Why I’m Grateful This Thanksgiving

My 10th-great grandfather was William Bradford, the leader of the Pilgrims. I’m grateful that he and his band of religious refugees made the trip and were saved from starvation by the native population.

I’m grateful for the wisdom of the American people and the resilience of their institutions.

I’m thankful for a culture that rewards risk-taking and innovation and that is slowly, haltingly, inexorably freeing itself of the prejudices of our collective past.

I’m grateful for American entrepreneurs who endlessly question the present and invent the future.

I’m grateful I didn’t invest with FTX.

I’m grateful – I’m not joking – to the SEC for providing oversight for the most complex, dynamic, trusted capital markets in the world.

I’m grateful to my colleagues at Lex Nova Law for helping to build a flexible, modern law firm.

I’m grateful to live in a diverse, changing, sometimes-chaotic country where it often seems we disagree about everything (we don’t). Like others, I worry that so many Americans have chosen alternative realities and conspiracy theories, but I have faith that these afflictions, like others in our history, will prove temporary.

I’m grateful that during my own midlife crisis I wasn’t on Twitter.

I’m grateful for Anthony Fauci, an ordinary American who rose to the moment and became extraordinary.

I’m grateful to participate in the fundamental rethinking of capitalism called Crowdfunding, making capital available where it has never been available before and making great investment opportunities available to more and more Americans.

I’m grateful to everyone in the Crowdfunding ecosystem, especially to Doug Ellenoff and others who worked to make the JOBS Act a reality.

I’m grateful to Ukraine and its brave people, who are giving the world a lesson in the power of freedom.

I’m grateful for my clients, a diverse, energetic, endlessly-creative group of entrepreneurs who are making America better and in the process making my life infinitely more rewarding.

Yesterday six Americans were killed in a shooting in Virginia. That follows four in Oklahoma on Sunday, five in Colorado on Saturday, and all the rest. Next year I hope I can be grateful that we have finally begun to address the uniquely American plague of violence.

Thanks for reading everyone! I hope you enjoy your Thanksgiving as much as I intend to enjoy mine. As always, contact me if you have any questions.

What eBAY Tells Us About Secondary Markets For Private Companies

The securities of private companies are illiquid, meaning they’re hard to sell.

Since 2017 I’d guess a billion dollars and a million person-hours have been spent by those who believe blockchain technology will create liquidity for private securities. Joining that chorus, a recent post on LinkedIn first noted that trillions of dollars are locked up in private securities, then claimed that blockchain technology (specifically, the technology created by the company posting) could unlock all that value.

This is all wrong, in my always-humble opinion. All that money and all those person-hours are more or less wasted.

My crystal ball is no clearer than anyone else’s. But when I try to believe that blockchain will create active secondary markets I run up against two facts:

  • Fact #1: Secondary markets for private securities have been perfectly legal in this country for a long time, yet there are very few of them.
  • Fact #2: The New York Stock Exchange and other exchanges around the world were vibrant even when they were using little slips of paper.

Those two things tell me that it’s not the technology that creates an active secondary market and hence that blockchain won’t change much.

An active secondary market is created when there are lots of buyers and lots of sellers, especially buyers. When millions of people wanted to buy Polaroid in the 1960s they didn’t care whether Polaroid used pieces of paper or stone tablets. Conversely, put the stock of a pink sheet company on a blockchain and you won’t increase the volume.

As described more fully here, there are a bunch of reasons why there aren’t lots of potential buyers for a typical private company:

  • It probably has a very limited business, possibly only one product or even one asset.
  • It probably has limited access to capital.
  • It probably lacks professional management.
  • Investors probably have limited voting rights.
  • There are probably no independent directors.
  • Its business probably depends on one or two people who could die or start acting like Elon Musk.
  • Insiders can probably do what they want, including paying themselves unlimited compensation.
  • No stock exchange is imposing rules to protect investors.

All that seems obvious now and was obvious in 2017. But now I’m thinking of another company with lessons about secondary markets: eBay.

If there’s anything even less liquid than stock in a private company, it’s a used refrigerator, a bracelet you inherited from your grandmother, the clock you haven’t used for 15 years.

All those things and thousands more were once completely illiquid and therefore worth nothing. eBay changed that, almost miraculously adding dollars to everyone’s personal balance sheet. Just as every ATS operating today seeks to create an active market for securities, eBay created a market for refrigerators, bracelets, and clocks. Quite amazing when you think about it.

eBay didn’t create the market by turning refrigerators, bracelets, and clocks into NFTs. To the contrary, when you sell something on eBay you have to ship it, physically, using the lowest of low technology. eBay created the secondary market simply by connecting buyers and sellers using Web2. Just like another company that has created a pretty active market, Amazon.

If any ATS operating today had a thousandth of the registered users eBay has, its founders and investors would be even rubbing their hands with glee.

As a Crowdfunding advocate, I wonder what the world would look like if all those dollars and person-hours had been spent improving the experience of initial investors rather than pursuing secondary markets and blockchain, things dreams are made of. As the shine comes off blockchain maybe we’ll find out.

Questions? Let me know

Title III Crowdfunding

When Should A Crowdfunding SAFE Or Convertible Note Convert?

Convertible notes and SAFEs often make sense for startups because they don’t require anyone to know the value of the company. Instead, the company and early investors can piggyback on a later investment when the value of the company might be easier to determine and the size of the investment justifies figuring it out.

Which raises the question, when should the convertible note or SAFE convert?

In the Silicon Valley ecosystem that’s an easy question. Per the Y Combinator forms, a convertible note or SAFE converts at the next sale of preferred stock, which necessarily involves a valuation of the company.

That works in the Silicon Valley ecosystem because (i) in the Silicon Valley ecosystem investors always get preferred stock, and (ii) the Silicon Valley ecosystem is largely an old boy network where founders and investors know and trust one another.

As I’ve said before, the Crowdfunding ecosystem is different. There are at least two reasons why the Y Combinator form doesn’t work here:

  • For a company that raises money with a SAFE in a Rule 506(c) or Reg CF offering, the next step might be selling common stock (not preferred stock) in a Regulation A offering. The SAFE has to convert.
  • Say I’ve raised $250K in a SAFE and think my company is worth $5M. If I’m clever, or from Houston*, I might arrange to sell $10,000 of stock to a friend at a $10M valuation, causing the SAFEs to convert at half their actual value. All my investors are strangers so I don’t care.

Which brings us back to the original question, what’s the right trigger for conversion?

Half the answer is that it should convert whether the company sells common stock or preferred stock. 

Now suppose that I’ve raised $250K in a SAFE round. The conversion shouldn’t happen when I raise $10,000 because that doesn’t achieve what we’re trying to achieve, a round big enough that we can rely on the value negotiated between the investors and the founder. What about $100,000? What about $1M?

In my opinion, the conversion shouldn’t be triggered by a dollar amount, which could vary from company to company. Instead, it should be triggered based on the amount of stock sold relative to the amount outstanding. So, for example:

“Next Equity Financing” means the next sale (or series of related sales) by the Company of its Equity Securities following the date of issuance of this SAFE where (i) the Equity Securities are sold for a fixed price (although the price might vary from purchaser to purchaser), and (ii) the aggregate Equity Securities issued represent at least ten percent (10%) of the Company’s total Equity Securities based on the Fully Diluted Capitalization at the time of issuance.

You might think 10% is too high or too low, but something in that vicinity.

Finally, the conversion should be automatic. Republic sells a SAFE where the company decides whether to convert, no matter how much money is raised. In my opinion that’s awful, one of the things like artificially low minimums that makes the Reg CF ecosystem look bad. You buy a SAFE and the company raises $5M in a priced round. The company becomes profitable and starts paying dividends. You get nothing. You lie awake staring at your SAFE in the moonlight.

*Go Phils!

Questions? Let me know.

LLC Vs C Corporation For Startups: A Short Explanation

Like COVID, the questions around choosing a limited liability company or C corporation for startups never seem to go away.

For lots of details see the article I wrote here. Except for making you the center of attention at the party, however, those details don’t matter very much. So I’m offering this short version.

In a limited liability company you pay only one level of tax upon a sale of the company, while with a C corporation you pay two levels. That can make an enormous different to the IRRs of founders and investors.

Yet many startups are formed as C corporations. Why?

In Silicon Valley successful startups are funded by venture capital funds. Indeed, the most common measure of “success” in Silicon Valley is which venture capital funds have funded a startup, for how much, and how many times.

Venture capital funds are themselves funded, in part, by deep-pocketed nonprofits like CALPERS and Harvard.

All nonprofits are subject to tax on business income, as opposed to income from their nonprofit activities. For example, Harvard can charge a billion dollars per year in tuition without paying tax, but if it opens a car dealership it pays tax on the dealership’s profits. The car dealership income is called “unrelated business taxable income,” or UBTI.

Now suppose Harvard owns an interest in a VC fund, which is structured as a limited liability company or limited partnership (as all are). If the VC fund invests in an LLC operating a car dealership, then the income of the dealership flows through first to the VC fund and then from the VC fund to Harvard, where it is again treated as UBTI, subjecting Harvard to tax and reporting obligations.

Harvard doesn’t want to report UBTI! So Harvard tells the VC fund “Don’t invest in LLCs or partnerships, only C corporations, where the income doesn’t pass through.” And because Harvard writes big checks, the VC fund does what Harvard wants.

That’s why the Silicon Valley ecosystem uses C corporations. Everyone knows about the extra tax on exit, but everyone is willing to pay it on exit to get the big checks from Harvard.

I will pause to note that in many cases the nonprofit’s concern about UBTI is illusory. Many startups never achieve profitability, including startups sold for big numbers. So there would never have been any UBTI in the first place.

(Yes, I know that there’s no extra tax in an IPO or tax-free reorganization, but those are small exceptions to the general rule.)

Because Silicon Valley is the center of gravity in the American startup ecosystem, like the black hole at the center of the Milky Way, it exerts a force that is not always rational. Many investors, including funds with no nonprofit LPs and hence no possibility of UBTI, will tell startups “I only invest in C corporations,” simply based on the Silicon Valley model.

This creates a dilemma for founders, especially in the Crowdfunding space. If I’m an LLC and list my company on a Reg CF platform, how do I know I’m not losing investors who think, irrationally, that they should only invest in C corporations?

In any case, that’s where we are. LLCs are better in most cases because of the tax savings on exit. But because of the disproportionate influence of the Silicon Valley ecosystem in general and deep-pocketed nonprofit investors in particular, many investors and founders think they’re supposed to use C corporations.

Questions? Let me know.

The Crowdfunding Bad Actor Rules Don’t Apply To Investors

I often see Subscription Agreements asking the investor to promise she’s not a “bad actor.” This is unnecessary. The term “bad actor” comes from three sets of nearly indistinguishable rules:

  • 17 CFR §230.506(d), which applies to Rule 506 offerings;
  • 17 CFR §230.262, which applies to Regulation A offerings; and
  • 17 CFR §227.503, which applies to Reg CF offerings.

In each case, the regulation provides that the issuer can’t use the exemption in question (Rule 506, Regulation A, or Reg CF) if the issuer or certain people affiliated with the issuer have violated certain laws.

Before going further, I note that these aren’t just any laws – they are laws about financial wrongdoing, mostly in the area of securities. Kidnappers are welcome to use Rule 506, for example, while ax murderers may find Regulation A especially useful even while still in prison.

Anyway.

Reg CF’s Rule 503 lists everyone whose bad acts we care about:

  • The issuer;
  • Any predecessor of the issuer;
  • Any affiliated issuer;
  • Any director, officer, general partner or managing member of the issuer;
  • Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Any promoter connected with the issuer in any capacity at the time of filing, any offer after filing, or such sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities; and
  • Any general partner, director, officer or managing member of any such solicitor.

Nowhere on that list do you see “investor.” The closest we come is “Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities,” but even there the calculation is based on voting power. In a Crowdfunding offering you wouldn’t give an investor 20% of the voting power, for reasons having nothing to do with the bad actor rules. 

So it just doesn’t matter. This is one more thing we can pull out of Subscription Agreements. 

I know some people will say “But we want to know anyway.” To me this is unconvincing. If you don’t ask about kidnapping you don’t need to ask about securities violations.

Questions? Let me know.

Crowdfunding web portal

Updated Crowdfunding Cheat Sheet

I first posted this Crowdfunding Cheat Sheet in January of 2014. Since then the rules have continued to change and improve. So here’s the current version, up to date with all the new rules and also expanded to answer questions my clients ask. For example, I’ve added a column for Regulation S because many clients want to raise money from overseas while simultaneously raising money here in the U.S.

I hope this helps, especially those new to the world of Crowdfunding.

CLICK HERE TO VIEW THE UPDATED CROWDFUNDING CHEAT SHEET

Questions? Let me know.

Three Ways To Improve Reg CF

Reg CF is off and running, on its way to becoming the way most American companies raise capital. Still, there are three things that would improve the Reg CF market significantly.

Revise Financial Statement Requirements

Financial disclosures are at the heart of American securities laws, I understand. The best way to understand an established company is often to pore over its audited financial statements, footnotes and all.

But that’s just not true of most small companies, whether the micro-brewery on the corner or a new social media platform. For these companies, reviewed or audited statements yield almost no worthwhile information to prospective investors. Yet the cost of the statements and the time needed to create them are significant impediments in Reg CF.

In my opinion, the following financial disclosures would be more than adequate:

  • Copies of the issuer’s tax returns for the last two years;
  • Interim financial statements (profit and loss and balance sheet) from Quickbooks or other financial software, through the last day of the month before the offering is launched;
  • A separate statement of the issuers’ assets and liabilities in Form C;
  • An attestation from the Chief Executive Officer;
  • A statement in Form C describing where and how the issuer expects to derive revenue during the next 12 months (e.g., subscription fees, advertisements, rents, etc.);
  • Reviewed financial statements for offerings in excess of $1,235,000; and
  • No requirement for audited statements.

Conversely, I believe annual audited financial statements should be required after a successful raise.

Address Artificially Low Target Amounts

Artificially low target amounts are the worst thing about Reg CF, by a long shot.

In the common approach, a company that needs $750,000 to execute its business plan sets a target amount of $25,000.

The artificially low target works for both the platform and the company. If the company raises, say $38,000, then the platform receives a small commission and advertises a “successful” offering, while the company can at least defray its costs.

But investors have thrown their money away.

Artificially low target amounts are terrible for investors and terrible for the industry, in a vicious cycle. Nobody wants to throw money away, and with so many Reg CF offerings using artificially low target amounts many serious investors will simply stay away from the industry.

Speaking of the Vietnam war, John Kerry asked “Who wants to be the last man to die for a lie?” Here, the question is “Who wants to be the first to invest in a company that needs a lot more?”

The fix is pretty simple. Issuers should be required to disclose what significant business goal can be accomplished if the offering yields only the minimum offering amount or, if no significant business goal can be achieved, should be required to say so.

In the meantime, it’s pretty shocking that while many offerings use an artificially low target amount, very few disclose the enormous additional risk to early investors. That’s a lot of lawsuits waiting to happen.

More Automation for Issuers

Speaking of lawsuits waiting to happen. . .

Most platforms do a pretty good job automating the process with investors. With issuers not so much.

Instead, platforms interact with issuers through people. Theoretically the role of these people is simply to guide the issuer through a semi-automated process. In practice, however, they end up as all-purpose advisors, giving issuers advice about everything from the type of security the issuer should offer to the issuer’s corporate structure to whether an SPV should be used.

As nice and well-meaning as these people may be, they aren’t qualified to give all that advice. Too often they end up giving advice that is either incomplete or wrong, doing a disservice to issuers and creating an enormous potential liability for the platform.

It’s unrealistic to think the platform will staff a team of investment bankers and securities lawyers giving individual advice to each issuer. Instead, in my opinion, the solution is to do a much better job automating the issuer side of the platform. That’s easier said than done, I realize. I hope and expect that the software providers active in Reg CF can provide some industry-wide solutions.

Questions? Let me know.

Kim Kardashian Fined For Promoting Crypto Without Disclosure

I was disappointed to learn that Kim Kardashian doesn’t read my blog posts, at least not all of them. With her hectic lifestyle she probably misses out on a lot of other fun stuff as well. Had Kim read my blog post on May 2, 2018 she would have known about section 17(b) of the Securities Act of 1933:

It shall be unlawful for any person. . . . to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof [italics added].

Kim was paid $250,000 to promote EMAX tokens to her 330 million Instagram followers. “ARE YOU GUYS INTO CRYPTO????” she wrote, including a link to Ethereum Max’s website. Whoops! By failing to disclose her compensation she violated section 17(b) and will now pay a $1.26 million fine to the SEC.

Sometimes it’s tempting to think of the SEC as all-powerful. In reality the SEC is a tiny agency compared with the size of the markets it regulates. Faced with a chronic shortage of resources, the SEC picks and chooses the cases to enforce, looking for easy cases with maximum visibility. Well, they couldn’t have asked for a better one. As of today another 330 million people know about section 17(b), almost doubling the number who knew from this blog.

Matt Damon, looking for a lawyer?

Questions? Let me know.

Think Twice Before Giving Crowdfunding Investors Voting Rights

I attend church and think of myself as a kind person, yet I discourage issuers from giving investors voting rights. Here are a few reasons:

  • Lack of Ability:  Even if they go to church and are kind people, investors know absolutely nothing about running your business. If you assembled 20 representatives in a room and talked about running your business, you would (1) be amazed, and (2) understand why DAOs are such a bad idea.
  • Lack of Interest:  Investors invest because they want to make money and/or believe in you and your vision. They aren’t investing because they want to help run your business.
  • Irrelevant Motives:  Investors will have motives that have nothing to do with your business. For example, an investor who is very old or very ill might want to postpone a sale of the business to avoid paying tax on the appreciation.
  • Bad Motives:  Investors can even have bad motives. An unhappy investor might consciously try to harm your business or, God forbid, a competitor might accumulate shares in your company.
  • Lack of Information:  Investors will never have as much information about your business as you have. Even if they go to church, are kind to animals, and have your best interests at heart, they are unable to make the same good decisions you would.
  • Drain on Resources:  If you allow investors to vote you’ll have to spend lots of time educating them and trying to convince them to do what you think is best. Any time you spend educating investors is time you’re not spending managing your business.
  • Logistics:  Even in the digital age it’s a pain tabulating votes from thousands of people.
  • Mistakes:  When investors have voting rights you have to follow certain formalities. If you forget to follow them you’re cleaning up a mess.

I anticipate two objections:

  • First Objection:  VCs and other investors writing big checks get voting rights, so why shouldn’t Crowdfunding investors?
  • Second Objection:  Even if they don’t help run the business on a day-to-day basis, shouldn’t investors have the right to vote on big things like mergers or issuing new shares?

As to the first objection, the answer is not that Crowdfunding investors should get voting rights but that VCs and other large investors shouldn’t. The only reason we give large investors voting rights is they ask for them, and our system is called “capitalism.”

Before the International Venture Capital Association withdraws its invitation for next year’s keynote, I’m not saying VCs and other large investors don’t bring anything but money to the table. They can bring broad business experience and, perhaps most important, valuable connections. A non-voting Board of Advisors makes a lot of sense.

The second objection is a closer call. On balance, however, I think that for most companies most of the time it will be better for everyone if the founder retains flexibility.

To resolve disputes between the owners of a closely-held business we typically provide that one owner can buy the others out or even force a sale of the company. Likewise, while we don’t give Crowdfunding investors voting rights we should try to give them liquidity in one form or another, at least the right to sell their shares to someone else.

Give investors a good economic deal. Give them something to believe in. But don’t give them voting rights.

Questions? Let me know.