Crowdfunding And Fiduciary Obligations

On By crowdfundattnyIn Crowdfunding, Crowdfunding Laws, Fiduciary Obligations, JOBS ActLeave a comment

The term “fiduciary obligations” sends a chill down the spine of corporate lawyers – although some may object to using the word “spine” and “corporate lawyer” in the same sentence.

A person with a fiduciary obligation has a special legal duty. A trustee has a fiduciary obligation to the beneficiaries of the trust. The executor of an estate has a fiduciary obligation to the beneficiaries of the estate. The fiduciary obligation is not an obligation to always be successful, or always be right, but rather an obligation to try your best, or something close to that. A trustee who fails to anticipate the stock market crash of 2008 has not breached her fiduciary obligation. A trustee who fails to read published reports of a company’s impending bankruptcy before buying its stock probably has.

A person with a fiduciary obligation is required to be loyal, to look out for the interests of those under her care, to put their interests before her own.

By law and longstanding principle, the directors of a corporation have a fiduciary obligation to the corporation and its shareholders. In the classic case, a director of a corporation in the energy business took for his own benefit the opportunity to develop certain oil wells. Foul! cried the court. He has breached his fiduciary obligation by failing to pass the opportunity along to the corporation, to which he is a fiduciary.

Modern corporate statutes allow the fiduciary obligations of directors to be modified, but not eliminated, even if all the shareholders would sign off. If the corporation is publicly-traded, the exchange likely imposes obligations on the director (and the President, and the CEO, etc.) in addition to the fiduciary obligations imposed by state corporate law.

Which takes us to Crowdfunding. crowd funding word cloud

Most deals in the Crowdfunding space are done in a Delaware limited liability company. The Delaware Limited Liability Company Act allows a manager – the equivalent of a director in a corporation – to eliminate his fiduciary obligation altogether. If I’m representing the sponsor of the deal then of course I want to protect my client as fully as possible. And yet, I’m not sure that’s the best answer for the industry overall.

The U.S. public capital markets thrive mainly because investors trust them, just as the U.S. consumer products industry thrives because people feel safe shopping (that’s why securities laws and consumer-protection laws, as aggravating as they can be, actually help business). My client’s investors may or may not pay attention to the fiduciary duty sections of his LLC Agreement, but I wonder whether the Crowdfunding market as a whole can scale if those running the show regularly operate at a lower level of legal responsibility than the managers of public companies. Will it drive investors away?

Part of my brain says that it will, and yet, over the last 25 years or so, as corporate laws have become more indulgent toward management and executive pay has skyrocketed, lots of people have wondered when investors will say “Enough!” It hasn’t happened so far.

Questions? Let me know.

Crowdfunding And The Trust Indenture Act Of 1939

On By crowdfundattnyIn Crowdfunding, JOBS Act, Regulation A, Trust Indenture Act of 1939Leave a comment

Handing over moneyThe Securities Act of 1933. The Exchange Act of 1934. The Investment Company Act of 1940. Those are the pillars of the U.S. securities laws, as relevant today as they were 80 years ago. And here’s one more old law relevant to Crowdfunding: the Trust Indenture Act of 1939.

Here’s the idea. A company issues its promissory notes (obligations) to a large group of investors. If the company defaults on one or two notes, it might not be financially feasible for those particular investors to take legal action. Even if the company defaults on all the notes it will be a mess sorting out the competing claims. Which investor goes first? If there is collateral, which investor has priority? At best it’s highly inefficient, economically.

The Trust Indenture Act of 1939 imposes order and economic efficiency. It provides that where a company issues debt securities, like promissory notes, it must do so pursuant to a legal document called an “indenture” and, most important, with a trustee, normally a bank, to represent the interests of all the investors together. The TIA goes farther:

  • It provides that the indenture document must be reviewed and approved by the SEC in advance.
  • It ensures that the trustee is independent of the issuer.
  • It requires certain information to be provided to investors.
  • It prohibits the trustee from limiting its own liability.

Why don’t Patch of Land and other Crowdfunding portals that issue debt securities comply with the TIA? Because offerings under Rule 506 are not generally covered by the law. Conversely, because Lending Club and Prosper sell publicly-registered securities (their “platform notes”), they are covered, and have filed lengthy indenture documents with the SEC.

The real surprise is with Regulation A+. If a Regulation A+ issuer uses an indenture instrument to protect the interests of investors then it will be subject to the TIA and its extensive investor-protection requirements. If the issuer does not use an indenture, on the other hand hand, it will not be subject to the TIA as long as it has outstanding less than $50 million of debt. That’s a strange result – giving issuers an incentive not to use an indenture even though indentures protect investors.

That’s what happens sometimes when you apply very old laws to very new forms of economic activity. Welcome to Crowdfunding.

Questions? Let me know.

How Much of My Company Should I Give Away?

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

Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?

One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.

Suppose you’re raising $500,000. To calculate how much your investor should receive:

  • Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
  • Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
  • Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
  • Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
  • Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
  • Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).

Very elegant and simple.

But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.

money treeThat’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.

The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.

In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.

Questions? Let me know.

How To Do It Wrong In Crowdfunding

On By crowdfundattnyIn Crowdfunding, SECLeave a comment

Missed chancesAn SEC enforcement order came across my desk that illustrates how to operate a Crowdfunding portal if you want to meet people who work for the government. The order, with names removed, is available here.

As a preface, everything I know about this portal comes from the SEC’s enforcement order. It is possible that the SEC’s allegations are false – even though the portal agreed to a settlement, without admitting wrongdoing – and that the portal actually was in full compliance with all applicable laws.

With that said, here’s what the portal did, or is alleged to have done:

  • In May 2013, before “general solicitation” was legal, it established a website that listed investments for anyone to see, i.e., not behind a firewall.
  • Although the site included a disclaimer that investments were not available to U.S. persons, the portal did not take steps – for example, using IP addresses – to enforce this rule. In fact, more than 50 individuals who listed the U.S. as their place of residence were allowed to register, and several actually invested.
  • The portal allowed at least some of the U.S. investors to self-certify that they were “accredited investors,” without even explaining what that meant.
  • The portal charged a commission for raising capital without being registered as a broker-dealer.

The violations alleged by the SEC do not fall within an ambiguous gray area. They are just flat-out over the line. And note the timing: May 2013, after the no-action letters to FundersClub and AngelList, in which the SEC gave the world a road map for legal Crowdfunding.

I can only guess this portal was represented by one of my competitors. 🙂

That’s a joke, of course. Much more likely, the company wasn’t represented by anybody and just did what seemed to make sense, without knowing they were violating anything.

The portal was incorporated and operated offshore. Nevertheless, it was subject to U.S. securities laws because it solicited U.S. investors.

Fortunately, everything this company wanted to do can be done legally and at a very low cost. If you want to raise money exclusively offshore, then exclude U.S. investors. If you want to raise money from the U.S. and offshore, use Regulation S. If you’re raising money from U.S. investors use VerifyInvestor.com or Crowdentials to verify they’re accredited. If you’re going to charge a commission use an online broker-dealer. If you want to allow investors to self-certify, then use Rule 506(b) and hide your deals behind a firewall. Spend just a little money on a lawyer and stay off the SEC’s Christmas card list.

Questions? Let me know.

Integration Of Regulation A+ Offerings With Other Offerings

On By crowdfundattnyIn Crowdfunding, Crowdfunding Laws, Crowdfunding Speaking Engagements, Regulation ALeave a comment

Yesterday I spoke about Regulation A+ on a panel at the National Press Club in Washington, D.C. One topic was whether offerings under Regulation A+ would be “integrated” with other offerings, including offerings under Title II.

The word “integration” describes a legal concept in U.S. securities laws, where two offerings that the issuer intends to keep separate are treated as one offering instead. For example, I raise $1 million in an offering under Rule 506(b), where I admit 19 non-accredited investors. Needing more money, I start another offering under Rule 506(b) a month later – and for the same project – and admit 23 more non-accredited investors. Wrong! The SEC says those two offerings are “integrated” and now I’ve exceeded the limit of 35 non-accredited investors.growth captial summit

Today, entrepreneurs can raise money under Title II Crowdfunding only from accredited investors. Under Regulation A+ they’ll be able to raise money from non-accredited investors as well, vastly expanding the potential investor base. Unlike a Title II offering, however, where accredited investors can invest an unlimited amount, an investor in a Regulation A+ offering, accredited or non-accredited, will be limited to investing 10% of his or her income or net worth.

The question naturally arises, why not do a Regulation A+ offering for non-accredited investors while at the same time doing a Title II offering for accredited investors, thus maximizing the amount raised from everyone?

The answer, unfortunately, is integration. The two offerings would be treated as one, and they would both fail as a result.

But along with that bad news, the integration rules under the proposed-but-not-adopted Regulation A+ regulations offer good news as well:

  • A Regulation A+ offering will not be integrated with an offering that came first. Thus, I can raise money in a Title II offering, accepting an unlimited amount from accredited investors, and the day after that offering ends conduct a Regulation A+ offering for non-accredited investors.
  • A Regulation A+ offering will not be integrated with an offering to foreign investors under Regulation S. The two can happen simultaneously.
  • A Regulation A+ offering will not be integrated with an offering that begins more than six months after the Regulation A+ offering ends.
  • A Regulation A+ offering will not be integrated with a Title III offering, even if they happen at the same time.

Another takeaway from the conference is that the SEC plans to finalize the proposed regulations under Regulation A+ by the end of the year (this year). Issuers and portals, get ready.

Questions? Let me know.

Videos In Crowdfunding

On By crowdfundattnyIn Crowdfunding, Videos in CrowdfundingLeave a comment

In this post, I wondered when we would see videos in Crowdfunding.

The video above was sent to me by Carolyn Collins of HUB International Northeast, a benefits consultant. Her company sells a health insurance product packaged as a “private exchange,” complementing the government exchanges operated under Obamacare.

In just over two minutes, the video explains:

  • What’s wrong with the current health insurance market
  • How the private exchange operates
  • Why the private exchange is the best of both worlds for employers

Take a look, and ask yourself at the end whether you’d like to know more (you will).

Of course, I’m not trying to sell health insurance. But if a video can explain our crazy health insurance system and offer an alternative in two minutes, then an effective video on equity Crowdfunding should be easy!

Questions? Let me know.

The Series LLC

On By crowdfundattnyIn Crowdfunding, LLCsLeave a comment

Series LLCI bought the iPhone 6 and get a chill using ApplePay. I was one of the earliest adapters of the limited liability company, way back when. I like new, useful things. But I don’t like the “series LLC” all that much.

A series LLC is a regular limited liability company with compartments inside, like a room divided into cubicles. Each compartment is called a “series.” By law, the assets and liabilities of each series stand by themselves, meaning that the creditors of one series cannot get at the assets of a different series. The series LLC was first adopted in Delaware, naturally, but has now been adopted by a handful of other states, including Texas and Nevada.

The series LLC was supposed to make life simpler. For example, a real estate developer with five projects could form just one LLC and divide it into five series, each with different assets, liabilities, and even owners. The developer would pay to form only one entity, pay only one annual registration fee, file only one tax return, etc.

The state tax authorities threw the first wrench into the gears by declaring that each series would be treated as a separate entity for franchise tax purposes.

But the real problem with the series LLC is that nobody knows whether it will work if challenged in court, especially in a bankruptcy court. If one series incurs a liability, will a bankruptcy court respect the state LLC statute saying that creditors can’t get to the assets of another series? A bankruptcy court is supposed to respect state property laws but. . . .the truth is nobody really knows.

Until that critical question is answered by a court, I can’t recommend using a series LLC. They’re convenient, but the convenience comes with too much risk for my taste.

I bought the iPhone 6, not the 6 plus.

Questions? Let me know.

Why Financial Firms Are Joining The Crowd, By Joy Schoffler, Principal of Leverage PR

On By crowdfundattnyIn Crowdfunding, Guest BlogLeave a comment

Crowdfunding is a marketing vehicle. Sure, it’s a great way for entrepreneurs to raise money and a great way for investors to find institutional-quality deals. But above all Crowdfunding is about marketing. And that’s why financial firms – venture capital firms, investment banks, private equity firms, and others – are moving into the space.

When I was the director of a private equity firm, we spent our time doing what all investment firms do, working to broaden the firm’s investor base and find more and better deals. Because of the legal constraints that have been in place since the early 1930s, we (and everyone else) had to rely on private networks. While we developed a large private network, the process of manual network development is slow by design.

With the passage of the JOBS Act, everything has changed. Now, investment firms can take what was essentially a marketing function and move it online, using tools and marketing best practices to build their networks.

Today I run a public relations firm, Leverage PR, which works at the intersection of technology and finance. With my background Fin-Tech I’ve naturally gravitated to Crowdfunding and serve in leadership roles in the industry, including serving on the board of CFIRA, the leading trade association. From that vantage point I can see the trends in both technology and finance. Without doubt, one of the most pronounced trends is that financial firms are moving into Crowdfunding, with established players launching their own portals or partnering with others.

Here are the six leading factors encouraging financial firms to join the Crowd:

Reason #1: Adding to the Capital Stack – Raising money is hard. Even established firms with a base of institutional money need smaller investors to augment the capital stack or fill holes. If done properly, with the right public relations, launching a Crowdfunding platform is a wonderful way to get in front of new bases of potential investors and prove expertise in an industry.

Reason #2: Marketing Automation – Private equity has, by and large, stayed in the marketing Stone Age. Some of the biggest firms still use spreadsheets to track current investors and monitor prospective investors. In contrast, the best Crowdfunding platforms have embraced the power of marketing automation. They set up investors on drip marketing campaigns from the minute they sign up. They learn what each investor likes and doesn’t like using data from the site. They convert small investors into larger investors. They use technology to create the economies of scale that make dealing with smaller investors possible and profitable.

Reason #3: Improve and Automate Investor Relations – When many of us in private equity first heard of Crowdfunding we imagined a nightmare of dealing with hundreds of investors. The opposite is true. A Crowdfunding platform provides a better customer platform. In fact, we’re seeing established private equity firms launch portals solely for investor relations post close.

Reason #4: More and Better Deals – Early entrants into the space who are marketing their Crowdfunding portal are not only seeing a deeper and wider investor pool but are also seeing increased deal flow. Even if firms are launching only to do their own deals they are generating interest and traffic from other in their space who are bringing them deals.

Reason #5: Partnerships – Innovative companies are partnering with Crowdfunding platforms across a number of sectors to identify potential acquisition targets, effectively using the platforms as quasi-outsourced R&D. We believe this trend, already begun by firms like Healthios Exchange and CircleUp, will continue and intensify. R&D is expensive and risky. Crowdfunding offers a better and cheaper alternative. View More: http://votiveimage.pass.us/leveragepr

Reason #6: Get Ahead of the Curve – Technology is changing everything and private equity is no exception. While we don’t know what private equity will look like in 10 years, we’re sure it will be online.

As we look forward to 2015, I’m excited about what lies ahead. While it’s true that the JOBS Act opened a world of opportunities for new, innovative players, it also gives established financial firms the tools to expand market reach, lower minimum investments, and bring technology to manual processes.

Joy Schoffler, principal of Leverage PR, is a nationally recognized author and speaker on financial services communications. An active member of the Crowdfunding community Joy sits on the board of CFIRA.org a leading Crowdfunding advocacy association. Before launching Leverage, Joy served as director of acquisitions for the Inc. award-winning private equity firm The PPA Group. Joy has written for a number of publications including Entrepreneur.com, Social Media Monthly and MarketingProfs. She is also a contributing author for the Wiley-published Bloomberg Media book “Crowdfunding: The Ultimate Guide to Raising Capital on the Internet.”

Making Intrastate Crowdfunding Regulations Work For State Regulators

On By crowdfundattnyIn Speaking Engagements, UncategorizedLeave a comment

I have been asked by Disrupt Radio to be a special guest on their Disruptive View program highlighting Intrastate Crowdfunding and how to make it work for state regulators.

Join us tomorrow, November 4, 2014 at 12:30 pm EST! To tune in, click here.

Disrupt Radio an online news source that delivers weekly articles covering the latest disruptive business, technology, equity investing and economic news for innovative entrepreneurs, business leaders, tech savvy women, and curious consumers who want the hottest trends, tips and real help from successful celebrity entrepreneurs, provocative thought-leaders and forward-thinking executives from around the globe.

To view the press release in its entirety, click here.

Questions? Let me know.

Improving Legal Documents In Crowdfunding: Model White Label Contract

On By crowdfundattnyIn Crowdfunding, Legal DocumentsLeave a comment

I see a lot of contracts between would-be Crowdfunding portals and “white label” portal software providers. It would help the industry, in my opinion, if everyone used or at least started with the same agreement. So I’ve drafted a model agreement, accessible as a Microsoft Word document here.

An agreement for a white label platform is a software license agreement. I’ve drafted more software license agreements than I can count, representing both licensors and licensees. That gives me a very good feel for what’s important, what’s not so important, and what’s fair.

My model agreement is designed to be a very fair document. It protects what’s important to the white label provider, and also protects what’s important to the would-be portal licensing the platform. It is also designed to be a comprehensive document, meaning it covers what’s important without overkill. I hope it’s easy to read and understand, as legal contracts go. And it’s completely flexible in terms of what the customer gets and how much the customer pays.

Multi-million-dollar portal businesses are being created based on the relationship created by this contract. It’s not a back-of-the-napkin kind of thing.

Because there could be special situations that the model agreement doesn’t cover, white label providers and their customers should have this model agreement reviewed by their own lawyers. Also, I haven’t provided a Service Level Agreement, because response times might vary significantly among white label providers.

But using one standard agreement should make things easier for everyone. Fewer transaction costs, less friction, greater certainty, faster to market. That’s what the industry needs.

Questions? Let me know.