Crowdfunding web portal

The Legal Liability of A TITLE III Funding Portal

In this blog post I summarized the potential legal liability of issuers raising capital using Title II Crowdfunding (aka Rule 506(c)), Title III Crowdfunding (aka Reg CF), and Title IV Crowdfunding (aka Regulation A). Here, I’ll summarize the potential legal liability of a registered Title III funding portal.

To start, let’s distinguish between two kinds of liability:  liability to the government (e.g., to the SEC) for breaking rules; and liability to private parties. Most people think about the first kind of liability but often the second is more important. The government doesn’t know about most violations of securities laws and even if it knows must pick and choose which cases to prosecute. Conversely, private parties – issuers and investors – are likely to know about actual or potential violations and there are plenty of plaintiffs’ lawyers willing to take a shot.

Section 4A(c) of the Securities Act

Section 4A(c) of the Securities Act of 1933 makes an “issuer” liable to an investor where:

  • The issuer made an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading;
  • The investor didn’t know of the untruth or omission; and
  • The issuer cannot demonstrate that the issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

The statute defines “issuer” to include:

  • Any person who is a director or partner of the issuer;
  • The principal executive officer, principal financial officer, and controller or principal accounting officer of the issuer;
  • Any person occupying a similar status or performing a similar function, regardless of title; and
  • Any person who offers or sells the security in the Reg CF offering.

The SEC has declined to say one way or another whether a funding portal is an “issuer” for these purposes. Given the role of funding portals in presenting securities to the public, however, it seems likely except in unusual circumstances.

If a funding portal is an issuer and a Form C contains false statements or omits important information, the funding portal would be liable to private lawsuits from investors unless the funding portal can prove that it didn’t know about the false statements or omissions and couldn’t have learned about them by exercising reasonable care.

The language of section 4A(c) is very similar to the language of section 12(a)(2) of the Securities Act, which applies to public companies. But the playing field is different. The document used in a public filing – a prospectus – is typically subject to layer upon layer of due diligence, not only by the issuer and its lawyers but also by the underwriter and others. In contrast, many of the Form Cs we see on funding portals are prepared by people with little or no experience in securities, typically online. I expect to see lots of litigation under section 4A(c), as courts decide what “reasonable care” means for funding portals.

Private Lawsuits:              Yes

Rule 10b-5

17 C.F.R. §240.10b-5, issued by the SEC under section 10(b) of the Exchange Act, makes it unlawful, in connection with the purchase or sale of any security:

  • To employ any device, scheme, or artifice to defraud,
  • 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, in the light of the circumstances under which they were made, not misleading, or
  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Liability arises under Rule 10b-5 only with the intent to deceive, known in legal jargon as “scienter.”

The Supreme Court has held that only the person who “makes” a deceptive statement or omission can be liable under the second prong of Rule 10b-5 – not a person who merely disseminates the statement innocently. But that begs the question:  does a funding portal merely disseminate information from issuers, or does it “make” the statements along with the issuer? Given the role of funding portals in Reg CF, very possibly the latter, although that could depend on the facts of a given case.

But that question could be moot. Under recent court decisions, a funding portal that knows about the misleading statements or omissions and allows them on its website anyway could be liable under either the first or third prongs of Rule 10b-5.

Private Lawsuits:              Yes

Section 17(a) of the Securities Act

Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer or sale of securities, to:

  • Employ any device, scheme, or artifice to defraud, or
  • Obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
  • Engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Even if it is not the issuer, a funding portal participating in a scheme to mislead investor could be subject to section 17(a) of the Act just as it could be liable to investors under Rule 10b-5.

Private Lawsuits:              No

Crowdfunding and FINRA Regulations

A funding portal that violates the regulations issued by the SEC or FINRA could be sanctioned or, in the extreme case, have its registration with the SEC and/or its membership in FINRA suspended, effectively putting it out of business.

An investor who loses money and learns that the funding portal violated SEC regulations will probably claim that the regulatory violation gives rise to a private right of action – that is, that if she was harmed by the regulatory violation then she can sue the funding portal. Although we can never say never, her claim should fail.

Private Lawsuits:              No

State Common Law

A funding portal could be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including fraud and misrepresentation. In the typical case, the investor would try to show that (i) the issuer did something wrong, and (ii) the funding portal is responsible for it.

Private Lawsuits:              Yes

Liability to Issuers

Funding portals will be sued by issuers. Among the possible claims:

  • The funding portal made promises about the offering that proved false (e.g., “You’re sure to raise at least $2 million!”);
  • The funding portal conducted the offering ineffectively (e.g., failing to notify subscribers by email);
  • The funding portal made factual misrepresentations (e.g., the number of its registered users or the percentage of its successful raises); and
  • Actions by the funding portal caused the issuer to face lawsuits from investors (e.g., the funding listed the issuer’s year-over-year revenue growth as 1,300% rather than 130%).

Private Lawsuits:              Yes

Criminal Rules

If a funding portal really screws up, it could even be subject to Federal and state criminal penalties, including:

  • Criminal penalties for intentionally violating securities laws
  • Criminal penalties for mail fraud
  • Criminal penalties for wire fraud
  • Criminal penalties for violating the Racketeer Influenced and Corrupt Organizations

Liability of People

Entrepreneurs too often believe that operating through a corporation or other legal entity protects them from personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a gaggle of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!”

No. She did it, so she’s personally liable, corporation or no corporation. If her employee did it, the story might be different (unless he was drunk when she handed him the keys).

The same is true in securities laws. To the extent you’re personally making decisions for the funding portal, all the potential liability I’ve described applies to you personally as well.

Reducing Your Risk

A funding portal can and should take steps to reduce its legal risk. These include:

  • Strong Contract with Issuers:  Funding portals should have a strong contract with issuers, clearly defining who is responsible for what and disclaiming liability on the funding portal’s part.
  • Training:  A junior employee of a funding portal once told my client to do something that clearly violated the securities laws. Recognizing that funding portals, like other employers, are liable for the acts of their employees, funding portals should have in place a strong training program. Among other things, employees should know about the funding portal’s potential liability and be familiar with its Manual of Policies & Procedures.
  • Due Diligence Processes:  Funding portals should have in place processes and policies for conducting due diligence. How much due diligence is required is an open question, but if a funding portal is sued for failing to discover a misstatement in a Form C, it’s going to be asked about its due diligence policies. The answer can’t be “None.”
  • Insurance:  Like any other business, funding portals should carry insurance. Even a very weak lawsuit can cost hundreds of thousands of dollars to defend.
  • Culture:  The sea at the tip of South America is among the roughest in the world, as two oceans collide. Crowdfunding is like that, sort of. On one hand, Crowdfunding is new and disruptive and attracts people who want to do something. On the other hand, the legal landscape in which Crowdfunding takes place is old and well-worn, developed before many American homes had radio. Leaping into the brave new world of online capital formation, eager to move fast and at least dent things, funding portals must nevertheless create a culture that takes seriously the often-tedious responsibility associated with selling securities.

USING REG CF TO RAISE MONEY FOR A NON-U.S. BUSINESS

To use Reg CF (aka Title III Crowdfunding), an issuer must be “organized under, and subject to, the laws of a State or territory of the United States or the District of Columbia.” That means a Spanish entity cannot issue securities using Reg CF. But it doesn’t mean a Spanish business can’t use Reg CF.

First, here’s how not to do it.

A Spanish entity wants to raise money using Reg CF. Reading the regulation, the Spanish entity forms a shell Delaware corporation. All other things being equal, as an entity “organized under, and subject to, the laws of a State or territory of the United States,” the Delaware corporation is allowed to raise capital using Reg CF. But all other things are not equal. If the Delaware corporation is a shell, with no assets or business, then (i) no funding portal should allow the securities of the Delaware corporation to be listed, and (ii) even if a funding portal did allow the securities to be listed, nobody in her right mind would buy them.

Here are two structures that work:

  • The Spanish business could move its entire business and all its assets into a Delaware corporation. Even with no assets, employees, or business in the U.S., the Delaware corporation could raise capital using Reg CF, giving investors an interest in the entire business.
  • Suppose the Spanish company is in the business of developing, owning, and operating health clubs. Today all its locations are in Spain but it sees an opportunity in the U.S. The Spanish entity creates a Delaware corporation to develop, own, and operate health clubs in the U.S. The Delaware corporation could raise capital using Reg CF, giving investors an interest in the U.S. business only.

NOTE:  Those familiar with Regulation A may be excused for feeling confused. An issuer may raise capital using Regulation A only if the issuer is managed in the U.S. or Canada. For reasons that are above my pay grade, the rules for Reg CF and the rules for Regulation A are just different.

Can an LLC Serve as a Crowdfunding Vehicle for a Corporation?

Crowdfunding doesn’t screw up the issuer’s cap table. Nevertheless, because many issuers and investors think it does, the SEC adopted 17 CFR §270.3a-9 earlier this year, providing that a Reg CF issuer may use a “crowdfunding vehicle” to issue securities to investors, thereby adding only one entry to its own cap table.

The use of SPVs to own securities is common in the Title II (Rule 506(c)) world and in the world of securities generally. We form a separate entity, typically a limited liability company, to own securities of the “main” company. Indeed, a variation of the SPV structure is required in securitized real estate financing.

But that’s not what the SEC has in mind with crowdfunding vehicles in Title III. The SEC has in mind an entity that is a mirror image, you might say an alter-ego, of the issuer. For example, the crowdfunding vehicle:

  • Can have no purpose other than owning securities of the issuer;
  • Must have the same fiscal year end as the issuer;
  • May not borrow money;
  • Must be reimbursed for all its expenses only by the issuer; and
  • Must “Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”

What does that last requirement mean? To me, it sounds as if the “rights” associates with the issuer’s securities must be the same as the “rights” associated with the crowdfunding vehicle’s securities.

The “rights” associated with securities are defined in part by contract, which we can control, but in part by state law. Corporate laws vary widely from state to state and even within a state the laws of corporations are often very different than the laws of limited liability companies. This is intentional:  limited liability company statutes were written to be different than the corresponding corporate statutes. For example, LLC statutes typically give members of an LLC far greater freedom of contract while corporate laws, for historical reasons, take a more paternalistic view.

When the regulations were proposed, CrowdCheck (Sara Hanks) submitted the comment pointing out that because of the differences in laws among types of entities and states, it would be difficult or impossible for the rights associated with owning an issuer to be identical to the rights associated with owning a crowdfunding vehicle. When the final regulations were issued, the SEC had not changed the language of the regulation and responded to comment as follows:

As one commenter pointed out, because investors are investing in the crowdfunding vehicle, and not directly in the crowdfunding issuer, there may be slight differences in the rights in the crowdfunding vehicle that investors receive. However, we do not believe these slight differences in rights should in any way affect the ability of the crowdfunding vehicle to issue securities with rights that are materially indistinguishable from the rights a direct investor in the crowdfunding issuer would have [bold added].”

The differences in rights described in the CrowdCheck’s comments were not “slight.” To the contrary, the differences in rights between, say, a New Jersey corporation and a Delaware limited liability company would be “material” in any other area of the securities laws. Having filed a registration statement that identified the wrong type of entity and the wrong state, I can imagine a lawyer arguing to the SEC staff “Who cares? Those are only slight differences!”

How should we interpret the SEC’s response? Why didn’t the SEC just change the language of the regulation, rather than pretend the differences in state laws aren’t “material”? Can issuers and funding portals do whatever they want?

There are two issues:

  • The first issue is just cost. Issuers and portals want to automate SPVs, using the same type of entity, the same state, and the same contracts for all of them.
  • The second issue is taxes. If the issuer is a corporation and the crowdfunding vehicle is also a corporation, then dividends paid by the issuer to the crowdfunding vehicle will be subject, in part, to double tax.

The question is more than academic. When investors lose money they’re unhappy and often look for someone to blame. If a Mississippi corporation uses a Delaware limited liability company as a crowdfunding vehicle and an investor loses money, a clever plaintiff’s lawyer (no jokes here) won’t find it hard to argue that the Delaware LLC failed to qualify under 17 CFR §270.3a-9 and that the offering was therefore illegal, giving his client the right to get her money back from the issuer and its principals and possibly from the funding portal and its principals as well.

As readers know, I think the SEC has done a terrific job with Crowdfunding, going out of its way to support the industry time after time. For that matter, the SEC introduced crowdfunding vehicles only because of the mistaken impression that Crowdfunding “screws up your cap table.” As crowdfunding vehicles become more widely-used, however, I think more straightforward guidance is required, if only to dissuade clever plaintiffs’ lawyers. For example, the SEC could say explicitly “Differences in rights arising solely from state laws governing corporations, limited liability companies, limited partnership and other legal entities will not be taken into account for these purposes.”

Until that happens, I would be cautious and bear in mind that issuers don’t really need a crowdfunding vehicle in the first place.

Using a Transfer Agent Doesn’t Mean You Have a Single Entry on Your Cap Table

Many issuers are concerned that “Crowdfunding will screw up my cap table.” In response, several Title III funding portals offer a mechanism they promise will leave only a single entry on the issuer’s cap table, no matter how many investors sign up.

The claim is innocuous, i.e., it doesn’t really hurt anybody. But it’s also false.

The claim begins with section 12(g) of the Securities Exchange Act. Under section 12(g), an issuer must register its securities with the SEC and begin filing all the reports of a public company if the issuer has more than $10 million of total assets and any class of equity securities held of record by more than 500 non-accredited investors or more than 2,000 total investors.

17 CFR §240.12g5-1 defines what it means for securities to be held “of record.” For example, under 17 CFR §240.12g5-1(a)(2), securities held by a partnership are generally treated as held “of record” by one person, the partnership, even if the partnership has lots of partners. Similarly, under 17 CFR §240.12g5-1(a)(4), securities held by two or more persons as co-owners (e.g., as tenants in common) are treated as held “of record” by one person.

With their eyes on this regulation, the funding portals require each investor to designate a third party to act on the investor’s behalf. The third party acts as transfer agent, custodian, paying agent, and proxy agent, and also has the right to vote the investor’s securities (if the securities have voting rights). The funding portal then takes the position that all the securities are held by one owner “of record” under 17 CFR §240.12g5-1.

Two points before going further:

  • Title III issuers don’t need 17 CFR §240.12g5-1 to avoid reporting under section 12(g). Under 17 CFR §240.12g6(a), securities issued under Title III don’t count toward the 500/2,000 thresholds, as long as the issuer uses a transfer agent and has no more than $25 million of assets.
  • 17 CFR §240.12g5-1(b)(3) includes an anti-abuse rule:  “If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of section 12(g). . . . the beneficial owners of such securities shall be deemed to be the record owners thereof.”

But put both those things to the side and assume that, by using the mechanism offered by the funding portal, the issuer has 735 investors but only one holder “of record.”

Does having one holder “of record” mean the issuer has only a single entry on its cap table? Of course not. At tax time, the issuer is still going to produce 735 K-1s.

The fact is, how many holders an issuer has “of record” for purposes of section 12(g) of the Exchange Act has nothing to do with cap tables. The leap from section 12(g) to cap tables is a rhetorical sleight-of-hand.

As I said in the beginning, the sleight-of-hand is mostly harmless. Except for some additional fees, neither the issuer nor the investors are any worse off. And the motivation is understandable:  too many issuers think Crowdfunding will get in the way of future funding rounds, even though that’s not true.

Even so, as a boring corporate lawyer and true believer in Crowdfunding, I’m uncomfortable with the sleight-of-hand. When SPVs become legal on March 15th perhaps the market will change.

Crowdfunding Real Estate

PODCAST: The Storage Investor Show

Real Estate Crowdfunding in 2021 with Mark Roderick – episode 9

In This Episode:

  • Updates to Accredited Investor qualifications
  • Who qualifies as a “Finder” of capital?
  • Title III crowdfunding changes
  • How can sponsors and investors take advantage of recent changes
  • Why crowdfunding is a marketing business

Guest Info:

Mr. Roderick concentrates his practice on the representation of privately-owned and emerging growth companies, including companies in the technology, real estate, and health care industries. Mark specializes in the representation of entrepreneurial, growth-oriented companies and their owners.

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: Title III Crowdfunding Changes with Mark Roderick

Crowdfunding continues to grow in popularity. It is a way to democratize the world of real estate investing, which historically has only been open to super-wealthy Americans. Its growth and positive outcomes have led to several changes being made in the space. Mark Roderick, our guest today, joins us to unpack these developments and the positive influence that they will have on real estate investing. In this episode, Mark presents an overview of the current crowdfunding space.

Title III Crowdfunding Changes with Mark Roderick

Key Points From This Episode:

  • Learn more about Mark and his expertise as a crowdfunding attorney
  • An overview of the crowdfunding basics and the difference between Title II, III, and IV.
  • Find out about some of the excellent changes the SEC has made related to crowdfunding.
  • How broker-dealers with a wide product mix make real estate accessible to more people.
  • ‘Title’ refers to the different types of crowdfunding as per the JOBS Act of 2012.
  • Why the Title III changes will make it easier to syndicate, even if you’re not a broker-dealer.
  • An explanation of what a funding portal is and the simple steps to set one up.
  • Learn about some of the drawbacks of establishing a funding portal.
  • Some of the changes Mark expects will happen with Title III advertising.
  • Other changes that the SEC has made around crowdfunding.
  • How Mark gives back and where you can get hold of him.
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.

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.

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.