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“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”

Such was the question posed by William Hinman, Director of the Securities and Exchange Commission’s Division of Corporation Finance, in his speech at the Yahoo Finance All Markets Summit: Crypto event in San Francisco on June 14. Hinman’s answer: a qualified “yes” where 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. This may be the most positive guidance yet from the SEC on when a digital asset might be deemed not to be a security under the Howey test. It may help create a pathway for blockchain startups to sell without registration or exemption digital tokens that had previously been sold in securities offerings, and should provide a measure of comfort to past and future issuers of SAFT-based ICOs.

After making his overarching point that a digital asset originally offered in a securities offering could be later 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, Hinman went on to describe the circumstances under which he believes that could occur. In doing so, Hinman concentrated primarily on the last prong of the Howey test, namely whether an expectation of profit derived through the efforts of others, and suggested that the inquiry should focus on two areas: (i) who are the participants, and (ii) how is the digital asset structured?

Who are the Participants?

When determining whether a digital asset should be deemed to be an investment contract, Hinman stated that one should “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”

He suggested that this question will always depend on the particular facts and circumstances of a transaction, and offered the following non-exhaustive list of factors:

  • Promoter’s efforts play a significant role in the development and maintenance of the digital asset and its potential increase in value.
  • Promoter retains a stake or other interest in the digital asset such that he would be motivated to expend efforts to cause an increase in its value, particularly where purchasers are made to reasonably believe such efforts will be undertaken.
  • Amount raised in the ICO exceeds amount needed to establish a functional network and use of proceeds includes supporting the token’s value or increasing enterprise’s value
  • Promoter continues to expend funds from proceeds or operations to enhance functionality and/or value of system within which the tokens operate.
  • No persons or entities other than the promoter exercise governance rights or meaningful influence.

How is the digital asset structured?

Hinman then pointed to the existence of contractual or technical methods to structure digital assets so they function more like consumer items and less like a security, including the following:

  • Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
  • Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
  • Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
  • Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
  • Is the asset marketed and distributed to potential users or the general public?
  • Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
  • Is the application fully functioning or in early stages of development?

Information Asymmetry

Director Hinman also pointed out that one of the rationales for the securities laws is to remove the information asymmetry between promoters and investors by mandating adequate disclosure to address that asymmetry. That disclosure regime is needed when a token purchaser relies on a token seller’s efforts to develop a network and generate a potential return on investment for the token purchaser.

Conversely, when the promoter’s efforts are no longer an important factor in determining the enterprise’s success, “material information asymmetries recede” and the protections of the securities laws may no longer be necessary. Moreover, as a practical matter, when a network becomes decentralized, the ability to identify a promoter to make the mandated disclosures “becomes difficult, and less meaningful.”

Implication for SAFTs

The Simple Agreement for Future Tokens or SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

In a SAFT-based ICO, the SAFT itself is generally acknowledged to be an investment contract and thus a security, and sold to accredited investors under Rule 506(c) of Regulation D. A quick search on EDGAR reveals there have been 37 Form D filings identifying the type of security offered as a SAFT. No court or regulator has interpreted the SAFT framework and whether or not the tokens to be ultimately issued are securities.

Director Hinman’s view that certain tokens initially issued by blockchain startups as securities may have the potential to become part of a decentralized network and no longer bear the attributes of securities may give legitimacy to SAFT-based ICOs. Interestingly, the only place where the word SAFT appears in the speech is in footnote 15 of the written version. In that footnote, Hinman states that although nothing in his remarks should be construed as opining on the legality of a SAFT (because the analysis of a particular SAFT must turn on the economic realities of the particular case), “it is clear from [his speech that he believes] that a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”

Buried in new legislation mainly intended to ease Dodd-Frank restrictions on small banks is an expansion of Regulation A eligibility to include SEC reporting companies. Previously, such companies were not eligible. The new access to Regulation A will create a viable mini-public offering pathway for SEC reporting companies, particularly those not eligible for registering securities on the streamlined Form S-3 registration statement.

Regulation A is an exemption from registration requirements for offerings of up to $50 million in any 12-month period, subject to eligibility, disclosure and reporting requirements.  The exemption, often referred to as Regulation A+, provides for two tiers of offerings: Tier 1 for offerings of up to $20 million and Tier 2 for offerings of up to $50 million, in each case during any 12-month period. Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements, but consequently benefit from preemption of state securities law registration and qualification requirements. As originally adopted, SEC reporting companies were not eligible to use Regulation A+.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which primarily is intended to ease the burdens on smaller banks under Dodd-Frank. Buried in the Act is Section 508, entitled “Improving Access to Capital”, which expands the availability of Regulation A+ by requiring the SEC to remove the requirement that the issuer not be an SEC reporting company. Section 508 also requires the SEC to amend Regulation A+ so that any company subject to Section 13 or 15(d) of the Exchange Act will be deemed to have met the periodic and current reporting requirements of Regulation A+ if it satisfies the Section 13 reporting requirements.

Currently, public companies seeking to conduct small public offerings in the range of up to $50 million would likely register such offering with the SEC through a streamlined registration statement on Form S-3, which has certain significant benefits. Form S-3 is a short-form registration statement which allows the issuer to update the registration statement’s disclosure prospectively through incorporation by reference of the issuer’s subsequently filed current reports on Form 8-K and periodic reports on Form 10-Q and Form 10-K. This “evergreen” feature means that a company generally will not need to file any post-effective amendments to the registration statement, a time and cost saving advantage.

The process of completing a registered offering on Form S-3 is generally quicker and cheaper than even a Reg A+ offering. So as a practical matter, it’s unlikely that S-3 eligible issuers will opt to do a Reg A+ offering over S-3.

But use of Form S-3 is subject to several stringent issuer and transaction eligibility requirements, including that the issuer be organized and have its principal business operations in the United States and that it have a public float, i.e., aggregate market value of common equity held by non-affiliates, of at least $75 million (unless it’s a listed company, limits the offering amount to not more than one-third of the company’s public float during any 12-month period and is not a shell company).

So issuers that are not S-3 eligible may decide that a Reg A+ offering is an attractive alternative for raising up to $50 million. The benefits of Reg A+, even to an SEC reporting company, could be significant: freedom to “test the waters” with investors prior to launch, faster SEC review relative to registered offerings and preemption of state blue sky registration in Tier 2 offerings.

A recent report on the state of Regulation Crowdfunding published by a major crowdfunding advisory firm is cause for both celebration and renewed reform efforts. The $100 million aggregate funding milestone and the prorated year over year growth data indicate that the market, while still in its infancy, is growing at a nice pace. Nevertheless, a closer look at the data suggests that Regulation Crowdfunding in its current framework is not reaching its potential and remains in serious need of reform.

The Report

The 2017 State of Regulation Crowdfunding, published by crowdfunding advisory firm Crowdfund Capital Advisors, contains several helpful points of data and analysis. The data in the report were retrieved from the various forms that are required to be filed by issuers in Regulation CF equity crowdfunding transactions under Title III of the JOBS Act, which are publicly available on the SEC’s EDGAR website. These include offering statements on Form C, amendments to those statements on Form C/A, offering progress updates on Form C-U and annual reports on Form C-AR.

The report could be downloaded for free here. Some of the key findings are as follows:

  • The number of unique offerings increased 267% from 178 in 2016 to 481 in 2017.
  • Proceeds increased 178% from $27.6 million in 2016 to $49.2 million in 2017.
  • As of today, there are $100,072,759 in aggregate capital commitments.
  • The number of successful offerings increased 202% from 99 in 2016 to 200 in 2017
  • The total number of investors in Reg CF investments increased 158% from 28,180 in 2016 to 44,433 in 2017.

The foregoing data need to be put into some context. First, Reg CF only went live on May 16, 2016, and so the year against which 2017 is compared is only slightly over one-half of a calendar year; data from that year should be annualized to reflect the fact that deals were only happening for approximately 65% of the year. Also, on the advice of funding portals, issuers are setting extremely low target offering amounts, in some cases as low as $10,700 (1% of the maximum allowed in any rolling 12-month period). Accordingly, the above data on successful offerings may need to be viewed somewhat skeptically to the extent “successful offering” is determined based on whether or not an issuer exceeded its own stated targeted offering amount.

The report also offers the following points of analysis:

  • The market is growing at a rapid pace.
  • The pace of capital into funded offerings appears to be steady without showing signs of abnormal activity or irrational investor behavior.
  • The rapid increase in the number of offerings and investors proves that there is appetite for Reg CF from both issuers and investors.
  • Given the lack of irregularities or fraud, Reg CF (and the structure under which it provides for transparency) should be advocated by policy makers and government organizations.

The report does not offer data to support the premise of that last point, i.e., that there exists a lack of irregularities or fraud.

But We Still Need Further Reform

While the $100 million milestone should be cheered, there are objective reasons to believe that Reg CF is grossly underperforming as a capital raising pathway and failing to meet its potential. It was intended to democratize startup investment, to enable hundreds of millions of people who were effectively shut out of private offerings because of their lack of accredited investor status to invest in these deals for the first time. It’s believed that over 90% of the U.S. population would fall into that category and that there’s an estimated $30 trillion socked away in their savings accounts. If only 1% of that were to be reallocated to Reg CF deals, we’d be seeing a market of $300 billion dollars, which would dwarf the $72 billion in U.S. VC investment in 2017.

Which leads me to the need for further reform. Much has already been said about the low $1.07 million cap on issuers. Although the cap should certainly be raised to balance out the amount raised with the disclosure, filing and other burdensome requirements as well as to make Reg CF more competitive with other available pathways, the reality is that most Reg CF offerings are not even reaching the existing cap. That suggests that there must be other impediments in the rules that should be addressed to help companies raise permissible amounts.

Chief among these impediments in my view is the exclusion of investment vehicles from Reg CF. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the 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. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

Reg CF should also be reformed to raise the investment caps for investors. Currently, investors are capped based on their income or net worth, with a separate hard cap irrespective of net worth or income. At a minimum, there should be no hard cap for accredited investors. Makes no sense that Mark Zuckerberg be capped at $107,000.

Finally, under current rules, any Reg CF funded company that crosses a $25 million asset threshold would be required to register with the SEC under the Securities Exchange Act and become an SEC reporting company. This would have the potential to create a perverse incentive for a company not to grow, and seems inconsistent with the spirit of Reg CF, which for the first time allows companies to fund their growth by offering securities to the public without registering with the SEC. The asset threshold triggering Exchange Act registration should either be raised or eliminated.

Although Reg CF is still in its infancy and the data in the report could be read to indicate steady growth in a seemingly healthy emerging market, there is also reason to believe that the market has not even begun to tap its potential, a potential that may never be realized if perceived impediments are not mitigated or removed.

Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs.  Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale.  In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong.  Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way.  It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit.  I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer.  I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.

A recent Delaware Chancery Court decision provides important guidance on what types of defective corporate acts may be ratified under Section 204 of the Delaware General Corporation Law (the “DGCL”), and what types may not.  Paul Nguyen v. View, Inc. also underscores the importance of focusing on whether to opt out of the class vote required by DGCL Section 242(b)(2) for changes in authorized capital, which effectively gives the common stock a veto over future funding rounds.

The facts of the case are as follows. View, Inc. develops smart windows that allow the light, heat, shade and glare properties of the glass to be controlled manually or electronically, thus enhancing comfort and reducing energy consumption and greenhouse gas emissions. After closing on a Series A round, View replaced its founder, Paul Nguyen, as CEO and CTO. While in mediation over the termination, View proposed a new Series B round of funding, which under Section 242(b)(2) of the DGCL required the consent of Nguyen as holder of a majority of the common. The parties then signed a settlement agreement in which Nguyen consented to the Series B, subject to a seven day revocation right. When Nguyen discovered the terms of the Series B would materially diminish his rights, he revoked his consent within the revocation period. Unbeknownst to him, View had already closed on the Series B. Nguyen then brought an arbitration proceeding against View, seeking a declaration that the revocation was valid and the Series B funding invalid. While the arbitration was pending, View closed on additional rounds C through F in an aggregate amount of over $500 million. After View filed two certificates of validation under DGCL Section 204 seeking to ratify the increase in authorized capital, Nguyen commenced the Chancery Court suit, which the parties agreed to stay pending the arbitrator’s decision on the validity of the consent revocation.

The arbitrator ruled that the revocation was valid and the Series B invalid. The ruling effectively meant that all of the related transaction documents were likewise invalid and void because Nguyen had not consented to them either. And since each of the subsequent rounds of financing rested on the Series B funding, the invalidation of the Series B effectively invalidated the Series C through Series F rounds as well, basically blowing up View’s capital structure. The Series A stockholders responded by seeking to resurrect the funding rounds through the ratification provisions of Section 204, initially by converting their preferred shares into common (thus becoming the majority holders of the class) and then by authorizing the filing of certificates of validation with the Delaware Secretary of State under Section 204.

The key issue in the case was whether an act that the holder of a majority of shares of a class entitled to vote deliberately declined to authorize, but that the corporation nevertheless determined to pursue, may be deemed a “defective corporate act” under Section 204 that is subject to later validation by ratification of the stockholders, an issue of first impression.

In 2014, the Delaware legislature created two alternative pathways for corporations to cure defective corporate acts. Section 204 provides that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided [in Section 204] or validated by the Court of Chancery in a proceeding brought under Section 205.” Previously, acts deemed “voidable” could be subsequently ratified, but acts deemed “void”, such as the issuance of shares beyond what is authorized in a company’s charter, were deemed invalid. Prior to Sections 204 and 205, corporations had no way to remedy “void” corporate acts, even if the failure to properly authorize the act was inadvertent. The ability to cure defective acts is critical. Startups often need to clean up such acts prior to a funding round or acquisition, both to satisfy investor or acquirer due diligence issues and to enable counsel to issue opinion letters.

The court found that the Series B round was not a “defective corporate act” that is subject to ratification under Section 204 and ruled that View should not be allowed to invoke ratification to validate a deliberately unauthorized corporate act. As the holder of a majority of the outstanding common which was entitled to a class vote, Nguyen’s vote was required in order to authorize the Series B. The failure to obtain such authorization was not an oversight; it was the result of an affirmative rejection by Nguyen. Thus, the distinction here is between a defective corporate act that results from an oversight, which is curable under Section 204, and a defective corporate act resulting from an affirmative rejection by the stockholders, which is not curable under Section 204 (or 205).

One obvious takeaway is that companies should respect arbitrators’ rulings and should not proceed with a transaction, let alone a series of transactions, until stockholder authorization has been secured. View’s pursuit of the Series B round during the revocation period, and thereafter of the Series C through F rounds while the arbitrator’s ruling on the consent revocation was pending, was reckless to say the least. As the court put it, “[o]ne must presume that View understood that if the arbitrator found in favor of Nguyen on the consent issue, then the later rounds of financing that rested on the Series B Financing would collapse when that block was removed from the tower of blocks that comprised the Company’s preferred stock offerings”.  One can only presume further that it did so against the advice of counsel or despite counsel’s warning of the risk.

The other takeaway here is that companies should consider carefully whether to opt out of the class vote requirement under DGCL Section 224(b)(2) for changes in capital structure. Section 224(b)(2) requires any increase or decrease in authorized shares to be approved by holders of a majority of each class of stock entitled to vote, but allows corporations to opt out by providing as much in the charter. The National Venture Capital Association’s model amended and restated certificate of incorporation has an optional provision that states that the common and preferred will vote together as a single class on all proposals to increase or decrease the authorized capital, irrespective of the provisions of Section 242(b)(2). Failure to opt out effectively provides the common stockholders with a veto over future capital raises because each subsequent round requires an amendment to the charter not just to create the new series of preferred, but also to increase the number of authorized common to accommodate conversion of the preferred. Failure to eliminate the class vote requirement will force the company to have to seek the consent of holders of a majority of the common, providing them with unintended leverage in connection with a deal that’s presumably in the best interests of the company and its shareholders.

On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the 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.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

Earlier this year, Union Square Ventures Managing Partner Fred Wilson famously referred to corporate VCs as “The Devil”, when he asserted that companies should not be investing in other companies, that they should be buying other companies but not taking minority positions in them, that the “access” rationale for corporate venture is a reason why entrepreneurs should not want them in the room and that startups who take investment from them are “doing business with the devil”.  Ouch!  So why the hostility?

Corporate venture capital refers to venture style investments in emerging companies made by venture capital divisions of large companies, as distinguished from venture investments made by the more google Vtraditional investment funds that most people associate with venture capital. I’ve been seeing corporate VC term sheets with greater regularity lately, so I decided to blog about some of its characteristics, advantages and disadvantages relative to institutional venture capital.

Indeed, corporate VC appears to be on the rise. According to the National Venture Capital Association, corporate venture deployed over $7.5 billion in 905 deals to startups in 2015, a fifteen year high and representing 13% of all venture capital dollars invested for the year but 21% of all deals consummated.  From 2011 to 2015, the number of corporate VC divisions in the United States rose nearly 50% from 1,068 to 1,501   And according to CB Insights, the average corporate VC deal size has consistently been larger than the average institutional VC deal size over the last 14 quarters ended June 2016, with corporate VC deal sizes averaging above $20 million over the previous five quarters.

intel capitalBig technology and healthcare companies have long made venture style investments in startups. Google Ventures, Intel Capital, Dell Ventures and Cisco Investments are veteran corporate VCs that immediately come to mind. But it’s the relatively recent cisco investmentsarrival of new corporate investors that have driven the growth in corporate VC, in sectors ranging from transportation (e.g., GM’s $500 million investment in Lyft) to financial services to convenience stores.

Corporate VC programs have dramatically different overall objectives than institutional VC funds. Primary among these objectives is bolstering internal research and development activities and gaining access to new technologies that complement the corporation’s product development efforts. Venture investments are also a way for corporations to gain intelligence on disruptive products and salesforce vtechnologies that could pose a competitive threat.  A minority investment could also be the first step toward an eventual acquisition of the portfolio company.  More limited objectives might include establishing an OEM partner, a channel for additional company product sales or even a product integration that might drive sales for the investing company.  And yes, there’s also the objective of financial returns.

If a company is considering launching a venture capital program, it’s important to choose a structure that will align with its investment objectives. Corporate VC programs can either be structured internally, where a company invests from its own balance sheet, or externally.  Generally speaking, internal divisions are more comcast venturesappropriate for strategic investments intended to support a corporate sponsor’s core business.  One downside of internal structures is that they tend to be more bureaucratic and slower in decision making. Another is that the financial capacity to invest is basically a function of the corporate sponsor’s financial health, which could fluctuate over time.

External structures are more nimble in making decisions and generally have greater flexibility to make investments that may be disruptive to the investing company’s core business. Since investments are made microsoft venturesoff the corporate sponsor’s balance sheet, external structures allow companies to pursue riskier and more disruptive R&D. They also tend to attract more experienced investment managers and so are often better able to achieve both strategic as well as financial objectives.

In terms of exit strategy, corporate VCs seek a wider range of possible outcomes from an investment. Maximizing proceeds is typically not the exit strategy.  A corporate VC may just as likely view as a successful outcome the portfolio company becoming an acquisition target, an OEM partner, a channel for GE Venturesadditional company product sales or even a product integration that would drive sales for the investing company.  VC funds, on the other hand, seek one type of exit: a multiple return on their investment dollars from either an acquisition or a sale of shares following an IPO.

Advantages

As I mentioned above, investments by a corporate VC are funded by the corporation’s own balance sheet, and are thus not subject to the ongoing pressure from limited partners and the ten year time restrictions of a typical VC fund’s limited partnership agreement. The result is that corporate VCs are generally more patient and have longer time horizons than VC funds.

Corporate VCs generally negotiate for less control over their portfolio companies than do VC funds. This is largely because when the investor company is deemed to have the power to influence the operating or financial decisions of the company its investing in, the investor company is required to account for its investment under the equity method of accounting, under which the investor recognizes its share of the profits and losses of the investee. If the investor has 20% or more of the voting stock of the investee, the investor is presumed to have control.  Consequently, corporate VCs generally avoid taking 20% or more of a portfolio company’s voting shares.  The need to avoid indicia of control is also why corporate VCs often decline board representation.

Another advantage is that, as I mentioned above, an investment from a corporate VC may be the first step toward being acquired by that corporation, thus giving the portfolio company and its founders a clear exit pathway without having to go through a prolonged investment banking process. It can also create instant credibility in the industry, which can then be leveraged to attract talent and customers.  Finally, it can provide channel access, product integration and other benefits to help accelerate market penetration.

Disadvantages

Investment from a corporate VC may have certain disadvantages, however. First, a corporate VC’s strategic objectives may conflict with a portfolio company’s financial goals, which for example may motivate the corporate VC to block a proposed acquisition or subsequent investment if the transaction does not align with the strategic goals of the corporate VC’s parent. Second, corporate VCs often negotiate for a right of first refusal or option to acquire the company which would limit the company’s options going forward and have a chilling effect on other potential acquirers.  Third, it could antagonize potential customers or business partners who view themselves as competitors of the corporate VC. Fourth, corporate VC divisions often receive an annual allocation of dollars to invest, as opposed to an aggregate commitment of dollars that a fund receives to invest during the fund’s investment period, which means that the availability of follow-on funding may be tied to the financial capacity and whims of the parent company. And finally, a strategic may set the valuation higher than what the market will bear, which could make it difficult for the company to secure co-investors, which in turn could leave the company under-funded and, as mentioned just above, could leave the company vulnerable if the corporate VC parent isn’t able or interested in making follow-on investments.

Final Thought

So back to Fred Wilson’s choice words for corporate VCs.  Perhaps the root of the antagonism is the tendency for corporate VCs to drive up valuations, which makes deals more expensive for institutional funds and may crowd them out of certain deals entirely.  Wilson sort of implied as much when he stated in the same interview that a startup would only do a deal with a corporate VC if it couldn’t secure funding elsewhere or if the corporate VC was paying a higher price than he would pay.