Gentlemen and Ladies—
The following are comments to the proposed rules published in the Federal Register on March 31, 2020 relating to offerings under §4(a)(6) of the Securities Act of 1933 and related matters.
Before commenting, I would like to applaud the Commission not only for these proposals but for its approach to the JOBS Act generally. I have practiced in this space extensively since 2012, representing funding portals, issuers, and other industry participants. Time after time I have been impressed with how the Commission has sought to achieve two complimentary goals: on one hand, protecting investors and ensuring that American capital markets remain the most transparent and robust in the world; and on the other hand, facilitating capital formation by small, job-creating enterprises and giving ordinary Americans the opportunity to invest in businesses historically available only to the wealthy.
Among many examples I will mention just one. On May 4, 2020 the Commission adopted temporary rules to facilitate capital formation under §4(a)(6) In response to the COVID-19 pandemic. No one knows how many jobs the temporary rules will save or create, but the willingness of the Commission to draft and issue the temporary rules in the midst of a crisis, taking the time to help very small businesses while overseeing a complex, multi-trillion dollar securities market, speaks volumes. The Commission clearly believes that Crowdfunding has an important role to play in our capital markets, and all Americans, not just those of us in the industry, should be grateful.
Speaking from the ground floor, so to speak, I have just a few comments, all geared toward making the industry more robust while protecting investors.
Raised Offering Limit and Elimination of Limit for Accredited Investors
To my mind, the two most important and welcome proposals are (i) to increase the limit set forth in 17 CFR §227.100(a)(1) from $1,070,000 to $5,000,000, and (ii) to eliminate the limit in 17 CFR §227.100(a)(2) for accredited investors. Either change would have been welcome, but together I believe they will change the Title III market significantly for the better, improving both the quality of the offerings and the level of compliance.
With offerings limited to $1,070,000 and very low per-investor limits, even for accredited investors, funding portals have had a very hard time making money, plain and simple. Struggling to make ends meet, they lack resources to spend on compliance or on other business practices that would attract more promising issuers and, especially, a larger number of prospective investors. In fact, the difficulty in turning a profit has led some funding portals to adopt practices that may provide some benefit in the short term but drive away rather than attract issuers and investors.
With larger offerings and unlimited investments from accredited investors, I believe that the proposed changes to 17 CFR §227.100(a)(1) and 17 CFR §227.100(a)(2) will reverse that cycle. A profitable funding portal can hire compliance officers, exercise more discretion in the presentation of disclosure materials, provide better documents, insist on quality in all aspects of its business. These steps will in turn attract more investors, which will attract more and better issuers, in a virtuous cycle. With the promise of potential profits, I expect the number, sophistication, and expertise of funding portals to grow rapidly, helping to deliver on the promises with which Title III was launched.
Hence, I strongly support these proposals.
Artificially Low Target Offering Amounts
Too often, we see Title III issuers launch offerings with an artificially low target offering amount, typically $10,000. I believe the artificially-low target amounts are unfair to investors and poisonous to the Title III Crowdfunding market.
The concept of offering “minimums” has always been part of private investments with sophisticated investors. For example, a company seeking to raise as much as $750,000 to obtain three patents and hire a Chief Operating Officer and Chief Marketing Officer might set a minimum offering amount of $450,000, which would allow it to at least obtain two patents and hire the COO. But if the company could raise only $150,000 the company was obligated to give the money back, because sophisticated understand that anything less than $450,000 wouldn’t move the needle for the business.
I believe the concept of target offering amounts in Title III should follow that model, i.e., that the target offering amount should represent an amount of money that would allow the issuer to achieve a significant business goal.
Too often we see on funding portals a company that seeks to raise, say, $350,000 setting a target offering amount as low as $10,000. The artificially low target amount serves the short-term interests of the funding portal and the issuer: if the company raises, say, $38,000, the issuer receives some cash while the funding portal receives a commission on $38,000 and includes the issuer in its list of “successful” offerings, skewing its statistics as well as the statistics of the industry as a whole. Meanwhile, investors have put $38,000 into a company that needed a lot more and have thereby made an investment fundamentally different and riskier than the investment promised. In the larger picture, I believe sophisticated investors see the game and stay away from the funding portal – and perhaps all of Title III – altogether.
I believe the Commission should amend 17 CFR §227.201(g) to provide as follows:
The target offering amount, the deadline to reach the target offering amount, a statement of the significant business goal the issuer expects to achieve if it can raise the target amount or, if there is no such significant goal, a statement to that effect, and a statement that if the sum of the investment commitments does not equal or exceed the target offering amount at the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned;
In addition, I believe the Commission should caution issuers and funding portals that if raising the target offering amount will not allow the issuer to achieve any significant business goal, a risk factor should be added to that effect.
The Commission proposes to add 17 CFR §227.100(b)(7), making Title III Crowdfunding unavailable for securities that “Are not equity securities, debt securities, and securities convertible or exchangeable to equity interests, including any guarantees of such securities.”
It is unclear to me whether this new rule would allow securities commonly referred to as “revenue-sharing notes.” I believe these securities should be allowed.
A typical revenue-sharing note has the following features:
- Investors are entitled to receive a specified percentage of the issuer’s gross revenues, or gross revenues from specified sources (e.g., from sales of a new product).
- The note specifies a maximum amount investors may receive, often a multiple of the amount invested. For example, investors might be entitled to receive a maximum of twice the amount invested.
- The note also specifies a maturity date – for example, three years from the date of issue.
- Payments continue until the sooner of the maturity date or the date investors have received the specified maximum amount.
- If investors have not received the specified maximum amount by the maturity date, they are entitled to receive the balance (the difference between the maximum amount and the amount they have received to date) on the maturity date.
- Sometimes, but not always, the revenue-sharing is convertible into equity.
Revenue-sharing notes are especially attractive for small companies and less-experienced investors:
- They are extremely easy to understand. For less-experienced investors a revenue-sharing note is much easier to understand than a share of common stock, for example.
- The payments on a revenue-sharing note depend on only one thing: sales. They do not depend on any expense items. For example, they do not depend on how much compensation is paid to the principals of the company. As a result, the potential for misunderstandings and disputes is reduced substantially.
- They provide investors with built-in liquidity.
- They allow issuers to maintain a “cleaner” cap table, possibly facilitating future financing rounds.
- All those benefits are also available with straight debt securities. For many small businesses, however, and especially for true startups, there is no interest rate – short of usury, that is – that would compensate investors adequately for the risk. As of this morning, the one-year return of the S&P 500 BB High Yield Corporate Bond Index is almost 9%. To compensate investors adequately for the risk of investing in a startup the potential return must be far higher. The revenue-sharing note provides that potential.
Revenue-sharing notes shares features of equity securities in the sense of providing a significant potential for profit, and also share features of debt securities in the sense of providing a date certain for payment. Sharing features of both equity securities and debt securities, it is hard to say a revenue-sharing note is only an equity security or only a debt security. Hence, it would be helpful if the Commission would clarify that revenue-sharing notes may be offered and sold under §4(a)(6).
In the context of large companies, reviews and audits of financial information by independent accountants is an unmitigated positive, indeed a cornerstone of transparency and integrity in the American capital markets. In the context of very small companies, however, the positives are less apparent and can be outweighed by the cost.
Currently, 17 CFR §227.201(t)(2) requires companies seeking to raise between $107,000 and $535,000 to provide financial statements reviewed by an independent accountant. The cost of such a review varies by region but can certainly amount to between $5,000 and $10,000. For a company seeking to raise, say, $150,000, the cost of the accountant review by itself represents between 3% and 7% of the capital raise, an enormous cost and far more as a percentage than the audit costs of large issuers.
In my opinion, the cost of these reviews is not justified by the value of the additional information they provide to investors. For companies raising no more than $107,000, 17 CFR §227.201(t)(2) requires only information from the company’s Federal tax certified by the principal executive officer, who is typically the founder of the company. My experience in representing hundreds of small companies over more than 30 years suggests that a certification for which a CEO and/or founder takes personal responsibility is much more likely to be accurate than a reviewed financial statement. Although I am confident that every small company files tax returns that are accurate in every respect, out of patriotic obligation, I also note that CEOs and founders are, if anything, incentivized to understate a company’s income on a tax return.
In short, I believe investors get very little, if anything, in terms of the accuracy of a company’s financial disclosures in exchange for the added cost to the company. To bring the cost and the benefit closer into line, I recommend raising the threshold in 17 CFR §227.201(t)(2) to at least $350,000, and possibly eliminating 17 CFR §227.201(t)(2) altogether and raising the threshold in 17 CFR §227.201(t)(1) to $500,000.
I will make two further points in this regard:
- It is possible that as the market becomes more robust investors will reward companies that provide reviewed financial statements and punish those who don’t. If so, the market will impose its own discipline.
- Although financial statements are extremely important in evaluating established companies, they are far less important in evaluating small companies and startups. For example, the financial statements of Facebook and Amazon and Microsoft were essentially irrelevant to the earliest investors. I believe that investors in the Title III market make investment decisions almost wholly without regard to historical financial statements and will continue to do so. In this sense the paradigm for large companies simply doesn’t fit the small company market.
Section 4A(b)(2) of the Securities Act provides that issuers relying on the exemption of §4(a)(6) “shall not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.” That rule is implemented in 17 CFR §227.204, which defines the “terms of the offering” to mean (i) the amount of securities offered, (ii) the nature of the securities, (iii) the price of the securities, and (iv) the closing date of the offering period.
In practice this rule has created a great deal of confusion and many inadvertent violations. It has also kept issuers from communicating effectively with prospective investors. I do not believe it has protected investors in any meaningful way.
A small company will reasonably wonder why it is allowed to say “We’re raising capital!” on its Facebook page but might not be allowed to say “We’re trying to raise $250,000 of capital!” I say “might not” because even with this simple example the rule is not clear. If “We’re trying to raise $250,000 of capital!” were the only item the company ever posted on Facebook, that would be okay. But of course the company’s Facebook page is filled with all sorts of other information, including information about the company’s founders and history and products – that’s the point of having a Facebook page. In this situation the statement “We’re trying to raise $250,000 of capital!” might be illegal, while the statement “We’re raising capital!” is fine.
In today’s digital, social-media-driven world that creates a mess, impossible for small companies to untangle.
The problems arise from applying the paradigm of large, public companies to the world of small companies and startups. If I want to buy stock of Google I don’t call Google, I call my broker. At some point in the future funding portals might play the role for small companies that brokers play for large companies today. For the present, however, the reality is that Title III issuers have primary and sometimes exclusive responsibility for marketing their own offerings. To hamstring advertising by Title III issuers is to hamstring Title III.
I do understand and support the goal of directing investors back to the portal and thus ensuring that all investors receive exactly the same information. However, I believe that goal can be accomplished, with no harm to investors, through a slightly different approach.
In a Title III offering, I understand the “terms of the offering” to mean all the information contained in Form C. Thus, I would interpret section 4A(b)(2) to mean only that if an issuer provides to prospective investors all or substantially all of the information provided in its Form C, it must direct them to the portal. Otherwise, issuers should be allowed to advertise their offerings, including the four terms enumerated in current 17 CFR §227.204, with three caveats:
- I would require every advertisement, no matter its contents, to direct potential investors to the funding portal. For these purposes I would define the term “advertisement” very broadly, even more broadly than the term “offer” is defined under current law. Thus, I would consider requiring even notices permitted by 17 CFR §230.169 to include a link back to the funding portal, if made while the offering is open.
- I would prohibit any advertisement containing information that is not in the issuer’s Form C.
- In the text of 17 CFR §227.204 I would remind issuers and their principals of their potential liability for material misstatements and omissions.
Those changes would provide clear rules for issuers and funding portals and, I believe, would unleash a torrent of creativity and energy in the Title III market, with no harm to investors.
The Role of FINRA
Under section 4A(a)(2) of the Securities Act, every funding portal must register with any applicable self-regulatory organization. Because there is only one such organization in the United States, all funding portals must become members of the Financial Industry Regulatory Authority, or FINRA. Consequently, although not directly germane to the Commission’s proposals published on March 31, 2020, any discussion of Title III must include at least a reference to FINRA and its regulation of funding portals.
Like everyone else involved in Title III, lawyers and the Commission included, FINRA was starting from scratch in 2016, its two point of reference being the Commission’s regulations on one hand and its own experience regulating broker-dealers on the other hand. In my view FINRA has leaned too heavily on its institutional experience regulating large broker-dealers without taking into account the unique aspects of Title III Crowdfunding.
The Commission’s proposals, and my comments to the proposals, are focused on the economic realities of raising capital for very small companies. One of those economic realities is that most funding portals, like most startups, are owned and operated by just a few people. Too often, the FINRA regulatory paradigm seems to ignore this reality and assume that the funding portal is a much larger enterprise, an enterprise with multiple layers of management – an enterprise like a national broker-dealer.
For example, FINRA requires funding portals to adopt and adhere to an extensive manual of policies and procedures addressing every aspect of its operations. Theoretically such a manual is unobjectionable, and in a large organization absolutely necessary, but in the real world of funding portals the manual typically has the effect of requiring Ms. Smith to supervise herself and maintain a meticulous log proving she did so, and how.
Just as the Commission itself seeks to regulate Title III Crowdfunding based on economic realities, understanding that the rules applicable to public filers might not always apply to very small issuers, I would like to see the Commission encourage FINRA to review its approach to funding portals.
Thank you for your consideration.
Questions? Let me know.