandate to make Exchange Act reporting companies Regulation A eligible.  The rule amendments are effective upon publication in the Federal Register.  This post will identify particular features that would make Regulation A attractive for Exchange Act reporting companies.

The amendments will likely impact U.S. and Canadian reporting companies seeking to conduct public offerings within the Regulation A offering limit of $50 million, particularly offerings of non-exchange-listed-securities. That’s because blue sky preemption is available for Tier 2 of Regulation A, but is generally not available for non-exchange-listed securities sold in registered offerings. During 2017, there were approximately 584 reporting companies with registered securities offerings of up to $50 million that would now be eligible for Regulation A, including approximately 267 offerings of non-exchange-listed securities.

The amendments may also benefit previous Regulation A issuers that became Exchange Act reporting companies and that may seek to engage in follow-on Regulation A offerings.

Exchange Act reporting companies may also be attracted to Regulation A’s more flexible “test-the-waters” communication rules for soliciting investor interest as compared with registered offerings. Although companies qualifying as “emerging growth companies” are also permitted to test the waters in registered offerings, such solicitations are limited to qualified institutional buyers and institutional accredited investors and exclude individuals. Regulation A’s test-the-water rules permit issuers to solicit all prospective investors, including individuals, and without a requirement to file test-the-waters materials (as is the case with registered offerings).

Regulation A also contains a safe harbor from integration of Regulation A offerings with prior offers or sales of securities, as well as with subsequent offers or sales of securities registered under the Securities Act. The flexibility to alternate between Regulation A and registered offerings may be particularly valuable for Exchange Act reporting companies, particularly those that are uncertain about whether their future funding strategy will rely on Regulation A or registered offerings.

Finally, the conditional exemption for Tier 2 securities from the shareholders of record threshold for Section 12(g) registration purposes would be attractive for Exchange Act reporting issuers because maintaining a lower number of shareholders of record would make it easier to deregister and suspend Exchange Act reporting in the future.

On the flip side, one disadvantage worth noting is that Regulation A does not permit at-the-market offerings, which may limit the attractiveness of Regulation A for some Exchange Act reporting companies seeking the flexibility of at-the-market offerings.

On November 27, 2018, the United States District Court for the Southern District of California denied the Securities and Exchange Commission’s motion for a preliminary injunction to block an initial coin offering, finding the Commission did not meet its burden of showing the digital token in question was a security. Although this appears to be the first Federal decision against the Commission on the question of whether a token is a security under the Howey test, and may encourage some issuers with the resources to do so to resist SEC enforcement efforts, the order is extremely narrow in scope and is not likely to deter the Commission’s ICO enforcement efforts or shed much light on when if ever a token is not a security.

The issuer in this case, Blockvest LLC, is purportedly seeking to develop the “first licensed and regulated tokenized crypto currency exchange and index fund based in the U.S.” Earlier this year, it announced a plan to issue tokens in three stages: a private sale with a 50% bonus, followed by a “pre-sale” with a 20% bonus, and then a $100 million ICO to be launched on December 1, 2018.

In its original complaint filed on October 3, the Commission premised its fraud case on the notion that Blockvest’s token was a security without analyzing the facts under Howey, but rather by asserting that Blockvest itself conceded that its BLV token was a security by filing a Form D with the Commission and stating on its website that it was “Regulation A+ compliant and can offer [its] securities offering to Unaccredited Investors all over the globe” (emphasis added). See my last blog post regarding the Blockvest offering and its apparent offering exemption confusion.

In mid-October, U.S. District Judge Gonzalo Curiel, issued an ex parte (i.e., with only the Commission appearing before him) temporary restraining order in this case freezing Blockvest’s assets related to the ICO, based solely on the Commission’s version of the facts and largely because of multiple false claims made by Blockvest in its ICO promotional materials that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte.

As to the issue of whether Blockvest’s BLV token was a security, because the earlier TRO motion was made ex parte, the Court based its factual findings at that procedural stage entirely on what the Commission had asserted, namely that investors had invested more than $2.5 million in BLV tokens, which constituted 18% of the offering, and that the purchasers were interested primarily in the profit the BLVs were expected to generate given that Blockvest’s website promised that the BLVs would generate passive income.

But in Blockvest’s brief opposing the preliminary injunction motion and in a related written declaration by its founder Buddy Ringgold, the defendants offered a completely different factual narrative. They asserted that in fact no tokens were sold to the public and that Blockvest never received any money from their sale, and that Blockvest had only one investor (Rosegold Investment, in which Ringgold himself and friends and family were investors). Further, they asserted that BLV tokens were only used to test the platform by 32 “testers” who contributed less than $10,000 in the aggregate.  The BLV tokens were never released to the testers and the testers could not remove the tokens from the platform. Presumably, the testers could not resell them for profit.

The injunction rejection order states that “Ringgold recognizes that mistakes were made” but does not specify what those were. Presumably, it’s a reference to the various misrepresentations about regulatory endorsement. It may also refer to allowing eight of 17 investors in Rosegold (the investment vehicle) to write “Blockvest” and/or “coins” on their checks. It may also be a reference to Blockvest’s website temporarily featuring a credit card function with a “buy now” button. As to the SEC’s allegation that Blockvest had raised $2.5 million from investors, as Blockvest had boasted on social media, Blockvest explained it away as an “overly optimistic” statement and that in any event the funds were not intended to come from the public but rather from one investor, David Drake, and had fallen through anyway. Ringgold maintains the mistakes were made in the early stages of development when Blockvest’s chief compliance officer had not yet reviewed all the materials.

Unlike the TRO order, the injunction rejection order does invoke the Howey test, under which an instrument is deemed to be an investment contract and thus a security if it involves (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others. Judge Curiel addressed the first and third prongs of Howey, but not the second.  Under the first prong, “investment of money”, Judge Curiel examined not what the testers’ intent was in committing funds, but rather what Blockvest represented to the testers and what the testers relied on. Here, Judge Curiel found that the Commission and Blockvest provided “starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test BLV tokens”, and that consequently the court could not make a determination as to whether the test BLV tokens were “securities” under the first prong of Howey.  As to the second prong, “expectation of profits”, which Judge Curiel identified as either through capital appreciation or profit participation, he once again found that the Commission had not met its burden of proving expectation of profit.

So what are the key takeaways here? The competing factual narratives suggest this to be a narrow ruling. It must be kept in mind that this order comes without the benefit of full discovery; it’s basically “he said/she said”.  And without full discovery to address disputed issues of material facts, the court could not conclude that the Commission had met its burden in establishing that the BLV token offered to the 32 test investors was a security. Also, the Commission may have brought this case prematurely inasmuch as it was under the impression that the tokens had already been sold to the public; Blockvest in turn asserted facts indicating that no tokens had yet been issued (or offered) to the public and the tokens purchased by the testers were for testing purposes only and never released from the platform. It’s also unclear whether the Commission will pursue this case inasmuch as it has already secured Blockvest’s commitment to cease all efforts with respect to the ICO and to give the Commission 30 days’ notice of any resumption of efforts in this regard. Nevertheless, the order does serve as a reminder that the Commission, when seeking enforcement against an ICO in court, will have the burden of establishing that each of Howey’s prongs have been met, and suggests that future cases may be decided on the issuer’s actual marketing efforts and representations to purchasers and not on subjective perceptions of those purchasers’ expectations of profit.

If you were looking for a safe blockchain investment and had the chance to invest in the “first licensed and regulated tokenized cryptocurrency exchange and index fund based in the U.S.” and audited by a Big 4 accounting firm, you might do it, right? One problem: turns out it’s not licensed, regulated or audited.

On October 11, 2018, the Securities and Exchange Commission announced it had obtained an emergency court order halting Blockvest, LLC’s initial coin offering, whose sponsors falsely claimed that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte. None of that was true. The sponsors claimed they had already raised more than $2.5 million in pre-ICO sales of its digital token, BLV, and that it sought to raise an aggregate of $100 million in the ICO. The order also halts ongoing pre-ICO sales by Blockvest and its founder, Reginald Buddy Ringgold, III, a/k/a Rasool Abdul Rahim El.

The most brazen aspect of the alleged fraudulent scheme was the sponsors’ apparent creation of a fictitious blockchain regulatory agency which they call the “Blockchain Exchange Commission” or “BEC”, which they claim “regulates the blockchain digital asset space to protect digital asset investors”.  In May 2018, roughly one month after filing a Form D for the BLV offering (see below), Ringgold created the BEC, renaming a company that had been previously incorporated under various names including “Fartlife.” The BEC seems to plagiarize the SEC’s logo and mission statement, and gives itself the same address as SEC headquarters (100 F Street, NE, Washington, DC).  The BEC’s LinkedIn page includes a logo nearly identical to the SEC’s logo (see left), as well as the following mission statement, also uncannily similar to the SEC’s:

“The mission of the BEC is to protect investors; and assist in maintaining fair, orderly, and efficient markets within the Blockchain Digital Asset Space…The Blockchain Exchange Commission, or BEC, is dedicated to investor protection and market integrity.”

Blockvest also appears to be confused about securities offering rules. It filed a Form D with the SEC on April 16, 2018, claiming an exemption under Rule 506(c), which requires that all purchasers be accredited investors and that the issuer use reasonable methods to verify status. The SEC’s complaint states that, on information and belief, Blockvest has not taken reasonable steps to ensure that BLV investors are accredited. Also, despite their Form D, Blockvest’s website invokes Regulation A. Never mind that Regulation A has an offering limit of $50 million (Blockvest is seeking $100 million in its ICO), and prohibits any sales until the issuer has filed an offering statement on Form 1-A and the SEC has issued a notice of qualification. The SEC’s complaint further states that Blockvest’s website stated falsely that its ICO was “Reg A+ compliant” and can offer its securities to unaccredited investors all over the globe. Blockvest’s website now states that the “Pre-IPO testing the waters phase has been halted.” Testing the waters is a Regulation A concept.  Blockvest hasn’t filed a Form 1-A offering statement, nor has any offering been qualified by the SEC under Regulation A.

The SEC complaint should serve as a warning to issuers conducting unregistered ICOs to exercise caution and avoid language implying that that their tokens have been registered with the SEC, or that the SEC has passed on the merits of the offered tokens. This is why exempt offerings include the following legend in their disclosure documents:

THE SECURITIES OFFERED HEREBY HAVE NOT BEEN APPROVED BY THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION, OR ANY STATE SECURITY AUTHORITY. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL.

THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION DOES NOT PASS UPON THE MERITS OF OR GIVE ITS APPROVAL TO ANY SECURITIES OFFERED OR THE TERMS OF THE OFFERING, NOR DOES IT PASS UPON THE ACCURACY OR COMPLETENESS OF ANY OFFERING CIRCULAR OR OTHER SOLICITATION MATERIALS. THESE SECURITIES ARE OFFERED PURSUANT TO AN EXEMPTION FROM REGISTRATION WITH THE COMMISSION; HOWEVER, THE COMMISSION HAS NOT MADE AN INDEPENDENT DETERMINATION THAT THE SECURITIES OFFERED HEREUNDER ARE EXEMPT FROM REGISTRATION.

 

Private companies in the gig economy like Uber and Airbnb would love to issue compensatory equity to their platform participants, just like they’re able to do with their employees. The problem is that the exemption from registration for compensatory issuances only covers issuances to employees and consultants of the issuer.  Last July, however, the Securities and Exchange Commission published a concept release seeking comment on whether the exemption should be extended to equity issued to participants in the gig economy.  This past Friday, Airbnb delivered a comment letter to the Commission advocating for an expansion of the exemption to cover sharing economy participants. This blog post will seek to explain some of the key issues involved here.

Background: Rule 701

Rule 701 of the Securities Act of 1933 provides a safe harbor exemption from registration for equity securities issued as compensation by non-reporting companies to employees, consultants, advisors or de facto employees providing services to the issuer. The purpose of the exemption is to facilitate securities-based compensation; it’s not available for capital-raising issuances or any other issuances for any purpose other than equity compensation.

The aggregate sales price or amount of securities that may be sold during any rolling 12-month period must not exceed the greatest of (i) 15% of the issuer’s total assets, (ii) 15% of the outstanding amount of the class of securities being offered and sold under Rule 701, or (iii) $1 million.

The issuer must give all participants a copy of the benefit plan or contract setting forth the incentive equity.  Beyond that, if the aggregate sales price or amount of securities sold under Rule 701 during any rolling 12-month period exceeds $10 million, the issuer must also provide additional mandated disclosure, including risk factors and specified financial statements.

Finally, under the amendments to Section 12(g) of the Securities Exchange Act of 1934 introduced by the JOBS Act (which increased the shareholder thresholds at which issuers must register a class of securities under the Exchange Act to 2,000 or 500 non-accredited investors), persons holding only securities received under an employee compensation plan in a transaction exempt from registration (including under Rule 701) are not considered to be holders of record for calculating record holders under Section 12(g).

Concept Release on Compensatory Securities Offerings and Sale

The Securities and Exchange Commission published its Concept Release on Compensatory Securities Offerings and Sales on July 18, 2018. In the introductory sections of the concept release, the Commission described the characteristics of the gig economy where service providers use a company’s Internet platform for a fee to provide peer-to-peer services such as ride-sharing, food delivery, household repairs, dog-sitting, tech support and lodging. These are not traditional employment relationships, and so the participants aren’t deemed to be “employees” — or consultants, advisors or de facto employees – and thus are ineligible to receive securities in compensatory arrangements under Rule 701. But the same compensatory and incentive motivations to include equity in employee compensation may exist with respect to gig economy participants, i.e., alignment of interests, recruitment, retention and enhanced compensation relative to what a company may be able to pay in cash or other benefits.

Accordingly, in light of the significant evolution in the composition of the workforce since Rule 701’s last meaningful amendment 20 years ago, the concept release sought comment on possible ways to modernize the exemption and expand it to cover securities issued to participants in the gig economy.  In seeking comment from the public to determine what attributes of gig economy relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption, the Commission posed several specific questions, including the following:

  • What activities should an individual need to engage in to be eligible?
  • Should the test identify Rule 701 eligible participants as individuals who use the issuer’s platform to secure work providing lawful services to end users?
  • Should there be a sufficient nexus between the individual and the issuer to justify application of the exemption for compensatory transactions?
  • Should it matter whether individuals provide services to the issuer, or instead to the issuer’s customers or end users?
  • Does it matter whether that business activity provides a service typically provided by an employee or is more of an entrepreneurial nature?
  • Whether a potential eligibility test should consider the individual’s level of dependence on the issuer, or, conversely, the issuer’s degree of dependence on the individuals?
  • Should it matter what percentage of the individual’s earned income is derived from using the issuer’s platform?

Recognizing that extending eligibility to individuals participating in the gig economy could significantly increase the volume of Rule 701 issuances, the Commission posed these additional questions:

  • Would revising the rule have an effect on a company’s decision to become a reporting company?
  • Would such revisions encourage companies to stay private longer?
  • To what extent do companies utilizing “gig economy” workers issue securities as compensation to those individuals?
  • What effect would the use of Rule 701 for “gig economy” companies have on competition among those companies and newer companies and more established companies vying for the same talent?
  • Should a gig economy participant receive the same disclosure as an employee?

The Airbnb Comment Letter

In a letter dated September 21, 2018, Airbnb responded to the concept release and offered a convincing rationale for reforming Rule 701 as well as several interesting specific proposals.

As to rationale, Arbnb’s comment letter argues that expanding the category of persons eligible to receive securities under the Rule is consistent with the goals of the JOBS Act to facilitate entrepreneurship and growth startups. Doing so would further democratize share ownership and enable many ordinary individuals who have been effectively excluded from early stage investing to benefit from the potential growth of startups. It would align the interests of sharing economy companies with the service providers who use their platforms to the benefit of both. (Note that Airbnb is careful to use the term “sharing economy” rather than “gig economy”; for a good, concise explanation of the distinction, see here.) Extending the exemption to issuances to sharing economy participants would also incentivize individuals to leverage their assets to participate in the sharing economy and supplement their income. Finally, it would help younger and smaller companies compete with older and larger competitors yielding better outcomes for end users.

Because of the magnitude of Airbnb’s and other sharing economy companies’ participants, Airbnb asserts that the extension of Rule 701 to sharing economy participants would only be useful to those companies if they were allowed to exclude the recipients from the number of record holders under Section 12(g), as is the case with recipients under the current Rule; otherwise, such issuers would easily exceed either or both the 2,000 holder or 500 non-accredited investor holder threshold forcing those companies to register with the Commission and be saddled prematurely with its regulatory and reporting regime.

But shouldn’t sharing economy participants receive adequate disclosure when receiving securities? Airbnb asserts that most Rule 701 recipients are not making an investment decision when they receive their shares (which is why there’s no mandated disclosure obligation under the current Rule unless a dollar threshold is exceeded). Moreover, sharing economy participants would be expected to know much more about the issuer than typical investors, thus minimizing the need for disclosure. Finally, the primary motivation for issuing equity to participants would not be to raise capital but rather to align interests.

Airbnb advocates for the creation of a new subcategory of eligible recipients under Rule 701, which would be more restrictive than for recipients under the current Rule. The focus of any amendment to Rule 701 to create what Airbnb calls the Sharing Economy Award Exemption should be on the nature of eligible companies, nature of securities awarded to participants and transferability of the securities.

Eligible companies would need to satisfy the following criteria to ensure they are bona fide sharing economy companies and not just seeking to sell securities:

  • Provide a platform to allow third parties to provide goods and/or services to end users;
  • Derive a significant portion of its revenue from fees paid by platform participants;
  • Control the platform by either having the right to exclude a listing or participant for violating terms, or by determining amount of user fees and terms and conditions for receiving payment for goods and services sold on the platform.

Airbnb believes the securities permissible under the Sharing Economy Award Exemption should be more limited than currently allowed. Recipients should not be permitted to choose between securities or cash, so that they aren’t making an investment decision. Not more than 50% of the value received by the recipient from the issuer for goods and services sold on the platform over a 24 month period should be in the form of equity. And any equity award should not be made contingent on making a capital contribution, to ensure the absence of a capital raising motive.

Finally, Airbnb believes the restrictions on transferability of securities issued in the Sharing Economy Award Exemption should be more restrictive than under current Rule 701, even suggesting that it would be appropriate to provide that such securities be non-transferable prior to an IPO or a change in control. If such serious transfer restrictions are imposed and no cash is contributed in connection with the issuance, Airbnb believes any disclosure obligation should be minimal.