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.

If you’re thinking of airdropping free tokens or implementing a cryptocurrency bounty program, be careful. The Securities and Exchange Commission just issued a cease and desist order (the “Order”) with respect to an initial coin offering, finding the issuance of “free” tokens through a related bounty program in exchange for online promotional services constituted an unregistered sale of securities and thus a violation of the registration provisions of the federal securities laws. Although courts and the Commission have traditionally held that the transfer of “free” shares of stock is a “sale” of securities where the issuer derives some benefit from the transfer, the Order is the first treatment of the issue in the context of cryptocurrency bounty programs.

Airdrops and Bounty Programs

An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. The main goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Like airdrops, bounty progrms are a means of advertising and have become a useful part of many ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as marketing and making improvements to aspects of the cryptocurrency framework. Airdrops and bounties are similar in that both involve issuing seemingly free tokens. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements. But in a bounty program, individuals must execute assigned tasks before receiving the tokens.

The Facts

According to the Order, Tomahawk Exploration LLC and its founder attempted to raise money through the sale of blockchain-based digital tokens called “Tomahawkcoins” or TOM to fund oil exploration in California. Although Tomahawk failed to raise money through the ICO, it issued approximately 80,000 TOM to approximately 40 wallet holders on a decentralized platform as part of a bounty program in exchange for online promotional and marketing services to promote the ICO. Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 TOM for activities such as making requests to list TOM on token trading platforms, promoting TOM on blogs and other online forums like Twitter or Facebook, and creating professional picture file designs, YouTube videos or other promotional materials.

Legal Background

Section 5 of the Securities Act of 1933 makes it unlawful to offer or sell any security unless a registration statement is in effect as to that security or there is an available exemption from registration. The terms “offer” and “sale” are defined very broadly in the Securities Act. Section 2(a)(3) of the Securities Act defines an “offer” of securities as any “attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value”. Similarly, Section 2(a)(3) defines a “sale” of securities” under Section 2(a)(3) of the Securities Act as “every disposition of a security or interest in a security, for value.”

The Order

The Order found that the bounty program constituted an offer of securities under Section 2(a)(3) of the Securities Act because it involved an offer to dispose of a security for value. The Order states that the lack of monetary consideration for the shares doesn’t mean there wasn’t a sale or offer for sale for purposes of Section 5, asserting that a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit. According to the Order, the value or real benefit that Tomahawk received in exchange for the token distributions under the bounty program was in the form of promotion of the ICO on blogs and other online forums and in the creation of a public trading market for its securities. The decentralized platform on which Tomahawk issued the TOM tokens was publicly accessible to U.S. persons and others throughout the offering period, and bounty recipients subsequently traded their TOM tokens on a platform for digital assets.

Bounty program and airdrop enthusiasts would probably point to the Howey test, identified by the Commission as the relevant standard for determining whether a token is an investment contract and thus a security, to support the proposition that tokens issued in airdrops and bounty programs should not be securities. Howey states that for an instrument to be a security, there must be an investment of “money” (in a common enterprise with a reasonable expectation of earning a profit through the efforts of others); since no money is exchanged, the argument is that there is no security. But the Order makes it clear that the Commission continues to interpret the Howey test’s reference to “money” very broadly. That interpretation was made clear in the 2017 DAO Report:

“In determining whether an investment contract exists, the investment of “money” need not take the form of cash. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”).

Possible Exemption: Rule 701

Just because a token is deemed to be a “security” or its issuance a “sale” of securities doesn’t mean it’s illegal. It just means the issuer needs either to register the offering with the SEC (not happening) or satisfy the requirements for an exemption from registration. One possible exemption that token issuers should consider when pondering a bounty program is Rule 701, which is the primary exemption used by non-reporting companies to issue equity incentive awards without registration to employees and certain consultants. There are three key elements here. First, the issuer would need to have a written instrument evidencing the recipients’ right to receive tokens as compensation for services. Second, the bounty program cannot be related to raising money, so the announcement regarding the bounty program should promote the product or service as opposed to fundraising. Finally, the recipients of the tokens in the bounty program may not be engaged in any securities promotion on behalf of the issuer.

It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

Accredited Investor Definition: Fair Investment Opportunities for Professional Experts Act

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

VC Fund Exemption – Investment Advisor Registration: Developing and Empowering our Aspiring Leaders Act

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder.  VC funds should have the flexibility to be able to buy those shares.  Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules.  Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser.  Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board.  Retail investors don’t enjoy these benefits under Reg CF.