Category: Investment Company Act

Title III Crowdfunding

Crowdfunding And The Investment Company Act

On By crowdfundattnyIn Crowdfunding, ICA, Investment Company Act, JOBS ActLeave a comment

I speak with lots of people about Crowdfunding and write this blog to answer questions they ask. I’ve had hundreds of conversations that start with Crowdfunding and end up with the Investment Company Act. I hope this post will help clarify the relationship between the two.

The Investment Company Act of 1940

Many entrepreneurs have never heard of the Investment Company Act, or ICA, so that part of my conversations begins with a short primer.

Think of a mutual fund, a company that exists only to invest in stock of other companies. That’s an investment company.  Unfortunately, the definition of “investment company” in the ICA is so broad it sweeps in many companies that would never think of themselves as mutual funds. Any company holding stock in another company can be treated as an investment company. 

Investment companies are subject to so many rules and expensive regulations, unless you’re a mutual fund you don’t want to be treated as an investment company.

Suppose a real estate sponsor forms ABC LLC to collect 87 investors, and ABC  LLC invests in the entity that owns the real estate, i.e., owns stock of one company. ABC LLC is an investment company and must comply with all the rules and regulations!  Suppose you and three friends form STU LLC to invest in the stock market together. You have an investment company and must comply with all the rules and regulations! Suppose XYZ LLC raises money from 220 people to invest in startups. XYZ LLC is an investment company and must comply with all the rules and regulations!

Unless, that is, ABC LLC, STU LLC, and XYZ LLC qualify for one of the exemptions describe below.

Common Exemptions

A Company with No More Than 100 Owners

A company with no more than 100 owners is exempt from the ICA. ABC LLC and STU LLC fall within this exemption.

A Venture Capital Fund with No More Than 250 Owners

A venture capital fund with no more than 250 owners is exempt from the ICA. A “venture capital fund” means a fund that holds itself out as a venture capital fund and:

  • Raises no more than $10,000,000;
  • Invests no more than 20% of its capital contributions in any single investments;
  • Doesn’t borrow money; and
  • Doesn’t give investors the right to withdraw, redeem or require the repurchase of their ownership interests.

Depending on its terms, XYZ LLC might fall within this exemption.

A Company with Only Wealthy Investors

A company where each investor is a “qualified purchaser” is exempt from the ICA. A qualified purchaser is, in general, an individual with at least $5,000,000 of investments.

ABC LLC, STU LLC, and XYZ LLC could be eligible for this exemption.

NOTE:  American securities laws have always distinguished between people who are wealthy and people who are not. The theory is that wealthy people, who can hire lawyers and accountants and possibly are smarter, don’t need the protection of the government while other people do. We see the theory in practice most commonly with the different treatment of accredited vs. non-accredited investors. With this exemption to the ICA, we see the theory taken one step farther. 

Intersection with Crowdfunding

These are the key points of intersection between Crowdfunding and the ICA:

The ICA Prohibits Many Good Investment Ideas 

I can’t count how many entrepreneurs have proposed a great idea, only to have me say it can’t be done because of the ICA. For example, suppose you believe in startup culture and want to give more Americans the chance to participate. You know that investing in just one startup is very risky, so you propose to raise money from hundreds of people and invest in 20 startups, a million dollars each.

You call me and I tell you that you can’t. Or more exactly, you can, but only if your hundreds of people are wealthy, which defeats the purpose. 

Neither Reg CF nor Regulation A can be Used by Investment Companies

Alright, you say, suppose I’m willing to limit the number of investors to 250, all non-accredited, raise $10 million rather than $20 million, and otherwise meet the requirements of a venture capital fund. Can I do that?

Yes! Or rather, No! 

Under that structure, your entity would fit within the ICA exemption described above. But to raise the $10 million, you have to find an offering exemption. The general rule, set forth in section 5 of the Securities Act of 1933, is that every time you raise money from investors you have to conduct a full-blown IPO. The most common offering types –Rule 506, Reg CF, and so forth – are exemptions from that rule. Which will you use for your new fund?

You can’t use Rule 506(c) because it doesn’t allow non-accredited investors. You can’t use Rule 506(b) because (i) it allows only 35 non-accredited investors, and (ii) it doesn’t allow advertising. And you can’t use Reg CF or Regulation A because they can’t be used by investment companies. With no offering exemptions available, the answer is No, you can’t do it. 

Hold on, you say. I understand that Reg CF and Regulation A can’t be used by an investment company, but didn’t you tell me five minutes ago that my venture fund won’t be treated as an investment company if I follow the rules? Are you experiencing dementia at such an early age, with such youthful features?

Possibly, but that’s not what’s going on here. Unfortunately, neither Reg CF nor Regulation A can be used by a company that would be an investment company if not for the three exemptions I described above. I didn’t say your fund wouldn’t be an investment company, I said it wouldn’t be subject to all the expensive rules and regulations of the ICA.  

It’s like a trick the law plays on you. ABC LLC STU LLC, and XYZ LLC will have “IC” emblazoned on their chests forever. 

The ICA Exemptions and the Offering Exemptions are Apples and Oranges 

People will say “I know I can’t have more than 100 non-accredited investors” or “Am I still subject to the Investment Company Act if I use Rule 506(c)?” 

Those are non-sequiturs. On one side of the fence sits the Investment Company Act of 1940 and its exemptions. On the other side of the fence sits the Securities Act of 1933 and its exemptions. The exemptions for one having nothing to do with the exemptions for the other. They aren’t friends.

Thus:

  • The ICA exemptions apply no matter how you raise the money. If you’re relying on the 100-owner exemption, for example, you can raise the money from 100 qualified purchasers, from 100 accredited investors, from 100 non-accredited investors, or a mix of investors. But you must qualify under one of the offering exemptions separately.
  • Of the offering exemptions commonly used, you can use Rule 506(b) (no advertising, up to 35 non-accredited investors) or Rule 506(c) (no non-accredited investors, unlimited advertising) without thinking about the ICA. But if you want to use Reg CF or Regulation A, you have to think about the ICA a lot.

Every conversation about Crowdfunding should include time for the Investment Company Act. Beware!

Questions? Let me know.

new risk factors for crowdfunding and beyond

More Noise About Accredited Investors In Crowdfunding

On By crowdfundattnyIn Accredited Investor, Exchange Act, Investment Company Act, Regulation A, SEC1 Comment

The House of Representatives just passed not one, not two, but three different bills that would expand the definition of “accredited investor.” Does this mean the definition will change? No.

The three proposed changes are:

  • Include in the definition of accredited investor anyone who says he or she understands the risks, using a form of not more than two pages issued by the SEC. This would effectively eliminate the concept of accredited investor.
  • Include in the definition of accredited investor anyone who has received personalized advice from a person who has himself or herself become an accredited investor under 17 CFR §230.501(A)(10), by passing an exam approved by the SEC. The mystery here is why the proposed bill wouldn’t include anyone who has received personalized advice for a registered investment adviser.
  • Allow anyone, including non-accredited investors, to invest in the aggregate up to 10% of their income or net worth in private securities. No time period is provided.

The proposed changes to the definition of accredited investor are part of a larger package of legislation that would ease more than a dozen rules in the federal securities laws, including:

  • Expand the definition of “emerging growth companies.”
  • Create a safe harbor for brokers and finders in private placements.
  • Ease the “independence” rule for auditors.
  • Ease the registration requirements under section 12(g) of the Exchange Act.
  • Expand the definition of venture capital fund for purposes of section 3(c)(1) of the Investment Company Act.
  • Add a new exemption under the Securities Act of 1933 for issuers raising less than $250,000.
  • Double the Regulation A offering limit from $75,000,000 to $150,000,000.

And so on.

This legislation can best be understood by reference to the man who introduced it, Representative McHenry of North Carolina. Representative McHenry was the principal sponsor of the JOBS Act, which created Crowdfunding. Before and since, he has been an advocate for improving access to capital for entrepreneurs and giving ordinary Americans access to opportunities now reserved for the very wealthy.

But Representative McHenry is leaving Congress. He was a close friend of Kevin McCarthy and briefly assumed leadership of the House when McCarthy was deposed. That episode seems to have drained his enthusiasm; he announced his plan to retire shortly afterward.

This legislation should probably be viewed as Representative McHenry’s swan song, his wish list, even his legacy. Unfortunately, and as I’m sure he recognizes, it’s likely that none of it will find its way into law.

Questions? Let me know.

Artificial Intelligence

Anthropic: SPVs And The Investment Company Act

On By crowdfundattnyIn Investment Company Act, SPV10 Comments

I spend lots of time talking about special purpose vehicles (SPVs) and the Investment Company Act of 1940. Now we have a real-world example.

Anthropic was founded by Dario Amodei, who wrote the basic artificial intelligence model for OpenAI before leaving to start his own company. Once ChatGPT launched Anthropic has had no trouble raising money. They’ve raised $7.5 billion and counting in the last year.

In my humble opinion, the amount of money being thrown at Anthropic is insane. Most obviously, it demonstrates the psychological power of The Fear of Missing Out. More subtly, it represents the brokenness of venture capital culture. VCs have backed themselves into a position where they can no longer invest in businesses that are merely profitable. They need huge wins, grand slams. They bet a chunk of the farm on crypto/blockchain and lost. Now they need even bigger wins, or at least the promise of bigger wins, to keep their LPs writing checks.

Anyway, the flood of money created a problem for Anthropic that will sound familiar to many founders. The company was looking for billions, but many investors were able to invest “only” $30 – $50 million. The company didn’t want all those investors on its cap table.

So the company took the logical step:  it put the “small” investors in a separate company, an SPV, and admitted only the SPV to its cap table as a single investor.

Because its business is limited to holding securities in Anthropic, the SPV is an “investment company” under section 3(a) of the Investment Company Act. Yet it has not registered as an investment company. How does that work?

The answer is that it qualifies for the exemption under section 3(c)(1) of the Investment Company Act, section 3(c)(7) of the Investment Company Act, or both.

The exemption under section 3(c)(1) is available if the SPV has no more than 100 owners. That’s possible. If each owner invests $40 million you would raise $4 billion.

(NOTE:  the exemption under section 3(c)(1) allows 250 owners if the SPV follows a “venture capital strategy,” but this SPV was formed to invest in only one company, Anthropic.)

The exemption under section 3(c)(7) is available if each owner is a “qualified purchaser.” That term includes individuals with at least $5 million of investable assets, entities where all the individual owners have at least $5 million of investable assets, as well as other entities. I suspect the SPV qualifies under this exemption as well.

Thus, the SPV is an investment company under section 3(a), but is not required to register as such.

Finally, note that the discussion about the Investment Company Act doesn’t depend on how Anthropic raised money. It probably raised the money using Rule 506(b), taking the position that because everyone in that world knows everyone else, it had a “pre-existing relationship” with all its investors. But it could also have used Rule 506(c), assuming every investor is accredited. The point is that how you raise money and whether you need or qualify for an exemption under the Investment Company Act are unrelated.

I personally was not invited to invest in Anthropic. Imagine!

Questions? Let me know.

SPVs in Crowdfunding

SPVs in Crowdfunding

On By crowdfundattnyIn Investment Advisers Act of 1940 (IAA), Investment Company Act, SPVLeave a comment

When you’re raising money for a company, it’s tempting to group all your investors in an entity and have that entity, rather than the individual investors, invest in the company. We often refer to an entity like this as a special purpose vehicle, or SPV. 

The Cursed Investment Company Act

Because the SPV is in the business of owning a security – even if it’s only one security – it’s an “investment company” within the meaning of section 3(a)(1)(A) and/or section 3(a)(1)(C) of the Investment Company Act of 1940. That means, among other things, that the SPV can’t use Reg CF or Regulation A to raise capital.

NOTE:  In 17 CFR §270.3a-9, the SEC created a special kind of SPV called a “crowdfunding vehicle” that can be used to raised capital in Reg CF. I’ve written about those here and here and here but am not writing about them today. Today I’m talking about SPVs formed to raise money under an exemption other than Reg CF, e.g., Rule 506(b) or Rule 506(c).

Because of the prohibitive regulatory burden, we don’t want our SPV to be an investment company. Therefore, having concluded that the SPV is an investment company within the meaning of section 3(a)(1) of the ICA, we look for an exemption.

If you’re raising money only from very wealthy people you find an exemption in section 3(c)(7) of the ICA, which allows an unlimited number of investors as long as each owns at least $5 million of investable assets. All the big hedge funds and private equity funds in Manhattan and Merchantville rely on this exemption. 

The Section 3(c)(1) Exception – 100 Security Holders

For the unwashed masses, the most common exemption – actually, the only other viable exemption for SPVs – is section 3(c)(1) of the ICA. The section 3(c)(1) exemption applies if the outstanding securities of the SPV are held by no more than 100 persons. A few points about the 100-investor limit:

  • The limit refers to the total number of security-holders, not the number of investors in a particular offering. If you’ve conducted one offering and admitted 72 investors, you can’t conduct another offering and admit 87 more.
  • “Securities” include equity, debt, and everything in between. An investor holding a promissory note or a SAFE counts.
  • In general, if an entity invests in the SPV the entity counts as only one security-holder, even if the entity itself has multiple owners. But the law will “look through” the entity, treating its owners as owners of the SPV, if either:
    • You formed the entity to get around the 100-security holder limit; or
    • The entity owns 10% or more of the voting power of the SPV and is itself an investment company.
  • Suppose your SPV has 98 security holders and P.J. Jankara is one of them. She dies and leaves her 100 shares of common stock to her five children, 20 shares each. Is your SPV now an investment company? No, the law provides latitude for involuntary transfers like death.
  • As long as you have no more than 100 security holders in one SPV, you’re allowed to have a separate SPV relying on the section 3(c)(7) exemption. In legal jargon, the two SPVs won’t be “integrated.”

Qualifying Venture Capital Funds – 250 Security Holders

The 100 limit is increased to 250 for a “qualifying venture capital fund.” That means a fund satisfying all six of the following conditions:

  1. The fund represents to investors and potential investors that it pursues a venture capital strategy;
  2. Other than short-term holdings, at least 80% of the fund’s assets must consist of equity interests in portfolio companies;
  3. Investors in the fund do not have the right to withdraw or have their interests redeemed;
  4. All investors in the fund must have the right to receive pro rata distributions;
  5. The fund may have no more than $10,000,000 in aggregate capital contributions and uncalled committed capital, indexed for inflation; and
  6. The fund’s borrowing does not exceed 15% of its aggregate capital contributions and uncalled committed capital.

The regulations don’t define the term “venture capital strategy,” but the SEC provided this explanation:

Under the rule, a qualifying fund must represent itself as pursuing a venture capital strategy to its investors and potential investors. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in our rule (because for example it only invests in short-term holdings, does not borrow, does not offer investors redemption rights, and is not a registered investment company). We believe that only funds that do not significantly differ from the common understanding of what a venture capital fund is, and that are actually offered to investors as funds that pursue a venture capital strategy, should qualify for the exemption.

Whether or not a fund represents itself as pursuing a venture capital strategy, however, will depend on the particular facts and circumstances. Statements made by a fund to its investors and prospective investors, not just what the fund calls itself, are important to an investor’s understanding of the fund and its investment strategy.

When asked to define pornography, former Supreme Court Justice Potter Stewart famously responded: “I know it when I see it.” (Contrary to some critics, he did NOT continue “. . . .and I see it a lot.”) The definition of “venture capital strategy” is like that.

Now, one of the high-volume Reg CF portals says this about using SPVs for Rule 506(c) offerings:

If you wish to consolidate all the investors into a single SPV or fund, the law places a limit of 249 investors if the offering is under $10M in investments. If the offering has more than $10M in investments, there is a 99 investor limit.

This is 100% wrong. By referring to a $10M limit, the portal clearly believes that an SPV can be a “qualifying venture capital funds.” But an entity formed to “consolidate all the investors into a single SPV” couldn’t be a qualifying venture capital fund because it doesn’t pursue a “venture capital strategy.” In fact, the SPV has no investment strategy at all. Investors themselves make the one and only investment decision at the time they invest. The SPV is simply a conduit between the investors and the team, used to simplify the team’s cap table.

This is the same high-volume Reg CF portal that uses a series LLC as crowdfunding vehicles, despite this. 

Whether the exception for qualifying venture capital funds is flexible enough for a bona fide venture capital fund is a different story. But unless you live in Manhattan or Merchantville, assume that your SPV can have only 100 security holders.

Questions? Let me know. 

A Summary of the Investment Company Act for Crowdfunding

On By crowdfundattnyIn Investment Company ActLeave a comment

Hardly a day goes by without someone asking a question that involves the Investment Company Act of 1940. Although the Act is hugely long and complicated, I’m going to try to summarize in a single blog post the parts that are most important to Crowdfunding.

Why the Fuss?

If you’re in the Crowdfunding space, you don’t want to be an “investment company” within the meaning of the Act:

  • As an investment company, you’re not allowed to raise money using either Title III (Regulation Crowdfunding) or Title IV (Regulation A).
  • Investment companies are subject to huge levels of cost and regulation.

What is an Investment Company?

An investment company is company in the business of holding the securities of other companies. That statement raises many interesting and technical legal issues that have consumed many volumes of legal treatises and conferences at the Waldorf. But almost none of it matters to understand the basics.

All that matters from a practical perspective is that stock in corporations, interests in limited liability companies, and interests in limited partnerships are all generally “securities” within the meaning of the Act.

And that means, in turn, that if you hold stock in corporations, interests in limited liability companies, and/or interests in limited partnerships, then assume you’re an “investment company” within the meaning of the Act, unless you can identify and qualify for an exception.

How Much is Too Much?

Holding some securities doesn’t make you an investment company. Under one of the many technical rules in the Act, a company won’t be considered an investment company if:

  • No more than 45% of its assets are invested in securities, as of the end of the most recent fiscal quarter; and
  • No more than 45% of its income is derived from investment securities, as of the end of the most recent four fiscal quarters.

Does That Mean a Typical SPV is an Investment Company?

Unless the SPV can find an exception, yes.

Many Crowdfunded investments use a “special purpose vehicle,” typically a Delaware limited liability company. Investors acquire interests in the SPV, and the SPV invests – as a single investor – in the actual operating company. Because the only asset of the SPV is the interest in the operating company, which is a “security,” the SPV is indeed an investment company, unless it qualifies for one of the exceptions below.

Simple Exceptions

The definition of “investment company” is so broad, most of the action is in the exceptions. I’m not going to talk about all of them, only those that are most relevant to Crowdfunding.

  • No More Than 100 Investors – A company with no more than 100 investors (who do not have to be accredited) isn’t an investment company. That’s the exception used by SPVs in Crowdfunding. Which means that as the size of deals in Crowdfunding grows, SPVs will no longer be used.
  • All Qualified Investors – A company with only “qualified investors” isn’t an investment company. A “qualified investor” is generally a person with more than $5 million of investable assets. Many hedge funds rely on this exception, but it’s not going to be used widely in Crowdfunding.

NOTE:  A company that would be an investment company but for either of those two exceptions is still not allowed to use Title III or Title IV.

  • Companies That Invest In Mortgages – A company that invests in or originates mortgages is usually not an investment company.
  • Wholly-Owned Subsidiaries – A company that conducts its business through wholly-owned subsidiaries isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “wholly-owned” means the parent owns at least 95% of the voting power.
  • Majority-Owned Subsidiaries – A company that conducts its business through majority-owned subsidiaries usually isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “majority-owned” means the parent owns at least 50% of the voting power.

The 45% Exception

Some companies, including some REITs, own interests in subsidiaries that are not wholly-owned or even majority-owned. To avoid being treated as investment companies, those companies typically rely on an exception that requires more complicated calculations. Under this exception, a company is excluded from the definition of “investment company” if it satisfies both of the followings tests:

  • No more than 45% of the value of its assets (exclusive of government securities and cash items) consist of securities other than what I will refer to as “allowable securities.”
  • No more than 45% of its after-tax income is derived from securities other than those same “allowable securities.”

For these purposes, the securities I am calling “allowable securities” include a number of different kinds of securities, but the two most important to us are:

  • Securities issued by majority-owned subsidiaries of the parent; and
  • Securities issued by companies that are controlled primarily by the parent.

So think of those securities as being in the “good” basket and other kinds of securities as being in the “bad” basket.

In determining whether a security – such as an interest in a limited liability company – is an “allowable security,” and therefore in the “good” basket, the following definitions apply:

  • A subsidiary is a “majority-owned subsidiary” if the parent owns at least 50% of the voting securities of the subsidiary.
  • A parent is deemed to “control” a subsidiary if it has the power to exercise a controlling influence of the management or policies of the subsidiary.
  • A parent is deemed to “control primarily” a subsidiary if (1) it has the power to exercise a controlling influence of the management or policies of the subsidiary, and (2) this power is greater than the power of any other person.

Summary

If your business model involves investing in other companies and you plan to raise money from other people, the Investment Company Act of 1940 should be on your To Do List.

As a rule of thumb, you can feel comfortable investing in wholly-owned subsidiaries, majority-owned subsidiaries, and subsidiaries where you have exclusive or at least primary control. If you find other investments making up, say, more than 25% of your portfolio, measured by asset value or income, look harder.

Questions? Let me know.