List OF Accredited Investors for PPMs

Every Private Placement Memorandum includes a list of accredited investors, summarizing 17 CFR §230.501(a). With the new definitions coming into effect on December 8th, I thought it might be useful to post a summary here.

“An ‘accredited investor’ includes:

  • A natural person who has individual net worth, or joint net worth with the person’s spouse or spousal equivalent, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
  • A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse or spousal equivalent exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;
  • A natural person who holds any of the following licenses from the Financial Industry Regulatory Authority (FINRA):  a General Securities Representative license (Series 7), a Private Securities Offerings Representative license (Series 82), or a Licensed Investment Adviser Representative license (Series 65);
  • A natural person who is a “knowledgeable employee” of the issuer, if the issuer would be an “investment company” within the meaning of the Investment Company Act of 1940 (the “ICA”) but for section 3(c)(1) or section 3(c)(7) of the ICA;
  • An investment adviser registered under the Investment Advisers Act of 1940 (the “Advisers Act”) or the laws of any state;
  • Investment advisers described in section 203(l) (venture capital fund advisers) or section 203(m) (exempt reporting advisers) of the Advisers Act;
  • A trust with assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person;
  • A business in which all the equity owners are accredited investors;
  • An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  • A bank, insurance company, registered investment company, business development company, small business investment company, or rural business development company;
  • A charitable organization, corporation, limited liability company, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets exceeding $5 million;
  • A “family office,” as defined in rule 202(a)(11)(G)-1 under the Advisers Act, if the family office (i) has assets under management in excess of $5,000,000, (ii) was not formed for the specific purpose of acquiring the securities offered, and (iii) is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment;
  • Any “family client,” as defined in rule 202(a)(11)(G)-1 under the Advisers Act, of a family office meeting the requirements above, whose investment in the issuer is directed by such family office;
  • Entities, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that were not formed to invest in the securities offered and own investment assets in excess of $5 million; or
  • A director, executive officer, or general partner of the company selling the securities, or any director, executive officer, or general partner of a general partner of that issuer.”

This list doesn’t try to capture every detail of every definition. For purposes of a disclosure document it’s plenty.

Why Everyone Benefits from the SEC’s New Crowdfunding Rules

To the delight of both issuers and investors, the SEC continues to make crowdfunding better as they have announced major changes to their crowdfunding rules. In this podcast, crowdfunding attorney Mark Roderick and Co-Founder of Lex Nova Law goes over what he believes are the most important and impactful changes including raising the limits for Regulation A and Regulation CF deals as well as the ability of “finders” to legally accept commissions for bringing deals to the table. And perhaps most importantly, the changes regarding accredited and non-accredited investors are a complete game changer! In this podcast, you’ll find out why that is.

Listen to “Why Everyone Benefits from the SEC's New Crowdfunding Rules” on Spreaker.

We can’t elect a President, but there’s certainly a preponderance of positive energy being circulated in the crowdfunding industry with respect to these rules revisions from the SEC! By increasing the raise limit of Reg.A and Reg.CF offerings, the entire process has become much more realistic in terms of making everything successful on just about every level and aspect of the industry. Now, accredited investors can have whatever stake of a project they want, and non-accredited investors can participate in ways unimaginable just a short time ago. And what’s an accredited investor? That rule has changed too!

One of the biggest changes the SEC has implemented is the legality of “finders” receiving commissions or payments for brokering deals and introducing investors to issuers, syndicators, developers, etc. Before this change, only broker-dealers were allowed to receive compensation for such deals. With the new changes, these finders can now legally receive these commissions and other transaction-based compensation from issuers. The ability to legally monetize your connections is something many have been waiting for for quite a long time!

There’s no question that crowdfunding still has its growing pains. However, one thing’s for sure: finders, investors, and issuers alike should all be jumping for joy after listening to the information Mr. Roderick goes over in this podcast. Broker-dealers, maybe not… But regardless, it’s a new world for crowdfunding and doors continue to open. The industry is definitely heading in the right direction.

Beneficiary Designations by Crowdfunding Issuers and Portals

Some Crowdfunding portals and issuers allow investors to designate a beneficiary, i.e., a person who will take ownership of the security (the LLC interest, debt instrument, whatever) should the investor die. Just be careful.

Most states (not Texas) allow the owners of securities, including privately-held securities, to designate a beneficiary outside the owner’s will, under a version of the Uniform TOD (Transfer on Death) Security Registration Act (the Delaware version is 12 DE Code §801 et seq). For the investor, the advantage of designating a beneficiary is that the security doesn’t go through the probate process but instead passes directly to the designated beneficiary.

For the Crowdfunding issuer or portal, there is a benefit to making life easier for investors. And it’s pretty straightforward to create a beneficiary designation form on your website.

Nevertheless, adding convenience for investors carries some risks. For example:

  • Suppose an investor wants to designate her cousin Jacob as the beneficiary of her LLC interest. She uses Jacob’s name on the beneficiary designation form but mistakenly uses her husband’s social security number, out of habit. What happens?
  • The investor correctly designates Jacob on the form but later changes her mind and designates her husband as the beneficiary of the LLC interest in her will. Unfortunately for her husband, the beneficiary designation made using your form cannot be undone by the will. Your form didn’t make that clear.
  • The investor property designates Jacob as the beneficiary of her LLC interest and doesn’t change her mind, but she lives in a community property state and your form didn’t tell her she needed her husband’s consent.
  • The investor property designates Jacob as the beneficiary of her LLC interest but he dies before she does, and she hasn’t designated a successor beneficiary.
  • Your site crashes and the investor’s beneficiary designation is lost.

What’s your budget for legal fees this year?

Designating a beneficiary on your site isn’t the investor’s only option. She can sign a simple will or codicil (if she already has a will) designating a beneficiary for her LLC interest and any other securities or other property, which probably makes more sense than designating beneficiaries security-by-security. And if her cousin and husband end up arguing over the codicil, you’re not involved.

If you’d like a sample of a Beneficiary Designation Form let me know.

Bumblebee and flowers

SEC PROPOSES LIMITED EXEMPTIONS FOR “FINDERS”

In theory, only broker-dealers registered under section 15 of the Exchange Act are allowed to receive compensation for connecting issuers with investors. In practice, the world of private securities includes lots of folks we refer to as “finders.” Like bumblebees, these folks should be unable to fly according to the laws of physics but many plants couldn’t survive without them.

Because of the disconnect between theory and reality, industry participants have been urging the SEC for years to develop exemptions for finders.

The SEC just proposed exemptions that would allow some finders to operate legally, i.e., to receive commissions and other transaction-based compensation from issuers.

The SEC proposes two tiers of Finders 

  • Tier 1 Finders would be limited to providing the contact information of potential investors to an issuer in one offering per 12 months. A Tier I Finder couldn’t even speak with potential investors about the issuer or the offering.
  • Tier II Finders could participate in an unlimited number of offerings and solicit investors on behalf of an issuer, but only to the extent of:
    • Identifying, screening, and contacting potential investors;
    • Distributing offering materials;
    • Discussing the information in the offering materials, as long as the Funder doesn’t provide investment advice or advice about the value of the investment; and
    • Arranging or participating in meetings with the issuer and investor.

A Tier II Finder would be required to disclose her compensation to prospective investors up front – before the solicitation – and obtain the investor’s written consent.

The Limits to the Proposed Finders

  • The Finder must be an individual, not an entity.
  • The Finder must have a written agreement with the issuer.
  • The proposed exemptions apply only to offerings by the issuer, not secondary sales.
  • Public companies (companies required to file reports under section 13 or section 15(d) of the Exchange Act) may not use Finders.
  • The offering must be exempt from registration.
  • The Finder may not engage in general solicitation.
  • All investors must be accredited.
  • The Finder may not be an “associated person” of a broker-dealer.
  • The Find may not be subject to statutory disqualification.

The SEC issued an excellent graphic summarizing the proposed exemptions

Because they are entities, the typical Crowdfunding portal can’t qualify as a Finder under the SEC’s proposals. And because the proposals don’t allow general solicitation, a Finder who is an individual can’t create a website posting individual deals.

But the no-action letters to Funders Club and AngelList that kick-started the Crowdfunding industry (no pun intended) will invite many Tier 2 Finders to take their businesses online. Under the proposals and the no-action letters, it seems that a Tier 2 Finder could legally create a website offering access to terrific-but-unnamed offerings, but give investors access to the offerings only after registering and going through a satisfactory KYC process per the CitizenVC no-action letter.

A Step Forward for Crowdfunding

Many finders and issuers will jump for joy at the new proposals, while others will be disappointed that the SEC drew the line at accredited investors. In a Regulation A offering or a Rule 506(b) offering open to non-accredited investors, the law requires very substantial disclosure, especially in Regulation A. The SEC must believe that non-accredited investors are especially vulnerable to the selling pressure that might be applied by a finder.

Nevertheless, like the SEC’s proposals to expand the definition of accredited investor, the proposals about finders are a step forward.

CAUTION:  As of today these proposals are just proposals, not the law.

TWO REASONS WHY EVERY TITLE II PORTAL SHOULD ADD A TITLE III PORTAL

If you operate a Title II Crowdfunding platform, whether Rule 506(c) or Rule 506(b), you should add the functionality for Title III. Two reasons:

  • It will be good for you, i.e., you will make more money.
  • It will be good for our country.

Adding Title III Will Be Good for You

Any day now the SEC will announce a bunch of changes to the Title III rules, including these: 

  • Sponsors will be able to raise $5M rather than $1.07M.
  • There will be no limit on the amount an accredited investor can invest.
  • The limits for non-accredited investors will be raised.

Most of the deals on your site are less than $5M. Even though the $5M limit under Title III is per-sponsor rather than per-deal, this means that if your Title III portal were up and running today you could expand your potential audience from about 10 million households to about 120 million households.

There are four benefits to making deals available to non-accredited investors.

The first, immediate benefit is that non-accredited investors do have money. By adding non-accredited investors you make it easier to fill deals.

The second, immediate benefit is that adding non-accredited investors allows you to market to affinity groups. If you’re selling a mixed-use project in Washington, D.C. you can market to the neighbors. If you’re selling a company developing a therapy for cystic fibrosis you can market to everyone whose family has been affected.

The third, immediate benefit is you can start taking commissions. If you’re like most Title II portals you spend time and effort to make sure you’re not a broker-dealer. If you were a Title III portal those issues would disappear.

The fourth benefit is not immediate but is much more important than the first three, in my opinion. It’s about building a brand and a funnel of investors.

If you operate a portal you are selling a product, no different than shoes or automobiles. Just as Mercedes offers the A-Class sedan to bring less-affluent customers into the showroom and the Mercedes family, adding Title III can vastly increase your audience and revenue as some non-accredited investors become accredited and the SEC further relaxes the rules for non-accredited investors.

Alternatively, they could start shopping in somebody else’s Title III showroom.

Adding Title III Will Be Good for the Country

Our country is suffering in many ways. Yes, we’re suffering politically, but in some ways the political suffering is just one manifestation of our deep and deepening income and wealth inequalities. You can find a hundred charts showing the same thing:  the very wealthy are becoming wealthier while everyone else, especially the lower 50%, becomes poorer and more desperate.

When I was a teenager I delivered newspapers in Arlington, Virginia. In my suburban territory I delivered papers to accredited investors, whose houses were a little bigger and drove Cadillacs and Town Cars, and to non-accredited investors, whose houses were a little smaller and drove Chevies and Toyotas. One of my customers was George Shulz, the Secretary of the Treasury, who came to the door in his bathrobe and tipped well.

Tax policies, trade policies, all the instrumentalities of government have been focused over the last 40 years to serve the interests of the well-off. Part of it was cynical politics, part too much faith (which I shared) in the power of markets to lift all boats. Most of the boats in our country remain moored at low tide. Steve Mnuchin and his wife wouldn’t dream of living in that neighborhood today while 98% of Americans couldn’t afford to.

Call me an idealist, but I believe Crowdfunding can at least claw back some of the inequality. The deals on your Title II portal should be available to ordinary Americans. They should participate in those returns. They should regain faith that the capitalist system can work for them. We should all hope that the phrase “institutional quality,” when applied to investments, will lose its meaning.

Crowdfunding isn’t the whole solution, but it’s part of the solution. And you can make it happen.

PODCAST: Is the SEC Democratizing Investment?

Democratizing investment. A huge step forward.

My guest today is Mark Roderick, founder of Lex Nova Law and one of the top online crowdfunding experts in the country. Mark and I discuss the very exciting changes proposed by the Securities and Exchange Commission to regulation crowdfunding, or Reg CF, the securities regulation that is really the first step taken by the S.E.C. towards democratizing investment. The additional changes proposed will give this regulation real legs.

Impact Real Estate Investing Podcast

Insights and Inspirations

  • Mark believes the latest round of changes to the crowdfunding rules will bring some fundamental changes to the industry including higher quality deals.
  • As the deals get better, so will the industry grow, and more investors join in.
  • He expects to see changes in the physical landscape in just 5 years as these rules begin to have a far-reaching effect.
WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

Too many issuers think of the Regulation A Offering Circular as just a dry legal document between the SEC and the lawyers. It should be more than that.

As I’ve said once or twice before, Crowdfunding is a marketing business. Creating a great company with a great product isn’t enough. “Build it and they will come” worked for Kevin Costner but it doesn’t work for most companies trying to raise capital.

Here are some examples of things you’d like to say to attract investors:

  • We have a terrific track record in this industry going back 15 years.
  • Our performance during the last five years has doubled industry averages.
  • Our Founder has had successful exits from her last three companies.
  • Experts forecast that our market will triple over the next seven years.

Those can be very powerful messages for prospective investors. But here’s the thing:  you’re not allowed to say them in your Facebook ads unless you’ve already said them in your Offering Circular.

You spend all the time and money to have your Regulation A offering qualified by the SEC, only to learn that you’re not allowed to say what you’d like to say to attract investors. 

Write your Offering Circular with advertising in mind. Make your lawyer speak with your marketing team and vice versa, even though they speak different languages. Create your marketing materials — your website, your Facebook ads, your email campaigns — in conjunction with your Offering Circular, so all the pieces are working together rather than pulling in opposite directions.

RULE 10b-5: THE HIDDEN DISCLOSURE REQUIREMENT IN REGULATION A

RULE 10b-5: THE HIDDEN DISCLOSURE REQUIREMENT IN REGULATION A

Preparing a Regulation A Offering Circular is as much an art as a science.

An issuer offering securities using Regulation A can choose from several disclosure formats, including Form 1-A, Form S-1, or Form S-11. Each of these SEC forms includes a list of information that must be disclosed. For example, Form 1-A lists 17 items, ranging from the cover page to the Exhibits, each with sub-categories and special rules. Transparency and disclosure have been the touchstones of U.S. securities laws since the 1930s, and each form includes hundreds of pieces of information that must be disclosed to prospective investors. 

But even an issuer that made a list of all those items and completed the form meticulously wouldn’t be finished, because 17 CFR §240.10b-5 effectively imposes a catch-all requirement for disclosure.

Rule 10b-5(b) provides:

“It shall be unlawful for any person, directly or indirectly. . . .[t]o make any untrue statement of a material fact or to omit to state a  material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

The first part of that statement is easy:  you’re not allowed to make untrue statements of material facts, i.e., to lie.

It’s the second part that requires some thought. A couple simple examples:

  • You’re raising money for a grocery delivery business and there’s a guy on your board named Jeffrey Bezos. You’d better tell investors he’s not that Jeffrey Bezos.
  • Your Offering Circular describes the patent with which you expect to revolutionize the world of online payments. You’d better mention the letter you received alleging that your patent is invalid.

In practice, Rule 10b-5(b) means that no matter how many times you compare the SEC form (Form 1-A, Form S-1, Form S-11) to your Offering Circular, checking off all the boxes, if investors lose money a plaintiff’s lawyer can snoop around, with the benefit of hindsight, looking for something else that should have been disclosed. 

That’s why preparing a Regulation A Offering Circular is as much an art as a science.

MY COMMENTS TO SEC’S CROWDFUNDING PROPOSALS

Gentlemen and Ladies—

The following are comments to the proposed rules published in the Federal Register on March 31, 2020 relating to offerings under §4(a)(6) of the Securities Act of 1933 and related matters.

Before commenting, I would like to applaud the Commission not only for these proposals but for its approach to the JOBS Act generally. I have practiced in this space extensively since 2012, representing funding portals, issuers, and other industry participants. Time after time I have been impressed with how the Commission has sought to achieve two complimentary goals:  on one hand, protecting investors and ensuring that American capital markets remain the most transparent and robust in the world; and on the other hand, facilitating capital formation by small, job-creating enterprises and giving ordinary Americans the opportunity to invest in businesses historically available only to the wealthy.

Among many examples I will mention just one. On May 4, 2020 the Commission adopted temporary rules to facilitate capital formation under §4(a)(6) In response to the COVID-19 pandemic. No one knows how many jobs the temporary rules will save or create, but the willingness of the Commission to draft and issue the temporary rules in the midst of a crisis, taking the time to help very small businesses while overseeing a complex, multi-trillion dollar securities market, speaks volumes. The Commission clearly believes that Crowdfunding has an important role to play in our capital markets, and all Americans, not just those of us in the industry, should be grateful.

Speaking from the ground floor, so to speak, I have just a few comments, all geared toward making the industry more robust while protecting investors.

Raised Offering Limit and Elimination of Limit for Accredited Investors

To my mind, the two most important and welcome proposals are (i) to increase the limit set forth in 17 CFR §227.100(a)(1) from $1,070,000 to $5,000,000, and (ii) to eliminate the limit in 17 CFR §227.100(a)(2) for accredited investors. Either change would have been welcome, but together I believe they will change the Title III market significantly for the better, improving both the quality of the offerings and the level of compliance.

With offerings limited to $1,070,000 and very low per-investor limits, even for accredited investors, funding portals have had a very hard time making money, plain and simple. Struggling to make ends meet, they lack resources to spend on compliance or on other business practices that would attract more promising issuers and, especially, a larger number of prospective investors. In fact, the difficulty in turning a profit has led some funding portals to adopt practices that may provide some benefit in the short term but drive away rather than attract issuers and investors.

With larger offerings and unlimited investments from accredited investors, I believe that the proposed changes to 17 CFR §227.100(a)(1) and 17 CFR §227.100(a)(2) will reverse that cycle. A profitable funding portal can hire compliance officers, exercise more discretion in the presentation of disclosure materials, provide better documents, insist on quality in all aspects of its business. These steps will in turn attract more investors, which will attract more and better issuers, in a virtuous cycle. With the promise of potential profits, I expect the number, sophistication, and expertise of funding portals to grow rapidly, helping to deliver on the promises with which Title III was launched.

Hence, I strongly support these proposals.

Artificially Low Target Offering Amounts

Too often, we see Title III issuers launch offerings with an artificially low target offering amount, typically $10,000. I believe the artificially-low target amounts are unfair to investors and poisonous to the Title III Crowdfunding market.

The concept of offering “minimums” has always been part of private investments with sophisticated investors. For example, a company seeking to raise as much as $750,000 to obtain three patents and hire a Chief Operating Officer and Chief Marketing Officer might set a minimum offering amount of $450,000, which would allow it to at least obtain two patents and hire the COO. But if the company could raise only $150,000 the company was obligated to give the money back, because sophisticated understand that anything less than $450,000 wouldn’t move the needle for the business.

I believe the concept of target offering amounts in Title III should follow that model, i.e., that the target offering amount should represent an amount of money that would allow the issuer to achieve a significant business goal.

Too often we see on funding portals a company that seeks to raise, say, $350,000 setting a target offering amount as low as $10,000. The artificially low target amount serves the short-term interests of the funding portal and the issuer:  if the company raises, say, $38,000, the issuer receives some cash while the funding portal receives a commission on $38,000 and includes the issuer in its list of “successful” offerings, skewing its statistics as well as the statistics of the industry as a whole. Meanwhile, investors have put $38,000 into a company that needed a lot more and have thereby made an investment fundamentally different and riskier than the investment promised. In the larger picture, I believe sophisticated investors see the game and stay away from the funding portal – and perhaps all of Title III – altogether.

I believe the Commission should amend 17 CFR §227.201(g) to provide as follows:

The target offering amount, the deadline to reach the target offering amount, a statement of the significant business goal the issuer expects to achieve if it can raise the target amount or, if there is no such significant goal, a statement to that effect, and a statement that if the sum of the investment commitments does not equal or exceed the target offering amount at the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned;

In addition, I believe the Commission should caution issuers and funding portals that if raising the target offering amount will not allow the issuer to achieve any significant business goal, a risk factor should be added to that effect.

Revenue-Sharing Notes

The Commission proposes to add 17 CFR §227.100(b)(7), making Title III Crowdfunding unavailable for securities that “Are not equity securities, debt securities, and securities convertible or exchangeable to equity interests, including any guarantees of such securities.”

It is unclear to me whether this new rule would allow securities commonly referred to as “revenue-sharing notes.” I believe these securities should be allowed.

A typical revenue-sharing note has the following features:

  • Investors are entitled to receive a specified percentage of the issuer’s gross revenues, or gross revenues from specified sources (e.g., from sales of a new product).
  • The note specifies a maximum amount investors may receive, often a multiple of the amount invested. For example, investors might be entitled to receive a maximum of twice the amount invested.
  • The note also specifies a maturity date – for example, three years from the date of issue.
  • Payments continue until the sooner of the maturity date or the date investors have received the specified maximum amount.
  • If investors have not received the specified maximum amount by the maturity date, they are entitled to receive the balance (the difference between the maximum amount and the amount they have received to date) on the maturity date.
  • Sometimes, but not always, the revenue-sharing is convertible into equity.

Revenue-sharing notes are especially attractive for small companies and less-experienced investors:

  • They are extremely easy to understand. For less-experienced investors a revenue-sharing note is much easier to understand than a share of common stock, for example.
  • The payments on a revenue-sharing note depend on only one thing:  sales. They do not depend on any expense items. For example, they do not depend on how much compensation is paid to the principals of the company. As a result, the potential for misunderstandings and disputes is reduced substantially.
  • They provide investors with built-in liquidity.
  • They allow issuers to maintain a “cleaner” cap table, possibly facilitating future financing rounds.
  • All those benefits are also available with straight debt securities. For many small businesses, however, and especially for true startups, there is no interest rate – short of usury, that is – that would compensate investors adequately for the risk. As of this morning, the one-year return of the S&P 500 BB High Yield Corporate Bond Index is almost 9%. To compensate investors adequately for the risk of investing in a startup the potential return must be far higher. The revenue-sharing note provides that potential.

 

Revenue-sharing notes shares features of equity securities in the sense of providing a significant potential for profit, and also share features of debt securities in the sense of providing a date certain for payment. Sharing features of both equity securities and debt securities, it is hard to say a revenue-sharing note is only an equity security or only a debt security. Hence, it would be helpful if the Commission would clarify that revenue-sharing notes may be offered and sold under §4(a)(6).

Accountant Review

In the context of large companies, reviews and audits of financial information by independent accountants is an unmitigated positive, indeed a cornerstone of transparency and integrity in the American capital markets. In the context of very small companies, however, the positives are less apparent and can be outweighed by the cost.

Currently, 17 CFR §227.201(t)(2) requires companies seeking to raise between $107,000 and $535,000 to provide financial statements reviewed by an independent accountant. The cost of such a review varies by region but can certainly amount to between $5,000 and $10,000. For a company seeking to raise, say, $150,000, the cost of the accountant review by itself represents between 3% and 7% of the capital raise, an enormous cost and far more as a percentage than the audit costs of large issuers.

In my opinion, the cost of these reviews is not justified by the value of the additional information they provide to investors. For companies raising no more than $107,000, 17 CFR §227.201(t)(2) requires only information from the company’s Federal tax certified by the principal executive officer, who is typically the founder of the company. My experience in representing hundreds of small companies over more than 30 years suggests that a certification for which a CEO and/or founder takes personal responsibility is much more likely to be accurate than a reviewed financial statement. Although I am confident that every small company files tax returns that are accurate in every respect, out of patriotic obligation, I also note that CEOs and founders are, if anything, incentivized to understate a company’s income on a tax return.

In short, I believe investors get very little, if anything, in terms of the accuracy of a company’s financial disclosures in exchange for the added cost to the company. To bring the cost and the benefit closer into line, I recommend raising the threshold in 17 CFR §227.201(t)(2) to at least $350,000, and possibly eliminating 17 CFR §227.201(t)(2) altogether and raising the threshold in 17 CFR §227.201(t)(1) to $500,000.

I will make two further points in this regard:

  • It is possible that as the market becomes more robust investors will reward companies that provide reviewed financial statements and punish those who don’t. If so, the market will impose its own discipline.
  • Although financial statements are extremely important in evaluating established companies, they are far less important in evaluating small companies and startups. For example, the financial statements of Facebook and Amazon and Microsoft were essentially irrelevant to the earliest investors. I believe that investors in the Title III market make investment decisions almost wholly without regard to historical financial statements and will continue to do so. In this sense the paradigm for large companies simply doesn’t fit the small company market.

Advertising

Section 4A(b)(2) of the Securities Act provides that issuers relying on the exemption of §4(a)(6) “shall not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.” That rule is implemented in 17 CFR §227.204, which defines the “terms of the offering” to mean (i) the amount of securities offered, (ii) the nature of the securities, (iii) the price of the securities, and (iv) the closing date of the offering period.

In practice this rule has created a great deal of confusion and many inadvertent violations. It has also kept issuers from communicating effectively with prospective investors. I do not believe it has protected investors in any meaningful way.

A small company will reasonably wonder why it is allowed to say “We’re raising capital!” on its Facebook page but might not be allowed to say “We’re trying to raise $250,000 of capital!” I say “might not” because even with this simple example the rule is not clear. If “We’re trying to raise $250,000 of capital!” were the only item the company ever posted on Facebook, that would be okay. But of course the company’s Facebook page is filled with all sorts of other information, including information about the company’s founders and history and products – that’s the point of having a Facebook page. In this situation the statement “We’re trying to raise $250,000 of capital!” might be illegal, while the statement “We’re raising capital!” is fine.

In today’s digital, social-media-driven world that creates a mess, impossible for small companies to untangle.

The problems arise from applying the paradigm of large, public companies to the world of small companies and startups. If I want to buy stock of Google I don’t call Google, I call my broker. At some point in the future funding portals might play the role for small companies that brokers play for large companies today. For the present, however, the reality is that Title III issuers have primary and sometimes exclusive responsibility for marketing their own offerings. To hamstring advertising by Title III issuers is to hamstring Title III.

I do understand and support the goal of directing investors back to the portal and thus ensuring that all investors receive exactly the same information. However, I believe that goal can be accomplished, with no harm to investors, through a slightly different approach.

In a Title III offering, I understand the “terms of the offering” to mean all the information contained in Form C. Thus, I would interpret section 4A(b)(2) to mean only that if an issuer provides to prospective investors all or substantially all of the information provided in its Form C, it must direct them to the portal. Otherwise, issuers should be allowed to advertise their offerings, including the four terms enumerated in current 17 CFR §227.204, with three caveats:

  • I would require every advertisement, no matter its contents, to direct potential investors to the funding portal. For these purposes I would define the term “advertisement” very broadly, even more broadly than the term “offer” is defined under current law. Thus, I would consider requiring even notices permitted by 17 CFR §230.169 to include a link back to the funding portal, if made while the offering is open.
  • I would prohibit any advertisement containing information that is not in the issuer’s Form C.
  • In the text of 17 CFR §227.204 I would remind issuers and their principals of their potential liability for material misstatements and omissions.

Those changes would provide clear rules for issuers and funding portals and, I believe, would unleash a torrent of creativity and energy in the Title III market, with no harm to investors.

The Role of FINRA

Under section 4A(a)(2) of the Securities Act, every funding portal must register with any applicable self-regulatory organization. Because there is only one such organization in the United States, all funding portals must become members of the Financial Industry Regulatory Authority, or FINRA. Consequently, although not directly germane to the Commission’s proposals published on March 31, 2020, any discussion of Title III must include at least a reference to FINRA and its regulation of funding portals.

Like everyone else involved in Title III, lawyers and the Commission included, FINRA was starting from scratch in 2016, its two point of reference being the Commission’s regulations on one hand and its own experience regulating broker-dealers on the other hand. In my view FINRA has leaned too heavily on its institutional experience regulating large broker-dealers without taking into account the unique aspects of Title III Crowdfunding.

The Commission’s proposals, and my comments to the proposals, are focused on the economic realities of raising capital for very small companies. One of those economic realities is that most funding portals, like most startups, are owned and operated by just a few people. Too often, the FINRA regulatory paradigm seems to ignore this reality and assume that the funding portal is a much larger enterprise, an enterprise with multiple layers of management – an enterprise like a national broker-dealer.

For example, FINRA requires funding portals to adopt and adhere to an extensive manual of policies and procedures addressing every aspect of its operations. Theoretically such a manual is unobjectionable, and in a large organization absolutely necessary, but in the real world of funding portals the manual typically has the effect of requiring Ms. Smith to supervise herself and maintain a meticulous log proving she did so, and how.

Just as the Commission itself seeks to regulate Title III Crowdfunding based on economic realities, understanding that the rules applicable to public filers might not always apply to very small issuers, I would like to see the Commission encourage FINRA to review its approach to funding portals.

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Thank you for your consideration.

MARK RODERICK

set of medical protective face masks

COVID-19 DISCLOSURES IN CROWDFUNDING OFFERINGS

The COVID-19 pandemic illustrates why we include a list of “risk factors” when we sell securities. Suppose a company issued stock on January 1, 2020 without disclosing that its major supplier was located in Wuhan, China and that Wuhan was experiencing an outbreak of a new virus. Investors who bought the stock likely would be entitled to their money back and have personal claims against the founders, officers, and directors.

If the company issued stock on October 1, 2019, before the pandemic began, its duty to tell investors about the pandemic would depend on which version of Crowdfunding it used:

  • If it used Title II Crowdfunding (Rule 506(c)) the company would have no duty to tell investors about the pandemic.
  • If it used Title III Crowdfunding (Regulation CF) the company would be required to tell investors about the pandemic in its next annual report.
  • If it used Title IV Crowdfunding (Regulation A) the company would be required to tell investors about the pandemic in its next semiannual or annual report, whichever comes first.

CAUTION:  That assumes the Company was finished selling stock on October 1, 2019. If it was continuing to sell stock when it learned of the pandemic, then the Company would be required to tell new investors. And if a Title III offering hadn’t yet closed, all existing investors would have the right to change their minds.

CAUTION:  A company – even a publicly-reporting company – generally is not required to tell investors about COVID-19 if it is not selling securities currently, because pandemics are not on the list of disclosure items found in Form 1-U (for Regulation A issuers) or Form 8-K (for publicly-reporting companies). But be careful. For example, if a Regulation A issuer redeems stock without disclosing the effect of COVID-19, it could be liable under Rule 10b-5 and otherwise.

Assume that we’re required to tell investors about COVID-19 today, whether because we’re selling stock or are filing an annual or semiannual report. What do we say?

If this were January, we might say something simple:  “Wuhan, China is experiencing an outbreak of a highly-contagious virus, which is disrupting economic activity. If this virus should spread to the United States, as epidemiologists predict, it could have an adverse effect on our business.”

But this isn’t January. We have much more information today and are therefore required to say more. Exactly how much information we share is as much an art as a science. Our goal is always to give investors enough information to make an informed decision without making the disclosure so dense as to be useless.

Here are two examples, one for multi-family housing projects and the other for a technology company.

Multi-Family Housing

With unemployment reaching levels not seen since the Great Depression, by some estimates already 20% and rising, we are already experiencing a number of negative effects from the COVID-19 pandemic:

  • We are experiencing a decrease in the number of phone calls and visits from potential new tenants. Year-to-year compared to 2019, we experienced a decrease in traffic of approximately ____% in March and ____% in April.
  • We are experiencing an increase in rent delinquency. Year-to-year compared to 2019, the rate of delinquencies greater than 30 days rose from ____% to ____% during March and ____% to ____% during April.
  • We are spending more time and resources on collections and marketing.

Although we are working from incomplete information, we expect these trends to continue and perhaps accelerate, depending on the trajectory of the virus and the ability to re-open the economy. Among possible outcomes:

  • Occupancy levels might decrease, although they have not decreased yet as compared to the same periods in 2019.
  • We do not intend to raise rents until the pandemic eases. Depending on circumstances we could be forced to decrease rents.
  • We expect some tenants to re-locate for economic reasons, from Class A projects to Class B projects and from Class B projects to Class C projects. In some cases tenants might leave the market altogether, by moving in with relatives, for example. Because we operate primarily Class B properties, we are uncertain whether the net effect for our properties will be positive or negative.
  • Conversely, we expect that economic uncertainty will cause some families to postpone buying a house and rent instead, increasing the pool of potential tenants.
  • The pandemic has caused significant uncertainly in the value of many assets, including real estate. Until the uncertainty is resolved it might be difficult for us to borrow money or raise capital by selling equity.
  • If occupancy rates and rents decrease while delinquencies increase, we could be unable to meet our obligations as they become due. A reduction in cash flows and/or asset values could also cause us to be in default under the loan covenants under our senior debt. Either scenario could lead to foreclosure and the loss of one or more properties.

At least in the short run we expect the pandemic to cause our revenue to decrease, perhaps significantly. As a result, we are taking steps to conserve cash. Among other things we have decided not to make any cash distributions until the economic outlook stabilizes and have reduced our staff. We have also begun to contact lenders to request a deferral of our mortgage loan obligations.

We do not know how long the pandemic will last or how its effects will ripple through the American economy. In a best-case scenario we would experience a short-term drop in cash flow and a dip in asset values as the economy adjusts to a new reality. In a worst-case scenario, where occupancy and rent levels drop significantly over an extended period of time, we would be unable to make mortgage payments and possibly lose assets, risking or even forfeiting investor equity if asset values drop far enough. Based on the information currently available to us we expect an outcome closer to the former scenario than to the latter and are marshalling all our experience and assets toward that end.

Technology

Our software provides a virtual connection between internet-based office telephone systems and cellular phones, allowing incoming calls to the office number to be re-directed to the cellular phone and outgoing calls made from the cellular phone to appear to the recipient as if they were made from the office number. Will tens of millions of people working remotely due the COVID-19 pandemic, the demand for our software has grown substantially. On January 1, 2020 our software had been installed on ________ cellular devices worldwide. On May 1, 2020 it was installed on ________ devices.

As a result, we expect both our revenue and our net income for 2020 to increase substantially. However, with many workers now returning to their offices on a full-time or part-time basis it is unclear whether the high demand for our software will continue. Consequently, we are unable to provide a reliable forecast for revenue or net income at this time.

With more than ________ new users, even if temporary, we are accelerating developing of our new consumer-based communications tools. We expected to launch these tools in Q1 2021 but are now aiming for Q3 2020.

Even before the pandemic many of our employees worked remotely at least part of the time. Therefore, our operations have not been affected significantly by the pandemic. Tragically, however, David Newsome, the leader of our marketing team, contracted COVID-19 and died on March 27th in Brooklyn, NY. We have not yet found a replacement for David, who was with the company from its founding in 2013.

We were considering purchasing a commercial building in Palo Alto as the headquarters for our engineering team. Given our successful experience working remotely we have decided to put those plans on hold at least for the time being.