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.

SEC PROPOSES MAJOR UPGRADES TO CROWDFUNDING RULES

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.

The Biggest Challenge With Title III Crowdfunding

Crowdfunding Image - XXXL - iStock_000037694192XXXLarge

The biggest challenge with Title III Crowdfunding isn’t the $1,070,000 maximum or the per-investor limits. The biggest challenge is how a small company complies with the disclosure requirements on a tight budget.

The disclosures required by Title III — I’m talking specifically about the long list of disclosures required by 17 CFR 227.201 — are fundamentally the same as those required by Title IV (aka Regulation A), which is itself only a slightly scaled-down version of a full-blown public offering.

There are easy questions, like naming the directors and officers, but the most important disclosures make sense only to securities lawyers. Ask the owner of a small business to list the “risks of investing” and you get mostly a blank stare, not the careful list the regulations anticipate. And when you get through everything else, you’re told to disclose “Any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

To a securities lawyer that’s just a restatement of SEC Rule 10b-5. To the founder of a small business it means nothing.

The result is what we see in the Title III market today, a mishmash. Some sites and companies manage to do it well, but many don’t. The widespread failure of compliance has led some to question whether Title III should be expanded before the Title III industry gets its house in order.

How does the industry get its house in order?

Before trying to answer that question, let’s think about how small companies raised money before Title III.

Before Title III, the typical small business was only vaguely aware of securities laws, if at all, and raised money however it could from whomever it could. Without knowing it, the microbrewery raising $250,000 from friends and family was eligible for the Federal exemption under Rule 504 and might have been eligible for state exemptions as well. But it probably wasn’t making the kind of disclosures required by Title III.

The same was true for would-be Silicon Valley unicorns. I’m pretty sure SoftBank didn’t ask Adam Neumann for a list captioned “Risks of Investing.”

The fact is that investing in a small business before 2016, big or small, generally was driven by relationships, not by legal disclosures. Because disclosure is the heart of the U.S. securities laws, it’s no surprise that the SEC turned to disclosure to protect widows and orphans in Title III. But the full-disclosure paradigm is new to this world. Ironically, the typical Title III issuer – even the issuer whose Form C falls short – is making far more disclosures than most small companies made before Title III, and far more than would-be unicorns are making to VCs today.

Does the paradigm used for large companies and institutional investors make sense for tiny companies and non-accredited investors? I’ll leave that for another day.

As an industry, we can take a few steps to improve:

  • Software and Templates – Better software and better templates can help. At the same time, no template or software can produce “Any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.” I translate that to “What would you tell your grandparents if they were investing?” But still, it’s hard.
  • Standardization – Depending on your point of view, standardization is either the price or the benefit of participating in a mass market. In either case, I’m convinced that Title III can’t function properly without far more standardization:
    • Standardized Corporate Structures – It would be great if every Title III issuer were a Delaware corporation or a Delaware limited liability company, using the same standardized Bylaws or Limited Liability Company Agreement.
    • Standardized Securities – Common stock, a simple preferred stock, a straight term loan, a simple revenue-sharing note, a SAFE, and their tokenized equivalents.
    • Standardized Disclosure Templates – An investor should be able to compare the disclosures between companies and portals apples-to-apples.
    • Standardized Legal Documents – Subscription Agreement, contract between portal and issuer, terms of the SAFE – everything should be standardized. Toward that end, within the next month I’m going to make a set of standardized documents available for issuers and portals.
  • No More $10,000 MinimumsC’mon, man! The Target Amount should reflect the minimum required for a viable business, or to get a necessary patent, or something. The widespread use of artificially-low Target Amounts has damaged the Title III market, driving away serious investors.

As long as I’m at it, I’ll ask just one thing of the SEC. Ideally, figure out a way to eliminate the per-investor limits for accredited investors under Title III, which serve no purpose and are inconsistent with Regulation D. Or, if that’s not possible under the language of the JOBS Act, get to almost the same place by creating a regulatory safe harbor under the Exchange Act, which would allow funding portals to receive commissions from accredited investors in a side-by-side offering.

Everyone benefits, and the Title III market gets healthier.

Questions? Let me know.

The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

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Our guest on this episode of The Wealthy Wellthy Podcast is Mark Roderick, an attorney who devotes most of his time to crowdfunding. Maybe you are like me in thinking that crowdfunding is pretty straightforward and self-explanatory. I mean, if your friend is looking to start a business and you want to support them, you can donate or invest through their crowdfunding page online and that’s that, right?

Every entrepreneur faces the stage in their business where they need to acquire capital, either from acquaintances, networking, angel investors, venture capitalists, or strategic partners. This process is messy and confusing, filled with regulations and stipulations that may make acquiring the capital more trouble than it is worth. This was partially due to the antiquated laws that were created in the aftermath of The Great Depression and were stifling in the modern economic climate. However, in 2012, the Jobs Act made it legal for entrepreneurs to advertise to raise capital. This opened up a whole new world for small business owners and others who were desperate to be able to connect more easily with potential investors as well as investors who were eager to find new opportunities.

During the interview, Mark distinguishes between the 3 kinds of crowdfunding: (1) to accredited investors only, (2) Regulation A to accredited or non accredited investors, and (3) Title 3 – which is the most common. He also talks about the factors that are most important from a legal perspective when you are determining which crowdfunding site to use to raise capital or to invest capital. It was also interesting to hear Mark spell out the 3 reasons why people invest through crowdfunding: (1) they want to support the company, (2) to do social good, and (3) to make money.

Mark even gave me some advice about a real estate deal I am considering and revealed that 90-95% of the capital exchanged through crowdfunding is for real estate transactions. Finally, he busted a couple of myths regarding the amount of risk involved in crowdfunding and whether money raised from others is subject to securities laws.

What We Covered

  • [2:16] – Who is Mark Roderick?
  • [3:28] – Mark describes the fragmented traditional ways of raising capital.
  • [8:58] – Angel investors and how to present your “deck” to them.
  • [11:08] – Working with venture capitalists and strategic partners.
  • [13:31] – A brief history of the laws affecting capital.
  • [22:34] – What does crowdfunding look like for startup entrepreneurs?
  • [27:20] – How to find a regulated site to post your capital request on.
  • [30:58] – Crowdfunding is the intersection of old and new school.
  • [34:57] – Advice to keep in mind when you are using a crowdfunding site.
  • [38:06] – Mark tells us 3 of the crowdfunding sites he works with.
  • [40:08] – When should an entrepreneur hire an attorney during this process?
  • [42:40]– The prevalence of real estate in the crowdfunding world.
  • [53:24] – What message does Mark want to get out there?
  • [56:17] – Mark busts 2 myths about crowdfunding.

Questions? Let me know.

Think Twice About a Low Target Amount in Title III Crowdfunding

Target amount in Title III Crowdfunding

Many Title III issuers are setting “target amounts” as low as $10,000. I understand the motivation, but I’d urge issuers and the platforms to think twice.

Background

In Title III Crowdfunding (also known as “Regulation Crowdfunding” or “Regulation CF” or “Reg CF”), the issuer establishes a “target amount” for the offering. Once the offering achieves the target amount, the issuer can start spending the money raised from investors, even while continuing to raise more money. That gives issuers a strong incentive to set a low target amount.

EXAMPLE:  A brewery needs to raise $400,000 for equipment, fit-out, marketing, and salaries. If the brewery establishes $400,000 as the target amount, it can’t start spending the money from investors until it raises the entire $400,000. If it establishes $10,000 as the target amount, on the other hand, it can start spending investor money as soon as it raises the first $10,000 — even if the business will fail without the full $400,000.

The platform benefits, also, in two ways:

  • If the brewery establishes a target amount of $10,000 and raises at least that much, the platform can include the brewery in its “Reached Target Amount” list, even if overall the brewery raised only $12,000 and failed.
  • The platform receives a commission only on funds released to the issuer. The sooner money is released to the issuer, the sooner the platform earns a commission.

Minimum Offering Amounts

Target amounts were around long before Title III Crowdfunding, in the form of “minimum offering amounts.” A company raising capital would establish a “minimum offering” equal to the lowest amount of money that would make the business viable. If a brewery absolutely needs $400,000 to be viable, then the minimum offering would be $400,000. If it could plausibly scrape by with $315,000 — maybe by deferring the purchase of an $85,000 piece of equipment — then the minimum offering would be $315,000.

Issuers don’t establish minimum offerings because they want to, but because experienced investors won’t invest otherwise. If $315,000 is the minimum that will make the brewery successful, an experienced investor writing the first check will demand that her money be held in escrow until the offering raises $315,000. If the offering doesn’t raise $315,000, she gets her money back. Investing is hard enough:  why invest in a company that’s guaranteed to fail?

That’s also why we have traditionally seen “minimum/maximum” offerings. The brewery that needs at least $315,000 to be viable might be able to make great use of up to $475,000, with both numbers anchored to a believable business plan.

The Decision in Title III

Cash is king for most entrepreneurs, the sooner the better, so a Title III issuer will be tempted to establish a low target amount. And to the extent an issuer can rely on inexperienced investors, it might be successful, at least in the short term.

But the issuer should also be aware of the downside:  by establishing a low target amount, the issuer is driving away experienced investors. How many experienced investors are driven away, and the amount they might have invested, can’t be captured.

On the positive side, an issuer that establishes a realistic target amount can and should advertise that fact in its Form C, perhaps drawing a favorable contrast vis-à-vis other Title III issuers, whose target amounts were picked from the air. That’s the kind of information an experienced investor will like to see.

An issuer that weighs the pros and cons and nevertheless decides on an artificially low target amount should include a prominent risk factor in its Form C:

“The ‘target amount’ we established for this offering is substantially lower than the amount of money we really need to execute our business plan. If we raise only the target amount and are unable to raise other funds, our business will probably fail and you will lose your entire investment.”

Artificially low target amounts carry a long-term downside for the platform, too. I would argue that as long as issuers are establishing $10,000 minimums, Title III won’t be taken seriously as an asset class, and the industry won’t grow.

Questions? Let me know.

Yes, A Parent Company Can Use Title III Crowdfunding

Title III Crowdfunding

We know an “investment company,” as defined in the Investment Company Act of 1940, can’t use Title III Crowdfunding. For that matter, an issuer can’t use Title III even if it’s not an investment company, if the reason it’s not an investment company is one of the exemptions under section 3(b) or section 3(c) of the 1940 Act. By way of example, suppose a a company is engaged in the business of making commercial mortgage loans. Even if the company qualifies for the exemption under section 3(c)(5)(C) of the 1940 Act, it still can’t use Title III.

We also know that, silly as it seems, a company whose only asset is the securities of one company is generally treated as an investment company under the 1940 Act. That’s why we can’t use so-called “special purpose vehicles,” or SPVs, in Title III Crowdfunding, to round up all the investors in one entity and thereby simplify the cap table.

Put those two things together and you might conclude that only an operating company, and not a company that owns stock in the operating company, can use Title III Crowdfunding. But that wouldn’t be quite right.

A company that owns the securities of an operating company – I’ll call that a “parent company” — can’t use Title III if it’s an “investment company” under the 1940 Act. However, while every investment company is a parent company, not every parent company is an investment company. Here’s what I mean.

Section 3(a)(1) of the 1940 Act defines “investment company” as:

  • A company engaged primarily in the business of investing, reinvesting, or trading in securities; or
  • A company engaged in the business of investing, reinvesting, owning, holding, or trading in securities, which owns or proposes to acquire investment securities having a value exceeding 40% of the value of its assets.

Suppose Parent, Inc. owns 100% of Operating Company, LLC, and nothing else. If Parent’s interest in Operating Company is treated as a “security,” then Parent will be an investment company under either definition above and can’t use Title III. However, it should be possible to structure the relationship between Parent and Operating Company so that Parent’s interest is not treated as a security, relying on a long line of cases involving general partnership interests.

These cases arise under the Howey test, made famous by the ICO world. Under Howey, an instrument is a security if and only if:

  • It involves an investment of money or other property in a common enterprise;
  • There is an expectation of profits; and
  • The expectation of profits is based on the efforts of someone else.

Focusing on the third element of the Howey test, courts have held that a general partner’s interest in a limited partnership generally is not a security because (1) by law, the general partner controls the partnership, and (2) the general partner is therefore relying on its own efforts to realize a profit, not the efforts of someone else.

If Operating Company were a partnership and Parent were its general partner, then the arrangement would fall squarely within this line of cases and Parent wouldn’t be treated as an investment company. As a general partner, however, Parent would be fully liable for the liabilities of Operating Company, defeating the main purpose of the parent/subsidiary relationship, i.e., letting the tail wag the dog.

Fortunately, Parent should be able to achieve the same result even though Operating Company is a limited liability company. The key is that Operating Company should be managed by its members, not by a manager. That should place Parent in exactly the same position as the typical general partner:  relying on its own efforts, rather than the efforts of someone else, to realize a profit from the enterprise.

If Parent’s interest in Operating Company isn’t a “security,” then Parent isn’t an “investment company,” and can raise money using Title III.

Questions? Let me know.

The Per-Investor Limits of Title III Require Concurrent Offerings

Since the JOBS Act was signed by President Obama in 2012, advocates have been urging Congress to increase the overall limit of $1 million (now $1.07 million, after adjustment for inflation) to $5 million. But for many issuers, the overall limit is less important than the per-investor limits.

The maximum an investor can invest in all Title III offerings during any period of 12 months is:

  • If the investor’s annual income or net worth is less than $107,000, she may invest the greater of:
    • $2,200; or
    • 5% of the lesser of her annual income or net worth.
  • If the investor’s annual income and net worth are both at least $107,000, she can invest the lesser of:
    • $107,000; or
    • 10% of the lesser of her annual income or net worth.

These limits apply to everyone, including “accredited investors.” They’re adjusted periodically by the SEC based on inflation.

These limits make Title III much less attractive than it should be relative to Title II. Consider the typical small issuer, NewCo, LLC, deciding whether to use Title II or Title III to raise $1 million or less. On one hand, the CEO of NewCo might like the idea of raising money from non-accredited investors, whether because investors might also become customers (e.g., a restaurant or brewery), because the CEO is ideologically committed to making a good investment available to ordinary people, or otherwise. Yet by using Title III, NewCo is hurting its chances of raising capital.

Suppose a typical accredited investor has income of $300,000 and a net worth of $750,000. During any 12-month period she can invest only $30,000 in all Title III offerings. How much of that will she invest in NewCo? Half? A third? A quarter? In a Title II offering she could invest any amount.

Because of the per-investor limits, a Title III issuer has to attract a lot more investors than a Title II issuer. That drives up investor-acquisition costs and makes Title III more expensive than Title II, even before you get to the disclosures.

The solution, of course, is that Congress should make the Title III rule the same as the Tier 2 rule in Regulation A:  namely, that non-accredited investors are limited, but accredited investors are not. I can’t see any policy argument against that rule.

In the meantime, almost every Title III issuer should conduct a concurrent Title II offering, and every Title III funding portal should build concurrent offerings into its functionality.

Questions? Let me know.

Two Related Party Rules In Title III Crowdfunding

Title III includes two definitions about related parties, similar but not identical.

The first definition dictates who is subject to the $1 million-per-year limit on raising money. There, the regulations provide that the limit applies not only to the issuer itself (the company raising money), but also to “all entities controlled by or under common control with the issuer and any predecessors of the issuer.” To determine who controls whom, the regulations borrow the definition from SEC Rule 405:

The term ‘control’ means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the entity, whether through the ownership of voting securities, by contract or otherwise.

This means, for example, that if Company X is raising money using Title III, then Company X and all members of the same corporate family are subject to the same $1 million cap, even if other members of the corporate family are engaged in very different businesses.

(Don’t even think about having your husband or girlfriend or best friend from college own the other businesses get around the rule. It doesn’t work.)

This is a very broad rule and, like so much of Title III, very different than anything we’ve seen before in the U.S. securities laws. For example, while Issuer X may include only 35 investors in an offering under Rule 506(b), Issuer X is allowed to have multiple offerings – an apartment building in this offering, an oil and gas development in this offering, a social media app in a third offering – and include 35 non-accredited investors in each.

Similarly, in Title IV an issuer can raise up to $50 million for a mortgage REIT. Nothing stops a company under common control with the issuer from raising another $50 million for a REIT that buys office buildings.

Why the stricter rule for Title III? I would say that, consistent with the whole Title III paradigm, the goal was to reserve Title III for little guys, the neighborhood businesses, while keeping the professional financiers from Wall Street and Silicon Valley out. It’s part of the big compromise that allowed enactment of Title III in the first place.

The second definition around related parties in Title III dictates who on the portal side may own securities of the issuer. The rule is that:

  • The portal itself may own a financial interest in the issuer only if (1) the portal received the financial interest as compensation for the services provided to or for the benefit of the issuer, and (2) the financial interest consists of the same securities that are being offered to investors on the portal’s platform.
  • No director, officer, or partner of the portal, or any person occupying a similar status or performing a similar function, may own a financial interest in an issuer.

The term “financial interest in an issuer” means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.

This rule means, for example, that:

  • A portal may not raise money for itself on its own platform.
  • Neither the portal nor any of its directors, officers, or partners may invest in an issuer before it raises money on the portal (they could invest afterward).
  • Purely contractual arrangements, not relating to the securities of the issuer, are okay.

The rule about financial interests doesn’t use the words “common control” but, because a portal is controlled by its directors, officers, and partners, the result is nearly the same. But not identical. In a typical Crowdfunding structure, for example, the Title III portal is owned in a separate company. Key contributors to other parts of the corporate family who are not directors, officers, or partners of the portal itself should be allowed to invest without violating the rule, even where all the companies are under common control.

Questions? Let me know.

What “Solicit” Means Under Title III

Before the JOBS Act came along, listing a security on a public website would itself have been treated as an act of “solicitation.” That’s the odd thing: Title III portals aren’t allowed to “solicit,” yet in the traditional sense of the term that’s the most important thing Congress created them to do.

The fact is that Congress was ambivalent when it created Title III portals. They are allowed to list offerings of securities, but are not allowed to do other things often associated with the sale of securities, including holding investor funds or offering investment advice. They are regulated by the SEC and FINRA, but with a light touch compared with other regulated entities. They are privately-owned, but are required to provide educational materials to investors, police issuers, provide an online communication platform, and ensure that investors don’t exceed their investment limits – in short, they are required to assume a quasi-governmental role.

Title III portals are a new animal, part fish, part bird. Which makes it that much more difficult to decide what “solicit” means when they do it.

Based on the statute, the SEC regulations, the legislative background of the JOBS Act, and the history and overall context of the U.S. securities laws, I think a Title III portal engages in prohibited “solicitation” anytime it tries to steer an investor to a particular security. If it’s not trying to steer an investor to a particular security, then it’s probably okay.

I’ve included some practical guidelines in the chart below. Although there are plenty of gaps, I hope this helps.

Click the following for a print ready version of the complete chart: Rules for Title III Portals

Rules for Title III Portals

 

 

Using Title III Disclosures In Title II Crowdfunding

Title III requires all these disclosures, reported on the new Form C:

  • The name, legal status, physical address, and website of the issuer
  • The names of the directors and officers of the issuer and their employment history over the last three years
  • The name of each person owning 20% or more of the issuer’s stock
  • The issuer’s business and business plans
  • The number of employees of the issuer
  • A statement of risks
  • How much money the issuer is trying to raise
  • How the money will be used
  • The price of the shares or the method for determining the price
  • The capital structure of the issuer, including the rights of all security-holders, restrictions on transfer, and how the securities are being valued
  • A description of the portal’s financial interests
  • A description of the issuer’s liabilities
  • A description of other offerings conducted within the past three years
  • A description of “insider” transactions
  • A discussion of the issuer’s financial conditionimpossible possible
  • Financial statements or their equivalent
  • Any other information necessary in order to make the statements made not misleading

As I write this, a lot of very smart entrepreneurs and software engineers are working to automate these disclosures. They have to:  to make money running a Title III portals, you’re going to have to automate everything that can be automated.

Now look at Title II. As a write this, the disclosures for almost all Title II deals are prepared the old-fashioned way, with a lawyer writing an old-fashioned Private Placement Memorandum. The PPM for Deal 1 on Portal X might or might not include the same information as the PPM for Deal 2 on Portal X, and almost certainly doesn’t include the same information or look the same as the PPM for deals on Portal Y. An investor trying to compare apples to apples would go, well, bananas.

That situation is ripe (sorry) for change and I think it will change as Title III comes online, for three reasons:

  1. As someone argued recently, investors couldn’t care less about the distinction between Title II and Title III. They are going to want to see the same information in the same format.
  2. Using the tools developed for Title III, Title II portals will be able to provide more information than they are currently providing, cheaper and more effectively.
  3. There is no law that dictates what information must be provided in a Title II offering. But we still think about 17 CFR §240.10b-5, which makes it unlawful to “. . . .make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made. . . .not misleading. . . .” As the industry develops, it seems at least possible, if not likely, that the disclosures required by Title III could be viewed as the standard for avoiding Rule 10b-5 liability.

Questions? Let me know.