Tag: crowdfunding vehicles

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. 

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. 

Caution: Don't Use Series LLC As A Crowdfunding Vehicle

FINRA: Don’t Use Series LLC As A Crowdfunding Vehicle

On By crowdfundattnyIn Crowdfunding, FINRA, Series LLCLeave a comment

At least one high-volume Crowdfunding portal once used a “series LLC” for each crowdfunding vehicle and used a crowdfunding vehicle for almost every offering. Maybe that portal and others still do.

In a post that has yet to be picked up by the Associated Press, this blog once explained why that was a bad idea from a legal liability point of view. Now FINRA has chimed in.

The Series LLC

Some states, notably Delaware, allow a single limited liability company to be divided into “series,” the way an auditorium could be physically divided into cubicles. If operated correctly, Delaware provides that the creditors of one series can’t get at the assets of another series. So if one series of the LLC operates an asbestos plant and is hit with a giant lawsuit, the plaintiffs can’t get at the assets of the real estate owned by a different series of the same LLC.

Why Not to Use a Series LLC

I argued that it would be foolish to use a series LLC as a crowdfunding vehicle because:

  1. The series LLC concept has never been tested in a bankruptcy court, so we’re still not 100% sure the walls between cubicles will hold up.
  2. Some states, like Arizona, don’t even recognize the series LLC concept. So if an Arizona resident invests in a series LLC that goes bad, she can theoretically get to the assets owned by every other series of the same LLC. When you have a high-volume portal using a new series over and over, that could be a nightmare.
  3. Using a series LLC rather than a brand new LLC saves less than $200.

FINRA Chimes In

According to a recent statement by FINRA, a series LLC would not satisfy 17 CFR §270.3a-9(a)(6), which requires a crowdfunding vehicle to “Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding.”

FINRA is saying, in effect, that while one series of an LLC might be protected from the liabilities of a different series under Delaware law, the series is not itself an “issuer.” The “issuer” is the LLC itself, i.e., the “parent” limited liability company formed by the portal. Because the securities of that parent do not reflect a one-to-one correspondence with the securities of any particular company raising money on the platform, it doesn’t qualify as a crowdfunding vehicle – it’s a plain vanilla investment company. And investments companies aren’t allowed to use Reg CF (they’re also subject to a bunch of other rules).

For what it’s worth, FINRA’s position about who can be an “issuer” is consistent with SEC practice.

The Upshot

If FINRA is right, it probably means that every offering that used a series LLC as a crowdfunding vehicle was illegal. 

Some possible ramifications:

  • Any investor who lost money can sue the issuer and the funding portal, and possibly their principals.
  • Every issuer can sue the funding portal.
  • Funding portals might be sanctioned by FINRA.

In short, a bonanza for plaintiffs’ lawyers and a black eye for the Crowdfunding industry.

Questions? Let me know. 

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

On By crowdfundattnyIn Crowdfunding, Crowdfunding VehiclesLeave a comment

Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.

Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through  successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.

A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.

For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.

But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law. 

A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:

Seek instructions from the holders of its securities with regard to:

  • The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
  • Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.

So let’s think of two scenarios.

In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.

Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.

The first scenario clearly complies with Rule 3a-9. Does the second?

To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.

Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.

When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.

Questions? Let me know.