Category: Investor

The Crowdfunding Bad Actor Rules Don’t Apply To Investors

On By crowdfundattnyIn 100 Investor Rule, Accredited Investor, Investor, Investor Disclosures, Reg CF, Regulation A, Rule 506, Title III, Title III CrowdfundingLeave a comment

I often see Subscription Agreements asking the investor to promise she’s not a “bad actor.” This is unnecessary. The term “bad actor” comes from three sets of nearly indistinguishable rules:

  • 17 CFR §230.506(d), which applies to Rule 506 offerings;
  • 17 CFR §230.262, which applies to Regulation A offerings; and
  • 17 CFR §227.503, which applies to Reg CF offerings.

In each case, the regulation provides that the issuer can’t use the exemption in question (Rule 506, Regulation A, or Reg CF) if the issuer or certain people affiliated with the issuer have violated certain laws.

Before going further, I note that these aren’t just any laws – they are laws about financial wrongdoing, mostly in the area of securities. Kidnappers are welcome to use Rule 506, for example, while ax murderers may find Regulation A especially useful even while still in prison.

Anyway.

Reg CF’s Rule 503 lists everyone whose bad acts we care about:

  • The issuer;
  • Any predecessor of the issuer;
  • Any affiliated issuer;
  • Any director, officer, general partner or managing member of the issuer;
  • Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Any promoter connected with the issuer in any capacity at the time of filing, any offer after filing, or such sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities; and
  • Any general partner, director, officer or managing member of any such solicitor.

Nowhere on that list do you see “investor.” The closest we come is “Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities,” but even there the calculation is based on voting power. In a Crowdfunding offering you wouldn’t give an investor 20% of the voting power, for reasons having nothing to do with the bad actor rules. 

So it just doesn’t matter. This is one more thing we can pull out of Subscription Agreements. 

I know some people will say “But we want to know anyway.” To me this is unconvincing. If you don’t ask about kidnapping you don’t need to ask about securities violations.

Questions? Let me know.

Think Twice Before Giving Crowdfunding Investors Voting Rights

On By crowdfundattnyIn Crowdfunding, Crowdfunding Investors, Investor, Investor DisclosuresLeave a comment

I attend church and think of myself as a kind person, yet I discourage issuers from giving investors voting rights. Here are a few reasons:

  • Lack of Ability:  Even if they go to church and are kind people, investors know absolutely nothing about running your business. If you assembled 20 representatives in a room and talked about running your business, you would (1) be amazed, and (2) understand why DAOs are such a bad idea.
  • Lack of Interest:  Investors invest because they want to make money and/or believe in you and your vision. They aren’t investing because they want to help run your business.
  • Irrelevant Motives:  Investors will have motives that have nothing to do with your business. For example, an investor who is very old or very ill might want to postpone a sale of the business to avoid paying tax on the appreciation.
  • Bad Motives:  Investors can even have bad motives. An unhappy investor might consciously try to harm your business or, God forbid, a competitor might accumulate shares in your company.
  • Lack of Information:  Investors will never have as much information about your business as you have. Even if they go to church, are kind to animals, and have your best interests at heart, they are unable to make the same good decisions you would.
  • Drain on Resources:  If you allow investors to vote you’ll have to spend lots of time educating them and trying to convince them to do what you think is best. Any time you spend educating investors is time you’re not spending managing your business.
  • Logistics:  Even in the digital age it’s a pain tabulating votes from thousands of people.
  • Mistakes:  When investors have voting rights you have to follow certain formalities. If you forget to follow them you’re cleaning up a mess.

I anticipate two objections:

  • First Objection:  VCs and other investors writing big checks get voting rights, so why shouldn’t Crowdfunding investors?
  • Second Objection:  Even if they don’t help run the business on a day-to-day basis, shouldn’t investors have the right to vote on big things like mergers or issuing new shares?

As to the first objection, the answer is not that Crowdfunding investors should get voting rights but that VCs and other large investors shouldn’t. The only reason we give large investors voting rights is they ask for them, and our system is called “capitalism.”

Before the International Venture Capital Association withdraws its invitation for next year’s keynote, I’m not saying VCs and other large investors don’t bring anything but money to the table. They can bring broad business experience and, perhaps most important, valuable connections. A non-voting Board of Advisors makes a lot of sense.

The second objection is a closer call. On balance, however, I think that for most companies most of the time it will be better for everyone if the founder retains flexibility.

To resolve disputes between the owners of a closely-held business we typically provide that one owner can buy the others out or even force a sale of the company. Likewise, while we don’t give Crowdfunding investors voting rights we should try to give them liquidity in one form or another, at least the right to sell their shares to someone else.

Give investors a good economic deal. Give them something to believe in. But don’t give them voting rights.

Questions? Let me know.

Married Couples As Accredited Investors

On By crowdfundattnyIn Accredited Investor, Crowdfunding, Investor, Regulation A, Rule 506(b), Rule 506(c), UncategorizedLeave a comment

When a married couple invests in an offering under Rule 506(b), Rule 506(c), or Tier 2 of Regulation A, we have to decide whether the couple is “accredited” within the meaning of 17 CFR §501(a). How can we conclude that a married couple is accredited?

A human being can be an accredited investor in only four ways:

iStock-1125972221.jpg

  • Method #1: If her net worth exceeds $1,000,000 (without taking into account her principal residence); or
  • Method #2: If her net worth with her spouse exceeds $1,000,000 (without taking into account their principal residence); or
  • Method #3: Her income exceeded $200,000 in each of the two most recent years and she has a reasonable expectation that her income will exceed $200,000 in the current year;
  • Method #4: Her joint income with her spouse exceeded $300,000 in each of the two most recent years and she has a reasonable expectation that their joint income will exceed $300,000 in the current year.

A few examples:

EXAMPLE 1: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $50,000 (credit cards!). Their joint annual income is $150,000. Husband is accredited under Method #1 or Method #2. Wife is accredited under Method #2.

EXAMPLE 2: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $500,000 (student loans!). Their joint annual income is $150,000. Husband is accredited under Method #1. Wife is not accredited.

EXAMPLE 3: Husband’s net worth is $850,000 and his income is $25,000. Wife’s has a negative net worth of $500,000 and income of $250,000. Husband is not accredited. Wife is accredited under Method #3.

Now, suppose Husband and Wife want to invest jointly in an offering under Rule 506(c), where all investors must be accredited.

They are allowed to invest jointly in Example 1, because both Husband and Wife are accredited. They are not allowed to invest jointly in Example 2 because Wife is not accredited, and they are not allowed to invest jointly in Example 3 because Husband is not accredited.

The point is that Husband and Wife may invest jointly only where both Husband and Wife are accredited individually. At the beginning, I asked “How can we conclude that a married couple is accredited?” The answer: There is no such thing as a married couple being accredited. Only individuals are accredited.

CAUTION: Suppose you are an issuer conducting a Rule 506(c) offering, relying on verification letters from accountants or other third parties. If a married couple wants to invest jointly, you should not rely on a letter saying the couple is accredited. Instead, the letter should say that Husband and Wife are both accredited individually.

Questions? Let me know.

You Can Use Subsidiaries Without Violating the 100 Investor Rule

On By crowdfundattnyIn 100 Investor Rule, Crowdfunding, Investment Advisers Act of 1940 (IAA), Investor, JOBS Act, LLCs2 Comments

crowdfunding_investorEveryone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.

The basics of the 100 investor rule:

  • A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
  • A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
  • There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.

Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.

In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?

Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?

Fortunately, the answer is No.

For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.

That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.

Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.

Questions? Let me know.

C Corp Vs. LLC: What’s The Right Choice?

On By crowdfundattnyIn C corporations, Crowdfunding, Entrepreneurs, Investor, LLCs, Uncategorized2 Comments

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an overview, Choosing The Right Legal Entity MSR describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Let me know.

How Much of My Company Should I Give Away?

On By crowdfundattnyIn Crowdfunding, Investing, Investor, 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.

money treeThat’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.

CFGE Crowdfund Bank And Lending Summit in San Francisco

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Crowdfunding Real Estate, Crowdfunding Speaking Engagements, Entrepreneurs, Equity Crowdfunding, Investing, Investor, JOBS ActLeave a comment

Roderick CFGE

Since Labor Day, I’ve spoken at half a dozen events: for entrepreneurs, for intellectual property lawyers, for finance professionals, for digital marketing groups. This week I’ll be speaking at one of the premier Crowdfunding events in country, the CFGE Crowdfund Banking and Lending Summit on the 16th and 17th in San Francisco.

The conference features some of the leaders in the industry, including:

  • Richard Swart, Director of Research for Innovation in Entrepreneur and Social Finance, Colman Fung Institute for Engineering Leadership at UC Berkeley.
  • Ron Suber, the President of Prosper.
  • Jason Fritton, the Founder and CEO of Patch of Land.
  • Tom Lockard, the Vice President for Real Estate Investment and Institutional Sales of Fundrise.
  • Nikul Patel, the Chief Lending Officer of LendingTree.
  • Jesse Clem, the Co-Founder of LOQUIDITY, LLC.
  • Joy Schoffler, the CEO of Leverage PR.

Whether you’re new to Crowdfunding or an industry veteran, I’d strongly suggest you attend. I’m always amazed how much more there is to learn.

To register, click here. Make sure to use my promo code and receive a 25% discount! Promo code: Roderick

And while you’re there, please stop by and say hello. Crowdfunding and skiing – those are my two favorite topics.

Questions? Let me know.

Encouraging Local Investment In Crowdfunding

On By crowdfundattnyIn Crowdfunding, Crowdfunding Articles, Investing, Investor, JOBS ActLeave a comment

Crowdfunding provides deep pools of capital to entrepreneurs and makes high-quality investments available to individuals for the first time. Those things are great, transformative.

But Crowdfunding achieves its greatest potential at the local level, where communities invest in themselves. An entrepreneur needs capital to start a local business. Her customers are her neighbors. They help design her business to respond to their needs, and they invest in her business to share in the financial rewards and to improve their own neighborhood. There’s a lot more going on there than finance.

I once served on a panel with David Paterson, the former Governor of New York. Governor Paterson spoke about the usefulness of Crowdfunding for community development and community redevelopment, and now works as the Director of Community for iFunding, one of the leading portals.

I have spoken with and represent others thinking along the same lines, putting local money back into local economies.

We should think about ways to encourage localized Crowdfunding investment. When we’re talking about revising Title III, or crafting better state Crowdfunding laws, we should include community development folks in the conversation. They’re going to have better ideas than I have, but I can think of one small step in the right direction.

Why not provide some economic incentive? For example, suppose State X allows a $5,000 maximum investment from non-accredited investors. Why not raise that limit to $7,500 or $10,000 if the project is in the same county as the investor?

That works for two reasons. One, it encourages investing locally. Two, the investor is likely to know more about the project in his neighborhood than he knows about a project on the other side of the state, so he can make a more informed decision. For that matter, as a consumer he might be in a position to help the project after it’s built.

It’s a small step. Crowdfunding is global, but it works even better when it’s local.

Questions? Let me know.

The iFunding Mobile App: An Interview With Sohin Shah

On By crowdfundattnyIn Crowdfunding, Crowdfunding Interview, Entrepreneurs, Investing, Investor, Mobile AppsLeave a comment

Sohin at desk croppedSohin Shah is the COO and co-founder of iFunding, and created iFunding’s mobile app, the first in the Crowdfunding market. Sohin also created Valuation App, which allows finance professionals to analyze businesses and start-ups. His prior experience is at New York investment banks and he holds a Masters in Finance & Risk Engineering from NYU.

Q:        Before getting to the iFunding mobile app, what’s your sense of technology innovation in real estate overall?

A:        Impressive but uneven. There is a lot of technology for the consumer looking for a home or apartment – the Zillow/Trulia merger is an example of scale in that segment. Also, developers looking to purchase properties wholesale have sites like Auction.com, and larger institutions are increasing their data and automation for deal assessment through services like Compstak and Reonomy. But there’s been surprisingly little innovation available to the individual investor who wants to participate in real estate projects and profits.

Q:        What can an individual investor do with your mobile app?

A:        Anything she could do on our website, from browse opportunities to review documents to actually invest. We can also send an alert to your app to let you know when deals are available.

Q:        Can I switch back and forth from mobile to website?

A:        Absolutely. We made it as seamless as possible going both ways.

Q:        I have to ask you: was the mobile app really necessary? Do your investors log in from mobile devices? Or is this a gimmick?

A:        You would be amazed. Already, about 25% of the visits to ifunding.co come from mobile devices, roughly two-thirds of these from smart phones and one-third from tablets. We realized our customers want to get information and make investments when it is convenient to them, from the couch to the hair stylist.

Q:        But are people really moving tens of thousands of dollars into investments via smartphone?

A:        Yes, definitely. Although we don’t have hard data, those completing the entire investment process by mobile device have probably invested with us before. They know what they want and are looking to roll their money into the next deal before someone else fills that slot. Keep in mind that some of our deals fund with a day or hours, so mobile access at any time is valuable to top investors.

Q:        Why do you think people might be skeptical investing significant dollars by phone?

A:        Sometimes people have a tendency to underestimate the individual investor and what they become comfortable with. Think about banking by phone, or sending funds by PayPal. What we’re learning in Crowdfunding is that individuals really do want the power to control their own destinies. Our mobile app is just one more tool helping them do that.

Q:        Can you use the app to just browse properties and learn about investing?

A:        You sure can. Many people do. We provide a lot of educational content and try to help investors make smart decisions. When you’re traveling or have idle time, instead of playing a game on your phone, why not learn more about real estate and empower yourself financially?

Q:        Did you build the app yourselves?

A:        Yes, our technology team built it. I had the experience of building Valuation App and we had all the industry knowledge in house, so that made sense for us to design and program it.

Q:        Is the mobile app secure? As secure as your website?

A:        Yes, definitely. In fact, no user information is stored on the mobile device – you could drop your phone in Grand Central Station and have no worry about compromised information. All information is on our secure servers and downloaded to the mobile device through an encrypted connection only when you use the app, then erased when you quit.

Q:        Do you plan to add more functionality in the future?

A:        We update the app several times a month based mainly on customer suggestions. The future will see more eye-catching features, though you can imagine we haven’t planned an “Apple Watch” version just yet.

Q:        So what’s it called and where can I get it?

A:        It’s called “iFunding – Real Estate Investing through Crowdfunding.” It’s available on iOS and Android devices. You can download it for free at bitly.com/ifundappios and bitly.com/ifundappandroid.

Choosing And Protecting A Name For Your Crowdfunding Business

On By crowdfundattnyIn Crowdfunding, Crowdfunding Articles, Crowdfunding Real Estate, Investing, Investor, LLCs, Real Estate, Technology PlatformsLeave a comment

Names matter, even for a local business, but they matter a great deal for a Crowdfunding business, where your customers know you only from a distance.

Generally speaking you can choose three kinds of names:

  • A name that describes what you do, e.g., Real Estate Crowdfunding Portal, LLC.
  • A name with no inherent meaning, e.g., Xeta, LLC.
  • A name somewhere in between, e.g., Lifelong Investments, LLC.

Each category has advantages and disadvantages:

  • A name that describes what you do…well, it describes what you do. When a consumer sees the name she knows what you’re selling. On the other hand, a name that describes what you do is often not very memorable.
  • The strongest names are those that start out with no inherent meaning. Amazon, Starbucks, E-Bay. When consumers think of Amazon they think about the gigantic online retailer, nothing else. The name is worth a billion dollars! On the other hand, Amazon had to spend more than a billion marketing dollars to give meaning to a name that otherwise belonged to a river.
  • A name somewhere in between is somewhere in between. It might be sexier than a name that is merely descriptive and require a lot less marketing fuel than a name with no meaning, but with the associated disadvantages as well.

In the Crowdfunding industry to date, most portals have chosen the more descriptive over the more powerful. Poliwogg is an exception. Fundrise might be another.

With two well-known Crowdfunding companies – Crowdentials and VerifyInvestors – we see two different approaches to choosing a name. And we can’t say for certain whether one is better than the other. That will depend on what each company does with its name.

Having chosen a name, how do you protect it?

To start with, a business acquires “common law” rights to a name merely by using it, without filing anything with the government and without involving lawyers. If another real estate Crowdfunding portal tried to use the Fundrise name today they couldn’t do it, even if the Miller brothers had never done anything to protect their name (they have).

Contrary to common belief, merely registering a company name with the state by forming a corporation or other entity provides no real protection. State filings are simply a matter of bureaucracy – the state wants to make sure that no two names are confusingly similar on its own records.

For the best protection, however, the business owner should obtain a Federal trademark from the U.S. Patent and Trademark Office. A Federal registration provides important benefits, including:

  • The registration constitutes “constructive notice” to all later users in all locations.
  • The registration permits the owner to get an injunction against a trademark infringer and sue for damages, including profits, costs, treble damages and attorneys fees.
  • The registration can strengthen the value of the name as a corporate asset.
  • The registration demonstrates your right to use the name to the owners of other websites, such as Google, Facebook, and Twitter, which are often called on to “officiate” disputes over names.

The trademark application process normally takes about a year, assuming no significant problems. Once granted, a trademark registration can last forever if continuously used and renewed.

NOTE: Not every name can be trademarked. A name like “Real Estate Crowdfunding Portal,” which merely describes the product or service, probably cannot be registered by itself. But it might be registered with a distinctive logo.

Finally, don’t forget to acquire the domain name.

Questions? Let me know.