Category: Investing

Beware Of Fraud In The Crowdfunding Market

On By crowdfundattnyIn Crowdfunding, Crowdfunding Fraud, Crowdfunding Portals, Entrepreneurs, Investing, Investor, JOBS ActLeave a comment

John Mattera offered a great deal to his investors. Through special-purpose investment vehicles, investors could buy shares in well-known companies like Facebook and Groupon, which were then privately-owned. When the companies went public, investors would reap millions.

Mattera raised more than $13 million from more than 140 investors, some of whom invested their life savings.

The only problem was that Mattera didn’t use the money to buy shares in Facebook or Groupon. Instead, he used the money for the normal trappings of ill-gotten wealth, including a waterfront home in Fort Lauderdale, two Rolls-Royces, and a Lamborghini, according to the government.

Mattera was caught and sentenced to 11 years in prison. But his investors aren’t getting their money back.

Bernie Madoff, John Mattera. . . .there is no shortage of people trying to steal your money through investment scams. Why are thieves attracted to the securities industry? As “Slick Willie” Sutton said when asked why he robbed banks, “Because that’s where the money is.”

It doesn’t matter if you’re smart, sophisticated, and have seen it all. Mattera’s investors thought they had seen it all, too.

Be careful out there.

Questions? Let me know.

Proposed Title III Crowdfunding Regulations: Better Late than Never

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Entrepreneurs, Investing, Investor, JOBS Act, Securities Exchange Commission, Securities Laws, Title III CrowdfundingLeave a comment

On October 23, 2013 the SEC proposed regulations to implement Title III Crowdfunding.

There are two extremely important things about the proposed regulations:

  • That they were issued. After a 90 day public comment period, it seems likely that Title III Crowdfunding will finally come into effect in the first quarter of 2014.
  • That they run to almost 600 pages. Given the complexity, there is some question whether, in the end, a company trying to raise money will find Title III Crowdfunding worthwhile.

Recall that the JOBS Act provides for two kinds of Crowdfunding:

  • Title II Crowdfunding allows companies to raise an unlimited amount of money from an unlimited number of accredited investors using general soliciting and advertising. That kind of Crowdfunding came into effect on September 23, 2013 and is now in full swing.
  • Title III Crowdfunding is a different animal. It allows companies to:
    • Raise up to $1 million per year;
    • On an SEC-registered internet portal;
    • From a unlimited number of investors who do not have to be accredited;
    • But with strict limits on the amount each investor can invest.

For a detailed outline of the Title III statute itself, click here.

Despite their length, the proposed regulations do not add much to the statute. There are just a few points worth noting for a company looking to raise money:

  • The company can use only one portal at a time.
  • The company must file information via EDGAR, the SEC’s electronic database.
  • The $1 million-per-year limit applies only to money raised in Title III offerings. Thus, a company could raise $3 million in a traditional private placement (or a Title II offering) while still raising $1 million in a Title III offering.
  • Investors can change their minds up to 48 hours before the investment deadline, in all circumstances, and must also be given the right to terminate in the event of a material change in the investment opportunity.
  • The company must disclose not only its own prior offerings, but the prior offerings in which its directors and other principals were involved.
  • The SEC has created a new Form C to report Title III offerings.
  • The company may advertise, but only to direct potential investors to the portal’s website. The company may not use general solicitation and advertising, as it can in a Title II offering.
  • “Bad actors” are excluded from Title III Crowdfunding, as they are from Title II Crowdfunding.

The proposed regulations are even more important for portals, or would-be portals. The portal is designated as the virtual policeman for ensuring compliance with the law. For example, the proposed regulations provide that the portal must have a reasonable basis for believing that company is complying with the law, and must deny access to the issuer under certain circumstances. In effect, the portal is required to act as an arm of the SEC itself.

Just as a company trying to raise money might decide that Title III is too onerous, an entrepreneur thinking about forming a Title III portal might decide that the fruit are a little too high and a little too green.

Questions? Let me know.

SEC Proposes For Title III Crowdfunding

On By crowdfundattnyIn Entrepreneurs, Investing, Investor, JOBS Act, SEC, Securities Exchange Commission, Securities Laws, Title III CrowdfundingLeave a comment

Today, at long last, the SEC issued proposed regulations implementing Title III Crowdfunding, which will allow companies to raise up to $1 million per year in small increments from non-accredited investors.

With commentary, the proposed regulations run to almost 600 pages. We’ll be posting a summary soon.

Title II Crowdfunding has been live since September 23, 2013. The era of Crowdfunding is now.

Stay tuned for more updates…

Questions? Let me know.

A Legal Structure for Crowdfunding

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Entrepreneurs, Financings, Investing, JOBS Act, SEC, Securities Exchange CommissionLeave a comment

It’s official:  Crowdfunding is now in effect and thousands of companies are about to start raising money under the new SEC regulations. If each company offers different deal terms for investors, it’s going to be that much more difficult for investors to make apples-to-apples investment decisions.

Meanwhile, some in the investment community are still concerned that a company raising money through Crowdfunding will be hobbled in raising more money afterward, e.g., from angel groups or venture capital funds.

The sooner the market adopts a standard investment structure, the better for all.

Here is a legal structure that would standardize the Crowdfunding market, satisfy SEC regulations, and ensure that the Crowdfunding round of financing does not preclude later rounds:

  • New Entity:  Form a new entity for the Crowdfunding investors. We’ll call this entity InvestCo, and we’ll call the operating company itself MyCo. InvestCo will be one owner of MyCo, no matter how many investors buy stock in InvestCo.
  • Structure of InvestCo:  InvestCo will be either a limited liability company or a C corporation, based on tax and state-law considerations. InvestCo will be controlled by the same individuals who control MyCo.
  • Percentage Ownership:  Each investor will own a pro rata share of InvestCo based on his or her investment. InvestCo, in turn, will own a percentage of MyCo stipulated by MyCo in the offering materials, based on the amount of money raised and the value of MyCo. Here is a post with suggestions on establishing this ownership percentage.
  • Voting Rights of Investors:  Investors will not be entitled to vote in InvestCo, and InvestCo will not be entitled to vote in MyCo. That is, the investors in a Crowdfunded offering will have no voting rights, except the right to appoint one member to the Board of Directors of MyCo.
  • Preference on Sale or Liquidation:  If MyCo is sold or liquidated, InvestCo will be entitled to receive a return of its investment before any distributions are made to the other owners of MyCo as they exist today. If MyCo raises more money in the future, the rights of InvestCo could be subordinated to the rights of the new investors.
  • Dividend Right:  InvestCo’s stock in MyCo will bear a dividend rate of 5%.
  • Tag-Along Rights: If the founder of MyCo sells some of his or her stock, InvestCo will have the right to participate in the sale.
  • Anti-Dilution Rights:  InvestCo will be entitled to “weighted average” anti-dilution protection.
  • Right to Information:  Investors will have the right to basic information from MyCo, such as annual financial statements. Of course, state law may give them (and any other owners) the right to additional information.

This structure should be acceptable to all of the constituents of the Crowdfunding market:  the entrepreneurs who started MyCo; the broad investing public that will make Crowdfunding a success; the angel groups that help so many startups succeed and currently anchor the early-stage market; and the venture capital funds that provide additional funds for companies that need and deserve them.

Questions? Let me know.

SEC Finalizes “General Solicitation” Regulations: Full Steam Ahead

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Entrepreneurs, FundersClub, General Solicitation, Investing, Investor, JOBS Act, Kickstarter, Rule 506, SEC, Securities Exchange CommissionLeave a comment

Since President Obama signed the JOBS Act into law on April 5, 2012, we have been waiting for the SEC to finalize the rules on Crowdfunding.

At long last the SEC has done just that, at least with respect to one of the two components of Crowdfunding. Sometime in mid-September, company will be allowed to use “general solicitation” in certain “Rule 506 offerings.” The rules governing the other component of Crowdfunding, where small issuers will be allowed to raise money through Internet portals from small, unsophisticated investors, will have to wait for later in the year.

Even so, these new regulations mark the largest change to the securities laws in almost 80 years. Companies will now be allowed to raise money from accredited investors (in the case of individuals, those with over $1 million of net worth or incomes over $200,000 per year) through social media, print materials, email, and other means. Not only will companies have greater access to the capital they need, but the new rules are likely to significantly disrupt the money-raising industry, displacing brokers, lawyers, and other middlemen just as the Internet has displaced so many middlemen before them.

Now the technical rules.

The rules allow general solicitation and general advertising where:

  • All purchasers are accredited investors; and
  • The company takes reasonable steps to verify that the purchasers are accredited investors; and
  • All of the requirements in Rule 501, Rule 502(a), and 502(d) are satisfied.

Whether the company has taken “reasonable steps” will be determined on a case-by-case basis. Among the relevant factors:

  • The type of accredited investor that the purchaser claims to be (e.g., the CEO of a Fortune 100 company or a store clerk).
  • The amount and type of information that the issuer has about the purchaser.
  • The nature of the offering, including the manner of the solicitation.

When the regulations were proposed last August, many people complained about the absence of hard-and-fast rules and the resulting ambiguity. The final rules take a large step in the direction of certainty by providing that a company will be considered to have taken reasonable steps to verify that a natural person is an accredited investor if it does any of the following:

  • If basing the decision on the purchaser’s net income:
    • Reviews W-2s, 1099s, or other IRS documents that report the person’s income for the past two years; and
    • Obtains a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
    • If basing the decision on the purchaser’s net worth:
      • Reviews one or more types of documents dated within the past three months, including bank statements, brokerage statements, tax assessments, and a report from one of the national consumer reporting agencies concerning liabilities; and obtains a written representation that the person has disclosed all liabilities necessary to make a net worth determination; or
      • Obtains a written representation from certain third parties, including registered broker-dealers or investment advisors, that they have taken reasonable steps to verify the person’s accredited investor status within the past three months and have determined that the person is an accredited investor; or
      • Permits existing security-holders who had acquired issuer securities in a previous Rule 506 offering and had qualified as accredited investors at that time to certify his or her accredited investor status at the time of the sale.

These steps are neither exclusive nor mandatory. The final rules also discuss other factors and procedures.

In addition to taking reasonable steps to verify that purchasers are accredited, the company must also have a reasonable belief that they are accredited. This has always been part of Rule 506 and was not changed by the JOBS Act.

NOTE:  These new rules offer enormous opportunities for entrepreneurs seeking to raise money for their existing businesses or start new businesses. Please contact us if you would like to discuss your idea.

Questions? Let me know.

SEC: FundersClub, AngelList Not Required To Register As Broker-Dealers

On By crowdfundattnyIn AngelList, Crowdfunding, Crowdfunding Portals, Entrepreneurs, FundersClub, Investing, Investor, LLCs, SECLeave a comment

Through “no-action letters” dated March 26, 2013, the Securities and Exchange Commission has just ruled neither FundersClub nor AngelList, both nationally-recognized equity-based Crowdfunding portals, is required to register as a broker dealer under Federal securities law.

But portals are structured as investment advisory services and are registered as investment advisors. When a company is funded by investors, the portals do not receive cash compensation, as a broker would typically receive, but instead receive compensation more customary for a fund advisor: an interest in the future profits of the company – a “carried interest.” The form of the compensation seemed to be the principal factor that convinced the SEC to rule favorably.

Other equity-based portals might register as broker-dealers to avoid the issue altogether. Because both of these coordinated decisions could have gone the other way, however, the larger lesson may be that the SEC is taking a relatively hands-off approach to the rapidly-evolving Crowdfunding industry. If you are a portal or company waiting anxiously for the SEC regulations later this year, that is good news.

Questions? Let me know.

When Can My Investors Sue Me?

On By crowdfundattnyIn Business Judgement Rule, Crowdfunding, D&O Insurance, Investing, Investor, JOBS Act, LLCsLeave a comment

You’ve raised money from investors, through Crowdfunding or otherwise. You did everything right through the money-raising process, such as disclosing all the right information. What are your obligations to the investors/shareholders as you now operate the company? Or, to ask the question in a more negative but practical way, when can they sue you successfully?

The exact answer depends primarily on (1) the state you chose to incorporate, (2) whether you are a corporation or a limited liability company, and (3) whether you included provisions in your governing instruments (Certificate of Incorporation, Operating Agreement) to protect yourself. State laws are not uniform and there can be enormous differences between LLCs and corporations.

Nevertheless, we will assume that you are in a “normal” state and that your lawyer prepared “normal” documents. That allows us to generalize by saying you can be sued successfully under these two circumstances:

  • You make business decisions that are unusually bad and careless.
  • You take actions that unfairly benefit yourself to the disadvantage of your company.

Under the laws of “normal” states, if you try your best, pay attention, review relevant information beforehand, and have the best interests of the company at heart, it is fairly hard to make a business decision so poor that you can be sued successfully by investors. The hands-off approach taken by statutes and courts in this area – referred to as the “business judgment rule” – recognizes that management must often make decisions without complete information, that decisions are easy to challenge with the benefit of hindsight, and that if investors were allowed to sue for every poor decision, judges could never take vacations.

It is much easier to be sued successfully where you take actions that unfairly benefit yourself to the disadvantage of your company. Examples:

  • You lease office space to your company for higher-than-market rent.
  • You borrow money from your company when you shouldn’t, or on unfair terms.
  • Your company is in the business of developing digital imaging software, but when you are approached by an inventor with a new technique, you form a new company with the inventor and don’t offer the opportunity to your old company.

Investors are an odd group inasmuch as when they lose their money they tend to be unhappy. This means that even before raising money you should:

  1. Make sure your governing instruments include the right language;
  2. Get good legal advice; and
  3. Get a quote for Director and Officer (“D&O”) insurance.

Questions? Let me know.

The Gold Rush – Part II

On By crowdfundattnyIn Crowdfunding, Crowdfunding Gold Rush, Crowdfunding Portals, Entrepreneurs, Investing, JOBS Act, KickstarterLeave a comment

Many young companies fail for lack of capital. With Crowdfunding making much more capital available, it seems plausible that more young companies will succeed. Even so, the nature of capitalism is that many will fail and investors will lose their money. And unfortunately, with so much money flowing through new channels, the nature of human beings is that Crowdfunding will attract its share of the outright unscrupulous.

You can never protect yourself completely, but here a few tips to reduce the risk.

If you are an Investor:

  • Use common sense. If something seems too good to be true it probably is.
  • A company financed by Crowdfunding is no more likely to be successful than a company financed the old-fashioned way.
  • One of the great things about Crowdfunding is that you get to see a lot of companies. It follows that you can afford to be picky.
  • By all means, register at more than one portal.
  • Don’t invest in a company just because others are investing.
  • Often, it makes sense to invest in industries you already know something about.
  • Make sure you are satisfied with the due diligence.
  • Figure out how much money the business must earn for your investment to be worthwhile, i.e., to earn a profit commensurate with your risk. Do you understand how the business will make that much money? If not, you probably shouldn’t invest.

If you are a Portal:

  • You are going to be swamped with companies looking to raise money. Your greatest risk is that a company you sponsor turns out to be a fraud. Beware:  con men are very good at what they do.
  • Develop strong contracts with companies and investors, making clear exactly what everyone can expect, and what they can’t.
  • Do not allow your portal to infringe upon the rights of third parties.
  • Comply with all laws and in particular the securities laws. When – not if – investors lose money, the chances are very high that you will be sued.
  • Buy insurance.

If you are a Company:

  • You are now using OPM – Other People’s Money. Your expenditure of every nickel may be scrutinized by a plaintiff’s lawyer with the benefit of 20/20 hindsight. Have strong accounting systems in place.
  • Develop strong contracts vis-a-vis investors.
  • Disclose everything about your company up front, especially all the bad news, and otherwise comply with Federal and State securities laws. Your greatest risk, by far, is that you fail to comply with these laws.
  • Make sure your portal is reputable and complies with the law also. If the portal doesn’t comply, you are going to be sued.
  • Try to raise enough money the first time around.
  • Make sure your corporate structure allows you flexibility in the future, including the flexibility to raise more money.
  • Buy insurance.

Questions? Let me know.

The Gold Rush – Part I

On By crowdfundattnyIn Crowdfunding, Crowdfunding Gold Rush, Crowdfunding Portals, Entrepreneurs, Investing, JOBS Act, Kickstarter, SECLeave a comment

A man and woman created a Crowdfunding campaign for their newborn. A company raised $2 million in one day. The SEC regulations to launch “real” Crowdfunding per the JOBS Act might be far off, but the Crowdfunding gold rush is already well underway.

The excitement – the discovery of an enormous vein of money flowing into a brand-new channel – holds many opportunities. If you are an entrepreneur looking for funding there have never been more places to look. No longer beholden to a broker or a wealthy aunt or a lawyer with a big Rolodex, every entrepreneur now has ready access to the biggest Rolodex in the world: the Internet.

Seizing their own opportunity, Crowdfunding portals are springing up like Western mining towns with names that can become nationally-recognized overnight. Circle Up, SeedInvest, and Funders Club are among the equity-based portals while Kickstarter and Indiego remain the leaders in donation- or rewards-based projects, at least for the time being. New portals are being formed and coming online all the time as eager prospectors look for their share of the gold.

Others are poised to benefit as well:

There is an enormous and growing need for someone to perform meaningful due diligence on all the new companies, beyond the information that might be posted online. The new structures and relationships will require new insurance products, some of which are already being developed. If it hasn’t happened already, someone is going to offer to represent Crowdfunding investors on the Boards of Directors of far-flung companies. Every company funded by the Crowd will need an investor relations platform.

With so few barriers to entry, the opportunity to stake a claim in the Crowdfunding gold rush is practically unlimited today.

Bear in mind, all this is happening before true JOBS Act Crowdfunding springs to life, probably by late summer. When that happens, companies will be able to legally raise money from large numbers of non-affluent, unsophisticated investors for the first time in 80 years, uncovering the largest vein of capital yet.

One thing seems certain. With all the gold and all the gunslingers, some things will go wrong and some people will get hurt. In our next post, we’ll offer some pointers so you’re not one of them.

Questions? Let me know.

How Much Of My Company Should I Give Away?

On By crowdfundattnyIn Crowdfunding, Entrepreneurs, Investing, JOBS ActLeave a comment

Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?

One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.

Suppose you’re raising $500,000. To calculate how much your investor should receive:

  • Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
  • Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
  • Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
  • Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
  • Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
  • Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).

Very elegant and simple.

But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.

That’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.

The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.

In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.

Questions? Let me know.