99-Investor Rule Affects Crowdfunding Deal Structure

From real estate to IT, many of the equity investments offered on Title II Crowdfunding portals share a common deal structure. Investors do not acquire interests directly in the operating company, but instead acquire interests in a separate entity, which itself acquires an interest in the operating company. If the operating company is Newco and the separate entity is Investco, then the investors purchase shares in Investco and Investco purchases shares in Newco.

This deal structure holds advantages for Newco and its principals. For one thing, Newco adds only one investor – Investco – to its cap table, rather than adding every individual who invests. For another, if Investco is controlled by the portal, Newco has effectively farmed out the logistics headaches of investor relations to a third party. Not coincidentally, the Investco structure may also allow the portal, not the sponsor, to maintain the all-important investor relationship.

(For a more complete description of how such a structure might operate, see my blog post here.)

The advantages notwithstanding, the Investment Company Act of 1940 holds a potential trap for portals and sponsors using this structure.

Because it holds only securities – the stock of Newco – and not real estate or other business assets, if Investco has more than 99 investors it could be treated as an “investment company” and required to register as such with the Securities and Exchange Commission. A registered investment company is subject to onerous reporting obligations, far beyond anything contemplated by Crowdfunding portals and sponsors.

Holding only one security and making few if any investment decisions, Investco certainly doesn’t look like the typical company registered under the 1940 Act. Just as the SEC took a permissive attitude toward general solicitation and advertising in the 2013 no-action letters that gave the green light to Crowdfunding before the JOBS Act became effective, perhaps it will rule that an entity organized to hold a single security is not an investment company.

Then again, as Crowdfunding becomes mainstream sponsors might start admitting the public investors directly to their own cap tables, eliminating the need for Investco. Until the SEC clarifies the definition of “investment company,” direct investment is probably the prudent course for any deal expected to attract more than 99 investors.

Questions? Let me know.

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