Lately I’ve been approached by current and prospective clients about online funding platforms, either by folks interested in forming and operating them or those interested in raising capital through them. There seems to be a lot of confusion surrounding how they work and what the legal issues are, so here’s my attempt to bring some clarity to this topic.
Quite simply, an online funding platform is any website that seeks to connect issuers seeking capital with investors willing to invest. Historically, the prohibition on general solicitation in private offerings meant as a practical matter that an issuer was limited to raising capital only from those with whom it had a preexisting relationship. In fact, the prohibition on general solicitation was considered by many to be the most significant obstacle to private capital formation. It’s for this reason that many private issuers seek the services of a placement agent, on whose preexisting relationships an issuer could piggyback. But securing the services of a decent placement agent by a startup looking to make a small offering (e.g., less than $1 million) could be daunting. Commonly referred to as crowdfunding, the phenomenon of online funding platforms is essentially the internet coming to the capital raising industry, which has the potential to transform it the same way the internet disrupted the publishing, retail and transportation industries.
Online funding platforms also have the potential to address another related problem. If you’re a startup located outside of the three major venture hubs – Bay Area, New York Metro and Boston – your chances of raising capital are even slimmer. According to PitchBook’s analysis of second quarter 2015 venture capital activity by region, those three regions accounted for nearly half of total global venture capital invested. Funding platforms have the potential to reach neglected regions of the world.
So, if you’re looking to create and operate an online funding platform, there are two legal issues to be concerned about: the prohibition on general solicitation, and broker dealer regulation.
The earliest online funding platforms were launched in the ‘90s long before the JOBS Act created an exemption for private offerings using general solicitation. So from their inception, funding platforms sought to avoid engaging in any act that could be construed to fall within the prohibition. And even to this day, nearly two years after the accredited investor only exemption under Rule 506(c) which allows general solicitation, most funding platforms still rely on the old exemption under Rule 506(b) which prohibits it.
So how does one use the internet to conduct an offering without engaging in a general solicitation? The answer lies in the concept of the preexisting relationship, which a platform may establish under the right circumstances through a process of pre-screening, password protection and cooling off. The practice was blessed by the SEC in its 1998 Lamp Technologies no-action letter, in which the SEC staff found that the pre-qualification of accredited investors and posting of a notice concerning a private fund on a website administered by Lamp Technologies, Inc. (“LTI”) that is password-protected and accessible only to pre-screened accredited investor subscribers would not involve general solicitation. Subscribers who pre-qualified as accredited investors and paid a subscription fee would receive a password granting them access to the site, and subscribers were then subject to a 30-day cooling off period during which they could not invest. The SEC staff noted that (i) both the invitation to complete the questionnaire and the questionnaire itself would be generic in nature and would not reference any of the investment opportunities on the site, (ii) the password-protected site would be accessible to an investor only after LTI confirmed accredited investor status, and (iii) a potential investor could purchase securities only after the 30-day cooling-off period.
Funding portals must choose between two alternative but mutually exclusive business models: broker-dealer and venture fund. In the former, investors purchase the securities of, and invest directly in, the operating company; in the latter, the platform organizers form a special purpose vehicle (“SPV”), investors buy shares in the SPV and the operating company closes the round with only one investor (the SPV). Among other things, the choice of business model has enormous consequences for the operating company’s cap table.
Many sponsors of funding platforms structure themselves so as to not be deemed to be a “broker-dealer”, which would mean having to register with the SEC as a broker-dealer and be subject to reporting, disclosure and other burdensome regulations.
Under Section 3(a)(4) of the Securities Exchange Act of 1934, a “broker” is defined as any person that is “engaged in the business of effecting transactions in securities for the account of others.” According to the SEC, a person “effects transactions in securities” if he participates in such transactions “at key points in the chain of distribution”, and that a person is “engaged in the business” if he receives transaction-related compensation and holds himself out as a broker. The determination as to whether an entity is acting as a “broker” requires a facts and circumstances analysis, but the SEC attributes great weight to whether transaction-based compensation is paid.
Some funding platforms are operated by registered broker-dealers, or are owned, operated by or partnered with registered broker-dealers. These platforms facilitate sales of the operating company’s securities directly to accredited investors. The broker-dealer model platforms receive transaction-based compensation, typically consisting of a percentage of the funds raised, generally ranging from one to ten percent, depending on the offering amount and type of deal.
Other funding platform operators avoid broker-dealer regulation like the plague. Before the JOBS Act, the SEC provided some guidance in the form of no-action letters that conditioned relief from broker-dealer regulation on the platform not providing investment advice, receiving transaction-based compensation, participating in negotiations or holding investor funds. Section 201 of the JOBS Act provides an explicit broker-dealer exemption for online platforms to broker capital raising transactions under Rule 506 (even with general solicitation), provide ancillary services other than investment advice and provide standardized deal documents so long as the platform does not receive transaction-based compensation or handle customer funds or securities and is not a “bad actor.”
FundersClub sources start-ups for its affiliated funds or SPVs to invest in and then posts information on its website that is only available to FundersClub members, all of whom are accredited investors. The SPV relies on Rule 506 to conduct an offering in the SPV. FundersClub negotiates the terms of the SPV’s investment in the start-up. FundersClub does not receive any transaction-based compensation other than administrative fees; instead, it receives a carry of 20% or less of the profits of the SPV but never exceeding 30%. In stating that it would not recommend enforcement action under Section 15(a)(1) of the Exchange Act, the Staff noted that FundersClub’s activities appear to comply with Section 201 of the JOBS Act, in part because it receives no compensation in connection with the purchase or sale of securities.
In AngelList, the SEC staff noted AngelList’s platform must be “exclusively available” to accredited investors and that AngelList may not receive any transaction-based compensation or solicit investors outside of the website itself. In AngelList, a “lead angel” would source the start-ups and structure terms in exchange for a back-end carried interest that would be shared between an AngelList-affiliated investment adviser and the lead angel. The significance of this letter appears to be in not treating back-end carried interest as transaction-based compensation.