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:
- The issuer uses a registered transfer agent to keep track of its securities; and
- 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
