I speak with lots of people about Crowdfunding and write this blog to answer questions they ask. I’ve had hundreds of conversations that start with Crowdfunding and end up with the Investment Company Act. I hope this post will help clarify the relationship between the two.
The Investment Company Act of 1940
Many entrepreneurs have never heard of the Investment Company Act, or ICA, so that part of my conversations begins with a short primer.
Think of a mutual fund, a company that exists only to invest in stock of other companies. That’s an investment company. Unfortunately, the definition of “investment company” in the ICA is so broad it sweeps in many companies that would never think of themselves as mutual funds. Any company holding stock in another company can be treated as an investment company.
Investment companies are subject to so many rules and expensive regulations, unless you’re a mutual fund you don’t want to be treated as an investment company.
Suppose a real estate sponsor forms ABC LLC to collect 87 investors, and ABC LLC invests in the entity that owns the real estate, i.e., owns stock of one company. ABC LLC is an investment company and must comply with all the rules and regulations! Suppose you and three friends form STU LLC to invest in the stock market together. You have an investment company and must comply with all the rules and regulations! Suppose XYZ LLC raises money from 220 people to invest in startups. XYZ LLC is an investment company and must comply with all the rules and regulations!
Unless, that is, ABC LLC, STU LLC, and XYZ LLC qualify for one of the exemptions describe below.
Common Exemptions
A Company with No More Than 100 Owners
A company with no more than 100 owners is exempt from the ICA. ABC LLC and STU LLC fall within this exemption.
A Venture Capital Fund with No More Than 250 Owners
A venture capital fund with no more than 250 owners is exempt from the ICA. A “venture capital fund” means a fund that holds itself out as a venture capital fund and:
- Raises no more than $10,000,000;
- Invests no more than 20% of its capital contributions in any single investments;
- Doesn’t borrow money; and
- Doesn’t give investors the right to withdraw, redeem or require the repurchase of their ownership interests.
Depending on its terms, XYZ LLC might fall within this exemption.
A Company with Only Wealthy Investors
A company where each investor is a “qualified purchaser” is exempt from the ICA. A qualified purchaser is, in general, an individual with at least $5,000,000 of investments.
ABC LLC, STU LLC, and XYZ LLC could be eligible for this exemption.
NOTE: American securities laws have always distinguished between people who are wealthy and people who are not. The theory is that wealthy people, who can hire lawyers and accountants and possibly are smarter, don’t need the protection of the government while other people do. We see the theory in practice most commonly with the different treatment of accredited vs. non-accredited investors. With this exemption to the ICA, we see the theory taken one step farther.
Intersection with Crowdfunding
These are the key points of intersection between Crowdfunding and the ICA:
The ICA Prohibits Many Good Investment Ideas
I can’t count how many entrepreneurs have proposed a great idea, only to have me say it can’t be done because of the ICA. For example, suppose you believe in startup culture and want to give more Americans the chance to participate. You know that investing in just one startup is very risky, so you propose to raise money from hundreds of people and invest in 20 startups, a million dollars each.
You call me and I tell you that you can’t. Or more exactly, you can, but only if your hundreds of people are wealthy, which defeats the purpose.
Neither Reg CF nor Regulation A can be Used by Investment Companies
Alright, you say, suppose I’m willing to limit the number of investors to 250, all non-accredited, raise $10 million rather than $20 million, and otherwise meet the requirements of a venture capital fund. Can I do that?
Yes! Or rather, No!
Under that structure, your entity would fit within the ICA exemption described above. But to raise the $10 million, you have to find an offering exemption. The general rule, set forth in section 5 of the Securities Act of 1933, is that every time you raise money from investors you have to conduct a full-blown IPO. The most common offering types –Rule 506, Reg CF, and so forth – are exemptions from that rule. Which will you use for your new fund?
You can’t use Rule 506(c) because it doesn’t allow non-accredited investors. You can’t use Rule 506(b) because (i) it allows only 35 non-accredited investors, and (ii) it doesn’t allow advertising. And you can’t use Reg CF or Regulation A because they can’t be used by investment companies. With no offering exemptions available, the answer is No, you can’t do it.
Hold on, you say. I understand that Reg CF and Regulation A can’t be used by an investment company, but didn’t you tell me five minutes ago that my venture fund won’t be treated as an investment company if I follow the rules? Are you experiencing dementia at such an early age, with such youthful features?
Possibly, but that’s not what’s going on here. Unfortunately, neither Reg CF nor Regulation A can be used by a company that would be an investment company if not for the three exemptions I described above. I didn’t say your fund wouldn’t be an investment company, I said it wouldn’t be subject to all the expensive rules and regulations of the ICA.
It’s like a trick the law plays on you. ABC LLC STU LLC, and XYZ LLC will have “IC” emblazoned on their chests forever.
The ICA Exemptions and the Offering Exemptions are Apples and Oranges
People will say “I know I can’t have more than 100 non-accredited investors” or “Am I still subject to the Investment Company Act if I use Rule 506(c)?”
Those are non-sequiturs. On one side of the fence sits the Investment Company Act of 1940 and its exemptions. On the other side of the fence sits the Securities Act of 1933 and its exemptions. The exemptions for one having nothing to do with the exemptions for the other. They aren’t friends.
Thus:
- The ICA exemptions apply no matter how you raise the money. If you’re relying on the 100-owner exemption, for example, you can raise the money from 100 qualified purchasers, from 100 accredited investors, from 100 non-accredited investors, or a mix of investors. But you must qualify under one of the offering exemptions separately.
- Of the offering exemptions commonly used, you can use Rule 506(b) (no advertising, up to 35 non-accredited investors) or Rule 506(c) (no non-accredited investors, unlimited advertising) without thinking about the ICA. But if you want to use Reg CF or Regulation A, you have to think about the ICA a lot.
Every conversation about Crowdfunding should include time for the Investment Company Act. Beware!
Questions? Let me know.