Category: Crowdfunding Vehicles

Illustration representing the structure of Regulation Crowdfunding and the difference between using a custodian and a crowdfunding vehicle

Don’t Use Custodians In Crowdfunding

On By crowdfundattnyIn Crowdfunding Custodian, Crowdfunding Vehicles, Reg CF4 Comments
Visual representation of Reg CF structure and custodian risk

There is no compelling reason to use a custodian in Reg CF and a very good reason not to. But some funding portals, like StartEngine, keep doing it. Why?

On its website, StartEngine explains that custodians are used for:

  • Safekeeping of Assets:  Custodians are responsible for holding and protecting securities and other assets. 
  • Settlement of Transactions:  Custodians facilitate the settlement of securities transactions, ensuring that trades are executed correctly and that the ownership of securities is accurately transferred.
  • Income Collection:  Custodians collect income generated by the securities, such as interest and dividends, and ensure that these funds are credited to the correct accounts.
  • Corporate Actions:  Custodians manage corporate actions, ensuring that all changes are accurately recorded and reflected in the investor’s accounts.
  • Reporting and Compliance:  Custodians provide detailed reports on the assets they hold and manage, ensuring transparency and compliance with regulatory requirements. They play a vital role in providing accurate and timely information to both issuers and investors.

For a publicly traded company, those things are true. But for a Reg CF offering, none of them matters very much.

In any case, they can all be handled more effectively by using a crowdfunding vehicle. NewCo, Inc. is raising money using Reg CF. NewCo forms and serves as the manager of NewCo CF LLC. NewCo CF LLC is one entry on the cap table of NewCo, Inc. Investors buy stock in NewCo CF LLC rather than in NewCo, Inc.

Everything – distributions, reporting, etc. – works the same as if investors owned stock in NewCo, Inc. directly, with no custodian needed.

The crowdfunding vehicle is also a more effective solution for the thing that really does matter, protecting the issuer from section 12(g) of the Exchange Act.

As discussed here, section 12(g) provides that if a company has more than $10 million of assets and at least 500 non-accredited shareholders (or 2,000 total), it must file all the reports required of a public company. When a crowdfunding vehicle is used – NewCo CF LLC in the example above – only entity investors, not individuals, are counted toward those limits. Hence, a crowdfunding vehicle all but eliminates the risk of section 12(g).

A custodian might avoid section 12(g) as well, but not necessarily. On one hand, SEC Rule 12g5-1(a)(3) (17 CFR §240.12g5-1(a)(3)) provides that, in general, where stock owned by many investors is held by a custodian, only the custodian will be treated as a shareholder for purposes of the 500 and 2,000 shareholder limits.

On the other hand, Rule 12g5-1(b)(3) provides that where the issuer knows or has reason to know that the custodian was used “primarily” to avoid section 12(g), then the custodian is ignored.

In the world of public companies, nobody thinks custodians are used primarily to avoid section 12(g), inasmuch as public companies are already filing like public companies. But in the world of Reg CF, section 12(g) was a central challenge from the beginning. In fact, the SEC created crowdfunding vehicles to help the Reg CF industry avoid section 12(g). Given that background, there is no chance, in my opinion, that StartEngine chose to use custodians without thinking about section 12(g). That they listed the benefits of custodians without mentioning section 12(g) suggests they were also thinking about Rule 12g5-1(b)(3).

Without seeing the internal discussions and emails, nobody can know whether StartEngine is using custodians primarily to avoid section 12(g). At some point, however, a successful issuer that raised capital using Reg CF and a custodian is going to ask its lawyer, “Do we have to start reporting publicly?” And after listening to the lawyer hesitate and talk about Rule 12g5-1(b)(3), “Why didn’t we use a crowdfunding vehicle instead?”

That’s the question. Why use a custodian in Reg CF?

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Who should use a crowdfunding vehicle and why

Who Should Use A Crowdfunding Vehicle And Why

On By crowdfundattnyIn Crowdfunding Vehicles, Entrepreneurs, Exchange Act, Reg CF, SEC3 Comments

Most of the time, the SEC writes rules to clarify technical legal issues. When the SEC allowed crowdfunding vehicles, on the other hand, it was in response to a psychological issue, not a legal issue.

Entrepreneurs tempted to raise capital using Reg CF, thereby bypassing VCs and other professional investors, were told by those same VCs and professional investors that Reg CF would “screw up your cap table.” Even though that wasn’t true, many entrepreneurs believed it was true. The SEC gave us crowdfunding vehicles to solve the psychological problem:  with a crowdfunding vehicle, you can put all your Reg CF investors in one entity with one entry on your cap table. 

In that way, using a crowdfunding vehicle for your Reg CF offering is like using a C corporation rather than an LLC. You the entrepreneur might know it’s unnecessary, but if your prospective investors think it’s necessary, then it’s necessary. As I often say only partly tongue-in-cheek, that’s why they call it capitalism.

In fact, there is one reason for using a crowdfunding vehicle beyond the psychological. That’s because of a quirk in section 12(g) of the Securities Exchange Act of 1934.

Section 12(g) of Exchange Act

Section 12(g) of the Exchange Act provides that any company with at least $10 million of assets and a class of equity securities held by at least 2,000 total investors or 500 non-accredited investors of record must provide all the reporting of a fully public company. You don’t want that burden for your startup.

The good news is that Reg CF investors aren’t counted toward the 2,000/500 limits, provided:

  1. The issuer uses a registered transfer agent to keep track of its securities; and 
  2. The issuer has no more than $25 million of assets. 

Most startups will never have $25 million of assets. Most startups will never have 500 non-accredited investors or 2,000 total investors. Some startups will issue debt securities rather than equity securities. But some startups could find themselves subject to full public reporting under section 12(g). 

For those startups, a crowdfunding vehicle makes sense. That because, through a quirk in the rules, if you use a crowdfunding vehicle then the only investors who count toward the 2,000/500 limits are entities, like LLCs and corporations. Individual investors aren’t counted at all, and the assets of the company don’t matter.

Thus, if you’re a startup that might otherwise trigger section 12(g), a crowdfunding vehicle makes sense.

Requirements for Crowdfunding Vehicles

A crowdfunding vehicle must:

  • Have no other business.
  • Not borrow money.
  • Issue only one class of securities.
  • Maintain a one-to-one relationship between the number, denomination, type, and rights of the issuer’s securities it owns and the number, denomination, type, and rights of the securities it issues.
  • Seek instructions from investors with regard to:
    • Voting the issuer’s securities (if they are voting securities).
    • Participating in tender or exchange offers of the issuer.
  • Provide to each investor the right to direct the crowdfunding vehicle to assert the same legal rights the investor would have if he or she had invested directly in the issuer.

Those are requirements, not suggestions. In a later post I’ll explain what they mean. Here, I’ll just point out that some high-volume portals violate some of the requirements routinely, in my always-humble opinion. 

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NOTE:  Crowdfunding vehicles work only with Reg CF. If you raise money from 127 accredited investors using Rule 506(c), you can’t put them in a separate entity. But don’t worry, it doesn’t have to screw up your cap table. 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

How to Write A Biography For A Crowdfunding Disclosure Document

How To Draft A Form C For Regulation Crowdfunding

On By crowdfundattnyIn Crowdfunding Vehicles, Form C, Reg CF, SPVLeave a comment

Form C is the disclosure document used in Reg CF. Because I see so many Form Cs that aren’t done properly, I thought it would be worthwhile to explain how a Form C should be drafted and why too many lawyers go astray.

Rule 201 (17 CFR §227.201) tells us exactly what should be disclosed in a Form C:

  • Rule 201(a) calls for the name, legal status, physical address, and website of the issuer.
  • Rule 201(b) calls for the names and business experience of officers and directors. 
  • Rule 201(c) calls for the name of each person owning 20% or more of the voting stock.
  • All the way through Rule 201(z), which calls for copies of testing the waters materials.

Rule 201 is exhaustive, i.e., there is no disclosure requirement in Reg CF outside Rule 201, other than a short financial summary. 

If you had never prepared a disclosure document, how would you provide the disclosures required by Rule 201? Chances are, you would simply go down the list, from Rule 201(a) to Rule 201(z), and provide answers to all the questions. And that is exactly the right way to do it.

Look at this Form C, for a company called ScienceCast, Inc. Look at the Table of Contents, how it just goes through Rule 201, item-by-item. Look at the body, where each item is labeled with the corresponding rule. Look how the Form C describes the role of the crowdfunding vehicle, or SPV. If you had never prepared a disclosure document and were trying to do things right, I bet this is how you would do it.

Yet look at most of the Form Cs that are filed with the SEC. They don’t follow this format at all or follow it only loosely. In the worst case, of which there are many examples, you can’t even tell it’s a Form C. It looks like a typical Private Placement Memorandum you would see in a Regulation D offering.

And that explains why too many lawyers go off track. A lawyer who has prepared hundreds of Private Placement Memoranda thinks “A Form C is just another type of disclosure document. I’ll start with the form I’m already familiar with rather than create something new from scratch.”

Legal forms can be very useful, but they can also become like an old ship encrusted with barnacles. Over time, lawyers tend to add things to form documents as new cases are decided or new concepts come to mind, but rarely is any of the old stuff scraped away, much less the whole document re-thought.

Using the fresh-out-of-the-box Form C rather than the encrusted Private Placement Memorandum has many benefits:

  • It’s far easier to make sure all the disclosures are there.
  • It’s far easier to check for accuracy.
  • It’s far easier to create an easy-to-understand template.
  • It’s far more efficient, cutting costs.
  • It’s far easier for a lawyer to prepare or review, cutting costs.
  • It’s far easier for the funding portal to explain to the issuer.
  • It avoids all the duplication you see in a typical PPM.
  • It avoids all the state notices and other unnecessary legal boilerplate you see in a typical PPM.
  • It’s far easier for an investor to compare one offering to another.
  • It’s far easier for an investor to read and understand.
  • It uses less energy, reducing the impact of Reg CF on the fragile coral reefs surrounding Australia.

For Reg CF to grow, the industry must standardize. I hope it can at least standardize around a Form C.

Questions? Let me know.

audience asking questions by raising hands

The Series LLC And Crowdfunding Vehicle: A Legal Explanation And A Funding Portal WSP

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Vehicles, Series LLCLeave a comment

Lots of people have asked for a legal explanation in response to my previous post about crowdfunding vehicles and the series LLC. Plus, many funding portals will want a Written Supervisory Procedure (WSP) addressing the issue.

Here’s the legal reason why a “series” of a limited liability company can’t serve as a crowdfunding vehicle.

Rule 3a-9(b)(1) (17 CFR §270.3a-9(b)(2)) defines “crowdfunding vehicle” as follows:

Crowdfunding vehicle means an issuer formed by or on behalf of a crowdfunding issuer for the purpose of conducting an offering under section 4(a)(6) of the Securities Act as a co-issuer with the crowdfunding issuer, which offering is controlled by the crowdfunding issuer.

You see the reference to the crowdfunding vehicle as an “issuer” and a “co-issuer.”

Now here’s a C&DI (Compliance & Disclosure Interpretation) issued by the SEC in 2009:

Question 104.01

Question: When a statutory trust registers the offer and sale of beneficial units in multiple series, or a limited partnership registers the offer and sale of limited partnership interests in multiple series, on a single registration statement, should each series be treated as a separate registrant?

Answer: No. Even though a series of beneficial units or limited partnership interests may represent interests in a separate or discrete set of assets – and not in the statutory trust or limited partnership as a whole – unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.

Note the conclusion:  “. . . .unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.”

A “series” of a limited liability company is not a separate legal entity. Under section 218 of the Delaware Limited Liability Company Act and corresponding provisions of the LLC laws of other states, if you keep accurate records then the assets of one series aren’t subject to the liabilities of another series. That makes a series like a separate entity, at least in one respect, but it doesn’t make the series a separate legal entity. A motorcycle is like a car in some respects but it’s not a car.

That’s the beginning and end of the story:  a crowdfunding vehicle must be an “issuer”; a series of a limited liability company can’t be an “issuer” because it’s not a separate legal entity; therefore a series of a limited liability company can’t be a crowdfunding vehicle.

Maybe someone will challenge the application of the C&DI in court. Until that happens the result is pretty clear.

A couple more things.

First, this same C&DI is the basis of many successful offerings under Regulation A. Suppose, for example, that you’d like to use Regulation A to raise money for real estate projects (or racehorses, or vintage cars, or anything else), but you don’t want to spend the time and money to conduct a Regulation A offering for each project. This same C&DI allows sponsors to treat the “parent” limited liability company as the only “issuer” in the Regulation A offering even while allowing investors to choose which project they’d like to invest in and segregating the projects in separate “series” for liability purposes. If each series were a separate issuer that wouldn’t work.

Second, suppose a funding portal creates a new series for each offering and has conducted 25 offerings (that is, 25 series for 25 crowdfunding vehicles), each with a different type of security (one for each offering). Because we know that only the “parent” can be an issuer:

  • They’ve violated Rule 3a-9(a)(3) because the parent has issued more than one class of securities; and
  • They’ve violated Rule 3a-9(a)(6) because there is no one-to-one correspondence between the securities of the parent and the securities of the crowdfunding issuer.

To quote Simon & Garfunkel, any way you look at this you lose.

If you’re a funding portal, you’ll probably be asked by FINRA to add a WSP dealing with crowdfunding vehicles. Here’s an example.

Questions? Let me know. 

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

On By crowdfundattnyIn Crowdfunding, Crowdfunding VehiclesLeave a comment

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.