Think Twice Before Giving Crowdfunding Investors Voting Rights

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

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

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

I anticipate two objections:

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

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

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

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

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

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

Questions? Let me know.

Proposed Changes To Taxation Of Carried Interests

On By crowdfundattnyIn JOBS Act, TaxLeave a comment

The Inflation Reduction Act of 2022 promises big changes to how America responds to global warming, aka climate change. But if enacted in its current form, it will also change how real estate sponsors and hedge fund managers are taxed on carried interests.

A “carried interest” or “promote” is what the sponsor gets for putting the deal together. In a typical hedge fund, the manager receives a 2% annual management fee plus 20% of the profits. In the syndication of an apartment building, the deal sponsor might receive 30% of the profits after investors have received a preferred return of 7% and all their money back. The 20% of the hedge fund manager and the 30% of the real estate sponsor are the “carried interest.”

For many years gains from carried interests were taxed as capital gains rather than ordinary income. This favorable tax treatment attracted widespread criticism, from Warren Buffett among others, and is often referred to derisively as the “carried interest loophole.”

As described here, section 1061 was added to the Internal Revenue Code to close, or at least narrow, the loophole. Under section 1061, gains from carried interests generally are treated as ordinary income if the interest is held less than three years. But in a loophole within a loophole, capital gain was preserved for most real estate syndications by excluding from section 1061 gains from the sale of property used in a trade or business, such as the ownership and operation of an apartment building.

The Inflation Reduction Act of 2022 includes two important changes to section 1061. One, the three year holding period will be extended to five years. Two, the exception for property used in a trade or business will be eliminated.

As someone famous once said, one man’s loophole is another man’s castle (or something like that). For many real estate sponsors, the carried interest is the primary source of income: annual management fees pay the bills, but the carried interest sends the kids to college. Increasing the tax rate on the carried interest by 20 percentage points or more is not trivial.

The capital gain rate is still available if the property is held for five years, but many real estate projects contemplate shorter holding periods.

If the changes are enacted in their current form, I expect sponsors will adjust the economic deal with investors. Most likely, we will see the carried interest percentage increase from around 30% to around 50%, at least for transactions where the holding period will be less than five years. For that matter, we will probably see longer holding periods for both hedge funds and real estate, as the market adjusts.

Senator Sinema of Arizona is a longtime fan of the carried interest loophole and hasn’t yet weighed in on the Inflation Reduction Act. You can bet she’s getting lots of phone calls as we speak.

Questions? Let me know.

Improving Legal Documents In Crowdfunding: New Risk Factor For Supreme Court Ruling

On By crowdfundattnyIn Crowdfunding2 Comments

It appears the Supreme Court is about to strike down Roe v. Wade, allowing states to regulate or outlaw abortion. Many states are poised to do so with varying degrees of severity. 

In his draft opinion in Dobbs v. Jackson Women’s Health Organization, Justice Alito states that the decision would not affect other rights, like the right to gay marriage (Obergefell v. Hodges), the right to engage in homosexual relationships (Lawrence v. Texas), or the right to contraception (Griswold v. Connecticut). In my opinion, you should take Justice Alito’s assurance with a large spoonful of salt.. Theoretically, all these cases rest on a constitutional right to privacy. If you knock that pillar down for one right it falls for all of them. On a practical level, Justice Alito himself voted against gay marriage and I have little doubt that there are at least five votes to overturn all these precedents.

Some states are already considering bans on contraception and surely challenges to gay marriage are close on the horizon.

When the COVID-19 pandemic swept the country, companies raising capital had to add one or more risk factor to their offering materials, describing how the pandemic could harm their businesses. I believe the Supreme Court’s opinion in Dobbs v. Jackson Women’s Health Organization calls for the same thing.

Imagine a SAAS company in Austin, Texas, looking to recruit talented young engineers. Imagine the company’s ideal candidate:  a woman who just graduated from Stanford with a specialty in AI. If she has one job offer from the company in Austin and another from a company in Oregon it isn’t hard to see why the Texas company would have a competitive disadvantage, all other things being equal.

Companies are already trying to mitigate the risk. For example, Starbucks has announced free travel to employees to states where abortion is legal. But even that might not eliminate the risk. Do women want to travel out of state for medical care? And, in any case, many states where abortion is or will be illegal are trying to make it illegal to travel out of state for an abortion

Whatever the realities of the marketplace, our job as securities lawyers is to make investors aware of risks so our clients can’t be sued afterward. I suggest the following or something like it in the offering materials of any company where recruitment is important

State Laws Might impair the Company’s Ability to Recruit: The U.S. Supreme Court [seems poised to overturn] [has recently overturned] women’s privacy rights in health care decisions set forth in Roe v. Wade. Moreover, the reasoning used by the Court in overturning Roe v. Wade suggests that other constitutional rights could also become subject to restriction by the states, including the right to gay marriage and use of contraception. Texas, where the Company’s headquarters are located, has enacted strict laws regulating abortion and its political climate is such that it might seek to limit or take away other rights as well. These state laws could impair the Company’s ability to recruit and retain personnel and could put the Company at a competitive disadvantage with companies in other states.

Questions? Let me know.

SEC Proposes New Restrictions For Private Fund Advisers

On By crowdfundattnyIn Private Fund Advisors, SECLeave a comment

The SEC recently proposed new rules for private fund advisers. If you raise and/or manage money from other people, you should probably pay attention.

A private fund adviser is an investment adviser who provides advice to private funds. A “private fund” is any issuer that would be treated as an “investment company” if not for the exemptions under section 3(c)(1) (no more than 100 investors) or section 3(c)(7) (all qualified purchasers) of the Investment Company Act.

  • EXAMPLE:  Nikki Chilandra forms an LLC of which she is the sole manager, raises money from her private network of investors (no more than 100), and uses the money to buy a limited partnership interest in one real estate deal. The LLC is a private fund, and Nikki is likely a private fund adviser.
  • EXAMPLE:  Jerry Cooperman forms an LLC of which he is the sole manager, raises money from his private network of investors (without limit), and uses the money to buy a duplex, which is rented to tenants. The LLC is not a private fund because it owns real estate, not securities. Hence, Jerry is not a private fund adviser.

In general, investment advisers are required to register either with the SEC or with the state(s) where they do business. But an advisor who provides advice only to private funds and manages assets of less than $150 million is exempt from registration with the SEC, and many states have similar exemptions. In fact, the SEC has expanded the definition of “private funds” for these purposes to include an issuer that qualifies for any exclusion under the Investment Company Act, not just the exemptions under sections 3(c)(1) and 3(c)(7).

An advisor who qualifies for the private fund exemption, like Nikki, is often referred to as an “exempt reporting adviser.” That’s because while she doesn’t have to register as an investment adviser, she does have to file reports with the SEC (an abbreviated Form ADV) and probably with the state where the fund is located also.

All of that is just to say that investment advisers who provide advice to private funds fall into two categories:  those who are required to register with the SEC and those who are not registered but still have to file reports. The SEC proposals affect both.

The following proposals would affect only advisers registered with the SEC:

  • Advisers would be required to provide investors with quarterly statements with information about the fund’s performance, fees, and expenses. Advisers would be required to obtain an annual audit for each fund and cause the auditor to notify the SEC upon certain events.
  • Advisers would be required to obtain fairness opinions in so-called adviser-led secondary transactions.

The following proposal would affect all advisers, including Nikki:

  • An adviser couldn’t charge for services not provided. For example, if an asset were sold, the adviser couldn’t charge for the advisory fees that would have been due over the next two years.
  • An adviser couldn’t charge the fund for expenses incurred in a regulatory examination of the adviser.
  • An advisor couldn’t reduce her clawback by the amount of any taxes.
  • An adviser couldn’t limit her liability for a breach of fiduciary duty, willful misfeasance, bad faith, recklessness, or even negligence.
  • An adviser couldn’t allocate fees among funds on a non-pro rata basis.
  • An adviser couldn’t borrow money from the fund.
  • An adviser couldn’t give preferential rights to redemption or preferential information rights to some investors if it would have a material negative effect on other investors.
  • An adviser couldn’t give other preferential rights to some investors without full disclosure to all investors.

I’ll just mention two of those items that come up frequently.

First, general partners typically seek to protect themselves from lawsuits brought by investors. Delaware and other states allow the general partner to disclaim all traditional fiduciary duties and adopt a “business judgment” standard in their place. If the SEC’s proposals are adopted, general partners acting as private fund advisers will no longer be allowed to protect themselves in this way and will be liable for a breach of fiduciary obligations as well as simple negligence.

NOTE:  Sponsors like Nikki wear more than one hat. They provide investment advice but perform other duties as well, like deciding whether to admit new LPs and on what terms. The SEC’s proposals would require Nikki to remain liable for negligence when she’s wearing her investment adviser hat but not when she’s wearing her other hats. The LLC Agreement could and should make that distinction.

Second, general partners typically enter into “side letters,” giving some limited partners a better economic deal than others – either a lower promote or a higher preferred return. These arrangements will still be allowed if the SEC’s proposals are adopted, but only if the terms are disclosed to everyone, which is not typically done today.

Questions? Let me know.

Using A SAFE In Reg CF Offerings

On By crowdfundattnyIn Crowdfunding, Reg CF, Regulation CF, SAFE, Title III, Title III Crowdfunding1 Comment

The SEC once wanted to prohibit the Simple Agreement for Future Equity, or SAFE, in Reg CF offerings. After a minor uproar the SEC changed its mind, and SAFEs are now used frequently. I think prohibiting SAFEs would be a mistake. Nevertheless, funding portals, issuers, and investors should think twice about using (or buying) a SAFE in a given offering.

Some have argued that SAFEs are too complicated for Reg CF investors. That’s both patronizing and wrong, in my opinion. Between a SAFE on one hand and common stock on the other, the common stock really is the more difficult concept. As long as you tell investors what they’re getting – especially that SAFEs have no “due date” – I think you’re fine.

The reason to think twice is not that SAFEs are complicated but that a SAFE might not be the right tool for the job. You wouldn’t use a hammer to shovel snow, and you shouldn’t use a SAFE in circumstances for which it wasn’t designed.

The SAFE was designed as the first stop on the Silicon Valley assembly line. First comes the SAFE, then the Series A, then the Series B, and eventually the IPO or other exit. Like other parts on the assembly line, the SAFE was designed to minimize friction and increase volume. And it works great for that purpose.

But the Silicon Valley ecosystem is very unusual, not representative of the broader private capital market. These are a few of its critical features:

  • Silicon Valley is an old boys’ network in the sense that it operates largely on trust, not legal documents. Investors don’t sue founders or other investors for fear of being frozen out of future deals, and founders don’t sue anybody for fear their next startup won’t get funded. Theranos and the lawsuits it spawned were the exceptions that prove the rule.
  • The Silicon Valley ecosystem focuses on only one kind of company: the kind that will grow very quickly, gobbling up capital, then be sold.
  • Those adding the SAFE at the front end of the assembly line know the people adding the Series A and Series B toward the back end of the assembly line — in fact, they might be the same people. And using standardized documents like those offered by the National Venture Capital Association ensures most deals will look the same. Thus, while SAFE investors in Silicon Valley don’t know exactly what they’ll end up with, they have a good idea.

The point is that SAFEs don’t exist in a vacuum. They were created to serve a particular purpose in a particular ecosystem. To name just a couple obvious examples, a company that won’t need to raise more money or a company that plans to stay private indefinitely probably wouldn’t be good candidates for a SAFE. If it’s snowing outside, don’t reach for the hammer.

If you do use a SAFE, which one? The Y Combinator forms are the most common starting points, but in a Reg CF offering, you should make at least three changes:

  1. The Y Combinator form provides for conversion of the SAFE only upon a later sale of preferred stock. That makes sense in the Silicon Valley ecosystem because of course the next stop on the assembly line will involve preferred stock. Outside Silicon Valley, the next step could be common stock.
  2. The Y Combinator form provides for conversion of the SAFE no matter how little capital is raised, as long as it’s priced. That makes sense because on the Silicon Valley assembly line of course the next step will involve a substantial amount of capital from sophisticated investors. Outside Silicon Valley you should provide that conversion requires a substantial capital raise to make it more likely that the raise reflects the arm’s-length value of the company.
  3. The Y Combinator form includes a handful of representations by the issuer and two or three by the investor. That makes sense because nobody is relying on representations in Silicon Valley and nobody sues anyone anyway. In Reg CF, the issuer is already making lots of representations —Form C is really a long list of representations — so you don’t need any issuer representations in the SAFE. And dealing with potentially thousands of strangers, the issuer needs all the representations from investors typical in a Subscription Agreement.

The founder of a Reg CF funding portal might have come from the Silicon Valley ecosystem. In fact, her company might have been funded by SAFEs. Still, she should understand where SAFEs are appropriate and where they are not and make sure investors understand as well.

Questions? Let me know.

The SEC Can Stop Your Regulation A Offering At Any Time

On By crowdfundattnyIn Featured, Regulation A, Uncategorized5 Comments

The SEC has two powerful tools to stop your Regulation A offering anytime.

Rule 258

Rule 258 allows the SEC to immediately suspend an offering if

  • The exemption under Regulation A is not available; or
  • Any of the terms, conditions, or requirements of Regulation A have not been complied with; or
  • The offering statement, any sales or solicitation of interest material, or any report filed pursuant to Rule 257 contains any untrue statement of a material fact or omits to state a material fact necessary to make the statements made, in light of the circumstances under which they are made, not misleading; or
  • The offering involves fraud or other violations of section 17 of the Securities Act of 1933; or
  • Something happened after filing an offering statement that would have made Regulation A unavailable had it occurred before filing; or
  • Anyone specified in Rule 262(a) (the list of potential bad actors) has been indicted for certain crimes; or
  • Proceedings have begun that could cause someone on that list to be a bad actor; or
  • The issuer has failed to cooperate with an investigation.

If the SEC suspends an offering under Rule 258, the issuer can appeal for a hearing – with the SEC – but the suspension remains in effect. In addition, at any time after the hearing, the SEC can make the suspension permanent.

Rule 258 gives the SEC enormous discretion. For example, the SEC may theoretically terminate a Regulation A offering if the issuer fails to file a single report or files late. And while there’s lots of room for good-faith disagreement as to whether an offering statement or advertisement failed to state a material fact, Rule 258 gives the SEC the power to decide.

Don’t worry, you might think, Rule 260 provides that an “insignificant” deviation will not result in the loss of the Regulation A exemption. Think again: Rule 260(c) states, “This provision provides no relief or protection from a proceeding under Rule 258.”

Rule 262(a)(7)

Rule 262(a)(7) is even more dangerous than Rule 258.

Rule 258 allows the SEC to suspend a Regulation A offering if the SEC concludes that something is wrong. Rule 262(a)(7), on the other hand, allows for suspension if the issuer or any of its principals is “the subject of an investigation or proceeding to determine whether a. . . . suspension order should be issued.”

That’s right: Rule 262(a)(7) allows the SEC to suspend an offering merely by investigating whether the offer should be suspended.

Effect on Regulation D

Suppose the SEC suspends a Regulation A offering under either Rule 258 or Rule 262(a)(7). In that case, the issuer is automatically a “bad actor” under Rule 506(d)(1)(vii), meaning it can’t use Regulation D to raise capital, either.

In some ways, it makes sense that the SEC can suspend a Regulation A offering easily because the SEC’s approval was needed in the first place. But not so with Regulation D, and especially not so with a suspension under Rule 262(a)(7). In that case, the issuer is prevented from using Regulation D – an exemption that does not require SEC approval – simply because the SEC is investigating whether it’s done something wrong. That seems. . . .wrong.

Conclusion

As all six readers of this blog know, I think the SEC has done a spectacular job with Crowdfunding. But what the SEC giveth the SEC can taketh away. I hope the SEC will use discretion exercising its substantial power under Rule 258 and Rule 262(a)(7).

Another Reason Real Estate Sponsors Should Try Crowdfunding

On By crowdfundattnyIn Crowdfunding Real Estate, Real EstateLeave a comment

I participated recently in the syndication of a high-quality, income-producing, multi-family project in a top market.

The sponsor raised $4.5 million from a family office. Among the terms of that investment:

  • The sponsor provided 40% of the capital.
  • The investor received $75,000 for making the investment.
  • The sponsor made representations about the property’s condition, including environmental representations.
  • The sponsor guaranteed the proposed renovation of the project as if it were the general contractor.
  • The sponsor was required to provide the investor with lots of financial reports, including audited financial statements.
  • The sponsor was required to update the project’s business plan on a regular basis, subject to the investor’s approval.
  • The LLC Agreement listed 38 separate actions requiring the investor’s consent.
  • The investor had the right to sell the project after three years.
  • The sponsor was subject to all traditional fiduciary obligations, like the director of a public company.
  • The investor had the right to replace and/or sue the sponsor based on mere negligence.
  • If the investor asserted a claim, it could stop all distributions to the sponsor — not just fees and distributions in the nature of a promotion, but distributions made with respect to the sponsor’s capital.
  • The Tax Appendix was itself 18 pages long.

I view that as pretty onerous, especially for a $4.5M investment.

As that deal was being negotiated, real estate Crowdfunding sites were raising $4.5 million and much for individual projects with terms nowhere near as onerous.

At the same time, they’re giving ordinary Americans, not just wealthy family offices, the opportunity to invest in great deals. That’s why the title of this post says “Another.”

Don’t Use a Series LLC as a Crowdfunding Vehicle

On By crowdfundattnyIn Crowdfunding, Delaware CrowdfundingLeave a comment

At least one high-volume Crowdfunding portal is using a series LLC as a crowdfunding vehicle. It’s a terrible idea.

A “series LLC” is a relatively new concept. Rather than form a new limited liability company for a business, you can form a “series” of an existing limited liability company. Think of the parent LLC as a building and the series as a cubicle in the building. If you do everything right, the assets and liabilities of each series are segregated from the assets and liabilities of every other series.

EXAMPLE:  A company wants to conduct two businesses, one an asbestos business and the other an auto dealership. It creates Series X to conduct the asbestos business and Series Y to conduct the auto business. Under Delaware law, if the company does everything right, maintaining separate books and records, creditors of the asbestos business can’t get at the assets of the auto business and vice versa.

That’s great in theory. But there are two problems.

The first is that while Delaware law is clear, as far as I know the series structure has never been tested in a bankruptcy court. Bankruptcy courts have enormous power to achieve equitable results and often use that power aggressively. Suppose the asbestos company has caused 57 children to develop a rare but deadly form of cancer and the assets of the asbestos company aren’t sufficient to pay the economic damages. Will a bankruptcy court allow the parent company to walk away with the auto business intact? Maybe, maybe not.

The second problem is that some states simply disregard the Delaware law. Arizona is one of them. Its statute provides:

A foreign limited liability company, its members and managers and its foreign series, if any, have no greater rights and privileges than a domestic limited liability company and its members and managers with respect to transactions in this state and relationships with persons in this state that are not managers or members.  A foreign series is liable for the debts, obligations or other liabilities of the designating foreign company and of any other foreign series of that designating foreign company, arising out of transactions in this state or relationships with persons in this state and a designating foreign company is liable for such debts, obligations or other liabilities of each foreign series of that designating foreign company.

That means if the kids got sick is in Arizona, the court is going to ignore the series and take the assets of the auto business, no question.

Now let’s think about a crowdfunding vehicle.

Suppose the funding portal has created crowdfunding vehicles, or SPVs, for three issuers, Company A, Company B, and Company C. It’s created each crowdfunding vehicle as a series of one limited liability company.

Two years from now a bankruptcy court somewhere in the United States declines to respect the separateness of the series structure. Immediately, the crowdfunding vehicle of Company A is subject to all the liabilities of the crowdfunding vehicles of Company B and Company C, and vice versa nine different ways. When the investors in Company B lose all their money because of a lawsuit involving Company C they’re going to sue, and because Company B didn’t even tell investors about that risk, its founders are going to be sued personally – and successfully.

Now let’s say someone from Arizona invests in the crowdfunding vehicle of Company C. Later, it’s revealed that Company C failed to disclose material information in its offering. Under the Arizona law that investor can sue the crowdfunding vehicles of Company A and Company B. The investor wins that lawsuit and now investors in Company A and Company B have claims against their own company and their founders.

It’s a legal disaster.

And for what great benefit did the funding portal take that risk, using a series LLC rather than a separate LLC as the crowdfunding vehicle? To save about $150 in filing fees. Really.

That’s why using a series LLC as a crowdfunding vehicle is such a terrible idea. If a funding portal tells you to use a series LLC as your crowdfunding vehicle remember Nancy Reagan’s famous slogan:  Just Say No! And if you already have a crowdfunding vehicle formed as a series LLC, change it right away.

And for that matter, remember that you don’t need a crowdfunding vehicle in the first place.

The Legal Liability of Funding Portals: Update for TruCrowd Complaint

On By crowdfundattnyIn Crowdfunding, Crowdfunding Liabilities, Crowdfunding PortalsLeave a comment

A few weeks ago I posted about the potential legal liability of funding portals. Lo and behold, on September 20, 2021 the SEC brought an enforcement action against an issuer and its principals, and also against the funding portal, TruCrowd, Inc., dba Fundanna, and its owner, Vincent Petrescu.

Here’s a link to the Complaint. If you take the Complaint at face value – and readers should bear in mind that there are least two sides to every story – this is a lesson in how a funding portal can get into hot water with a questionable issuer.

The allegations against the issuer and its principals are straightforward:  they failed to disclose the criminal record of one of the principals; they used investor money for personal purposes; they misled investors about a purported real estate project.

More interesting for our purposes are the allegations against the funding portal and its owner. Calling TruCrowd and Mr. Petrescu “gatekeepers,” the SEC alleges, among other things, that:

  • TruCrowd and Mr. Petrescu allowed the offerings to proceed despite multiple warning signs of possible fraud or other harm to investors.
  • Mr. Petrescu participated in drafting the inaccurate Form C and offering statement.
  • TruCrowd and Mr. Petrescu failed to order a “bad actor” check.
  • Mr. Petrescu ignored warning from a securities lawyer.

It’s hard to walk away from a big commission. But this enforcement action illustrates that sometimes you have to.

Publicly-Traded Partnerships: The Trap for LLCs Traded on ATS

On By crowdfundattnyIn LLCs2 Comments

One drawback of private companies is they’re not liquid, meaning you can’t sell your shares easily. That’s why lots of people are spending lots of time and money creating secondary markets for private companies. These secondary markets typically take the form of an “alternative trading system,” or ATS, owned and operated by a broker-dealer. More on secondary markets here.

If you’re raising money for an LLC it’s attractive to have the interests traded on an ATS because you can tell prospective investors they’ll have liquidity, in theory if not in practice. But there’s a drawback, too:  if interests of in the LLC are traded on an ATS then the LLC might be treated as a corporation for tax purposes, not as a partnership, with potentially bad consequences.

If you’re interested in the differences between partnerships and corporations you can read this, but suffice it to say that (i) if you’re an LLC you probably made that choice intentionally, and (ii) a corporation is subject to two levels of tax on exit, significantly reducing the anticipated after-tax return to investors.

Under section 7704 of the Internal Revenue Code, a partnership (including an LLC taxed as a partnership) will be treated as a corporation for tax purposes if either:

  • Interests in the partnership are traded on an established securities market; or
  • Interests in the partnership are readily tradable on a secondary market “or the substantial equivalent thereof.”

The interests in a private LLC typically aren’t going to be traded on NASDAQ or any other established securities market, so we don’t worry about the first rule. But we do worry about the second rule. Interests in a partnership will be deemed readily tradable on a secondary market or the equivalent if:

  • Interests in the partnership are regularly quoted by any person, such as a broker or dealer, making a market in the interests; or
  • Any person regularly makes available to the public (including customers or subscribers) bid or offer quotes with respect to interests in the partnership and stands ready to effect buy or sell transactions at the quoted prices for itself or on behalf of others; or
  • The holder of an interest in the partnership has a readily available, regular, and ongoing opportunity to sell or exchange the interest through a public means of obtaining or providing information of offers to buy, sell, or exchange interests in the partnership; or
  • Prospective buyers and sellers otherwise have the opportunity to buy, sell, or exchange interests in the partnership in a time frame and with regularity and continuity.

Focus on the third bullet point. The whole point of listing LLC interests on an ATS is to give investors a readily available, regular, and ongoing opportunity to sell or exchange the interest. Hence, listing your LLC’s interests on an ATS will automatically turn your partnership into a corporation for tax purposes – unless you satisfy one of the exceptions.

This is the Internal Revenue Code so there are exceptions and exceptions to the exceptions and so on. How else would lobbyists put food on the table?

These are the primary exceptions:

  • Exception for Private Placements:  Your LLC raised capital in a private offering (including Rule 506(c) and Reg CF) and has no more than 100 members.
  • No Actual Trading:  Interests in your LLC are listed on an ATS but no more than 2% of all interests are traded each year.
  • Exception for Passive Income and the Oil & Gas Industry:  At least 90% of your LLC’s income is from interests, dividends, rent, gains from the sale of real estate or capital assets, or the oil & gas business.
  • Qualified Matching Service:  Interests in your LLC are traded only through a “qualified matching service” and no more than 10% of the interests are traded each year. A qualified matching service is where:
    • The service consists of a system that lists bid and/or ask quotes in to match sellers to buyers;
    • Matching occurs either by matching the list of buyers with the list of sellers or through a bid and ask process;
    • The selling partner cannot enter into a binding agreement to sell the interest until the 15th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
    • The closing of the sale does not occur prior to the 45th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
    • The matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price or quotes that express interest in a partnership interest without an accompanying price and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price;
    • The selling partner’s information is removed from the matching service within 120 days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner’s information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 days.

Many real estate LLCs will satisfy the exception for passive income (real estate rent), although they should be careful with other sources of income, like income from a parking lot or laundry facility. Most LLCs in the oil & gas business will satisfy the same exception because it was written for them. An LLC formed to hold treasury bonds is obviously okay.

But the large majority of LLCs raising money in Crowdfunding conduct other businesses, everything from technology to baby wipes. These companies must weigh the benefit of trading on an ATS – theoretical liquidity – against the cost of being treated as a corporation for tax purposes.

NOTE:  You could list the interests of your LLC on an ATS but limit trading to stay below the allowed annual thresholds. But of course that limits liquidity for your investors, taking some of the air out of your marketing message.