USING A SAFE IN REG CF

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.

The SEC Can Stop Your Regulation A Offering At Any Time

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).

Making Money in Multifamily Real Estate Podcast

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Today’s guest on the Making Money in Multifamily Real Estate Show is Mark Roderick, one of the leading crowdfunding and FinTech lawyers in the United States. He has in depth knowledge of capital raising and securities law and represents many portals and other players in crowdfunding. He has a blog, which provides readers a wealth of knowledge for legal and practical information. He also has a crowdfunding event across the country and represents industry…

Questions? Let me know.

Regulation A: What Country Do You See When You Wake Up?

sara palin

A company may use Regulation A (Tier 1 or Tier 2) only if the company:

  • Is organized in the U.S. or Canada, and
  • Has its principal place of business in the U.S. or Canada.

I’m often asked what it means for a company to have its principal place of business in the U.S. or Canada. The first step is to identify the people who make the important decisions for the company. The next step is to ask what country those people see when they wake up in the morning. If they see the U.S. or Canada, they’re okay. If they see some other country, even a beautiful country like Norway or Italy, they’re not okay, or at least they can’t use Regulation A.

Seeing the U.S. or Canada via Facetime doesn’t count.

A company called Longfin Corp. ignored this rule and suffered the consequences. The people who made the important decisions for the company saw India when they woke up in the morning. The only person who saw the U.S. was a 23-year-old, low-level employee who worked by himself in a WeWork space. In its offering materials the company claimed to be managed in the U.S., but a Federal court found this was untrue and ordered rescission of the offering, $3.5 million in disgorgement, and $3.2 million in penalties.

Harder questions arise if, for example, three of the directors and the CFO see the U.S. when they wake up, but two directors and the CEO see Ireland.

On the plus side, a U.S. mining company with headquarters in Wyoming definitely can use Regulation A even if all its mines are in South America. The “principal place of business” means the location where the company is managed, not where it operates.

Questions? Let me know.

The High Return Real Estate Show Podcast: Crowdfunding For Real Estate Investors 

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Jack gets the day off, and Shecky gets to have a one-on-one conversation with Mark Roderick, the leading Crowdfunding and FinTech lawyer in the US.

In this episode, you’ll learn…

  • What is Crowdfunding?
  • The two different kinds of Crowdfunding
  • What and who to look for in a Crowdfunding company.
  • How does Crowdfunding apply to Real Estate Investing?
  • Who are the big players in the Crowdfunding space?
  • The three types of Equity Crowdfunding

This episode is a MUST listen to anyone wanting to understand how technology is changing our investing landscape!

Questions? Let me know.

The Biggest Challenge With Title III Crowdfunding

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

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

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

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

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

How does the industry get its house in order?

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

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

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

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

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

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

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

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

Everyone benefits, and the Title III market gets healthier.

Questions? Let me know.

IRS Issues New Guidance on Taxation of Cryptocurrencies

MSR Update

The Internal Revenue Service just issued more guidance on the taxation of cryptocurrencies. The guidance comes in the form of Revenue Ruling 2019-24 and a set of FAQs. Officially, the guidance applies only to Federal income taxes. However, states are likely to follow the IRS rules.

Revenue Ruling 2019-24 is about hard forks in a distributed ledger. The IRS concludes that the hard fork is not itself a taxable event – that is, if you hold a cryptocurrency immediately before a hard fork and still hold it immediately after, the hard fork has no tax consequences. On the other hand, if you receive an air drop of the new cryptocurrency following the hard fork, you’re taxed on the value of the air drop.

Otherwise, there are no surprises in the new guidance. Thus:

  • Cryptocurrency is treated for Federal income tax purposes just like any other property, a diamond or a rusty 1964 Chevrolet. Cryptocurrency is not treated like U.S. dollars in any sense.
  • If you receive cryptocurrency in exchange for something else, whether property or services, you’re treated as having received a payment equal to the value of the cryptocurrency at the time you received it. If the bitcoin was worth $3,000 at the time you received it, you received a payment of $3,000 for each bitcoin you received, even if the bitcoin was worth $500 the month before or $10,000 the month afterward.
  • When you dispose of cryptocurrency, you have gain or loss based on the difference between the amount you paid for the cryptocurrency – your tax “basis” – and the amount you received for it, just as if you were selling the 1964 Chevy.
  • In general, you have capital gain or loss from selling cryptocurrency. But if you’re in the business of trading cryptocurrency the cryptocurrency will be treated as “inventory” and you’ll have ordinary income or loss.
  • Cryptocurrency received for services is treated as income for purposes of self-employment taxes as well as for purposes of income taxes.
  • Most people would guess that receiving cryptocurrency is taxable, g., my employer paid me $5,000 of ether, so I’m taxed on $5,000 of income. Less obvious is that you’re subject to tax when you pay someone with cryptocurrency. For example, if you’re the employer and pay your employee $5,000 of ether, you have engaged in a taxable sale of your ether, as if you had sold the ether for $5,000 and then turned around given $5,000 of cash to your employee.
  • If you trade one cryptocurrency for another, it’s a taxable sale. There is no such thing as a tax-free exchange of cryptocurrency, as there is for real estate.
  • If you own a bunch of bitcoin and want to use some to buy a house, you can choose which of your bitcoin to use (presumably the bitcoin with the highest tax basis).
  • If you receive cryptocurrency as a gift, it’s not taxable. Caution: there is no such thing as a business “gift.”
  • You can make a charitable contribution using cryptocurrency. If you’ve held the cryptocurrency for more than a year, your deduction is generally equal to the value of the cryptocurrency. Otherwise, your deduction is the lesser of the value of the cryptocurrency or your tax basis.
  • If you contribute cryptocurrency to an LLC or partnership, it’s not taxable at the time of the contribution. But when the LLC later disposes of the cryptocurrency, you will be taxed on any gain that was “built in” to the cryptocurrency at the time you contributed it.
  • If you own multiple crypto wallets, you can transfer among them without tax consequences.

Questions? Let me know.

REITS vs. Pass Through Entities: Section 199A and Real Estate Crowdfunding

Skyscraper Buildings Made From Dollar Banknotes

The 2017 tax act added §199A to the Internal Revenue Code and, with it, two complementary tax deductions:

  • A deduction of up to 20% of the income from a limited partnership, limited liability company, or other “pass through” entity.
  • A deduction equal to 20% of “qualified REIT dividends.”

Which is better for sponsors and investors?

As described here, the 20% deduction for pass-through entities is enormously complicated. Most important, the deduction can be limited for taxpayers whose personal taxable income exceeds $157,500 ($315,000 for a married couple filing jointly). These limits depend on the W-2 wages paid by the pass-through entity (not much for most real estate syndications) and the cost of the entity’s depreciable property (pretty substantial for most real estate syndications). And, naturally, those limits are themselves subject to special rules and definitions.

In contrast, the 20% deduction for qualified REIT dividends (which includes most dividends from REITs, other than capital gain dividends) is straightforward, with no cutdown for higher-income taxpayers.

Does that mean §199A favors REITs over LLCs and other pass-through entities? Not necessarily.

The key is that most real estate syndications don’t generate taxable income. Typically, the depreciation from the building “shelters” the net cash flow, at least during the early years of the project. The tax-favored nature of real estate is, in fact, part of what makes it such an attractive investment in the first place.

If an investor in an LLC is receiving cash flow from the syndication and paying zero tax, the 20% deduction of §199A is irrelevant. And, for that matter, so is the 20% deduction for REIT dividends. If a REIT isn’t generating taxable income because its cash flow is sheltered by depreciation, then its distribution will probably treated as a non-taxable return of capital rather than a taxable dividend.

As discussed here, the key advantage of a REIT over an LLC or other pass-through entity is that the LLC investor receives a complicated K-1 while a REIT investor receives a simple 1099. The relative simplicity of the 20% deduction for REIT dividends over the 20% deduction for pass-through entities is nice, but wouldn’t tip the balance in favor of a REIT by itself.

Questions? Let me know.

The Cashflow Hustle Podcast: Crowdfunding Techniques to Level Up Your Business

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Mark Roderick appeared on the Cashflow Hustle Podcast with Justin Grimes, where he discussed Crowdfunding Techniques to Level Up Your Business.

In this Episode, You’ll Learn About:

1. The Crowdfunding and its flavors
2. The deductions in Crowdfunding
3. The role of SEC
4. Blockchain technology in Crowdfunding
5. The Investor portals
6. Tokenized security in Crowdfunding

Questions? Let me know.

Syndications, Cryptocurrencies and Crowdfunding, Oh My!

Real Estate Nerds Podcast: Syndications, Cryptocurrencies and Crowdfunding, Oh My!

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Mark Roderick fills us in on how the rich can take care of themselves and the non-rich need the government which is why he thinks crowdfunding is so important to the regular Joe. Since the JOBS Act of 2012, Mark has spent much of his time in the crowdfunding space.

If you have ever thought to yourself the internet is a ruthless landscape slowly squeezing the middleman and driving human being up the value chain? Then you’ll want to tune into this week’s episode where Mark will explain everything from syndications to cryptocurrencies to crowdfunding, oh my!

Questions? Let me know.