Rules are always changing in the crowdfunding space. Make sure that it is the best way for you to raise private capital by understanding the mechanics of this process. In this episode, let one of the leading Crowdfunding and FinTech attorneys, Mark Roderick, get you up to speed with the new laws and technology, and how the internet has disrupted this industry. Mark also talks about three flavors of Equity Crowdfunding and the rules for each type. Get an investor’s point-of-view and determine factors that dictate how much money you need to raise.
Technology has made it easier to raise capital for real estate deals. Since Crowdfunding has grown exponentially, John Casmon, host of the popular Target Market Insights podcast, invited me on his show to learn more about crowdfunding and fintech (financial technology). On this episode, I talk about different ways to use the internet to raise money and the impact new technologies will have on the way we buy real estate.
Key Market Insights
Crowdfunding is raising money on the internet
Two versions – donation based (think Kickstarter) and equity based
Crowdfunding is online syndication with 3 flavors: title 2, title 3 and title 4
All crowdfunding falls under the JobsAct
Title 2 is very similar to 506c for accredited investors
Title 3 is very different, can only raise $1MM annually
Title 4 can raise $50 million
FinTech – any technology disrupting the financial services industry
Many believe banks should be a disintermediary
Roboadvisor apps are apart of FinTech
Online syndication is not more risky than traditional syndication
Anytime you take money, you can be sued
When done properly, you should not be exposed to any actual liability – even if they lose money
Blockchain technology could disrupt the real estate industry
Blockchain is a database or ledger that cannot be changed and has no central authority – everyone must consent
Title companies and other “middle men” could be pushed away through blockchain
If you’re a entrepreneur, you’re probably looking for some way to raise capital. You probably have heard of crowdfunding, but you may not have heard of the Jobs Act of 2012 and how it relates to crowdfunding – which is significant because its potential is enormous. Besides Regulation A+, Reg. CF, and Title II crowdfunding options to name a few, now investors and issuers can take advantage of the “tokenization” of assets via Security Token Offerings based on blockchain technology. However, there are complicated rules associated with all aspects of crowdfunding, which is why it’s so important to have legal representation throughout all phases of the process.
In this podcast episode, we interviewed crowdfunding attorney Mark Roderick from Flaster Greenberg PC who gave us many insights on crowdfunding in general, plus his take on tokenization and what security tokens can actually do for issuers and investors alike. Forget what everyone says about raising money. As stated on the podcast, crowdfunding is a marketing business, but it’s smart to have legal counsel at all times too – which is why anyone thinking of getting involved with crowdfunding on any level would be wise to contact Mr. Roderick and read his crowdfunding blog where you can find hundreds of posts with excellent information dedicated to legal crowdfunding success. See that? Sometimes lawyers can be your friend!
And speaking of crowdfunding, according to Mark, about 90% of the Reg.A+ crowdfunding deals he’s seen is regarding real estate. You know what most of the Reg.CF deals are? (here’s a hint).
Cryptocurrencies are hot. And often the sale of cryptocurrencies is referred to as Crowdfunding. Unfortunately, the use of “cryptocurrencies” and “Crowdfunding” together creates confusion about both, along with some pretty serious legal risks.
We use “Crowdfunding” to mean raising money for a business or other venture online. We say “donation-based Crowdfunding” when we’re talking about Kickstarter, where people ask for donations. We say “equity-based Crowdfunding” when we’re talking about raising money from investors, who receive a stock certificate or some other security.
A cryptocurrency is, well, hard to pin down. It’s a transaction registered in a distributed, secure database. Because it exists in limited quantities and is secure, it has value. Like anything of value, it can be used as a currency. For purposes of this post, the key feature of a true cryptocurrency is that is has value of itself, like a nugget of gold.
You use Crowdfunding to sell shares of stock. Obviously, the paper certificates representing the shares of stock have no value by themselves, they have value only to evidence ownership in the business that issued the certificates or, more exactly, in the cash flow the business is expected to generate. So it wouldn’t make sense to say “I’m selling nuggets of gold using Crowdfunding.” The nuggets of gold have an intrinsic value without reference to the cash flow of anything else, or at least you hope they do. I can go shopping with a cryptocurrency like Bitcoin or Ethereum, just as I can shop with US dollars or, historically, with gold.
This is where things get tricky and words matter. The blockchain – the technology underlying all cryptocurrencies – can be used for a lot of things other than cryptocurrencies. As it happens, one of the things the blockchain can be used for is to keep track of stock certificates. In fact, the blockchain works so well keeping track of stock certificates that it will undoubtedly be used by (or replace) all public stock transfer agents within the next five years.
What’s happening today is that companies are selling what they call “cryptocurrencies” that are really just interests in the future operations of a business, i.e., really just hi-tech stock certificates. Cool, they’re using blockchain technology to keep track of who owns the company! But that doesn’t mean what you’re buying is really a cryptocurrency and that you’re going to get rich like the early buyers of Ethereum.
Words are powerful, and the confusion around cryptocurrencies is deepened by the nomenclature. Sales of cryptocurrencies are often referred to as “initial coin offerings,” or ICOs, which implies a similarity to “initial public offerings,” or IPOs. Yet if we’re being careful, the two have nothing in common. In an IPO a company sells its own securities, which have value only based on the success of the company. In an ICO somebody sells a product that has intrinsic value of itself.
Ignoring the difference is going to land someone in hot water, probably sooner rather than later. A company that sells something it calls a cryptocurrency but is really just a share of stock is selling a security, even if that company has an address near Palo Alto. And a company that sells a security is subject to all those pesky laws from the 1930s. If you sell a cryptocurrency that is really just a hi-tech stock certificate, then not only do you risk penalties from the SEC and state securities regulators, you’ll also face lawsuits from your investors if things don’t go as planned.
How to know whether you’re selling a true cryptocurrency or a hi-tech stock certificate? Here are some tips:
If the value of the cryptocurrency depends on the success of the business, it’s a security.
If the value of the cryptocurrency depends on, or is backed by, real estate or other property, it’s a security.
If the cryptocurrency is marketed as an investment, it’s probably a security.
If the value of the cryptocurrency depends what the buyer does with it, rather than the success of the business, it’s probably not a security.
If the cryptocurrency merely gives the holder the right to participate in a group effort (g., the development of software), it’s probably not a security.
If you’re selling the cryptocurrency in lieu of issuing stock, it’s probably a security.
A couple weeks ago, Howard Marks of StartEngine and I presented a webinar about Regulation A. Listeners asked far more questions than we were able to answer in the time given, and I promised to post their questions and answers on the blog. Here goes.
What’s the difference between Regulation A and Regulation A+?
There is no difference. Regulation A has been around for a long time, but was rarely used primarily because issuers could raise only $5 million and were required to register with every state where they offered securities. Title IV of the JOBS Act required the SEC to create a new and improved version of Regulation A, and the new and improved version is sometimes referred to colloquially as Regulation A+. But it’s the same thing legally as Regulation A.
Can I use Regulation A to raise money from non-U.S. investors?
Definitely. Non-U.S. investors may participate in all three flavors of Crowdfunding: Title II, Title III, and Title IV (Regulation A).
But don’t forget, the U.S. isn’t the only country with securities laws. If you raise money from a German citizen, Germany wants you to comply with its laws.
Can non-U.S. companies use Regulation A?
Only companies organized in the U.S. or Canada and having their principal place of business in the U.S. or Canada may use Regulation A.
What about a company with headquarters in the U.S. but manufacturing facilities elsewhere?
That’s fine. What matters is that the issuer’s officers, partners, or managers primarily direct, control and coordinate the issuer’s activities from the U.S (or Canada).
Is Regulation A applicable to use for equity or debt for a real estate development project?
I believe that real estate will play the same dominant role in Regulation A that it plays in Title II. I also believe that real estate development will be more difficult to sell than stable, cash-flowing projects simply because of the different risk profile.
Is there any limit on the amount an accredited investor can invest?
No. An accredited investor may invest an unlimited amount in both Tier 1 and Tier 2 offerings under Regulation A. A non-accredited investor may invest an unlimited amount in Tier 1 offerings, but may invest no more than 10% of her income or 10% of her net worth, whichever is greater, in each Tier 2 offering.
What kinds of securities can be sold using Regulation A?
All kinds: equity, debt, convertible debt, common stock, preferred stock, etc.
But you cannot sell “asset-backed securities” using Regulation A, as that term is defined in SEC Regulation AB. The classic “asset-backed security” is where a hedge fund purchases $1 billion of credit card debt from the credit card issuer, breaks the debt into “tranches” based on credit rating and other factors, and securitizes the tranches to investors. However, the SEC views the term more broadly.
Can I combine a Regulation A offering with other offerings?
In general yes. For example, there’s no problem if an issuer raises money using Rule 506 (Rule 506(b) or Rule 506(c)) while it prepares its Regulation A offering. The legal issues become more cloudy if an issuer wants to combine multiple types of offerings simultaneously. Theoretically just about anything is possible.
Can the same platform list securities under both Regulation A and Title II?
Yes. In fact, the same platform can list securities under all three flavors of Crowdfunding: Title II, Title III, and Title IV. But on that platform, only licensed “Funding Portals” can offer Title III securities.
Does a platform offering securing under Regulation A have to be a broker-dealer?
The simple answer is No. But a platform that crosses the line into acting like a broker-dealer, or is compensated with commissions or other “transaction based compensation,” would have to register as a broker-dealer or become affiliated with a broker-dealer.
Can a non-profit organization use Regulation A?
Regulation A is one exception to the general rule that all offerings of securities must be registered with the SEC under section 5 of the Securities Act of 1933. Non-profit organizations are allowed to sell securities without registration under a different exception. So the answer is that non-profits don’t have to use Regulation A.
With that said, I represent non-profit organizations that have created for-profit subsidiaries that plan to engage in Regulation A offerings. For example, a non-profit in the business of urban development might create a subsidiary to develop an urban in-fill project, raising money partly from grants and partly from Regulation A.
Can I use Regulation A to create a fund?
If by “fund” you mean a pool of assets, like a pool of 30 multi-family apartment communities, then Yes. You can either buy the apartment communities first and then raise the money, or raise the money first and then deploy it in your discretion. If you want to own each apartment community in a separate limited liability company subsidiary, that’s okay also.
If by “fund” you mean a pool of investments, like a pool of 30 minority interests in limited liability companies that themselves own multi-family apartment communities, then No. Your “fund” would be treated as an “investment company” under the Investment Company Act of 1940, and Regulation A may not be used to raise money for investment companies.
Can a fund be established for craft beverages?
Same idea. You could use Regulation A to raise money for a brewery that will develop multiple craft beverages. You cannot use Regulation A to buy minority interests in multiple craft beverage companies.
For a brand new company, can the audited financial statements required by Tier 2 be dated as of the date of formation, and just show zeroes?
Yes, as long as the date of formation is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date.
How does the $50 million annual limit apply if I have more than one project?
The $20 million annual limit under Tier 1, and the $50 million limit under Tier 2, are per-issuer limits. A developer with, say, three office building projects, each requiring $50 million of equity, can use Regulation A for all three at the same time.
NOTE: This is different than Title III, where the $1 million annual limit applies to all issuers under common control.
What does “testing the waters” mean?
It means that before your Regulation A offering is approved (“qualified”) by the SEC, and even before you start preparing all the legal documents, you can advertise the offering and accept non-binding commitments from prospective investors. If you don’t find enough interest, you can save yourself the trouble and cost of going through with the offering.
NOTE: Any materials you use for “testing the waters” must be submitted to the SEC, if the offering proceeds.
Where can Regulation A securities be traded?
Theoretically, Regulation A securities could be registered with the SEC under the Exchange Act and traded on a national market. But I’m sure that’s not what the listener meant. Without being registered under the Exchange Act, a Regulation A security may be traded on the over-the-counter market, sponsored by a broker-dealer.
This sounds expensive! Can you give us an estimate?
Very few retail investors have the skill to pick a great deal from a mediocre deal. I know I don’t, and I’ve been representing real estate developers and entrepreneurs my whole career.
Taking a cue from the public stock market, one way to address the retail market is to create the equivalent of a mutual fund for Crowdfunding investments. You would create a limited liability company to act as the fund, raise money from investors using Crowdfunding, and the manager would select investments from Crowdfunding portals.
Great idea conceptually, but it doesn’t work legally:
The LLC would, by definition, be an “investment company” under the Investment Company Act of 1940. As such, you would be prohibited from using Title III or Title IV to raise money for the fund.
You could use Title II to raise money for the fund, but as an investment company the fund would be subject to extremely onerous and costly regulation, e., the same regulation that applies to mutual funds. To avoid the regulation, you would have to limit the fund to either (1) no more than 100 accredited investors, or (2) only investors with at least $5 million of investments. In either case, you defeat the purpose.
But there is another way! A licensed investment adviser could offer investment advice with respect to investments in Crowdfunding projects and, for that matter, make the investments on behalf of his or her retail customers, charging an annual fee based on the amount invested. The adviser would allow each retail investor to effectively create his or her own “mutual fund” of projects based on individual preferences.
Not only would the investment adviser make money, the availability of unbiased advice would draw retail investors into the space – a win for the industry.
The SEC just provided guidance for Title III issuers in the form of Compliance and Disclosure Interpretations. You can read the CD&I’s themselves here.
Before filing Form C (the disclosure document used in Title III) and being listed on a Funding Portal, a Title III issuer may not take any action that would “condition the public mind or arouse public interest in the issuer or in its securities.” That means:
No Demo Days
No email blasts or social media posts about the offering
No meetings with possible investors
Once a Title III issuer has filed Form C and been listed on a Funding Portal, any advertising that includes the “terms of the offering” is subject to the “tombstone” limits of Rule 204. The “terms of the offering” include the amount of securities offered, the nature of the securities, the price of the securities, and the closing date of the offering period.
Advertising that does not include the “terms of the offering” is not subject to Rule 204. Theoretically, for example, an issuer could attend a Demo Day after filing its Form C, as long as it didn’t mention (1) how much money it’s trying to raise, (2) what kind of securities it’s offering, (3) the price of the securities, or (4) the closing date of its offering.
Have you ever been to a Demo Day? It’s hard to imagine someone wouldn’t ask “How much money are you trying to raise?” or that the company representative wouldn’t answer. Theoretically possible, yes, but in practice highly unlikely.
Even the statements “We’re selling stock” or “We’re issuing debt” are “terms of the offering” and therefore cross the line.
There’s an interesting difference between the regulations themselves and the CD&Is. The regulations say “terms of the offering” means the items mentioned. The CD&Is, on the other hand, say “terms of the offering” include the items mentioned. Thus, if you take the CD&Is literally, maybe “terms of the offering” also include other things, like the start date of the offering.
After filing, a Title III issuer can use video to advertise the “terms of the offering,” as long as the video otherwise complies with Rule 204.
After filing, if a Title III issuer is “directly or indirectly involved in the preparation” of a media article that mentions the “terms of the offering,” then the issuer is responsible if the article violates Rule 204.
EXAMPLE: You attend a Demo Day, and the organizer announces how much money you’re trying to raise. You violated Rule 204.
EXAMPLE: A reporter from your local paper calls. Eager for the free press, you tell her you’re raising $200,000 for a new microbrewery in town, which she repeats in her article. You violated Rule 204.
EXAMPLE: A reporter from your local paper calls. Eager for the free press, but very savvy legally, you tell her about your plans for the microbrewery but carefully avoid telling her how much money you’re raising or any other “terms of the offering.” She goes to the Funding Portal and finds out herself, and reports that you’re raising $200,000. You violated Rule 204.
To be safe, you just can’t be involved, directly or indirectly, with anyone from the press who doesn’t understand Title III and promise, cross her heart and hope to die, not to disclose any “terms of the offering.”
Advertisements on the Funding Portal
Advertising a Title III offering outside the Funding Portal is a minefield. But inside the Funding Portal is a completely different story. Inside the Funding Portal is where everything is supposed to happen in Title III. Focus your attention there, where the minefields are few and far between.
You probably already know that the Americans with Disabilities Act applies to “places of public accommodation,” like hotels and restaurants. What you might not know is that the ADA probably applies to your Crowdfunding website, or will soon.
Courts have held the ADA applies to websites that supply products or services, reasoning that websites, like buildings, can be “places of public accommodation.” For example, Netflix.com and Peapod reportedly settled cases with the Department of Justice, while Home Depot and Target have faced claims relating to website accessibility. On the other hand, websites that are merely informational, like Mark’s blog, are less likely to be required to comply with accessibility standards.
If you’re operating a Crowdfunding portal then everything you do is online, making you a lot more like Netflix than like a blog. That’s particularly true of Title III Funding Portals, where everything has to happen online by law, but it’s probably true for Title II and Title IV portals as well. Therefore, while there have been no rulings or cases, and the law around the ADA and websites remains unsettled, we can feel pretty confident that the ADA or its state-law equivalents will apply.
How can you get on the right side of the law? The industry has developed a set of standards known as WCAG 2.0 – Web Content Accessibility Guidelines, which include a set of recommendations to make website coding changes with accessibility in mind. WCAG2.0 is an industry standard for non-governmental entities and, most importantly, it is the standard the Department of Justice has used as a measuring stick in the cases brought to date. WCAG2.0 actually has three tiers of accessibility standards but, until the Department of Justice issues new rules or the courts produce clearer rulings, it’s not clear which tier will apply to Crowdfunding portals.