Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.
Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.
A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.
For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.
But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law.
A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:
Seek instructions from the holders of its securities with regard to:
- The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
- Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.
So let’s think of two scenarios.
In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.
Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.
The first scenario clearly complies with Rule 3a-9. Does the second?
To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.
Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.
When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.
Questions? Let me know.
2 thoughts on “Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles”
Having 1000s of investors without a proxy or voting agreement in place can discourage potential acquirers. Even though it’s possible nowadays to have a vote of all of the security holders without too much trouble — at least compared to 20 years ago — potential acquirers unfamiliar with crowdfunding are definitely concerned about having to get the consent of all of these folks. How do you recommend handling this issue?
Great comment as usual.
There are at least four answers.
1) Don’t issue voting securities to investors.
2) If you issue voting securities, make sure the vote of your Reg CF investors isn’t needed. For example, Reg CF investors might own 18.7% of a given class of voting securities.
3) Admit the investors directly to the issuer’s cap table with a proxy, without a crowdfunding vehicle.
4) When you create a class of voting securities, ensure that the voting mechanism “works” for a large number of investors. That means providing for electronic voting and also providing that the failure to respond counts as a Yes.
I hope that someday soon the SEC eliminates the $25M-of-assets rule and everyone will stop using crowdfunding vehicles, which create more problems than they solve.