A Legal Structure for Crowdfunding

It’s official:  Crowdfunding is now in effect and thousands of companies are about to start raising money under the new SEC regulations. If each company offers different deal terms for investors, it’s going to be that much more difficult for investors to make apples-to-apples investment decisions.

Meanwhile, some in the investment community are still concerned that a company raising money through Crowdfunding will be hobbled in raising more money afterward, e.g., from angel groups or venture capital funds.

The sooner the market adopts a standard investment structure, the better for all.

Here is a legal structure that would standardize the Crowdfunding market, satisfy SEC regulations, and ensure that the Crowdfunding round of financing does not preclude later rounds:

  • New Entity:  Form a new entity for the Crowdfunding investors. We’ll call this entity InvestCo, and we’ll call the operating company itself MyCo. InvestCo will be one owner of MyCo, no matter how many investors buy stock in InvestCo.
  • Structure of InvestCo:  InvestCo will be either a limited liability company or a C corporation, based on tax and state-law considerations. InvestCo will be controlled by the same individuals who control MyCo.
  • Percentage Ownership:  Each investor will own a pro rata share of InvestCo based on his or her investment. InvestCo, in turn, will own a percentage of MyCo stipulated by MyCo in the offering materials, based on the amount of money raised and the value of MyCo. Here is a post with suggestions on establishing this ownership percentage.
  • Voting Rights of Investors:  Investors will not be entitled to vote in InvestCo, and InvestCo will not be entitled to vote in MyCo. That is, the investors in a Crowdfunded offering will have no voting rights, except the right to appoint one member to the Board of Directors of MyCo.
  • Preference on Sale or Liquidation:  If MyCo is sold or liquidated, InvestCo will be entitled to receive a return of its investment before any distributions are made to the other owners of MyCo as they exist today. If MyCo raises more money in the future, the rights of InvestCo could be subordinated to the rights of the new investors.
  • Dividend Right:  InvestCo’s stock in MyCo will bear a dividend rate of 5%.
  • Tag-Along Rights: If the founder of MyCo sells some of his or her stock, InvestCo will have the right to participate in the sale.
  • Anti-Dilution Rights:  InvestCo will be entitled to “weighted average” anti-dilution protection.
  • Right to Information:  Investors will have the right to basic information from MyCo, such as annual financial statements. Of course, state law may give them (and any other owners) the right to additional information.

This structure should be acceptable to all of the constituents of the Crowdfunding market:  the entrepreneurs who started MyCo; the broad investing public that will make Crowdfunding a success; the angel groups that help so many startups succeed and currently anchor the early-stage market; and the venture capital funds that provide additional funds for companies that need and deserve them.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

SEC Proposes Rules to Track Crowdfunded Offerings

Having just allowed the use of advertisements and “general solicitation” to raise money, the SEC now proposes several steps to protect investors and keep track of the explosion in Crowdfunding the new rules are certain to trigger.

Beefing Up Form D

Form D has been around for along time, but now the SEC proposes to beef it up significantly. The company raising money through general solicitation will now have to:

  • File a Form D no later than 15 days before first engaging in general solicitation.
  • File a closing amendment to Form D within 30 days after the offering has been completed or abandoned.
  • Disclose much more information in the Form D, including:
    • Its website address;
    • Specific uses of the proceeds of the offering;
    • The number and types of accredited investors participating in the offering;
    • Whether general solicitation materials were filed with FINRA;
    • The types of general solicitation used or to be used; and
    • Methods used or to be used to verify the accredited investor status of purchasers.

More Legends

The SEC also proposes a number of new legends that must appear in general solicitations, including that the securities can only be sold to accredited investors, that the SEC has not passed on the merits of the offering, that investing entails risk (!), and that past performance does not guaranty future performance.

Sending General Solicitation Material to the SEC

Finally, the SEC proposes that companies must submit their written general solicitation materials to the SEC, on a temporary basis, by no later than the date of first use of the materials. This rule would expire two years after its effective date, presumably giving the SEC enough time to see what is happening in the marketplace and issue a new or different rule as it sees fit.

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Unlike the rules allowing general solicitation, these new rules are merely proposals, and could be revised or withdrawn after a 60 day public comment period.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

SEC: FundersClub, AngelList Not Required To Register As Broker-Dealers

Through “no-action letters” dated March 26, 2013, the Securities and Exchange Commission has just ruled neither FundersClub nor AngelList, both nationally-recognized equity-based Crowdfunding portals, is required to register as a broker dealer under Federal securities law.

But portals are structured as investment advisory services and are registered as investment advisors. When a company is funded by investors, the portals do not receive cash compensation, as a broker would typically receive, but instead receive compensation more customary for a fund advisor: an interest in the future profits of the company – a “carried interest.” The form of the compensation seemed to be the principal factor that convinced the SEC to rule favorably.

Other equity-based portals might register as broker-dealers to avoid the issue altogether. Because both of these coordinated decisions could have gone the other way, however, the larger lesson may be that the SEC is taking a relatively hands-off approach to the rapidly-evolving Crowdfunding industry. If you are a portal or company waiting anxiously for the SEC regulations later this year, that is good news.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.


Many young companies fail for lack of capital. With Crowdfunding making much more capital available, it seems plausible that more young companies will succeed. Even so, the nature of capitalism is that many will fail and investors will lose their money. And unfortunately, with so much money flowing through new channels, the nature of human beings is that Crowdfunding will attract its share of the outright unscrupulous.

You can never protect yourself completely, but here a few tips to reduce the risk.

If you are an Investor:

  • Use common sense. If something seems too good to be true it probably is.
  • A company financed by Crowdfunding is no more likely to be successful than a company financed the old-fashioned way.
  • One of the great things about Crowdfunding is that you get to see a lot of companies. It follows that you can afford to be picky.
  • By all means, register at more than one portal.
  • Don’t invest in a company just because others are investing.
  • Often, it makes sense to invest in industries you already know something about.
  • Make sure you are satisfied with the due diligence.
  • Figure out how much money the business must earn for your investment to be worthwhile, i.e., to earn a profit commensurate with your risk. Do you understand how the business will make that much money? If not, you probably shouldn’t invest.

If you are a Portal:

  • You are going to be swamped with companies looking to raise money. Your greatest risk is that a company you sponsor turns out to be a fraud. Beware:  con men are very good at what they do.
  • Develop strong contracts with companies and investors, making clear exactly what everyone can expect, and what they can’t.
  • Do not allow your portal to infringe upon the rights of third parties.
  • Comply with all laws and in particular the securities laws. When – not if – investors lose money, the chances are very high that you will be sued.
  • Buy insurance.

If you are a Company:

  • You are now using OPM – Other People’s Money. Your expenditure of every nickel may be scrutinized by a plaintiff’s lawyer with the benefit of 20/20 hindsight. Have strong accounting systems in place.
  • Develop strong contracts vis-a-vis investors.
  • Disclose everything about your company up front, especially all the bad news, and otherwise comply with Federal and State securities laws. Your greatest risk, by far, is that you fail to comply with these laws.
  • Make sure your portal is reputable and complies with the law also. If the portal doesn’t comply, you are going to be sued.
  • Try to raise enough money the first time around.
  • Make sure your corporate structure allows you flexibility in the future, including the flexibility to raise more money.
  • Buy insurance.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.


Is My Portal Legal?

As Crowdfunding gains traction, Crowdfunding portals are springing up and marketing themselves aggressively to entrepreneurs and prospective investors.

No, I take that back. Websites are springing up and marketing themselves aggressively to entrepreneurs and prospective investors, but technically there aren’t any “Crowdfunding portals” yet. Crowdfunding portals are a creature of the JOBS Act, and the JOBS Act hasn’t yet come into effect because the Securities and Exchange Commission (SEC) hasn’t yet issued regulations.

If the websites springing up today are not really Crowdfunding portals, then what are they? Are they legal? That matters a lot for entrepreneurs.


The JOBS Act created two kinds of Crowdfunding:

  1. Using one kind of Crowdfunding, companies can raise up to $1 million from in unlimited number of investors through Internet “portals” that would be registered with the SEC and licensed by FINRA.
  2. Using the other kind, companies can use “general solicitation” to raise an unlimited amount of money from “accredited investors” by following Rule 506 issued by the SEC under Regulation D.

But neither kind of Crowdfunding is available yet.

Today, we see websites that combine the concept of a “portal” with a traditional private offering of securities. At these sites, accredited investors sign up to review companies, and companies sign up to raise money from investors. If everything goes right you end up with a happy entrepreneur and a legal Rule 506 offering.

What Could Go Wrong?

By definition, these Internet sites are not Crowdfunding portals and what they do is not JOBS Act Crowdfunding. For the sites to be legal they must satisfy the securities law rules as they existed before the JOBS Act. And it turns out that it’s not easy to mesh the very fast, very public world of the Internet with the rules in place long before the Internet was a twinkle in Al Gore’s eye.

These are a few of the tough issues these sites face:

  • Until the SEC issues Crowdfunding regulations, companies are not allowed to use “general solicitation” to attract investors. But if you visit some of these sites – public to anyone with Internet access – you see the companies listed.
  • If a portal isn’t careful, it might end up with one or more unaccredited investors, disqualifying the whole offering.
  • The sites generally don’t work for free – they are paid by the companies that raise money. In general, only a licensed broker can receive compensation in connection with the sale of securities.
  • Some sites provide “due diligence” on companies, offering to help investors to separate the good from the bad. That kind of service generally requires a license as an investment advisor.
  • State securities regulators can be even more aggressive than the SEC. If an offering violates Federal law then it probably violates state law, too.

Some sites seem more aggressive legally than others. Entrepreneurs should pay attention.

Why Does It Matter to the Entrepreneur?

If a website raises money improperly, the website can find itself in hot water. The operators of the website may be fined, banned from the securities industry (thus missing out on Crowdfunding when the SEC finally issues regulations), even go to jail.

But it’s no picnic for the entrepreneur and his or her company, either. If the portal does something wrong it likely means the company engaged in an unregistered, and therefore illegal, public offering of securities. The entrepreneur can also be fined, banned from the securities industry, or even go to jail. Moreover, the entrepreneur could be forced to give all the money back to the investors.


Raising money has always been hard. The internet and the JOBS Act are making it easier, but in the Wild West version of Crowdfunding we live in today, entrepreneurs have to be picky about their portals.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.