Tag: crowdfunding attorney

Artificial Intelligence

Anthropic: SPVs And The Investment Company Act

On By crowdfundattnyIn Investment Company Act, SPV10 Comments

I spend lots of time talking about special purpose vehicles (SPVs) and the Investment Company Act of 1940. Now we have a real-world example.

Anthropic was founded by Dario Amodei, who wrote the basic artificial intelligence model for OpenAI before leaving to start his own company. Once ChatGPT launched Anthropic has had no trouble raising money. They’ve raised $7.5 billion and counting in the last year.

In my humble opinion, the amount of money being thrown at Anthropic is insane. Most obviously, it demonstrates the psychological power of The Fear of Missing Out. More subtly, it represents the brokenness of venture capital culture. VCs have backed themselves into a position where they can no longer invest in businesses that are merely profitable. They need huge wins, grand slams. They bet a chunk of the farm on crypto/blockchain and lost. Now they need even bigger wins, or at least the promise of bigger wins, to keep their LPs writing checks.

Anyway, the flood of money created a problem for Anthropic that will sound familiar to many founders. The company was looking for billions, but many investors were able to invest “only” $30 – $50 million. The company didn’t want all those investors on its cap table.

So the company took the logical step:  it put the “small” investors in a separate company, an SPV, and admitted only the SPV to its cap table as a single investor.

Because its business is limited to holding securities in Anthropic, the SPV is an “investment company” under section 3(a) of the Investment Company Act. Yet it has not registered as an investment company. How does that work?

The answer is that it qualifies for the exemption under section 3(c)(1) of the Investment Company Act, section 3(c)(7) of the Investment Company Act, or both.

The exemption under section 3(c)(1) is available if the SPV has no more than 100 owners. That’s possible. If each owner invests $40 million you would raise $4 billion.

(NOTE:  the exemption under section 3(c)(1) allows 250 owners if the SPV follows a “venture capital strategy,” but this SPV was formed to invest in only one company, Anthropic.)

The exemption under section 3(c)(7) is available if each owner is a “qualified purchaser.” That term includes individuals with at least $5 million of investable assets, entities where all the individual owners have at least $5 million of investable assets, as well as other entities. I suspect the SPV qualifies under this exemption as well.

Thus, the SPV is an investment company under section 3(a), but is not required to register as such.

Finally, note that the discussion about the Investment Company Act doesn’t depend on how Anthropic raised money. It probably raised the money using Rule 506(b), taking the position that because everyone in that world knows everyone else, it had a “pre-existing relationship” with all its investors. But it could also have used Rule 506(c), assuming every investor is accredited. The point is that how you raise money and whether you need or qualify for an exemption under the Investment Company Act are unrelated.

I personally was not invited to invest in Anthropic. Imagine!

Questions? Let me know.

blind pool offerings in crowdfunding

Does Reg CF Allow Blind Pool Offerings?

On By crowdfundattnyIn Reg CF, Regulation CF4 Comments

It’s a trick question.

It’s a trick question because the term “blind pool offering” doesn’t appear in Reg CF. If you try to figure out whether Reg CF allows “blind pool offerings” you’ll drive yourself crazy and/or reach the wrong answer. 

To illustrate the point, suppose NewCo was formed to buy Class B multi-family projects in the southeastern United States but has not yet identified any such properties. If you focus on the term “blind pool offering” you might decide that NewCo can’t use Reg CF. But if you read Reg CF instead, you’ll reach the opposite – and correct – conclusion. 

To see whether NewCo is eligible for Reg CF, we look at the eligibility rules in 17 CFR §227.100(b). NewCo is a Delaware entity, so we’re good under section 100(b)(1). NewCo isn’t subject to the reporting requirements of the Exchange Act, so we’re good under section 100(b)(2). And we keep going through the list until we get to section 100(b)(6), which provides that Reg CF may not be used if the issuer:

Has no specific business plan or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies.

Does that describe NewCo? Well, no. NewCo does have a specific business plan and it’s not about merging with anyone. 

Thus, having gone through the whole list of section 100(b), we conclude that NewCo is eligible to use Reg CF, 100%.

I’ll add two epilogues.

First, Regulation A uses exactly the same language as Reg CF, in 17 CFR §230.251(b)(3). And even a cursory review of the Regulation A offerings reviewed and qualified by the SEC reveals many, many companies like NewCo.

Second, Industry Guide 5, issued by the SEC to provide disclosure guidelines for real estate offerings, specifically contemplates issuers like NewCo. Item 20D provides for certain disclosures in offerings where “a material portion of the maximum net proceeds (allowing for reasonable reserves) is not committed (i.e., subject to a binding purchase agreement) to specific properties. . . .” 

During my first year of law school in 1838, a partnership tax guru named Bill McKee insisted that we read the statute first. It has turned out to be excellent advice.

Questions? Let me know.

FinCEN

The Corporate Transparency Act

On By crowdfundattnyIn Corporate Transparency ActLeave a comment

Beginning on January 1, 2024, new and existing companies, with some exceptions, must disclose their owners to the US Department of the Treasury Financial Crimes Enforcement Network (“FinCEN”). This is big news in the legal world, not just for Crowdfunding but for everyone.

The following summary was prepared by Chimuanya Osuoha. If you’re a client of our firm you’ve probably dealt with Chimuanya and know her to be an extremely capable young lawyer.

The Corporate Transparency Act 

General Rule

Beginning January 1, 2024, all entities that are either formed or registered to do business in the United States by filing documents with a secretary of state or a similar office under the law of a State or Indian Tribe (a “Reporting Company”) are subject to the Corporate Transparency Act (the “CTA”). Reporting Companies will be required to file a report with FinCEN including information about its “Beneficial Owners” and “Company Applicants.”

Any changes to the information, including ownership, must be reported within 30 days.

NOTE:  For the time being, the information provided to FinCEN will not be public. I say “For the time being” for two reasons. One, once the information exists there will probably be pressure to make it public. Two, some states are already headed in that direction. For example, the New York legislature has passed something call the New York LLC Transparency Act, requiring public disclosure of the owners of limited liability companies.

Exceptions

Twenty-three kinds of entities are exempt from the CTA. They include (i) “large operating companies,” defined as a company with more than 20 full-time employees, that has filed income tax returns demonstrating more than $5,000,000 in gross receipts or sales and has an operating presence at a physical office within the United States; (ii) companies required to report under section 12 of the Exchange Act; (iii) investment advisers; (iv) public accounting firms registered under Sarbanes-Oxley;  and (v) tax-exempt entities,.

Click here for a list of the 23 exemptions.

Beneficial Owners

A Beneficial Owner is any individual who, directly or indirectly, (i) exercises substantial control over the entity (e.g., LLC Manager, Corporate Officer, etc.) or (ii) owns or controls twenty-five (25%) percent or more of the ownership interests in a Reporting Company. 

An individual exercises substantial control over a Reporting Company if he or she (i) is a senior officer; (ii) has authority to appoint or remove certain officers or a majority of directors of the Reporting Company; (iii) is an important decision-maker; or (iv) has any other form of substantial control over the Reporting Company. That’s very broad!

If the shares or interest of a Reporting Company are held by a trust, the Beneficial Owner of the Reporting Company could be (i) the Grantor or Settlor of the trust who has a right to revoke the trust or withdraw assets, (ii) the Trustee or person holding authority to dispose of trust assets, or (iii) a sole beneficiary who is the recipient of income and principal, or a beneficiary who has the right to demand distribution or withdraw substantially all assets from the trust. 

The definition of Beneficial Owners includes exceptions for minor children,  non-senior employees, and an individual whose only interest in a corporation, LLC, or other similar entity is through a right of inheritance. 

Company Applicant

A Company Applicant is an individual who directly files or is primarily responsible for the filing of the document that creates or registers the company. Each Reporting Company is required to report at least one Company Applicant, and at most two.

Example:  Individual A is creating a new company. Individual A prepares the necessary documents to create the company and files them with the relevant office, either in person or using a self-service online portal. No one else is involved in preparing, directing, or making the filing. Individual A is the Company Applicant and should be included in the report.

Example: Individual A is creating a company. Individual A prepares the necessary documents to create the company and directs individual B to file the documents with the relevant office. Individual B then directly files the documents that create the company. Individual A and B are Company Applicant and both should be included in the report.

The requirement to name Company Applicants applies only to Reporting Companies formed or registered on or after January 1, 2024. 

Information Required 

The Reporting Company must provide the following information about itself:

  1. Legal name, trade name and d/b/a;
  2. Address of principal place of business;
  3. The State, Tribal or foreign jurisdiction of formation or registration of the Reporting Company; and
  4. IRS Tax ID Number

The Reporting Company must provide the following information for each Beneficial Owner and each Company Applicant:

  1. Full Legal Name;
  2. Date of Birth;
  3. Current residential or business street address; and
  4. A Unique identifying number from an acceptable identification document (passport, driver’s license, etc.), or a FinCEN Identifier.

Deadline for Filing

Reporting Companies created or registered to do business on or after January 1, 2024, must file a report with FinCEN within 30 days after receiving notice of the company’s creation or registration. Reporting Companies formed or registered before January 1, 2024, have until January 1, 2025.

******

For more information, please contact Chimuanya A. Osuoha, Esq. at cosuoha@lexnovalaw.com or call 856-382-8452. We look forward to being of service. 

Why I’m Grateful This Thanksgiving

On By crowdfundattnyIn Uncategorized2 Comments
William Bradford leader of the pilgrims

My 10th-great grandfather was William Bradford, the leader of the Pilgrims. I’m grateful that he and his band of religious refugees made the trip and were saved from starvation by the native population.

I’m grateful for the wisdom of the American people and the resilience of their institutions.

I’m thankful for a culture that rewards risk-taking and innovation and that is slowly, haltingly, inexorably freeing itself of the prejudices of our collective past.

I’m grateful for American entrepreneurs who endlessly question the present and invent the future.

I’m grateful I declined an invitation to sit on OpenAI’s Board.

I’m grateful – I’m not joking – to the SEC for providing oversight for the most complex, dynamic, trusted capital markets in the world.

I’m grateful that FINRA. . . .

I’m grateful to my colleagues at Lex Nova Law for helping to build a flexible, modern law firm.

I’m grateful to live in a diverse, changing, sometimes-chaotic country where it often seems we disagree about everything (we don’t). Like others, I worry that so many Americans have chosen alternative realities and conspiracy theories, but I have faith that these afflictions, like others in our history, will prove temporary.

I’m grateful that even while the voices of hate are the loudest, those who yearn for peace – the majority – refuse to be drowned out.

I’m grateful that people can change their minds.

I’m grateful to participate in the fundamental rethinking of capitalism called Crowdfunding, making capital available where it has never been available before and making great investment opportunities available to more and more Americans.

I’m grateful to everyone in the Crowdfunding ecosystem, especially to Doug Ellenoff and others who worked to make the JOBS Act a reality.

I’m grateful for my clients, a diverse, energetic, endlessly-creative group of entrepreneurs who are making America better and in the process making my life infinitely more rewarding.

While complaining that my health insurance premiums went up again, I’m grateful they have not dropped to zero.

Thanks for reading everyone! I hope you enjoy your Thanksgiving as much as I intend to enjoy mine. As always, contact me if you have any questions.

MARK

financial statements in crowdfunding

Whose Financial Statements?

On By crowdfundattnyIn Filing Financial Statements & Other Reports, Reg CF4 Comments

Reg CF requires financial statements. To refresh your memory:

Those thresholds are based on the maximum you’re trying to raise. So if your “target amount” is $600,000 but you’re trying to raise up to $900,000, and this is your second Reg CF offering, you need audited statements. 

Now suppose you conducted your business as a sole proprietorship or an LLC until six months ago, when someone in Silicon Valley told you to convert to a C corporation. Your sole proprietorship or your LLC is a “predecessor” of your C corporation within the meaning of 17 CFR §230.405. Hence, under the Reg CF rules, your financial statements should include the results of the sole proprietorship or LLC. Which makes sense, given the purpose of the disclosure rules.

The same is true if your company intends to acquire another company. If you’re raising money to buy TargetCo Inc. then TargetCo Inc. is a “predecessor” of your company for purposes of Reg CF. Hence, you should include the financial statements of TargetCo Inc. Which also makes sense.

Especially for small companies, financial statements represent one of the biggest impediments to Reg CF. The rules around predecessors make the impediment that much higher.

Questions? Let me know.

SPVs in Crowdfunding

SPVs in Crowdfunding

On By crowdfundattnyIn Investment Advisers Act of 1940 (IAA), Investment Company Act, SPVLeave a comment

When you’re raising money for a company, it’s tempting to group all your investors in an entity and have that entity, rather than the individual investors, invest in the company. We often refer to an entity like this as a special purpose vehicle, or SPV. 

The Cursed Investment Company Act

Because the SPV is in the business of owning a security – even if it’s only one security – it’s an “investment company” within the meaning of section 3(a)(1)(A) and/or section 3(a)(1)(C) of the Investment Company Act of 1940. That means, among other things, that the SPV can’t use Reg CF or Regulation A to raise capital.

NOTE:  In 17 CFR §270.3a-9, the SEC created a special kind of SPV called a “crowdfunding vehicle” that can be used to raised capital in Reg CF. I’ve written about those here and here and here but am not writing about them today. Today I’m talking about SPVs formed to raise money under an exemption other than Reg CF, e.g., Rule 506(b) or Rule 506(c).

Because of the prohibitive regulatory burden, we don’t want our SPV to be an investment company. Therefore, having concluded that the SPV is an investment company within the meaning of section 3(a)(1) of the ICA, we look for an exemption.

If you’re raising money only from very wealthy people you find an exemption in section 3(c)(7) of the ICA, which allows an unlimited number of investors as long as each owns at least $5 million of investable assets. All the big hedge funds and private equity funds in Manhattan and Merchantville rely on this exemption. 

The Section 3(c)(1) Exception – 100 Security Holders

For the unwashed masses, the most common exemption – actually, the only other viable exemption for SPVs – is section 3(c)(1) of the ICA. The section 3(c)(1) exemption applies if the outstanding securities of the SPV are held by no more than 100 persons. A few points about the 100-investor limit:

  • The limit refers to the total number of security-holders, not the number of investors in a particular offering. If you’ve conducted one offering and admitted 72 investors, you can’t conduct another offering and admit 87 more.
  • “Securities” include equity, debt, and everything in between. An investor holding a promissory note or a SAFE counts.
  • In general, if an entity invests in the SPV the entity counts as only one security-holder, even if the entity itself has multiple owners. But the law will “look through” the entity, treating its owners as owners of the SPV, if either:
    • You formed the entity to get around the 100-security holder limit; or
    • The entity owns 10% or more of the voting power of the SPV and is itself an investment company.
  • Suppose your SPV has 98 security holders and P.J. Jankara is one of them. She dies and leaves her 100 shares of common stock to her five children, 20 shares each. Is your SPV now an investment company? No, the law provides latitude for involuntary transfers like death.
  • As long as you have no more than 100 security holders in one SPV, you’re allowed to have a separate SPV relying on the section 3(c)(7) exemption. In legal jargon, the two SPVs won’t be “integrated.”

Qualifying Venture Capital Funds – 250 Security Holders

The 100 limit is increased to 250 for a “qualifying venture capital fund.” That means a fund satisfying all six of the following conditions:

  1. The fund represents to investors and potential investors that it pursues a venture capital strategy;
  2. Other than short-term holdings, at least 80% of the fund’s assets must consist of equity interests in portfolio companies;
  3. Investors in the fund do not have the right to withdraw or have their interests redeemed;
  4. All investors in the fund must have the right to receive pro rata distributions;
  5. The fund may have no more than $10,000,000 in aggregate capital contributions and uncalled committed capital, indexed for inflation; and
  6. The fund’s borrowing does not exceed 15% of its aggregate capital contributions and uncalled committed capital.

The regulations don’t define the term “venture capital strategy,” but the SEC provided this explanation:

Under the rule, a qualifying fund must represent itself as pursuing a venture capital strategy to its investors and potential investors. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in our rule (because for example it only invests in short-term holdings, does not borrow, does not offer investors redemption rights, and is not a registered investment company). We believe that only funds that do not significantly differ from the common understanding of what a venture capital fund is, and that are actually offered to investors as funds that pursue a venture capital strategy, should qualify for the exemption.

Whether or not a fund represents itself as pursuing a venture capital strategy, however, will depend on the particular facts and circumstances. Statements made by a fund to its investors and prospective investors, not just what the fund calls itself, are important to an investor’s understanding of the fund and its investment strategy.

When asked to define pornography, former Supreme Court Justice Potter Stewart famously responded: “I know it when I see it.” (Contrary to some critics, he did NOT continue “. . . .and I see it a lot.”) The definition of “venture capital strategy” is like that.

Now, one of the high-volume Reg CF portals says this about using SPVs for Rule 506(c) offerings:

If you wish to consolidate all the investors into a single SPV or fund, the law places a limit of 249 investors if the offering is under $10M in investments. If the offering has more than $10M in investments, there is a 99 investor limit.

This is 100% wrong. By referring to a $10M limit, the portal clearly believes that an SPV can be a “qualifying venture capital funds.” But an entity formed to “consolidate all the investors into a single SPV” couldn’t be a qualifying venture capital fund because it doesn’t pursue a “venture capital strategy.” In fact, the SPV has no investment strategy at all. Investors themselves make the one and only investment decision at the time they invest. The SPV is simply a conduit between the investors and the team, used to simplify the team’s cap table.

This is the same high-volume Reg CF portal that uses a series LLC as crowdfunding vehicles, despite this. 

Whether the exception for qualifying venture capital funds is flexible enough for a bona fide venture capital fund is a different story. But unless you live in Manhattan or Merchantville, assume that your SPV can have only 100 security holders.

Questions? Let me know. 

Escrow account crowdfunding portals

By Itself, An Escrow Account Won’t Stop Sponsors From Stealing Investor Money

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Real Estate, Portals, Real EstateLeave a comment

As reported everywhere, CrowdStreet investors recently suffered very large losses when a sponsor apparently absconded with their money. It’s a very bad thing, not only for those investors but for the real estate crowdfunding industry. You’d almost think this were crypto! 

In the aftermath, many have called for crowdfunding sites to use escrow accounts. My point today is that escrow accounts by themselves aren’t enough.

CrowdStreet hosts offerings under Rule 506(c), where escrow accounts aren’t required. On the other side of the street, in the Reg CF world, funding portals must use an escrow agent. Rule 303(e) even specifies who can serve as the escrow agent (a broker-dealer, a bank, or a credit union) and directs which instructions the funding portal is required to give to the escrow agent under what circumstances. If and when the issuer reaches its target amount the funding portal must instruct the escrow agent to release the funds to the issuer, while if the investor cancels his, her, or its investment commitment or the offering is terminated, the funding portal must instruct the escrow agent to return the funds to the investor.

Now let’s assume exactly such an arrangement had been in place for the doomed offering on CrowdStreet.

The offering would have stipulated a “target amount” of $63 million, with the money held securely in escrow. With the target amount raised, CrowdStreet would have given the escrow agent instructions to release the money to the sponsor, following the regulations to the letter. And the sponsor would have stolen it.

By itself the escrow account wouldn’t have prevented the theft. Extrapolating to Reg CF, the escrow accounts used by funding portals do not prevent theft. They just make the unscrupulous sponsor wait until reaching the target amount to steal the money.

To prevent the theft you have to layer something on top of the escrow agent. In the CrowdStreet offering you could have prevented the theft by wiring the money not to the sponsor but to the title company conducting the closing, with instructions that it would be used only to acquire the property. In a typical Reg CF offering, where the money is being used by the issuer for marketing or other general business purposes, it’s much harder.

This is another reason why the “bad actor” rules are odd. They catch people who have violated the securities laws but not people who have robbed strangers at gunpoint. 

Questions? Let me know. 

Reinvigorate American Capitalism Through Crowdfunding

Reinvigorate American Capitalism Through Crowdfunding

On By crowdfundattnyIn PodcastsLeave a comment

In this episode, we dive into the world of crowdfunding and see how it can reinvigorate American Capitalism with our special guest Mark Roderick. Crowdfunding is an exciting and transformative concept that simplifies capital formation through the Internet. Mark, a corporate lawyer with extensive experience in helping entrepreneurs raise capital, shares his insights on how crowdfunding has the potential to revolutionize investment opportunities.

With the internet expanding opportunities in raising capital, similar to how it revolutionized the retail and dating industries, Mark explains how crowdfunding can connect entrepreneurs with investors in unprecedented ways. Specifically, he delves into the Jobs Act of 2012, which created different types of crowdfunding, including the highly successful Rule 506 C that allowed real estate professionals to advertise and raise billions of dollars. With Mark’s guidance, we also explore the three essential documents in real estate deals that are vital for legality and protection against potential challenges. Join us for this enlightening episode as we uncover the power and potential of crowdfunding with the knowledgeable and experienced Mark Roderick.

Key Points from This Episode:

  • Crowdfunding has the potential to revolutionize real estate investment opportunities.
  • The Internet greatly expands opportunities for raising capital and connecting with investors, similar to how it has revolutionized retail and other industries.
  • Mark has extensive experience in helping entrepreneurs and real estate professionals raise capital.
  • Mark is knowledgeable and experienced in navigating the complexities of crowdfunding laws and helping real estate professionals comply with new regulations.
  • The Jobs Act of 2012 created three types of crowdfunding, including the most successful one, which was a change in the previous rule that prohibited the advertising of real estate syndications.
  • Rule 506 C allows for advertising and requires verification of accreditation for investors.
  • This change enabled real estate professionals to raise billions of dollars of capital, making it a spectacularly successful source of funding.
  • As a corporate lawyer, Mark can provide legally sound and easily understandable documents to ensure compliance and avoid legal troubles in the crowdfunding process.
  • While Mark can assist with legal aspects, he is not able to directly help with raising funds. Established real estate crowdfunding sites like RealCrowd or CrowdStreet may be a viable option for experienced individuals to access an existing investor base.
  • For those starting out, crowdfunding requires active digital marketing efforts. Simply creating a website is not enough to attract investors; it is a marketing business that requires proactive efforts to generate interest and secure investments.
  • Three essential documents in real estate deals – the subscription agreement, limited liability company agreement, and the disclosure document (PPM) – play a vital role in keeping the process legal and protecting against potential legal challenges.
  • Crowdfunding thrives in spaces where limited information is available and can make deals more efficient and known to a broader audience.
  • Crowdfunding is not well-suited for fully efficient markets like single-family home mortgage loans or large-scale development projects where most major investors have access to in-depth information about the deal.


About Mark Roderick

Since the JOBS Act of 2012, Mark Roderick has spent all of his time in the Crowdfunding space, and today he is one of the leading Crowdfunding and Fintech lawyers in the United States. He writes a widely-read blog, which offers a wealth of legal and practical information for portals and issuers. He also speaks at Crowdfunding events across the country and represents industry participants across the country and around the world.

Series A Preferred Stock

Owning Securities Won’t Make Your Funding Portal An Investment Company

On By crowdfundattnyIn Crowdfunding Portals, FINRA, PortalsLeave a comment

Funding portals are allowed to receive part of their compensation in securities of the issuer, as long as the securities are of the same class being offered to investors. For example, if an issuer raises $2M selling Series A Preferred Stock and the funding portal charges a 7% commission, it may take all or any part of the $140,000 as Series A Preferred Stock rather than cash.

Before long, the value of these securities might exceed the value of the funding portal’s business. Inquiring minds would wonder whether owning all those securities will turn the funding portal into an “investment company” within the meaning of the Investment Company Act of 1940.

It’s a good question, but fortunately the answer is No. Section 3(c)(2) of the Investment Company Act provides an exception for:

Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, acting as broker, and acting as market intermediary, or any one or more of such activities, whose gross income normally is derived principally from such business and related activities.

Funding portals are engaged in the business of distributing securities issued by other persons (issuers) and should therefore fall within that description.

Two related issues.

Effect of Upstream Distribution: The owners of the funding portal would like to protect the pool of securities from the potential liabilities of the funding portal business (e.g., if the portal has been using a series LLC as a crowdfunding vehicle). Their first thought might be to distribute the securities upstream to the parent company and then put them into a new, wholly-owned subsidiary. But be careful. The new subsidiary might cause the parent to be treated as an investment company.

Effect on Option Pool:  Suppose the funding portal continues to own the securities, either directly or in a wholly-owned subsidiary. On one hand, the potential value of the securities would be attractive to employees and others holding options in the funding portal. On the other hand, the fair-market-value rules of section 409A of the tax code would require the funding portal to place a value on the securities frequently and, as the value of the securities climbs in relation to the value of the funding portal’s business, the value of the options would be less and less correlated with the success of the business, defeating the purpose.

Questions? Let me know. 

audience asking questions by raising hands

The Series LLC And Crowdfunding Vehicle: A Legal Explanation And A Funding Portal WSP

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Vehicles, Series LLCLeave a comment

Lots of people have asked for a legal explanation in response to my previous post about crowdfunding vehicles and the series LLC. Plus, many funding portals will want a Written Supervisory Procedure (WSP) addressing the issue.

Here’s the legal reason why a “series” of a limited liability company can’t serve as a crowdfunding vehicle.

Rule 3a-9(b)(1) (17 CFR §270.3a-9(b)(2)) defines “crowdfunding vehicle” as follows:

Crowdfunding vehicle means an issuer formed by or on behalf of a crowdfunding issuer for the purpose of conducting an offering under section 4(a)(6) of the Securities Act as a co-issuer with the crowdfunding issuer, which offering is controlled by the crowdfunding issuer.

You see the reference to the crowdfunding vehicle as an “issuer” and a “co-issuer.”

Now here’s a C&DI (Compliance & Disclosure Interpretation) issued by the SEC in 2009:

Question 104.01

Question: When a statutory trust registers the offer and sale of beneficial units in multiple series, or a limited partnership registers the offer and sale of limited partnership interests in multiple series, on a single registration statement, should each series be treated as a separate registrant?

Answer: No. Even though a series of beneficial units or limited partnership interests may represent interests in a separate or discrete set of assets – and not in the statutory trust or limited partnership as a whole – unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.

Note the conclusion:  “. . . .unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.”

A “series” of a limited liability company is not a separate legal entity. Under section 218 of the Delaware Limited Liability Company Act and corresponding provisions of the LLC laws of other states, if you keep accurate records then the assets of one series aren’t subject to the liabilities of another series. That makes a series like a separate entity, at least in one respect, but it doesn’t make the series a separate legal entity. A motorcycle is like a car in some respects but it’s not a car.

That’s the beginning and end of the story:  a crowdfunding vehicle must be an “issuer”; a series of a limited liability company can’t be an “issuer” because it’s not a separate legal entity; therefore a series of a limited liability company can’t be a crowdfunding vehicle.

Maybe someone will challenge the application of the C&DI in court. Until that happens the result is pretty clear.

A couple more things.

First, this same C&DI is the basis of many successful offerings under Regulation A. Suppose, for example, that you’d like to use Regulation A to raise money for real estate projects (or racehorses, or vintage cars, or anything else), but you don’t want to spend the time and money to conduct a Regulation A offering for each project. This same C&DI allows sponsors to treat the “parent” limited liability company as the only “issuer” in the Regulation A offering even while allowing investors to choose which project they’d like to invest in and segregating the projects in separate “series” for liability purposes. If each series were a separate issuer that wouldn’t work.

Second, suppose a funding portal creates a new series for each offering and has conducted 25 offerings (that is, 25 series for 25 crowdfunding vehicles), each with a different type of security (one for each offering). Because we know that only the “parent” can be an issuer:

  • They’ve violated Rule 3a-9(a)(3) because the parent has issued more than one class of securities; and
  • They’ve violated Rule 3a-9(a)(6) because there is no one-to-one correspondence between the securities of the parent and the securities of the crowdfunding issuer.

To quote Simon & Garfunkel, any way you look at this you lose.

If you’re a funding portal, you’ll probably be asked by FINRA to add a WSP dealing with crowdfunding vehicles. Here’s an example.

Questions? Let me know.