Every day brings more bad news about ICOs: another class action lawsuit, another subpoena by the SEC, another “request for information” by a state Attorney General, another country that outlawed ICOs altogether.
The bad news is probably hurting the industry’s reputation and driving away investors in the short term. But from my perspective the bad news is, on balance, actually good.
The ICO market was crazy in 2017. Lawyers were giving questionable advice, investors were buying anything called a token, and the billions of dollars sloshing around attracted bad actors and instant-millionaires. People convinced themselves this was normal and justified, as they did with tulip bulbs in 1636.
From my perspective, the bad news in today’s headlines shows that the fog is clearing. Among the lessons learned:
ICOs were not, after all, a law unto themselves.
It’s easier to describe a network than to build one.
Some smart contracts are dumb.
Honesty is still the best policy with investors.
An honest cop is good for the neighborhood.
The laws of economics have not been repealed.
Most important, it turns out that there really is value in blockchain, even without the hype, and that real entrepreneurs are building serious value and finding it easier to connect with investors as the fog clears. Your Uber driver is no longer offering tips on Bitcoin, but you can do a legal ICO, there really is such thing as a utility token, and there are a lot of really smart folks building real companies that are going to disrupt and transform a lot of industries.
We’re going through a much-needed adjustment right now. It’s all good, as we young people say.
We use the term “secondary sales” to refer to sales of securities by anyone other than the issuer, and the term “secondary market” to refer to a marketplace where those sales take place.
Suppose NewCo, LLC, a private (non-public) company, raises money by issuing limited liability company interests under Rule 506(c). One investor, Amanda Sakaguri, later sells her limited liability company interest to a third party. The sale by Ms. Sakaguri is what we refer to as “secondary sale.” If Ms. Sakaguri sold her limited liability company interest on a marketplace – as opposed to a private sale – we call that a “secondary market.”
The Basic Legal Rules for Secondary Sales
All offers of securities must be fully registered with the SEC, under section 5 of the Securities Act of 1933. If there were no exceptions to section 5, Ms. Sakaguri would have to register with the the SEC before selling her limited liability company interest. But of course, this being the securities laws, there are lots of exceptions. For example:
If Ms. Sakaguri bought her limited liability company interest in a Regulation A offering, she could sell it to anyone right away.
If Ms. Sakaguri bought her limited liability company interest in a Regulation CF offering, she could sell it to some buyers right away, and to anyone after one year.
Ms. Sakaguri bought her limited liability company interest under Rule 506(c), so she isn’t eligible for either of those exceptions. For Ms. Sakaguri and other owners of private securities, the most likely potential exception is in section 4(a)(1) of the Securities Act, which exempts “[Sales] by any person other than an issuer, underwriter, or dealer.”
We know Ms. Sakaguri isn’t the issuer. How about a dealer or an underwriter?
A dealer is “[A]ny person engaged in the business of buying and selling securities . . . .for such person’s own account. . . .” but does not include “. . . .a person that buys or sells securities. . . . but not as a part of a regular business.” Provided she isn’t buying and selling securities as a business, Ms. Sakaguri isn’t a dealer.
Whether she’s an underwriter is a harder question, believe it or not. We think of underwriters as big Wall Street firms in gleaming towers, but the definition is much broader than that: “[A]ny person who has purchased from an issuer with a view to. . . .the distribution of any security. . . .” If Ms. Sakaguri expected to sell her limited liability company interest from NewCo when she bought it, she might be an underwriter, ineligible for the exception.
Whether the seller of a security is an underwriter once caused so much confusion that the SEC adopted a long rule on that topic.
Rule 144
Rule 144 provides a “safe harbor” for sellers. If a seller satisfies all the conditions of Rule 144, the seller will definitely not be treated as an underwriter for purposes of section 4(a)(1). If a seller doesn’t satisfy all the conditions, it doesn’t mean she will be treated as an underwriter. It just means she’s taking her chances.
Rule 144 imposes different requirements on sellers depending on whether:
The issuer is a private or a publicly-reporting company;
The seller is an “affiliate” of the issuer (generally meaning under common control); and
How the seller acquired the securities in the first place.
We’re going to focus only on private companies, like NewCo, and situations where the seller acquired her interest directly from the issuer.
If Ms. Sakaguri were an affiliate of NewCo, she would be subject to four requirements:
She would have to provide current information about the issuer, including its name, its business, its CEO and Directors, and two years’ of financial statements.
She would have to hold the securities for at least one year.
She would be limited in the volume of securities she could sell.
She would be limited in the manner in which she sells the securities.
On the other hand, because Ms. Sakaguri isn’t an affiliate of NewCo, but just an ordinary investor, she’s subject to only one requirement: she has must hold her limited liability company in NewCo for at least one year. That means:
She’s not required to provide any information about NewCo to the buyer.
She can sell as much of her limited liability company interest as she wants.
She can sell it to anyone, accredited or non-accredited.
She can sell it in any manner she want, including on a website.
(Remember, Rule 144 is a safe harbor, not a legal rule. If Ms. Sakaguri is a minority investor in a private company and sells her limited liability company interest after four months because she lost her job and needs the cash, nobody thinks she’s an underwriter. At worst, she’d be sentenced to a week of Fox News.)
Where are the Secondary Markets?
There are lots of investors in the same shoes as Ms. Sakaguri: everyone who owns an interest in a real estate limited partnership, or a tech startup, or even a family business. If it’s so easy legally for them to sell their interests, why aren’t there lots of places where they can sell them?
A place – a website, for example – where investors could sell their privately-owned securities would probably be treated as an “exchange” under the Securities Exchange Act of 1934 (“[A]ny organization. . . .which. . . .provides a market place. . . .for bringing together purchasers and sellers of securities. . . .”). Section 5 of the Exchange Act makes it illegal for any exchange to operate unless it is either a registered “national securities exchange” under section 6 of the Exchange Act (like NASDAQ or the NYSE) or exempt from registration under SEC rules. The typical private security couldn’t qualify for listing on a national exchange, so Ms. Sakaguri and others in her shoes would be looking for something else.
Fortunately, that something else exists in the form of an “alternative trading system,” or ATS, authorized by the SEC in 17 CFR 240.3a1-1(a)(2) and defined in 17 CFR 242.300 – 303. Today there are dozens of alternative trading systems operating in the United States for many different purposes, including several operated by OTC Markets, Inc. Any broker-dealer can create an ATS without much difficulty, and for that matter anyone can create a broker-dealer.
All the legal pieces of the puzzle are in place: Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144; and it’s not hard to create an ATS where she can sell it. So why does everyone complain about the lack of liquidity in private securities?
The answer is that the legal pieces of the puzzle turn out not to be the most important. Ms. Sakaguri is allowed to sell her limited liability company interest, but finding someone who wants to buy it is another story. We can create all the legal mechanisms we want, but a secondary market needs lots of buyers and sellers, especially buyers.
Remember, Ms. Sakaguri is allowed to sell her limited liability company interest under Rule 144 without providing any information about NewCo. That’s great, except there aren’t a lot of people willing to buy that limited liability company interest without information about NewCo. Other characteristics of NewCo, if it’s a typical privately-owned company, also make it unattractive:
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.
Sakaguri probably has limited or no voting rights.
There are probably no independent directors.
The insiders of NewCo are probably allowed to pay compensation to themselves more or less free of limits, and have probably protected themselves from just about every kind of legal claim that investors could bring.
When Franklin Roosevelt and Sam Rayburn created the American securities laws in the 1930s, what emerged from all the new regulation was the most efficient, most transparent, most vibrant public capital market in the world. Eighty-five years later, you might say Americans have become spoiled by the safety of buying publicly-traded companies on national exchanges. When Ms. Sakaguri asks them to buy her limited liability company interest in NewCo on an alternative trading system, she’s asking for a lot.
To create a more vibrant secondary market for private securities we need greater standardization, greater protections for investors, and greater transparency. Some of these things the industry can do by itself – for example, by using blockchain technology. Other things will probably require regulation.
To create a vibrant market in automobiles we didn’t adopt laws protecting auto manufacturers. We adopted laws protecting consumers, e.g., lemon laws. My guess is that to create a vibrant secondary market for private securities the law should focus on buyers, not sellers.
What About Tokens?
More companies than I can remember have said they want to convert their limited liability company interests or preferred stock to token form because “There’s a secondary market for tokens.”
From a legal point of view that’s not true. The laws governing secondary sales of securities apply equally to the most boring share of common stock, represented by a paper certificate stored in a battered aluminum filing cabinet, and the most interesting token treated as a security under the Howey test, residing only in the cloud on a public blockchain.
But it is true in two other senses:
The rules I’ve talked about above apply only to tokens that are securities under the Howey test. A token that is a currency and not a security is not subject to those rules. I would also say that a true utility token isn’t subject to the rules, either, except a token being traded is probably a security under the Howey test, i.e., it probably isn’t a true utility token.
The reason there isn’t a vibrant market in private securities isn’t the legal restrictions, but the risk inherent in private securities. The frenzy over anything called a token in the last 12 months has overridden investor fears of private securities. Whether that frenzy will continue is impossible to predict (it won’t).
The same people ask “What about all those crypto exchanges?” There are two answers to that question as well. One, many or all of them have become alternative trading systems controlled by broker-dealers, or are in the process of doing so. Two, many got in trouble. Some are being sued privately, some are being sanctioned by the SEC, and three of the really bad ones had to watch Fox News for a month.
Blockchain technology is revolutionary, promising to disrupt many of today’s industries. In contrast, the cryptocurrencies that live on the blockchain – to avoid confusion, I’m going to refer to cryptocurrencies as “tokens” – are really just high-tech manifestations of traditional ideas.
Broadly speaking, there are three kinds of tokens today:
Tokens like Bitcoin that are intended to function as currencies
Tokens that represent economic interests in businesses, e., securities
Tokens that give the holder some kind of contract right in the business conducted by the issuer, g., a distributed storage network
Tokens that are intended to function as currencies are like, well, they’re like currencies. They’re secure, they’re anonymous (maybe), they’re decentralized, but fundamentally they’re like paper money. The idea of paper money was revolutionary, rendering the barter economy obsolete. A digital representation of paper money is incrementally better, but not revolutionary.
Tokens that are securities – digital stock certificates – are helpful and better than paper or Excel spreadsheets but obviously not revolutionary.
The most interesting kind of tokens are the third: tokens that give the holder the right to participate in a business.
Imagine you’re Henry Ford designing an automobile. You need a lot of capital. Your investment banker suggests you sell stock on Wall Street, but someone else suggests a different approach. You publish design specifications for your new automobile in something you happen to call a “Whitepaper,” and you sell to the public a limited number of licenses giving the holder the right to manufacture tires (or oil filters, or whatever) based on those specifications.
You just sold tokens, even though the blockchain doesn’t exist and you keep track of the sales in a red leather book.
Financially, you’ve pre-sold licensing rights. Some pros and cons versus selling stock:
On the plus side, you still own 100% of your company.
On the minus side, you have reduced or eliminated a future revenue stream for the company, e., licensing revenue.
On the plus side, because the tokens weren’t a security, you didn’t incur all that time and cost.
On the minus side, you really, really care about the quality of your cars – the whole future of your business depends on it – but the tokens might not end up in the hands of the highest-quality suppliers. That’s especially true in a market frenzy that reminds you of Tulip Mania in 1637, where many buyers are low-information speculators.
On the plus side, if raising money by pre-selling licensing rights happens to be a super-cool thing, the token sale might raise a lot more money than the licensing rights are actually worth.
On the minus side, you didn’t get to deal with securities lawyers.
What about the pros and cons to token buyers?
On the minus side, you have far less legal protection, as a buyer and owner of the token, than you would as the buyer and owner of securities in a public company.
On the plus side, your specialized expertise as a parts designer or manufacturer might give you a unique ability to increase the value of Ford, and therefore the value of your token.
On the minus side, while you know a lot about your own abilities, and might know a lot about Henry Ford and his team, you know nothing at all about the other token buyers. If they turn out to be lousy parts designers and manufacturers, you lose.
On the plus side, if you think Ford Motor Company is going to be hugely successful and tokens are the only thing they’re selling, you have no choice.
On the minus side, the token probably gives you the right to benefit from only one aspect of the company’s business, g., parts for the the Model T. If the company pivots or expands, you might find yourself left behind.
On the plus side, if you’re in a Tulip Mania market, maybe you’ll buy the token today and next week you can double your money selling it to someone else.
On the minus side, if we look hard at Ford’s Whitepaper we realize it’s very ambiguous. Do I or Ford really know what I’m getting? Or is this going to end up in litigation?
Who knows where the pros and cons come out. Someday economists will explain whether and in what circumstances a token is more economically efficient than a traditional security.
I feel quite sure that tokens that are currencies and tokens that are digital stock certificates are here to stay, because while not revolutionary, each represents an undeniable, if incremental, improvement over today’s technology. I’m not so sure about tokens that represent prepaid products or services. Until we hear from the economists, the jury is still out.
You own an LLC and want to compensate key contributors with some kind of equity. Do you give them an equity interest in the Company today or an option acquire an equity interest in the future?
Before we get to that question:
Make sure that equity is the right answer for this particular employee. It’s great for key contributors to have a stake in the company, but if this particular employee is your CMO, a cash commission on sales might make more sense because it provides a more targeted incentive.
Make sure you’re giving the employee equity in the right business unit. If you operate a Crowdfunding platform, for example, and want to incentivize an IT guy, maybe the IT should be held in a separate entity and licensed to the operating company.
To dispel some confusion, a limited liability company can issue options. In fact, here’s a Stock Incentive Plan drafted for a limited liability company. The only thing a limited liability company can’t do is offer “incentive stock options,” otherwise known as ISOs, which provide special tax benefits to employees but are also subject to lots of rules.
Okay, equity is the right answer for this particular employee and you’re giving her equity in the right company. Now, what kind of equity?
There are lots of flavors of equity. These are the three you’re most likely to consider:
Outright Grant of Equity: Your employee will become a full owner right away, sharing in the current value of the business, possibly subject to a vesting period.
Profits Interest: Your employee will become a full owner right away, but economically will share only in the future appreciation of the Company, not the current value.
Option: Your employee won’t become an owner right away, but will have the right to buy an interest in the future based on today’s value – again allowing her to share in future appreciation but not current value.
In making your choice, there are three primary factors:
Economics: How much value are you trying to transfer to your employee, and when?
Messiness of Ownership Interests: If your employee becomes an owner of the business, even an owner subject to vesting and/or an owner whose economic rights are limited to future appreciation, you have to treat her as an owner. You have to give her information, you have to return her email when she asks (as an owner) why your salary is so high and why your husband is on the payroll, you have to send her a K-1 every year, and so forth.
Taxes: For better or worse (mostly worse), tax considerations are the principal driver behind many executive compensation decisions, a great example of the tail wagging the dog. If you thought the JOBS Act was hard to follow, take a look at section 409A of the Internal Revenue Code!
So here’s where we come out.
An outright grant of equity might be a good choice for a real startup assembling a team to get off the ground, as long as there is little or no value. By definition the founder isn’t giving up much economically, and the outright grant achieves a great tax result for the employee, namely capital gain rates on exit. The main downside is that the employee is a real owner, entitled to information, etc. But that’s not the end of the world, especially if the employee is in the nature of a co-founder.
(If your company already has value, then you’re giving something away, by definition, and your employee has to pay tax.)
A profits interest is just like an outright grant except for the economics: there is no immediate transfer of value. But the tax treatment is the same (no deduction for the company, capital gain at exit for the employee) and the employee is a full owner right away.
An option is economically very similar to a profits interest, because the employee shares only in future appreciation, not current value (for tax reasons, the option exercise price can’t be lower than the current value). But otherwise they’re the opposite. The employee isn’t treated as an owner until she exercises the option. And upon exercise, she recognizes ordinary income, not capital gain, while the company gets a deduction.
For a company with just a few key contributors a profits interest isn’t bad. You give your employees a great tax result and what the heck, what are a few more owners among close friends? But for a company with more than a few key contributors the option is better only because it’s so much easier to keep a tighter cap table. And while the tax treatment of the employee isn’t as favorable, I’ve never seen an employee refuse an option for that reason.
If you’re a real estate developer accustomed to raising capital through traditional channels, you’re probably wondering about Crowdfunding. In this post, I’m going to provide some basic information, then try to answer the questions I hear most.
Basics of Crowdfunding
It’s Not Kickstarter. On Kickstarter, people make gifts, often to strangers. You’re not going to ask for gifts. Instead, you’re looking for investors, and in exchange for their money you’re going to give them the same kinds of legal instruments you’d give an investor in the offline world: an interest in an LLC, a convertible note, or something else.
It’s Just the Internet. For better or worse, a certain mystique has developed around Crowdfunding, if only because it’s so new. But Crowdfunding is just the Internet, finally come to the capital formation industry. We buy airline tickets online, we call a cab online, we search for significant others online, now we can search for capital online. If you’re comfortable buying socks on Amazon, you’ll be comfortable raising money using Crowdfunding.
Why Crowdfunding? How many investors do you know? Twelve? Seventy-two? With Crowdfunding, you can put your project in front of every investor in the world. And you’ll probably get better terms.
The Market Is Small But Growing Quickly. Title II Crowdfunding became legal in September 2013, Title IV in June 2015, and Title III in May 2016. The amounts being raised are in the billions of dollars per year, small in terms of the overall U.S. capital markets but growing quickly.
There Are Three Flavors of Crowdfunding. Crowdfunding was created by the JOBS Act of 2012. The three flavors of Crowdfunding are named for three of the sections, or “Titles,” of the JOBS Act:
Title II, which allows only accredited investors (in general, those with $200,000 of income or $1 million of net worth, not counting a principal residence) but is otherwise largely unregulated.
Title III, which allows issuers to raise up to $1 million per year, through a highly-regulated online process.
Title IV, which allows issuers to raise up to $50 million per year in what amounts to a mini-public offering.
For more information, take a look at this chart. But first, read the next bullet point.
You Don’t Have to Learn the Legal Rules. You’re a real estate developer, not a lawyer. You don’t have to become a lawyer to raise money using Crowdfunding, and in terms of lifestyle I wouldn’t recommend it.
You Don’t Have to Write Computer Code. You’re a real estate developer, not an IT professional. You don’t have to know or learn anything about technology to raise money through Crowdfunding.
Crowdfunding is About Marketing. It’s not a technology business, it’s not even a real estate business. Crowdfunding is all about marketing. You create a product that investors will want, and you market both the product and your track record. Just as you rely on your lawyer for legal advice and your IT folks for technology, you rely on marketing professionals to sell yourself and the product.
Common Questions
Will I Have More Liability? Here’s a long and technical blog post, listing all the ways that an issuer of securities in Crowdfunding can be liable. By all means share this with your regular lawyer and ask for his or her opinion. But the bottom line is that if you do it right, raising money through Crowdfunding creates no more liability than raising money through traditional channels. It’s just the Internet.
Will Banks Lend Money for Crowdfunded Deals? In the earliest stages of Crowdfunding, some lenders balked at deals that involved a bunch of passive investors. But we crossed that bridge long ago. Today, banks and other institutional lenders routinely finance Crowdfunding deals.
Isn’t It a Hassle Dealing with All Those Investors? It can be, but doesn’t have to be. For one thing, investors in the Crowdfunding world get no voting or management rights. If you’re used to the private equity guys looking over your shoulder, you’ll be thrilled with Crowdfunding. For another thing, if you use one of the existing Crowdfunding portals (see below), you can outsource a large part of the initial investor relations.
I’ve Heard That Investors Must Be Verified – How Does That Work? In Title II Crowdfunding, the issuer – you – must verify that every investor is accredited. In theoretical terms that could mean asking for tax returns, brokerage statements, and other confidential information. But in practical terms it just means engaging a third party like VerifyInvestor. Most verification is done with a simple letter from the investor’s lawyer or accountant.
How Much Money Can I Raise? In a typical Title II offering, developers typically raise $1M to $3M of equity.
If Crowdfunding is Still Small, Why Start Now? One, you can raise capital for smaller deals. Two, it’s about building a brand in the online market. In a few years, when developers are raising $30M rather than $3M, the developer who built his brand early is more likely to be funded.
Is Crowdfunding All or Nothing? No, not at all. You can raise part of the capital stack through Crowdfunding and the balance through traditional channels.
Will I Need a PPM? You’ll generally provide the same information to prospective investors in the online world as you’re accustomed to providing in the offline world.
Why Am I Seeing All These REITs in Crowdfunding? Three reasons:
Most retail investors have neither the skill nor the desire to select individual real estate projects. Just as retail investors prefer mutual funds to picking individual stocks, retail investors will prefer to invest in pools of assets that have been chosen by a professional.
Theoretically, thousands of retail investors could invest in a traditional limited liability company. But when you own equity in an LLC you receive a K-1 each year. For someone who’s invested $1,000, the cost of adding a K-1 to her tax return at H&R Block could be prohibitive. In a REIT you receive a 1099, not a K-1.
Privately-traded REITs have a very bad reputation, plagued by high fees and sales commissions. But if light is the best disinfectant, the Internet is like a spotlight, relentlessly driving down costs and providing investors with instantly-accessible information.
What Kind of Yields Do Investors Expect? That’s a tough question, obviously. But here are two data points. For an equity investment in a high-quality, cash-flowing garden apartment complex, investors might expect a 7% preferred return and 70% on the back end (e., a 30% promote for you). For a debt investment in a single-family fix-and-flip, with a 65% LTV, they might expect a 9% interest rate on a one-year investment.
Should I Use Rule 506(b) or Rule 506(c)? If you’re asking that question, you probably shouldn’t be reading this blog post. Try this one.
Do I Need a Broker-Dealer? Two answers:
As a general rule, you are not legally required to be registered as a broker-dealer, or to be affiliated with a broker-dealer, if you’re offering your own deals. For a more technical legal answer, you can read this blog post.
To sell your deal, you might want to use a broker-dealer, or a broker-dealer network.
How Can I Get Started? You have two choices:
You can establish your own website and list your own deals. But there are millions of websites in the world, many featuring photographs of naked people. Against that competition you might find it difficult to attract eyeballs.
You can get your feet wet by listing projects on an existing real estate Crowdfunding portal, one with a good reputation and a large pool of registered investors. If that goes well, you can think about establishing your own website later. The portal will take the mystery out of the online process, making it look and feel like any other offering from your perspective.
Three and a half years into Title II Crowdfunding, I am asked this question a lot, sometimes by portals, sometimes by issuers.
A Chart, of Course
Three Important Differences
Verification
In a Rule 506(b) offering, the issuer may take the investor’s word that he, she, or it is accredited, unless the issuer has reason to believe the investor is lying.
In a Rule 506(c) offering, on the other hand, the issuer must take reasonable steps to verify that every investor is accredited. The SEC regulations allow an issuer to rely on primary documents from an investor like tax returns, brokerage statements, or W-2s, but they also allow the issuer to rely on a letter from the investor’s lawyer or accountant. In practice, that’s how verification is typically handled.
I strongly recommend that issuers do not verify investors themselves. Instead, they should use a third party like VerifyInvestor. If an issuer handles verification itself and makes a mistake, it’s possible that the entire offering could be disqualified. Conversely, once an issuer hands the task to VerifyInvestor, the issuer has, by definition, taken the “reasonable step” required by the SEC, and can sleep well at night.
Information
If all the investors are accredited, there is no difference between Rule 506(b) and Rule 506(c).
If there is even one non-accredited investor in a Rule 506(b) offering, on the other hand, the issuer must provide a lot more information, specifically most of the information that would be included in a Regulation A offering.
The technicalities are important to the lawyer, but to the issuer or the portal, the bottom line is that if non-accredited investors are included the offering will cost $5,000 – $7,500 more, and take a little longer to prepare.
Advertising
In a Rule 506(b) offering you can advertise only the brand. In a Rule 506(c) offering you can advertise the deal.
Ever watch the commercials for brokers and investment banks during a golf tournament? They feature an older guy and his very attractive wife, planning for a carefree and meaningful retirement. They message is: we can help you achieve your dreams. But they don’t show any of the actual investments they recommend! They’re only advertising the brand.
That’s the model for a website offering investments under Rule 506(b). We can advertise the website – the brand – but we cannot show actual investments. The website attracts investors who sign up and go through a KYC (know your customer) process following SEC guidelines. We have the investor complete questionnaires, we speak with the investor on the phone a couple times, we learn about his or her experience and knowledge investing – we develop a relationship. Then, and only then, can we show the investor actual investments.
In contrast, a website offering investments under Rule 506(c) can show actual investments to everyone right away.
Which is Better?
If I own a jewelry store, I have two choices:
I can display jewelry in the front window where passersby can see it.
I can display a sign in the front window saying “Great jewelry inside. Must register to enter.”
That’s why I prefer Rule 506(c).
But I also acknowledge three benefits of Rule 506(b):
To include non-accredited investors, you must use Rule 506(b), or another kind of offering altogether.
If you use Rule 506(c), you might lose bona fide accredited investors who are unwilling to provide verification.
If you use Rule 506(b), which doesn’t require verification, you might get money from non-accredited investors who are willing to lie.
Switching Midstream
You can start an offering using Rule 506(b), then switch to Rule 506(c), as long as you haven’t accepted any non-accredited investors.
Conversely, once you’ve advertised a Rule 506(c) offering, you cannot go back and accept non-accredited investors, claiming you’re relying on Rule 506(b).
To answer the second question, I’ve created a chart calledRegulation A Offering Team. The chart identifies the services required for a successful Regulation A offering (legal, accounting, etc.) and estimates how much each service will cost. At the end, I’ve included a pro forma chart for issuers to estimate the cost of their own offerings.
I find that many would-be Regulation A issuers find the process opaque and somewhat intimidating. I hope these two tools – the Regulation A Timeline and the Regulation A Offering Team and – can make it simpler, more transparent, and more predictable.
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?
The JOBS Act created three flavors of Crowdfunding:
Title II Crowdfunding, which allows issuers to raise an unlimited amount of money from an unlimited number of investors using unlimited advertising – but is limited to accredited investors.
Title III Crowdfunding, which allows issuers to raise up to $1 million per year from anyone, including non-accredited investors.
Title IV Crowdfunding, which modified the old Regulation A and is sometimes referred to as Regulation A+.
Quick Summary of Regulation A
Raise up to $50 million per year for each issuer
Raise money from both accredited and non-accredited investors
Register with the SEC
Takes about five months, start to finish
No State-level registration
Shares freely tradeable from day one
Sales by existing shareholders
Regulation A shareholders not counted toward Exchange Act limits for full reporting
Mini-IPO, but with much lower cost
Two Tiers
Theoretically, there are two “tiers” under Regulation A:
Tier One
Tier Two
Amount Per Year
$20 million
$50 million
Non-Accredited Allowed
Yes
Yes
Limits on Investment
None
For non-accrediteds, 10% of income or net worth, whichever is greater, per offering.
Audited Financials
No
Yes
Registration with SEC
Yes
Yes
Registration with State
Yes
No
Excluded from Exchange Act Limits
Yes
Yes
Shares Freely Tradeable
Yes
Yes
Post-Offering Reporting
No
Yes
Testing the Waters
Yes
Yes
Online Distribution Allowed
Yes
Yes
Bad Actor Limits
Yes
Yes
Because of the exemption from State registration, most companies will choose Tier Two.
Companies That Cannot Use Regulation A
Investment Companies
Companies that own stock or other securities in other companies.
Foreign Companies
Issuers must be organized and have their principal place of business in the U.S. or Canada.
Oil and Gas Companies
Can’t sell fractional undivided interests in oil and gas rights, or a similar interest in other mineral rights.
Public Companies
Can’t be a publicly-reporting company.
Companies Selling Asset-Backed Securities
For example, interests in a pool of credit card debt.
Where Regulation A Makes the Most Sense
Pools of high-quality real estate assets, especially REITs
High quality assets in inefficient markets
Sexy companies (companies with high social-media followers or potential)
Title III includes two definitions about related parties, similar but not identical.
The first definition dictates who is subject to the $1 million-per-year limit on raising money. There, the regulations provide that the limit applies not only to the issuer itself (the company raising money), but also to “all entities controlled by or under common control with the issuer and any predecessors of the issuer.” To determine who controls whom, the regulations borrow the definition from SEC Rule 405:
The term ‘control’ means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the entity, whether through the ownership of voting securities, by contract or otherwise.
This means, for example, that if Company X is raising money using Title III, then Company X and all members of the same corporate family are subject to the same $1 million cap, even if other members of the corporate family are engaged in very different businesses.
(Don’t even think about having your husband or girlfriend or best friend from college own the other businesses get around the rule. It doesn’t work.)
This is a very broad rule and, like so much of Title III, very different than anything we’ve seen before in the U.S. securities laws. For example, while Issuer X may include only 35 investors in an offering under Rule 506(b), Issuer X is allowed to have multiple offerings – an apartment building in this offering, an oil and gas development in this offering, a social media app in a third offering – and include 35 non-accredited investors in each.
Similarly, in Title IV an issuer can raise up to $50 million for a mortgage REIT. Nothing stops a company under common control with the issuer from raising another $50 million for a REIT that buys office buildings.
Why the stricter rule for Title III? I would say that, consistent with the whole Title III paradigm, the goal was to reserve Title III for little guys, the neighborhood businesses, while keeping the professional financiers from Wall Street and Silicon Valley out. It’s part of the big compromise that allowed enactment of Title III in the first place.
The second definition around related parties in Title III dictates who on the portal side may own securities of the issuer. The rule is that:
The portal itself may own a financial interest in the issuer only if (1) the portal received the financial interest as compensation for the services provided to or for the benefit of the issuer, and (2) the financial interest consists of the same securities that are being offered to investors on the portal’s platform.
No director, officer, or partner of the portal, or any person occupying a similar status or performing a similar function, may own a financial interest in an issuer.
The term “financial interest in an issuer” means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.
This rule means, for example, that:
A portal may not raise money for itself on its own platform.
Neither the portal nor any of its directors, officers, or partners may invest in an issuer before it raises money on the portal (they could invest afterward).
Purely contractual arrangements, not relating to the securities of the issuer, are okay.
The rule about financial interests doesn’t use the words “common control” but, because a portal is controlled by its directors, officers, and partners, the result is nearly the same. But not identical. In a typical Crowdfunding structure, for example, the Title III portal is owned in a separate company. Key contributors to other parts of the corporate family who are not directors, officers, or partners of the portal itself should be allowed to invest without violating the rule, even where all the companies are under common control.
