Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

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

What eBAY Tells Us About Secondary Markets For Private Companies

The securities of private companies are illiquid, meaning they’re hard to sell.

Since 2017 I’d guess a billion dollars and a million person-hours have been spent by those who believe blockchain technology will create liquidity for private securities. Joining that chorus, a recent post on LinkedIn first noted that trillions of dollars are locked up in private securities, then claimed that blockchain technology (specifically, the technology created by the company posting) could unlock all that value.

This is all wrong, in my always-humble opinion. All that money and all those person-hours are more or less wasted.

My crystal ball is no clearer than anyone else’s. But when I try to believe that blockchain will create active secondary markets I run up against two facts:

  • Fact #1: Secondary markets for private securities have been perfectly legal in this country for a long time, yet there are very few of them.
  • Fact #2: The New York Stock Exchange and other exchanges around the world were vibrant even when they were using little slips of paper.

Those two things tell me that it’s not the technology that creates an active secondary market and hence that blockchain won’t change much.

An active secondary market is created when there are lots of buyers and lots of sellers, especially buyers. When millions of people wanted to buy Polaroid in the 1960s they didn’t care whether Polaroid used pieces of paper or stone tablets. Conversely, put the stock of a pink sheet company on a blockchain and you won’t increase the volume.

As described more fully here, there are a bunch of reasons why there aren’t lots of potential buyers for a typical private company:

  • It probably has a very limited business, possibly only one product or even one asset.
  • It probably has limited access to capital.
  • It probably lacks professional management.
  • Investors probably have limited voting rights.
  • There are probably no independent directors.
  • Its business probably depends on one or two people who could die or start acting like Elon Musk.
  • Insiders can probably do what they want, including paying themselves unlimited compensation.
  • No stock exchange is imposing rules to protect investors.

All that seems obvious now and was obvious in 2017. But now I’m thinking of another company with lessons about secondary markets: eBay.

If there’s anything even less liquid than stock in a private company, it’s a used refrigerator, a bracelet you inherited from your grandmother, the clock you haven’t used for 15 years.

All those things and thousands more were once completely illiquid and therefore worth nothing. eBay changed that, almost miraculously adding dollars to everyone’s personal balance sheet. Just as every ATS operating today seeks to create an active market for securities, eBay created a market for refrigerators, bracelets, and clocks. Quite amazing when you think about it.

eBay didn’t create the market by turning refrigerators, bracelets, and clocks into NFTs. To the contrary, when you sell something on eBay you have to ship it, physically, using the lowest of low technology. eBay created the secondary market simply by connecting buyers and sellers using Web2. Just like another company that has created a pretty active market, Amazon.

If any ATS operating today had a thousandth of the registered users eBay has, its founders and investors would be even rubbing their hands with glee.

As a Crowdfunding advocate, I wonder what the world would look like if all those dollars and person-hours had been spent improving the experience of initial investors rather than pursuing secondary markets and blockchain, things dreams are made of. As the shine comes off blockchain maybe we’ll find out.

Questions? Let me know

Title III Crowdfunding

When Should A Crowdfunding SAFE Or Convertible Note Convert?

Convertible notes and SAFEs often make sense for startups because they don’t require anyone to know the value of the company. Instead, the company and early investors can piggyback on a later investment when the value of the company might be easier to determine and the size of the investment justifies figuring it out.

Which raises the question, when should the convertible note or SAFE convert?

In the Silicon Valley ecosystem that’s an easy question. Per the Y Combinator forms, a convertible note or SAFE converts at the next sale of preferred stock, which necessarily involves a valuation of the company.

That works in the Silicon Valley ecosystem because (i) in the Silicon Valley ecosystem investors always get preferred stock, and (ii) the Silicon Valley ecosystem is largely an old boy network where founders and investors know and trust one another.

As I’ve said before, the Crowdfunding ecosystem is different. There are at least two reasons why the Y Combinator form doesn’t work here:

  • For a company that raises money with a SAFE in a Rule 506(c) or Reg CF offering, the next step might be selling common stock (not preferred stock) in a Regulation A offering. The SAFE has to convert.
  • Say I’ve raised $250K in a SAFE and think my company is worth $5M. If I’m clever, or from Houston*, I might arrange to sell $10,000 of stock to a friend at a $10M valuation, causing the SAFEs to convert at half their actual value. All my investors are strangers so I don’t care.

Which brings us back to the original question, what’s the right trigger for conversion?

Half the answer is that it should convert whether the company sells common stock or preferred stock. 

Now suppose that I’ve raised $250K in a SAFE round. The conversion shouldn’t happen when I raise $10,000 because that doesn’t achieve what we’re trying to achieve, a round big enough that we can rely on the value negotiated between the investors and the founder. What about $100,000? What about $1M?

In my opinion, the conversion shouldn’t be triggered by a dollar amount, which could vary from company to company. Instead, it should be triggered based on the amount of stock sold relative to the amount outstanding. So, for example:

“Next Equity Financing” means the next sale (or series of related sales) by the Company of its Equity Securities following the date of issuance of this SAFE where (i) the Equity Securities are sold for a fixed price (although the price might vary from purchaser to purchaser), and (ii) the aggregate Equity Securities issued represent at least ten percent (10%) of the Company’s total Equity Securities based on the Fully Diluted Capitalization at the time of issuance.

You might think 10% is too high or too low, but something in that vicinity.

Finally, the conversion should be automatic. Republic sells a SAFE where the company decides whether to convert, no matter how much money is raised. In my opinion that’s awful, one of the things like artificially low minimums that makes the Reg CF ecosystem look bad. You buy a SAFE and the company raises $5M in a priced round. The company becomes profitable and starts paying dividends. You get nothing. You lie awake staring at your SAFE in the moonlight.

*Go Phils!

Questions? Let me know.

Crowdfunding web portal

Updated Crowdfunding Cheat Sheet

I first posted this Crowdfunding Cheat Sheet in January of 2014. Since then the rules have continued to change and improve. So here’s the current version, up to date with all the new rules and also expanded to answer questions my clients ask. For example, I’ve added a column for Regulation S because many clients want to raise money from overseas while simultaneously raising money here in the U.S.

I hope this helps, especially those new to the world of Crowdfunding.

CLICK HERE TO VIEW THE UPDATED CROWDFUNDING CHEAT SHEET

Questions? Let me know.

Kim Kardashian Fined For Promoting Crypto Without Disclosure

I was disappointed to learn that Kim Kardashian doesn’t read my blog posts, at least not all of them. With her hectic lifestyle she probably misses out on a lot of other fun stuff as well. Had Kim read my blog post on May 2, 2018 she would have known about section 17(b) of the Securities Act of 1933:

It shall be unlawful for any person. . . . to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof [italics added].

Kim was paid $250,000 to promote EMAX tokens to her 330 million Instagram followers. “ARE YOU GUYS INTO CRYPTO????” she wrote, including a link to Ethereum Max’s website. Whoops! By failing to disclose her compensation she violated section 17(b) and will now pay a $1.26 million fine to the SEC.

Sometimes it’s tempting to think of the SEC as all-powerful. In reality the SEC is a tiny agency compared with the size of the markets it regulates. Faced with a chronic shortage of resources, the SEC picks and chooses the cases to enforce, looking for easy cases with maximum visibility. Well, they couldn’t have asked for a better one. As of today another 330 million people know about section 17(b), almost doubling the number who knew from this blog.

Matt Damon, looking for a lawyer?

Questions? Let me know.

New Podcast – In-Depth Commercial Real Estate

In this episode Paul speaks to Crowdfunding attorney Mark Roderick about Crowdfunding in real estate. They go in-depth how the JOBS act that created crowdfunding changed funding portals, advertising, and where the future of raising capital is and what sponsors should focus on and be careful with.

In-Depth Commercial Real Estate

In-Depth Commercial Real Estate is an exploration of the people, ideas, strategies, and methods behind commercial real estate. In each episode, we’ll talk to an expert about a particular topic: from CMBS and cap. rates to innovation and hiring strategies, and everything in between.

Disclaimer: This real estate podcast is for informational and educational purposes only and does not imply suitability. The views and opinions expressed by the presenters are their own. The information is not intended as investment advice.For any inquiries or comments, you can reach us as info@indepthrealestate.com.

Questions? Let me know.

New Year and a New Law Firm

For all its warts and disappointments, 2019 was a record-breaking year for the Crowdfunding industry, promising even better things to come.

I wish for everyone — readers, friends, colleagues, clients, even casual hookups — a terrific New Year filled with self-awareness, peace, close, meaningful personal relationships, financial success, and a sense of having made the world better than we found it.

I’ll also take the opportunity to announce that effective tomorrow, January 1st, I and a group of selected lawyers from this firm and others are forming a new law firm, Lex Nova Law LLC.

The new firm will allow me to expand my practice in Crowdfunding, Fintech, and digital assets, with an even greater focus on aligning my legal practice with the way my clients run their businesses. More generally, Lex Nova Law will focus on the needs of entrepreneurs and their businesses, always the engine of the American economy. We will be guided by our motto: character matters.

My contact information:

Mark Roderick
Lex Nova Law LLC
1810 Chapel Avenue West, Suite 200
Cherry Hill, NJ 08002
t:(856) 382-8402
e: mroderick@lexnovalaw.com

Connect with me on LinkedIn

As always, thank you for reading.

Making Money in Multifamily Real Estate Podcast

Making Money in Multifamily Real Estate Podcast-logoCLICK HERE TO LISTEN

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 

2019-10-22_10-03-37CLICK HERE TO LISTEN

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.