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

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

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

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

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

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

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

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

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

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

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

Issuer Cap                                                                                     

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

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

Portal Liability

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

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

Section 12(g) Registration Exemption

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

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

Special Purpose Vehicles

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

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

Testing the Waters

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

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

SEC logoAt an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.   The final rules and forms are effective 180 days after publication in the Federal Register.

Crowdfunding is an evolving method of raising funds online from a large number of people without regard to investor qualification and with each contributing relatively small amounts.[i]   Until now, public crowdfunding has not involved the offer of a share in any Crowdfunding1financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security to the public.  Equity crowdfunding has the potential to dramatically alter the landscape of capital markets for startup companies. It has also been the subject of a contentious debate ever since it was included in the JOBS Act, pitting those who want to allow startups to leverage the internet to reach investors and to permit ordinary people to invest small amounts in them against those that view crowdfunding as a recipe for a fraud disaster.

The SEC had issued proposed rules in October 2013 (see my blog post here), and received hundreds of comment letters in response. When the final rules become effective (early May 2016), issuers for the first time will be able to use the internet to offer and sell securities to the public without registration.  Here’s a brief summary of the new crowdfunding exemption rules and where they deviate from the original proposal.

Issuer and Investor Caps

  • Issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings in any 12-month period.
  • Individual investors, in any 12-month period, may invest in the aggregate across all crowdfunding offerings up to:
    • The greater of $2,000 or 5% of the lesser of annual income or net worth, if either annual income or net worth is less than $100,000, or
    • 10% of the lesser of their annual income or net worth if both their annual income and net worth are equal to or more than $100,000.
  • Aggregate amount an investor may invest in all crowdfunding offerings may not exceed $100,000 in any 12-month period.

Many commenters believed that the proposed $1 million offering limit was too low, but the SEC in the end believed the $1 million cap is consistent with the JOBS Act. The SEC did state in the final rules release, however, that Regulation Crowdfunding is a novel method of raising capital and that it’s concerned about raising the offering limit of the exemption at the outset of the adoption of final rules, suggesting that it would be open to doing so down the road.

As for the individual investment limit, the final rules deviate from the original proposal by clarifying that the limit reflects the aggregate amount an investor may invest in all crowdfunded offerings in a 12-month period across all issuers, and also specifies a “lesser of” approach to the income test.

Financial Disclosure

Financial disclosure requirements are based on the amount offered and sold in reliance on Section 4(a)(6) within the preceding 12-month period, as follows:

  • For issuers offering $100,000 or less: disclosure of total income, taxable income and total tax as reflected in the federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer; but if independently reviewed or audited financial statements are available, must provide those financials instead.
  • Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant, unless otherwise available.
  • Issuers offering more than $500,000:
    • For issuers offering more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by independent public accountant, unless otherwise available.
    • For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by independent public accountant.

The financial disclosure requirements contain a number of changes from the proposal that hopefully will help reduce the costs and risks associated with preparing the required financials. Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer only to disclose total income, taxable income and total tax, or the equivalent line items, from filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the returns.  This minimizes the risk of disclosure of private information which would exist if tax returns had to be provided.  In addition, reducing the requirement for first time issuers of between $500,000 and $1 million from audited financials (as had been proposed) to reviewed financials is a sensible accommodation inasmuch as the concern about the cost and burden of the audit relative to the size of the offering is even greater for first timers who would need to incur the audit expense before having proceeds from the offering.

Intermediaries

  • Offerings must be conducted exclusively through one platform operated by a registered broker or funding portal.
  • Intermediaries required to provide investors with educational materials, take measures to reduce the risk of fraud, make available information about the issuer and the offering and provide communication channels to permit discussions about offerings on the platform.
  • Funding portals prohibited from offering investment advice, soliciting sales or offers to buy, paying success fees and handling investor funds or securities.
  • Funding portals must register with the SEC by filing new Form Funding Portal, which will be effective January 29, 2016.

The rationale behind the requirement to use only one intermediary is that it helps foster the creation of a “crowd”. Having one meeting place enables a crowd to share information effectively, and minimizes the chances of dilution or dispersement of the crowd. This in turn supports one of the main justifications for equity crowdfunding, which is that having hundreds or thousands of investors sharing information increases the chances that any fraud will be exposed, thus the “wisdom of the crowd”. The one platform requirement also helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one platform would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.

One important deviation from the proposed rules is that funding portals will be permitted to curate offerings based on subjective criteria, not just based on perceptions of fraud risk.  A second important deviation is that all intermediaries will be allowed to receive as compensation a financial interest in the issuers conducting offerings on their platforms, which will expand the options available to cash-starved startups.

Preliminary Thoughts

The ink is still wet on the SEC’s 686 page release, but here are some preliminary thoughts. Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach and sell to prospective investors without regard to accredited investor status. The federal securities laws were written over 80 years ago when investors had no access to information about issuers.  In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising companies and ensure that ample information is spread to interested parties.

As I’ve stated before, however, the SEC’s preoccupation with investor crowdprotection has created a disconnect between the potential of equity crowdfunding and its reality, now expressed in the final rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act and the final rules do contain some welcome relief from the original proposal. Nevertheless, I fear that the burden and expense associated with some of the rules will make Regulation Crowdfunding far less attractive to most companies than traditional offerings under Rule 506 notwithstanding the latter’s pro-accredited investor bias. For example, the requirement to produce audited financial statements for offerings above $500,000 (except for first time Regulation Crowdfunding issuers) will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all. It’s also unclear how the burdensome rules governing intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience. Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors. Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.

In the final analysis, though, Title III equity crowdfunding will finally become law, meaning that issuers will for the first time be allowed to leverage the internet to sell securities to an unlimited number of investors without registration and without regard to accredited investor status, and that is decidedly a treat.

[1] The term “crowdfunding” has also been used more broadly as a somewhat generic term for any campaign to raise funds through an online platform.  These include non-equity crowdfunding (i.e., rewards or pre-order based), “accredited” crowdfunding (in reliance on Rule 506(b) or 506(c)) and registered crowdfunding (in reliance on Regulation A+).  This post will use the term only as it applies to small equity offerings to many investors, each contributing relatively small amounts, and soon to be available under Regulation Crowdfunding.

SEC logoIn its most recent meeting on September 23, 2015, the Securities and Exchange Commission’s Advisory Committee on Small and Emerging Companies recommended specific reforms that would significantly liberalize the rules governing private offering intermediaries and make it easier for companies to use them. If adopted, these reforms could greatly enhance the capacity of startups and early stage companies to reach investors and raise capital.

Background

More than 95% of private offerings in America rely on the exemptions provided by Regulation D, particularly Rule 506. But fewer than 15% of Reg D offerings use a financial intermediary, such as a placement agent, broker-dealer or finder. This is largely due to the general requirement financial intermediariesthat anyone receiving a transaction based success fee in a securities transaction be registered with the SEC as a broker-dealer (and subject to regulatory oversight as such) and be a member of the Financial Industry Regulatory Authority or FINRA. This is so even if the intermediary’s participation in an offering is limited to giving the issuer the name of a prospective investor, and refrains from engaging in other services often provided by full service intermediaries, such as holding funds or securities, helping to negotiate the transaction, assisting in the preparation of offering materials or providing investment advice. The risks to both intermediaries and issuers of paying a success fee to a non-registered intermediary is fairly draconian. For intermediaries, the risk is forfeiture of the success fee, as issuers could use non-registration as a defense for non-payment. For issuers, the risk is rescission, i.e., that all investors in a round could have the right to demand their money back.

The Committee’s Recommendations

The Committee prefaced its recommendations by stating that imposing only limited regulatory requirements on private placement intermediaries whose activities are restricted to specified parameters, do not hold customer funds or securities and deal only with accredited investors would enhance capital formation and promote job creation without materially undermining investor protections. Presumably, the Committee is asserting that such unregistered intermediaries should be allowed to receive a success fee.

The Committee then made the following recommendations to the SEC:

  1.  Take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Securities Exchange Act.
  2. Exempt intermediaries that are actively involved in the discussions, negotiations and structuring, as well as the solicitation of prospective investors, for private financings on a regular basis from broker registration at the federal level, conditioned upon registration as a broker under State law.
  3. Spearhead a joint effort with the North American Securities Administrators Association and the Financial Industry Regulatory Authority to ensure coordinated State regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement.
  4. Take immediate intermediary steps to begin to address this set of issues incrementally instead of waiting until development of a comprehensive solution.

A recording of the September 23 Committee meeting could be accessed here.

SEC 2August 6, 2015 was a productive day for the Staff of the Securities and Exchange Commission’s Division of Corporation Finance on the issue of the prohibition on general solicitation in the context of online private offerings under Rule 506(b). My last blog post, entitled “It’s Complicated”: Establishing “Preexisting Relationships” with Prospective Investors, analyzed the Citizen VC no-action letter delivered that day dealing with establishing pre-existing relationships with investors online to demonstrate the absence of general solicitation in a Rule 506 offering. On the same day, the Staff provided additional guidance on the issue of general solicitation in the form of new Compliance and Disclosure Interpretations (“CDIs”).

Background

Rule 502(c) promulgated under the Securities Act of 1933, as amended, prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings intended to be exempt from registration under Regulation D. The prohibition on general solicitation has been perceived as perhaps the single biggest obstacle to raising capital in the private general solicitationmarkets. In September 2013, the SEC released final rules for a new offering exemption contained in Rule 506(c) that permits general solicitation efforts, provided securities are sold only to accredited investors and the issuer uses reasonable methods to verify that each purchaser is an accredited investor. What constitutes reasonable verification methods will depend on the facts and circumstances of each case, but generally involves a more intrusive inquiry than an offering under traditional Rule 506(b), which is why most private offerings are still being conducted under Rule 506(b) despite the prohibition on general solicitation.

New Guidance

The new CDIs come in the form of Q&As, some of which provide official confirmation of existing practice while others provide new flexibility in online offering activities. Here’s an outline of the new CDIs:

Factual Business Information

Factual business information that does not condition the public mind or arouse public interest in a securities offering is not deemed an offer and may be disseminated widely. In the new guidance, the Staff stated that factual business information is a facts and circumstances concept, but is typically limited to information about the issuer’s business, financial condition, products or services, and generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.

Angel Investors

angelThe Staff confirmed that it is possible for angel investors who have a relationship with an issuer to make introductions to other prospective investors in their personal network and share information about a securities offering without such issuer being deemed to engage in a general solicitation. Whether or not a general solicitation has occurred requires a facts and circumstances analysis, but an issuer could rely on such network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Establishing “Pre-Existing” and “Substantive” Relationships

A relationship with an offeree is “pre-existing” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the relationship was formed prior to the commencement of the securities offering or, alternatively, when it was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participating in the offering. Similarly, a relationship is “substantive” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

Demo Days

Whether or not “demo days” or “pitch days” constitute general solicitation is also – you guessed it – a factsimages12NM2J0D and circumstances question. If the presentation does not discuss the securities being offered, the securities laws are not implicated. Where the presentation does discuss the securities being offered, however, attendance at the demo day or pitch day should be limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or who have been contacted through an informal, personal network as described above under “Angel Investors”. For more on this issue involving demo days, see my previous blog post “Will Your Demo Day Presentation Violate the Securities Laws?”.

In my last post, I blogged about online funding platforms. In that post, I described the typical model of indirect investing through a special purpose vehicle (“SPV”) with the platform sponsor taking a carried interest in the SPV’s profits from the portfolio company and no ourcrowdtransaction fee, as a means of avoiding broker-dealer regulation. I also discussed the concept of a pre-screened password protected member-only website as a means of establishing a preexisting fundablerelationship with prospective investors and thus avoiding the use of any act of “general solicitation,” which would otherwise violate the rules of the registration exemption under Rule 506(b).

SEC logoIn a no-action letter dated August 6, 2015 entitled Citizen VC, Inc., the SEC has provided important guidance on the procedures needed for an online funding platform to establish the kind of preexisting relationship needed to avoid being deemed to be engaged in general solicitation. As an aside, the concern over general solicitation and preexisting relationships is relevant to offerings under new Rule 506(b), but not under Rule 506(c).   Despite the creation in 2013 of an exemption under new Rule 506(c) pursuant to the JOBS Act for general solicitation offerings in which sales are made only to accredited investors, most online funding platforms continue to prefer to conduct portfolio company offerings indirectly through SPVs under Rule 506(b), despite the prohibition on general solicitation, primarily because of the additional requirement under Rule 506(c) that issuers use reasonable methods to verify accredited investor status.

In its request for a no-action letter, Citizen VC described itself as an citizen vconline venture capital firm that facilitates indirect investment in portfolio companies (through SPVs) by pre-qualified, accredited and sophisticated “members” in its site. It asserted to have qualification procedures intended to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the website. Anyone wishing to investigate the password protected sections of the site accessible only to members must first register and be accepted for membership. To apply for membership, prospective investors are required to complete an “accredited investor” questionnaire, followed by a relationship building process in which Citizen VC collects information to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks related to an investment. It does so by contacting the prospective investor by phone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist Citizen VC in understanding the investor’s sophistication, utilizing third party credit reporting services to gather additional financial information and credit history information and other methods to foster online and offline interactions with the prospective investor. In the request letter, Citizen VC asserted that the relationship establishment period is not limited by a specific time period, but rather is a process based on specific written policies and procedures created to ensure that the offering is suitable for each prospective investor.

Citizen VC stated in its request letter that prospective investors only become “members” and are given access to offering information in the password protected section of the site after Citizen VC is satisfied that the prospective investor has sufficient knowledge and experience and that it has taken reasonable steps necessary to create a substantive relationship with the prospective investor. Once a sufficient number of qualified members have expressed interest in a particular portfolio company, those members are provided subscription materials for investment in the SPV formed by Citizen VC to aggregate such members’ investments, the sale of interests of such SPV is consummated and the SPV then invests the funds, and becomes a shareholder of, the portfolio company.

In its request letter, after providing the foregoing background, Citizen VC asked the SEC staff to opine that the policies and procedures described in the letter are sufficient to create a substantive, pre-existing relationship with prospective investors such that the offering and sale on the site of interests in an SPV that will invest in a particular portfolio company will not constitute general solicitation.

sec no-actionIn its no-action letter, the SEC staff concluded that Citizen VC’s procedures were sufficient to establish a preexisting relationship and do not constitute general solicitation. It stated that the quality of the relationship between an issuer and an investor is the most important factor in determining whether a “substantive” relationship exists and noted Citizen VC’s representation that its policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff went on to say that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship, and that whether an issuer has sufficient information to evaluate a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances of each case. The staff also based its conclusion on Citizen VC’s representation that an investment opportunity is only presented after the prospective investor becomes a “member” in the site.

An argument could be made that SPV-based online funding platforms represent the future of VC investing. The Citizen VC no-action letter provides valuable guidance relating to the establishment of the kind of substantive relationship with prospective investors needed to enable the online funding platform to conduct Rule 506(b) offerings without being deemed to engage in general solicitation.

Lately I’ve been approached by current and prospective clients about ourcrowdonline 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 fundableconnect 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.

pitchbookOnline 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.

General Solicitation

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.

Broker-Dealer Regulation

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.”

In 2013, the SEC gave further guidance to investment fund model platforms in the form of two no-action letters, FundersClub and AngelsList.

FundersClub sources start-ups for its affiliated funds or SPVs to invest in and fundersclubthen 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.

The SEC yesterday issued its highly anticipated final rules amending Regulation A to allow issuers u-s-secto raise up to $50 million in any 12 month period through public offering techniques but without registration with the SEC or state blue sky authorities.  The 453 page rules release features a scaled disclosure regime to provide issuers with increased flexibility with regard to offering size and should lower the burden of fixed costs associated with conducting Reg A offerings as a percentage of proceeds. The new rules go into effect 60 days after they are published in the Federal Register.

Reg A has been one of the most rarely used exemptions for securities offerings because it’s been perceived as cost ineffective: the $5 million maximum is just not worth the burdens associated with blue sky registration and qualification requirements in each state where the securities are offered.  JOBS act 2Fixed costs such as legal and accounting fees have served as a disincentive to use the exemption for lower offering amounts. Congress addressed the problem in 2012 through Title IV of the JOBS Act, which required the SEC to amend Reg A by exempting from Securities Act registration certain securities offerings of up to $50 million in any 12 month period. The anticipated amendment to Reg A has been referred to affectionately by securities lawyers as Reg A+, since it’s intended to be a more useful version of the old Reg A.

Old Reg A

Old Reg A provides an exemption from Securities Act registration for offerings of up to $5 million in any 12-month period, including no more than $1.5 million in resales by selling stockholders.  Reg A transactions have been referred to as mini public offerings because they permit general solicitation and advertising (prohibited in private offerings other than accredited investor-only offerings under Rule 506(c) passed in September 2013) and require a mini-registration statement to be filed and reviewed by the SEC containing the offering statement to be delivered to offerees.  Most importantly, shares sold in old Reg A offerings are not “covered securities” under the National Securities Markets Improvement Act, meaning that issuers  must comply with the registration and qualification requirements of the blue sky laws of each state where the offering is made.  A Reg A issuer was allowed to “test the waters,” or communicate with potential investors to see if they might be interested in the offering, before it made the filing with the SEC (Form 1-A).  Finally, securities sold in Reg A offerings are not restricted securities, meaning they can be freely resold by non-affiliates of the issuer.

New Reg A

The final rules expand Reg A into two tiers: Tier 1 for securities offerings of up to $20 million; and Tier 2 for offerings of up to $50 million.  The new rules preserve, with some modifications, existing provisions regarding issuer eligibility, offering circular content, testing the waters and “bad actor” disqualification.  Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC.  Except when buying securities listed on a national securities exchange, purchasers in Tier 2 offerings must either be accredited investors or be subject to certain limitations on their investment.

The key provisions of the final rules are as follows:

Offering Limitations and Secondary Sales

The final rules establish two tiers of offerings:

  • Tier 1: annual offering limit of $20 million, including no more than $6 million on behalf of selling stockholders that are affiliates of the issuer.
  • Tier 2: annual offering limit of $50 million, including no more than $15 million on behalf of selling stockholders that are affiliates of the issuer.

Investment Limitation

The SEC’s objective with the tiered approach is to scale regulatory requirements based on offering size, to give issuers more flexibility in raising capital under Reg A and to provide appropriately tailored protections for investors in each tier. The rules impose additional disclosure requirements and investor protection provisions in Tier 2 offerings. Issuers seeking a smaller amount of capital (i.e., no more than $20 million) benefit from scaled disclosure. Although Tier 2 offerings will require enhanced disclosure, it’s possible that the reduction in information assymetry will lead to higher valuations. Thankfully, the final rules raised the Tier 1 offering cap to $20 million from the proposed $5 million. The increase in maximum offering size could also contribute to the development of intermediation services, such as market making, as well as analyst coverage, which could have a positive impact on investor participation and aftermarket liquidity of Reg A shares.

In addition, selling stockholders are limited to no more than 30% of the aggregate offering price in an issuer’s initial Reg A offering and any subsequently qualified Reg A offering within the first 12-month period following the date of qualification of the initial Reg A offering.

As mentioned above, the new rules contain certain investor protections in Tier 2 offerings. The proposed rules included a 10% investment limit for all investors in Tier 2 offerings.  The final rules limit non-accredited investors in Tier 2 offerings to purchases of no more than 10% of the greater of annual income or net worth (for natural persons) or the greater of annual revenue or net assets (for non-natural persons), as proposed.  In response to commentator concerns, the Tier 2 investment limit does not apply to accredited investors or to securities that will be listed on a national securities exchange.  This is a sensible approach, inasmuch as accredited investors, due to their level of income or net worth, are more likely to be able to withstand losses from undiversified exposure to an individual offering, and there’s a higher level of investor protection with issuers required to meet the listing standards of a national securities exchange and become subject to ongoing Exchange Act reporting.

Treatment under Section 12(g)

Section 12(g) of the Exchange Act requires that an issuer with total assets exceeding $10 million and a class of equity securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the SEC. In its proposal release, the SEC did not propose to exempt Reg A securities from mandatory registration under Section 12(g), but solicited comment on the issue.  Some commentators questioned the extent to which Reg A securities would be held in street name through brokers, which the proposal mentioned as a factor that could potentially limit the impact of not proposing an exemption from Section 12(g).

The final rules conditionally exempt Tier 2 securities from the provisions of Section 12(g) provided the issuer (i) remains subject to, and is current in (as of fiscal year end), its Reg A periodic reporting obligations, (ii) engages the services of a transfer agent registered with the SEC under the Exchange Act, and (iii) meets requirements similar to those for “smaller reporting companies” (public float of less than $75 million or, in the absence of a public float, annual revenues of less than $50 million).  The transfer agent condition will provide added comfort that stockholder records and secondary trades will be handled accurately.

Offering Statement

The final rules require issuers to file offering statements with the SEC electronically on EDGAR, but permit non-public submission of offering statements and amendments for review by SEC staff before filing so long as all such documents are publicly filed not later than 21 days before qualification.  The new rules eliminate the Model A (Question-and-Answer) disclosure format under Part II of Form 1-A.

Testing the Waters

The new rules permit issuers to “test the waters” with, or solicit interest in a potential offering testing the watersfrom, the general public either before or after the filing of the offering statement, so long as any solicitation materials used after publicly filing the offering statement are preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained. Solicitation materials remain subject to the antifraud and other civil liability provisions of the federal securities laws.

Continuing Disclosure Obligations

Reg A currently requires issuers to file a Form 2-A with the SEC to report sales and the termination of sales made under Reg A every six months after qualification and within 30 calendar days after the termination, completion or final sale of securities in the offering. The final rules eliminate Form 2-A.  In its place, the rules require Tier 1 issuers to provide information about sales in such offerings and to update certain issuer information by electronically filing a Form 1-Z exit report with the SEC not later than 30 calendar days after termination or completion of an offering.  The rules require Tier 2 issuers to file electronically with the SEC on EDGAR annual and semiannual reports, as well as current event reports.

Application of Blue Sky Laws

The final rules preempt state registration and qualification requirements for Tier 2 offerings but preserve these requirements for Tier 1 offerings, consistent with state registration of Reg A offerings of up to $5 million under existing rules.  The SEC had originally proposed to preempt state regulation with respect to (i) all offerees in Reg A offerings and (ii) all purchasers in Tier 2 offerings.  The proposal to preempt blue sky requirements with respect to all offerees in a Reg A offering was intended to allow issuers relying on Reg A to communicate with potential investors via the internet and social media without concern that these communications might trigger registration requirements under state law.

The issue of state law preemption generated a great deal of public commentary.  To address commenter concerns and avoid potential confusion about the application of the preemption provisions in Tier 1 offerings, the final definition of “qualified purchaser” does not include offerees in Tier 1 offerings.  This is unfortunate.  In order to create an attractive alternative to IPOs, Congress mandated preemption for “qualified purchasers”, which it defined as any purchaser in a (new) Reg A offering. As made clear in the 2012 General Accounting Office Report, a primary reason Reg A has been seldom used is the delay, cost and uncertainty of divergent state review of offerings. Perhaps the SEC should have preempted state regulation of Reg A resales as well. One of the greatest benefits of a Reg A offering versus a Rule 506 offering is that the securities sold in the former will be freely tradeable immediately upon closing of the offering. Without clear federal preemption of blue-sky laws governing the resale of Reg A shares, however, investors may be concerned about their ability to resell their shares which will reduce their willingness to purchase these shares in the first place.

On December 15, 2014, the North American Securities Administrators Association launched the Electronic Filing Depository (“EFD”), an internet accessible database that allows issuers to submit Form D for Rule 506 offerings under Regulation D and pay related fees to state securities regulators.  It also allows anyone to search EFD’s Form D database.

This is a big deal.  Rule 506 of Regulation D is a “safe harbor” for the private offering exemption under Section 4(a)(2) of the Securities Act. Issuers relying on the Rule 506 exemption do not have to register their offering of securities with the SEC or state securities regulators, but they must file a Notice of Exempt Offering of Securities on Form D with the SEC and state securities regulators after they first sell their securities. The National Securities Markets Improvement Act of 1996 (“NSMIA”) was enacted to preempt state securities laws where they duplicate federal laws. As a result of NSMIA, states may not require registration under their blue sky laws of “covered securities”, which includes securities sold under Rule 506 of Regulation D, but are allowed to require issuers to make notice filings and pay filing fees when conducting offers and sales of covered securities in their state.  Most states only require that Rule 506 issuers file a copy of the Form D and pay a filing fee, but there are subtle substantive and mechanical differences among the states that make the process of complying with the blue sky requirements in multistate offerings enormously tedious and burdensome.

The launch of EFD will help alleviate these burdens.  EFD will reduce the time needed to prepare individual state paper filings as well as provide additional benefits such as a means of following the status of a state’s processing of a filing and a digitized depository of filings for public review.

Although state participation is voluntary, 38 states have already opted in.  Characteristically, New York is one of those not to have done so, which is unfortunate because New York’s filing requirements are arguably the most cumbersome, with the requirement to send blue sky filings to three different addresses in the state. 

So far, EFD only covers Form D filings and fee payment; it is not yet designed to handle any other blue sky filings required by participating states.

The NASAA hosts free training webinars on the use of EFD.  The next webinar is scheduled for February 5, 2015, with another webinar tentatively scheduled for February 23, 2015.  You can register here for the webinars.