Crow of people wearing masks

PODCAST: Is Coronavirus Impacting Crowdfunding?

Coronavirus is the epitome of what a “risk factor” is in any crowdfunding or real estate deal. As such, whatever the deal, issuers are required to warn potential investors about the riskiness of such an investment. If they don’t, then these businesses can get into serious trouble. Coronavirus compounds that issue even more. In this podcast, attorney Mark Roderick of Lex Nova Law provides some real world examples of what Covid19 disclosures are required in crowdfunding offerings and goes over some of the emergency rules that the SEC issued to facilitate Title III crowdfunding during the coronavirus crisis.

How Coronavirus is Impacting Crowdfunding

The COVID-19 pandemic illustrates exactly why a list of “risk factors” should be included in offering documents when companies issue and sell securities. As Mr. Roderick notes on the podcast, crowdfunding itself can be the catalyst of what may actually restart the economy, but the proper disclosures are a must!

For example, if a company issued stock before the pandemic began, its duty to tell investors about the pandemic would depend on which version of Crowdfunding it used.

Are you aware of these specifics? If not, listening to this podcast will get you up to speed on important items you may not know about, yet are crucial to your crowdfunding efforts (especially if something goes wrong). In addition, are you aware of the temporary rules that the SEC has adopted to make Title III crowdfunding a bit easier in the short term in four major ways? You’d be wise to get a pen and paper and take notes regarding the significant points Mr. Roderick explains in detail in this episode.

New Podcast: Is the SEC Democratizing Investment?

Democratizing investment. A huge step forward.

My guest today is Mark Roderick, founder of Lex Nova Law and one of the top online crowdfunding experts in the country. Mark and I discuss the very exciting changes proposed by the Securities and Exchange Commission to regulation crowdfunding, or Reg CF, the securities regulation that is really the first step taken by the S.E.C. towards democratizing investment. The additional changes proposed will give this regulation real legs.

Impact Real Estate Investing Podcast

Insights and Inspirations

  • Mark believes the latest round of changes to the crowdfunding rules will bring some fundamental changes to the industry including higher quality deals.
  • As the deals get better, so will the industry grow, and more investors join in.
  • He expects to see changes in the physical landscape in just 5 years as these rules begin to have a far-reaching effect.
WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

Too many issuers think of the Regulation A Offering Circular as just a dry legal document between the SEC and the lawyers. It should be more than that.

As I’ve said once or twice before, Crowdfunding is a marketing business. Creating a great company with a great product isn’t enough. “Build it and they will come” worked for Kevin Costner but it doesn’t work for most companies trying to raise capital.

Here are some examples of things you’d like to say to attract investors:

  • We have a terrific track record in this industry going back 15 years.
  • Our performance during the last five years has doubled industry averages.
  • Our Founder has had successful exits from her last three companies.
  • Experts forecast that our market will triple over the next seven years.

Those can be very powerful messages for prospective investors. But here’s the thing:  you’re not allowed to say them in your Facebook ads unless you’ve already said them in your Offering Circular.

You spend all the time and money to have your Regulation A offering qualified by the SEC, only to learn that you’re not allowed to say what you’d like to say to attract investors. 

Write your Offering Circular with advertising in mind. Make your lawyer speak with your marketing team and vice versa, even though they speak different languages. Create your marketing materials — your website, your Facebook ads, your email campaigns — in conjunction with your Offering Circular, so all the pieces are working together rather than pulling in opposite directions.

How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many,

THE BIG PROBLEM FOR CROWDFUNDING THAT REALLY ISN’T A PROBLEM

Ask 10 entrepreneurs why they haven’t used Crowdfunding. Three will answer they haven’t heard of it while seven will say “Crowdfunding will screw up my cap table.” Once and for all, let’s lay that fallacy to rest.

We’ll start by noting that many companies have raised money from Crowdfunding and gone on to later rounds of funding, including public offerings. That proves that what passes for common knowledge in some circles can’t actually be true. But let’s drill down a bit more.

What is it about Crowdfunding that could screw up a cap table?

It couldn’t be the number of investors. Public companies with hundreds of thousands of shareholders have no problem managing their cap tables or raising more capital when they need it. Beyond that, technology has made keeping track of investors pretty simple. You can send 1099s to 2,000 shareholders as easily as you can send them to 20, while Excel spreadsheets have 1,048,576 rows. Cap table management tools like Carta make the process even easier.

Don’t want to manage the cap table yourself? Fund managers like Assure Fund Management will handle it for you.

If having lots of investors doesn’t screw up a cap table, what does?

The answer is that a cap table is screwed up by the terms of the securities issued to investors. For example:

  • A company issues 52% of its voting stock to early investors.
  • A company issues stock to early investors with an agreement giving the investors veto rights over a sale of the company.
  • A company issues stock giving early investors a “put” after five years.

In those circumstances and many others, the rights given to early investors inhibit or even preclude the company from raising money in the future. Who’s going to invest in a company where the founder no longer has voting control?

But for purposes of this post, the important observation is that none of those examples depends on the number of rows in your Excel spreadsheet or how the money was raised. If the first round of funding came from just 10 friends and family members who together received 52% of the voting stock, that company has a screwed up cap table and will have a hard time raising more money. By contrast, the company that raised money from 1,000 strangers in Title III by issuing non-voting stock does not have a screwed up cap table and can raise money from anyone in the future, no problem.

To avoid screwing up your cap table, don’t worry about the number of investors and certainly don’t avoid Crowdfunding. Instead, focus on what matters:  the kinds of securities you issue and the rights you give investors. 

Where did the fallacy come from? The venture capital and organized angel investor folks, i.e., the same folks who predicted a few billion dollars ago that Rule 506(c) would never work because accredited investors wouldn’t submit to verification. Considering themselves indispensable middlemen, these folks view Crowdfunding as a threat. (I’ve always thought they should use Crowdfunding as a tool instead of fighting the tide, but that’s a different blog post.)

The fallacy has proven very hard to shoot down, perhaps because of the outsized influence venture capital and organized angel investor folks enjoy in the capital formation industry. In fact, it’s proven so hard to shoot down that the soon-to-be-released SEC rules allowing SPVs in Title III were written in response. If we’re smart about the kinds of securities we issue we don’t need an SPV, while if we issue the wrong kind of security then an SPV doesn’t help. The new SEC rules were written solely for the sake of perception, “solving” a problem that didn’t really exist.

Similarly, the perception that Crowdfunding screws up your cap table led one of the largest Title III platforms, WeFunder, to create an even more convoluted “solution.” WeFunder has investors appoint a transfer agent to hold their securities. Under 17 CFR §240.12g5-1, this means that all the securities are “held of record” by one person for purposes of section 12(g) of the Exchange Act. Based on the section 12(g) definition WeFunder then claims that a round of financing on its platform leaves the issuer with “a single entry on your cap table.” That’s a creative claim, given that the term “cap table” has no legal meaning and if an issuer is an LLC and raises money from 600 investors there are going to be 600 K-1s.  But the point is that WeFunder goes to this trouble and the attendant costs over a problem of perception, not reality.

How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many, that’s for sure.

RULE 10b-5: THE HIDDEN DISCLOSURE REQUIREMENT IN REGULATION A

RULE 10b-5: THE HIDDEN DISCLOSURE REQUIREMENT IN REGULATION A

Preparing a Regulation A Offering Circular is as much an art as a science.

An issuer offering securities using Regulation A can choose from several disclosure formats, including Form 1-A, Form S-1, or Form S-11. Each of these SEC forms includes a list of information that must be disclosed. For example, Form 1-A lists 17 items, ranging from the cover page to the Exhibits, each with sub-categories and special rules. Transparency and disclosure have been the touchstones of U.S. securities laws since the 1930s, and each form includes hundreds of pieces of information that must be disclosed to prospective investors. 

But even an issuer that made a list of all those items and completed the form meticulously wouldn’t be finished, because 17 CFR §240.10b-5 effectively imposes a catch-all requirement for disclosure.

Rule 10b-5(b) provides:

“It shall be unlawful for any person, directly or indirectly. . . .[t]o make any untrue statement of a material fact or to omit to state a  material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

The first part of that statement is easy:  you’re not allowed to make untrue statements of material facts, i.e., to lie.

It’s the second part that requires some thought. A couple simple examples:

  • You’re raising money for a grocery delivery business and there’s a guy on your board named Jeffrey Bezos. You’d better tell investors he’s not that Jeffrey Bezos.
  • Your Offering Circular describes the patent with which you expect to revolutionize the world of online payments. You’d better mention the letter you received alleging that your patent is invalid.

In practice, Rule 10b-5(b) means that no matter how many times you compare the SEC form (Form 1-A, Form S-1, Form S-11) to your Offering Circular, checking off all the boxes, if investors lose money a plaintiff’s lawyer can snoop around, with the benefit of hindsight, looking for something else that should have been disclosed. 

That’s why preparing a Regulation A Offering Circular is as much an art as a science.

THE EXPANDED DEFINITION OF ACCREDITED INVESTOR: A (FIRST) STEP IN THE RIGHT DIRECTION

For all the ink spilled wondering and worrying how the SEC might change the definition of accredited investor, yesterday’s announcement seems almost anti-climactic.

Perhaps the main story is what the SEC didn’t do. It didn’t limit the definition of accredited investor in any way. Everyone who was an accredited investor yesterday is an accredited investor today. In that sense the SEC continues to demonstrate its support for the private investment marketplace and give the lie to those who believe otherwise.

On the other hand, the SEC didn’t break much new ground expanding the definition, at least for now.

The principal expansion, as expected, was in adding to the list of accredited investors individuals who hold Series 7, Series 65, or Series 82 licenses. The SEC also added investment advisers registered with the SEC or any state and, more surprisingly, venture capital fund advisers and exempt reporting advisers. I say “more surprisingly” because neither venture capital fund advisers nor exempt reporting advisers are required to pass exams or otherwise demonstrate financial knowledge or sophistication.

The list of accredited investors was also extended to include:

  • Entities, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that (1) own “investments” (as defined in Rule 2a51-1(b) under the Investment Company Act of 1940) in excess of $5 million, and (2) were not formed to invest in the securities offered;
  • Rural business development companies;
  • Family offices with at least $5 million in assets under management and their family clients, as each term is defined under the Investment Advisers Act of 1940; and
  • Knowledgeable employees of a private fund, but only with respect to investments in that fund.

Finally, the SEC clarified that existing provisions of the accredited investor definition that refer to spouses also includes “spousal equivalents,” meaning someone who has gotten under your nerves for at least seven years (actually “a cohabitant occupying a relationship generally equivalent to that of a spouse”).

While a modest first step, these additions are welcome and a harbinger of bigger things to come. The new rule explicitly invites FINRA, other industry self-regulatory authorities, and accredited education institutions to develop “certifications, designations, or credentials” that the SEC would approve for accredited investor qualification. I imagine FINRA and professional organizations will jump at the chance. If this leads to millions or tens of millions of Americans learning about securities and participating in the Crowdfunding market, well, that’s a very good thing for everyone.

The new definition will become effective 60 days after being published in the Federal Register.

MY COMMENTS TO SEC’S CROWDFUNDING PROPOSALS

Gentlemen and Ladies—

The following are comments to the proposed rules published in the Federal Register on March 31, 2020 relating to offerings under §4(a)(6) of the Securities Act of 1933 and related matters.

Before commenting, I would like to applaud the Commission not only for these proposals but for its approach to the JOBS Act generally. I have practiced in this space extensively since 2012, representing funding portals, issuers, and other industry participants. Time after time I have been impressed with how the Commission has sought to achieve two complimentary goals:  on one hand, protecting investors and ensuring that American capital markets remain the most transparent and robust in the world; and on the other hand, facilitating capital formation by small, job-creating enterprises and giving ordinary Americans the opportunity to invest in businesses historically available only to the wealthy.

Among many examples I will mention just one. On May 4, 2020 the Commission adopted temporary rules to facilitate capital formation under §4(a)(6) In response to the COVID-19 pandemic. No one knows how many jobs the temporary rules will save or create, but the willingness of the Commission to draft and issue the temporary rules in the midst of a crisis, taking the time to help very small businesses while overseeing a complex, multi-trillion dollar securities market, speaks volumes. The Commission clearly believes that Crowdfunding has an important role to play in our capital markets, and all Americans, not just those of us in the industry, should be grateful.

Speaking from the ground floor, so to speak, I have just a few comments, all geared toward making the industry more robust while protecting investors.

Raised Offering Limit and Elimination of Limit for Accredited Investors

To my mind, the two most important and welcome proposals are (i) to increase the limit set forth in 17 CFR §227.100(a)(1) from $1,070,000 to $5,000,000, and (ii) to eliminate the limit in 17 CFR §227.100(a)(2) for accredited investors. Either change would have been welcome, but together I believe they will change the Title III market significantly for the better, improving both the quality of the offerings and the level of compliance.

With offerings limited to $1,070,000 and very low per-investor limits, even for accredited investors, funding portals have had a very hard time making money, plain and simple. Struggling to make ends meet, they lack resources to spend on compliance or on other business practices that would attract more promising issuers and, especially, a larger number of prospective investors. In fact, the difficulty in turning a profit has led some funding portals to adopt practices that may provide some benefit in the short term but drive away rather than attract issuers and investors.

With larger offerings and unlimited investments from accredited investors, I believe that the proposed changes to 17 CFR §227.100(a)(1) and 17 CFR §227.100(a)(2) will reverse that cycle. A profitable funding portal can hire compliance officers, exercise more discretion in the presentation of disclosure materials, provide better documents, insist on quality in all aspects of its business. These steps will in turn attract more investors, which will attract more and better issuers, in a virtuous cycle. With the promise of potential profits, I expect the number, sophistication, and expertise of funding portals to grow rapidly, helping to deliver on the promises with which Title III was launched.

Hence, I strongly support these proposals.

Artificially Low Target Offering Amounts

Too often, we see Title III issuers launch offerings with an artificially low target offering amount, typically $10,000. I believe the artificially-low target amounts are unfair to investors and poisonous to the Title III Crowdfunding market.

The concept of offering “minimums” has always been part of private investments with sophisticated investors. For example, a company seeking to raise as much as $750,000 to obtain three patents and hire a Chief Operating Officer and Chief Marketing Officer might set a minimum offering amount of $450,000, which would allow it to at least obtain two patents and hire the COO. But if the company could raise only $150,000 the company was obligated to give the money back, because sophisticated understand that anything less than $450,000 wouldn’t move the needle for the business.

I believe the concept of target offering amounts in Title III should follow that model, i.e., that the target offering amount should represent an amount of money that would allow the issuer to achieve a significant business goal.

Too often we see on funding portals a company that seeks to raise, say, $350,000 setting a target offering amount as low as $10,000. The artificially low target amount serves the short-term interests of the funding portal and the issuer:  if the company raises, say, $38,000, the issuer receives some cash while the funding portal receives a commission on $38,000 and includes the issuer in its list of “successful” offerings, skewing its statistics as well as the statistics of the industry as a whole. Meanwhile, investors have put $38,000 into a company that needed a lot more and have thereby made an investment fundamentally different and riskier than the investment promised. In the larger picture, I believe sophisticated investors see the game and stay away from the funding portal – and perhaps all of Title III – altogether.

I believe the Commission should amend 17 CFR §227.201(g) to provide as follows:

The target offering amount, the deadline to reach the target offering amount, a statement of the significant business goal the issuer expects to achieve if it can raise the target amount or, if there is no such significant goal, a statement to that effect, and a statement that if the sum of the investment commitments does not equal or exceed the target offering amount at the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned;

In addition, I believe the Commission should caution issuers and funding portals that if raising the target offering amount will not allow the issuer to achieve any significant business goal, a risk factor should be added to that effect.

Revenue-Sharing Notes

The Commission proposes to add 17 CFR §227.100(b)(7), making Title III Crowdfunding unavailable for securities that “Are not equity securities, debt securities, and securities convertible or exchangeable to equity interests, including any guarantees of such securities.”

It is unclear to me whether this new rule would allow securities commonly referred to as “revenue-sharing notes.” I believe these securities should be allowed.

A typical revenue-sharing note has the following features:

  • Investors are entitled to receive a specified percentage of the issuer’s gross revenues, or gross revenues from specified sources (e.g., from sales of a new product).
  • The note specifies a maximum amount investors may receive, often a multiple of the amount invested. For example, investors might be entitled to receive a maximum of twice the amount invested.
  • The note also specifies a maturity date – for example, three years from the date of issue.
  • Payments continue until the sooner of the maturity date or the date investors have received the specified maximum amount.
  • If investors have not received the specified maximum amount by the maturity date, they are entitled to receive the balance (the difference between the maximum amount and the amount they have received to date) on the maturity date.
  • Sometimes, but not always, the revenue-sharing is convertible into equity.

Revenue-sharing notes are especially attractive for small companies and less-experienced investors:

  • They are extremely easy to understand. For less-experienced investors a revenue-sharing note is much easier to understand than a share of common stock, for example.
  • The payments on a revenue-sharing note depend on only one thing:  sales. They do not depend on any expense items. For example, they do not depend on how much compensation is paid to the principals of the company. As a result, the potential for misunderstandings and disputes is reduced substantially.
  • They provide investors with built-in liquidity.
  • They allow issuers to maintain a “cleaner” cap table, possibly facilitating future financing rounds.
  • All those benefits are also available with straight debt securities. For many small businesses, however, and especially for true startups, there is no interest rate – short of usury, that is – that would compensate investors adequately for the risk. As of this morning, the one-year return of the S&P 500 BB High Yield Corporate Bond Index is almost 9%. To compensate investors adequately for the risk of investing in a startup the potential return must be far higher. The revenue-sharing note provides that potential.

 

Revenue-sharing notes shares features of equity securities in the sense of providing a significant potential for profit, and also share features of debt securities in the sense of providing a date certain for payment. Sharing features of both equity securities and debt securities, it is hard to say a revenue-sharing note is only an equity security or only a debt security. Hence, it would be helpful if the Commission would clarify that revenue-sharing notes may be offered and sold under §4(a)(6).

Accountant Review

In the context of large companies, reviews and audits of financial information by independent accountants is an unmitigated positive, indeed a cornerstone of transparency and integrity in the American capital markets. In the context of very small companies, however, the positives are less apparent and can be outweighed by the cost.

Currently, 17 CFR §227.201(t)(2) requires companies seeking to raise between $107,000 and $535,000 to provide financial statements reviewed by an independent accountant. The cost of such a review varies by region but can certainly amount to between $5,000 and $10,000. For a company seeking to raise, say, $150,000, the cost of the accountant review by itself represents between 3% and 7% of the capital raise, an enormous cost and far more as a percentage than the audit costs of large issuers.

In my opinion, the cost of these reviews is not justified by the value of the additional information they provide to investors. For companies raising no more than $107,000, 17 CFR §227.201(t)(2) requires only information from the company’s Federal tax certified by the principal executive officer, who is typically the founder of the company. My experience in representing hundreds of small companies over more than 30 years suggests that a certification for which a CEO and/or founder takes personal responsibility is much more likely to be accurate than a reviewed financial statement. Although I am confident that every small company files tax returns that are accurate in every respect, out of patriotic obligation, I also note that CEOs and founders are, if anything, incentivized to understate a company’s income on a tax return.

In short, I believe investors get very little, if anything, in terms of the accuracy of a company’s financial disclosures in exchange for the added cost to the company. To bring the cost and the benefit closer into line, I recommend raising the threshold in 17 CFR §227.201(t)(2) to at least $350,000, and possibly eliminating 17 CFR §227.201(t)(2) altogether and raising the threshold in 17 CFR §227.201(t)(1) to $500,000.

I will make two further points in this regard:

  • It is possible that as the market becomes more robust investors will reward companies that provide reviewed financial statements and punish those who don’t. If so, the market will impose its own discipline.
  • Although financial statements are extremely important in evaluating established companies, they are far less important in evaluating small companies and startups. For example, the financial statements of Facebook and Amazon and Microsoft were essentially irrelevant to the earliest investors. I believe that investors in the Title III market make investment decisions almost wholly without regard to historical financial statements and will continue to do so. In this sense the paradigm for large companies simply doesn’t fit the small company market.

Advertising

Section 4A(b)(2) of the Securities Act provides that issuers relying on the exemption of §4(a)(6) “shall not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.” That rule is implemented in 17 CFR §227.204, which defines the “terms of the offering” to mean (i) the amount of securities offered, (ii) the nature of the securities, (iii) the price of the securities, and (iv) the closing date of the offering period.

In practice this rule has created a great deal of confusion and many inadvertent violations. It has also kept issuers from communicating effectively with prospective investors. I do not believe it has protected investors in any meaningful way.

A small company will reasonably wonder why it is allowed to say “We’re raising capital!” on its Facebook page but might not be allowed to say “We’re trying to raise $250,000 of capital!” I say “might not” because even with this simple example the rule is not clear. If “We’re trying to raise $250,000 of capital!” were the only item the company ever posted on Facebook, that would be okay. But of course the company’s Facebook page is filled with all sorts of other information, including information about the company’s founders and history and products – that’s the point of having a Facebook page. In this situation the statement “We’re trying to raise $250,000 of capital!” might be illegal, while the statement “We’re raising capital!” is fine.

In today’s digital, social-media-driven world that creates a mess, impossible for small companies to untangle.

The problems arise from applying the paradigm of large, public companies to the world of small companies and startups. If I want to buy stock of Google I don’t call Google, I call my broker. At some point in the future funding portals might play the role for small companies that brokers play for large companies today. For the present, however, the reality is that Title III issuers have primary and sometimes exclusive responsibility for marketing their own offerings. To hamstring advertising by Title III issuers is to hamstring Title III.

I do understand and support the goal of directing investors back to the portal and thus ensuring that all investors receive exactly the same information. However, I believe that goal can be accomplished, with no harm to investors, through a slightly different approach.

In a Title III offering, I understand the “terms of the offering” to mean all the information contained in Form C. Thus, I would interpret section 4A(b)(2) to mean only that if an issuer provides to prospective investors all or substantially all of the information provided in its Form C, it must direct them to the portal. Otherwise, issuers should be allowed to advertise their offerings, including the four terms enumerated in current 17 CFR §227.204, with three caveats:

  • I would require every advertisement, no matter its contents, to direct potential investors to the funding portal. For these purposes I would define the term “advertisement” very broadly, even more broadly than the term “offer” is defined under current law. Thus, I would consider requiring even notices permitted by 17 CFR §230.169 to include a link back to the funding portal, if made while the offering is open.
  • I would prohibit any advertisement containing information that is not in the issuer’s Form C.
  • In the text of 17 CFR §227.204 I would remind issuers and their principals of their potential liability for material misstatements and omissions.

Those changes would provide clear rules for issuers and funding portals and, I believe, would unleash a torrent of creativity and energy in the Title III market, with no harm to investors.

The Role of FINRA

Under section 4A(a)(2) of the Securities Act, every funding portal must register with any applicable self-regulatory organization. Because there is only one such organization in the United States, all funding portals must become members of the Financial Industry Regulatory Authority, or FINRA. Consequently, although not directly germane to the Commission’s proposals published on March 31, 2020, any discussion of Title III must include at least a reference to FINRA and its regulation of funding portals.

Like everyone else involved in Title III, lawyers and the Commission included, FINRA was starting from scratch in 2016, its two point of reference being the Commission’s regulations on one hand and its own experience regulating broker-dealers on the other hand. In my view FINRA has leaned too heavily on its institutional experience regulating large broker-dealers without taking into account the unique aspects of Title III Crowdfunding.

The Commission’s proposals, and my comments to the proposals, are focused on the economic realities of raising capital for very small companies. One of those economic realities is that most funding portals, like most startups, are owned and operated by just a few people. Too often, the FINRA regulatory paradigm seems to ignore this reality and assume that the funding portal is a much larger enterprise, an enterprise with multiple layers of management – an enterprise like a national broker-dealer.

For example, FINRA requires funding portals to adopt and adhere to an extensive manual of policies and procedures addressing every aspect of its operations. Theoretically such a manual is unobjectionable, and in a large organization absolutely necessary, but in the real world of funding portals the manual typically has the effect of requiring Ms. Smith to supervise herself and maintain a meticulous log proving she did so, and how.

Just as the Commission itself seeks to regulate Title III Crowdfunding based on economic realities, understanding that the rules applicable to public filers might not always apply to very small issuers, I would like to see the Commission encourage FINRA to review its approach to funding portals.

****

Thank you for your consideration.

MARK RODERICK

COVID-19 DISCLOSURES IN CROWDFUNDING OFFERINGS

The COVID-19 pandemic illustrates why we include a list of “risk factors” when we sell securities. Suppose a company issued stock on January 1, 2020 without disclosing that its major supplier was located in Wuhan, China and that Wuhan was experiencing an outbreak of a new virus. Investors who bought the stock likely would be entitled to their money back and have personal claims against the founders, officers, and directors.

If the company issued stock on October 1, 2019, before the pandemic began, its duty to tell investors about the pandemic would depend on which version of Crowdfunding it used:

  • If it used Title II Crowdfunding (Rule 506(c)) the company would have no duty to tell investors about the pandemic.
  • If it used Title III Crowdfunding (Regulation CF) the company would be required to tell investors about the pandemic in its next annual report.
  • If it used Title IV Crowdfunding (Regulation A) the company would be required to tell investors about the pandemic in its next semiannual or annual report, whichever comes first.

CAUTION:  That assumes the Company was finished selling stock on October 1, 2019. If it was continuing to sell stock when it learned of the pandemic, then the Company would be required to tell new investors. And if a Title III offering hadn’t yet closed, all existing investors would have the right to change their minds.

CAUTION:  A company – even a publicly-reporting company – generally is not required to tell investors about COVID-19 if it is not selling securities currently, because pandemics are not on the list of disclosure items found in Form 1-U (for Regulation A issuers) or Form 8-K (for publicly-reporting companies). But be careful. For example, if a Regulation A issuer redeems stock without disclosing the effect of COVID-19, it could be liable under Rule 10b-5 and otherwise.

Assume that we’re required to tell investors about COVID-19 today, whether because we’re selling stock or are filing an annual or semiannual report. What do we say?

If this were January, we might say something simple:  “Wuhan, China is experiencing an outbreak of a highly-contagious virus, which is disrupting economic activity. If this virus should spread to the United States, as epidemiologists predict, it could have an adverse effect on our business.”

But this isn’t January. We have much more information today and are therefore required to say more. Exactly how much information we share is as much an art as a science. Our goal is always to give investors enough information to make an informed decision without making the disclosure so dense as to be useless.

Here are two examples, one for multi-family housing projects and the other for a technology company.

Multi-Family Housing

With unemployment reaching levels not seen since the Great Depression, by some estimates already 20% and rising, we are already experiencing a number of negative effects from the COVID-19 pandemic:

  • We are experiencing a decrease in the number of phone calls and visits from potential new tenants. Year-to-year compared to 2019, we experienced a decrease in traffic of approximately ____% in March and ____% in April.
  • We are experiencing an increase in rent delinquency. Year-to-year compared to 2019, the rate of delinquencies greater than 30 days rose from ____% to ____% during March and ____% to ____% during April.
  • We are spending more time and resources on collections and marketing.

Although we are working from incomplete information, we expect these trends to continue and perhaps accelerate, depending on the trajectory of the virus and the ability to re-open the economy. Among possible outcomes:

  • Occupancy levels might decrease, although they have not decreased yet as compared to the same periods in 2019.
  • We do not intend to raise rents until the pandemic eases. Depending on circumstances we could be forced to decrease rents.
  • We expect some tenants to re-locate for economic reasons, from Class A projects to Class B projects and from Class B projects to Class C projects. In some cases tenants might leave the market altogether, by moving in with relatives, for example. Because we operate primarily Class B properties, we are uncertain whether the net effect for our properties will be positive or negative.
  • Conversely, we expect that economic uncertainty will cause some families to postpone buying a house and rent instead, increasing the pool of potential tenants.
  • The pandemic has caused significant uncertainly in the value of many assets, including real estate. Until the uncertainty is resolved it might be difficult for us to borrow money or raise capital by selling equity.
  • If occupancy rates and rents decrease while delinquencies increase, we could be unable to meet our obligations as they become due. A reduction in cash flows and/or asset values could also cause us to be in default under the loan covenants under our senior debt. Either scenario could lead to foreclosure and the loss of one or more properties.

At least in the short run we expect the pandemic to cause our revenue to decrease, perhaps significantly. As a result, we are taking steps to conserve cash. Among other things we have decided not to make any cash distributions until the economic outlook stabilizes and have reduced our staff. We have also begun to contact lenders to request a deferral of our mortgage loan obligations.

We do not know how long the pandemic will last or how its effects will ripple through the American economy. In a best-case scenario we would experience a short-term drop in cash flow and a dip in asset values as the economy adjusts to a new reality. In a worst-case scenario, where occupancy and rent levels drop significantly over an extended period of time, we would be unable to make mortgage payments and possibly lose assets, risking or even forfeiting investor equity if asset values drop far enough. Based on the information currently available to us we expect an outcome closer to the former scenario than to the latter and are marshalling all our experience and assets toward that end.

Technology

Our software provides a virtual connection between internet-based office telephone systems and cellular phones, allowing incoming calls to the office number to be re-directed to the cellular phone and outgoing calls made from the cellular phone to appear to the recipient as if they were made from the office number. Will tens of millions of people working remotely due the COVID-19 pandemic, the demand for our software has grown substantially. On January 1, 2020 our software had been installed on ________ cellular devices worldwide. On May 1, 2020 it was installed on ________ devices.

As a result, we expect both our revenue and our net income for 2020 to increase substantially. However, with many workers now returning to their offices on a full-time or part-time basis it is unclear whether the high demand for our software will continue. Consequently, we are unable to provide a reliable forecast for revenue or net income at this time.

With more than ________ new users, even if temporary, we are accelerating developing of our new consumer-based communications tools. We expected to launch these tools in Q1 2021 but are now aiming for Q3 2020.

Even before the pandemic many of our employees worked remotely at least part of the time. Therefore, our operations have not been affected significantly by the pandemic. Tragically, however, David Newsome, the leader of our marketing team, contracted COVID-19 and died on March 27th in Brooklyn, NY. We have not yet found a replacement for David, who was with the company from its founding in 2013.

We were considering purchasing a commercial building in Palo Alto as the headquarters for our engineering team. Given our successful experience working remotely we have decided to put those plans on hold at least for the time being.

SEC ISSUES EMERGENCY RULES TO FACILITATE TITLE III CROWDFUNDING DURING COVID-19 CRISIS

With credit markets tightened and 30 million Americans newly out of work, the SEC has adopted temporary rules to make Title III Crowdfunding a little easier from now until August 31, 2020.

The temporary rules are available here. They aim to make Title III a little faster and easier in four ways:

#1 – Launch Offering without Financial Statements

An issuer can launch the offering – go live on a funding portal – before its financial statements are available. (But investment commitments aren’t binding until the financial statements have been provided.)

#2 – Lower Standard for Some Financial Statements

An issuer trying to raise between $107,000 and $250,000 in a 12-month period doesn’t have to produce financial statements reviewed by an independent accountant, only financial statements and certain information from its tax return, both certified by the CEO.

#3 – Quicker Closing

An issuer can close the offering as soon as it has raised the target offering amount, even if the offering hasn’t been live for 21 days, as long as the closing occurs at least 48 hours after the last investment commitment and the funding portal notifies investors of the early closing.

#4 – Limit on Investor Cancellations 

Investors can cancel within 48 hours of making a commitment, but can’t cancel after that unless there’s a material change in the offering.

CAVEAT:  These rules are not available if the issuer:

  • Was organized or operating within six months before launching the offering (e., this is not for brand-new companies); or
  • Previously raised money using Title III Crowdfunding but failed to comply with its obligations.

I’m not sure how much difference these rules will make in practice. But that’s not the main point as far as I’m concerned. The main point is that with about a million other things on its plate, the SEC took the time to think about and draft these rules. The SEC must believe that equity Crowdfunding can play an important role in our capital markets.

On that basis, I predict that the proposals the SEC made on March 4th will be adopted soon after the public comment period expires on June 1st. And after that, who knows.

SEC PROPOSES MAJOR UPGRADES TO CROWDFUNDING RULES

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.