Tag: fintech

Choosing The Right Security For Your Crowdfunding Offering

Choosing The Right Security For Your Crowdfunding Offering

On By crowdfundattnyIn Crowdfunding Offerings, SAFE2 Comments

A company trying to raise capital is faced with a lot of decisions. One of the first is the type of security the company will issue to investors. To newcomers, that decision can seem daunting. In this post I’ll try to make it less so.

I’ll describe the most common types of securities in broad terms. As you read, bear in mind that within each category are an endless number of possible permutations. For example, the preferred stock used by one company might be very different than the preferred stock used by a second company.

Each type of security has advantages and disadvantages and some types might be better for your business than others. You will choose the security that’s right for your offering after speaking with your professional advisors.

Common Stock

Common stock represents the most basic kind of equity ownership of a company. You probably own common stock in your own company.

All other things being equal, the owners of common stock have the right to share in any dividends paid by the company and the right to receive the proceeds if the company is sold or liquidated, after all the company’s creditors have been paid.

A company can have more than one class of common stock – for example, one class could be entitled to vote while another class is not entitled to vote.

Investors almost never want common stock. They want something with economic rights superior to the rights of the company’s founders, i.e., your rights.

Preferred Stock

Preferred stock gets its name because it is usually “preferred” as compared to common stock.  That usually means that holders of preferred stock have a right to receive dividends and the proceeds of a liquidation before holders of the common stock receive anything.

EXAMPLE:  Company X raises capital by selling $1M of preferred stock. Three years later Company X is sold and after paying creditors there is only $900K left. Typically, the holders of the preferred stock would get the whole $900K and the holders of the common stock (typically the founders) would get nothing.

The holders of preferred stock usually have the right to convert their preferred stock into common stock if the common stock becomes valuable.

Sometimes, but not always, the company needs the consent of the holders of the preferred stock to take major corporate actions like amending the Certificate of Incorporation or issuing more securities.

Sometimes, but not always, the holders of preferred stock have the right to vote along with the holders of common stock. 

Preferred stock can come with all kinds of other rights, including these:

  • Preemptive Rights:  The right to participate in any future offering of securities.
  • Anti-Dilution Rights:  The right to receive more shares for free if the company sells shares in the future with a lower price.
  • Participation Rights:  The right to receive more than you invested when the company liquidates, before holders of the common shares receive anything.
  • Dividend Rights:  The right to receive annual dividends.
  • Control Rights:  The right to appoint Directors or otherwise exercise control.
  • Liquidity Rights:  The right to force a sale of the company, or to force the company to buy back the preferred shares.

LLC or Limited Partnership Interests

The ownership interests of limited liability companies and limited partnerships go by all kinds of names, including units, interests, percentage interests, membership interests, and shares. Giving a name to the ownership interests is really up the lawyer who writes the governing agreement for the entity.

Whatever name you use, these are all equity interests, just like the stock of a corporation. And just as a corporation can have common stock and preferred stock, an LLC can have common units and preferred units or common membership interests and preferred membership interests. And the common and preferred ownership interests of an LLC or limited partnership can have exactly the same characteristics as the corporate counterparts, described above.

In fact, an LLC or limited partnership can issue all the other types of securities described here, too.

In fact, another choice facing a startup is whether to use a corporation or an LLC in the first place. I talk about that choice here and explain why Silicon Valley prefers corporations here.

SAFEs

“SAFE” stands for Simple Agreement for Future Equity.

Investors in Silicon Valley grew tired of arguing about the value of a startup where the amount of the investment was small (for them). So they invented the SAFE. A SAFE bypasses valuation, or rather postpones valuation until the company raises a lot more money in the future. The idea is that when the company raises a lot more money in the future the new investors and the company will negotiate the value of the company, and the SAFE investors will piggyback on that. This makes SAFEs faster and simpler than common stock or preferred stock.

EXAMPLE:  A company raises $100,000 by selling SAFEs. Two years later the company raises $2M by selling stock for $10 per share. The SAFEs would convert into 10,000 shares, i.e., the same price paid by the new investors.

Nothing stays that simple for long. Today SAFEs come in in many shapes and varieties. Among other possibilities:

  • Discount:  Sometimes the SAFE investors are entitled to a discount against the price paid by the new investors. If SAFE investors had a 15% discount in the example above, the SAFEs would convert at $8.50 per share, not $10.
  • Valuation Cap:  Sometimes the SAFE includes a maximum conversion price. If the SAFE in the example above included a valuation cap of $1.5M, then the SAFEs would convert at $7.50 per share, not $10.
  • Delayed Conversion:  Sometimes the company can stop the SAFE from converting, even if the company raises more capital.
  • Right to Dividends:  Sometimes the holders of the SAFEs have the right to participate in dividends even before they convert.
  • Payment on Sale:  If the company is sold before the SAFE converts, the holder typically is entitled to receive the greater of the amount she paid for the SAFE or the amount she would receive if the SAFE converted just before the sale. But sometimes she’s entitled to more, e.g., 150% of what she paid.

A Silicon Valley SAFE probably isn’t the best for Crowdfunding. Read about it here.

Convertible Note

When a company issues a Convertible Note, the holder has the right to be repaid, with interest, just like a regular loan, but also has the right to convert the note into equity when and if the company raises a lot more money in the future.

EXAMPLE:  A company raises $100,000 by selling Convertible Notes. The Convertible Notes are due in three years and bear interest at 8%. Two years later the company raises $2M by selling stock for $10 per share. The Convertible Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

If you’ve already read the section about SAFEs, you’ll see that the conversion of a Convertible Note into equity is exactly the same as the conversion of a SAFE into equity. That’s not a coincidence. A SAFE is really just a Convertible Note without the interest rate or the obligation to repay. 

Convertible Notes were once the favored instrument in Silicon Valley but were replaced when SAFEs came along. The idea is that interest is immaterial in the context of a startup investment and that the obligation to repay is illusory because the startup will either be very successful, in which case the Convertible Note will convert to equity, or it will go bust. Today Convertible Notes are rare in the startup ecosystem.

Not surprisingly, all the features of SAFEs described above are also available with Convertible Notes:  conversion discounts, valuation caps, and so forth.

Revenue Sharing Note

A Revenue Sharing Note gives the investor the right to receive a portion of the company’s revenue, regardless of profits.

EXAMPLE:  A company issues a Revenue Sharing Note giving investors the right to receive 5% of the company’s gross revenue for three years or until the investors have received 150% of their investment, whichever happens first. If investors haven’t received 150% of their investment at the end of the third year the company will pay the balance.

For investors, a Revenue Sharing Note offers liquidity, assuming the company is generating revenue. In return, they give up the “grand slam” returns they might get with an equity security.

For the company, a Revenue Sharing Note is less dilutive than equity because the investors will soon be gone – in no more than three years in the example above. Plus, because investors have any interest only in gross revenues and not profits, there should be no disputes over expenses, including the salaries of management. But the company is using valuable cash to pay investors.

Some Revenue Sharing Notes convert to equity, just like SAFEs.

EXAMPLE:  Suppose that, in the example above, investors purchased Revenue Sharing Notes for $100,000. At a time when they have received total distributions of $50,000, the company raises $2M by selling stock for $10 per share. The Revenue Sharing Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

Revenue Sharing Notes make a lot of sense for early-stage companies. I’m surprised they aren’t used more.

Simple Loan

The simplest security of all – simpler than a SAFE, simpler than a Revenue Sharing Note – is a plain vanilla promissory note, where the investor lends money to the company and the company promises to pay it back with interest.

A simple loan is good for the company in the sense that there is no dilution of ownership. On the other hand, the company is obligated to pay the money back on a date certain.

A simple loan is good for the investor in the sense that he or she has the right to repayment, unlike an equity investment. On the other hand, the company might not be able to repay the loan. And if the company is a startup the investor might wonder whether the interest rate on the loan is adequate for the risk of non-payment.

******

Don’t be fooled by labels. You can do anything you want. Just make sure you choose a security that’s right for you and your company.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

how to get rid of artificially low targets in reg cf

How To Get Rid Of Artificially Low Targets In Regulation Crowdfunding

On By crowdfundattnyIn Crowdfunding Portals, Reg CF, SEC, Securities Exchange CommissionLeave a comment

As I’ve explained several times to both readers, I believe artificially low minimums are a huge impediment to Reg CF. A company needs to raise $750,000, sets its target at $10,000, and raises $17,439.98. Poof, that money disappears. The company offsets some of its expenses and the funding portal claims a successful offering.

In my opinion, very few serious investors will participate in such an offering. And because it’s so common, I believe most serious investors just stay away from the industry.

I’ve never heard anyone defend artificially low minimums. What I have heard from both portal and issuers is they need artificially low minimums for financial reasons. The issuer comes to the portal with no money. Both the issuer and the portal plan to use the first dollars raised to market the offering. If we can raise $10,000 and invest in marketing, maybe we can raise $50,000 more. If we raise $50,000 more and invest in marketing, maybe we can raise the rest. 

As my friend Irwin Stein says, a well-planned, well-funded Reg CF offering should succeed. The challenge is that many issuers come to the table without a marketing plan or budget. The issuer and the funding portal bridge the gap by effectively asking early investors to take a lot more risk without telling them about it or compensating them for it. 

Long ago I learned it’s better to deal with reality. If the reality is that the issuer lacks a marketing plan or budget, then rather than hide the ball from early investors, let’s split the offering into two parts. Let’s have a first offering for $50,000 to pay for marketing, then a second offering for $750,000 (or whatever) with a real target, maybe $550,000. The company is saying, “Ideally we’d like $750,000 but we can still manage to execute a viable business plan with $550,000.” 

Investors in the first offering are taking far more risk than investors in the second and should be compensated accordingly. They might get two or three times the shares per $1.00 invested or might even get a different security altogether.

We might find that the company’s most ardent supporters – friends and family – will fund the first round. We would also find, I expect, that companies seeking to raise money for marketing will explain their marketing plans in detail and want to advertise high-quality marketing firms.

Far too often, well-intentioned people look to the SEC or Congress to improve Crowdfunding, only to see their hopes dashed. For example, many people look to the SEC or Congress to improve liquidity in Crowdfunding. Last Autumn I suggested a way that portals and issuers could ensure liquidity themselves. I have a client doing that right now. 

We can do the same with artificially low minimums. They’re bad for investors and bad for the industry. And we don’t need them.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

shark tank for regulation crowdfunding

Shark Tank For Regulation Crowdfunding?

On By crowdfundattnyIn Reg CF, Regulation CF, Rule 2042 Comments

I’ve been asked by more than a handful of entrepreneurs about using Reg CF in a Shark Tank format. The founder appears in a TV studio with experienced investors, who pepper her with questions. If viewers like what they see, they scan a QR code at the bottom left, which takes them through the Reg CF investment process.

Non-accredited investors getting easy access to great startups, agnostic as to geography. Exactly what the JOBS Act wanted. 

I’ve had to tell each of those entrepreneurs No.

Each entrepreneur thought I was the bad guy, but the real bad guy is Rule 204, the Reg CF advertising rule. Rule 204 gives a company raising money two choices for advertising outside the funding portal. One, you can say anything you want as long as you don’t mention any of the six “terms of the offering.” Two, you can mention the terms of the offering but say almost nothing else, just the company’s name, address, phone number, and URL, and a brief description of the business (i.e., a “tombstone” ad).

The six deadly “terms of the offering” are:

  1. How much you’re trying to raise
  1. What kind of securities you’re selling (e.g., stock or SAFE)
  1. The price of the securities
  1. How you plan to use the money
  1. The closing date of your offering
  1. How much you’ve raised to date

Now imagine the founder answering questions in the studio. She can say anything she wants about the product, about herself, her team of advisors, the market, the social benefits of the company, all that stuff. Even with careful scripting, however, it’s unrealistic to think she can answer questions accurately and generate enthusiasm in the audience (which is the point) without mentioning any of those six items. Maybe a founder can do it here and there, but you wouldn’t bet your TV show on it.

The purpose of Rule 204 is to ensure that every Reg CF investor gets the same information as every other investor. The regulations want everything about the company and the offering to be in one place:  the funding portal. They don’t want someone who watches your TV show to know either more or less than someone who doesn’t.

Personally, I think Rule 204 is misguided. If there’s a risk that someone who watches your TV show will know either more or less than someone who doesn’t, you can (i) post a video of the TV show on the funding portal, and (ii) make sure TV viewers invest through the funding portal’s platform, where they can see everything. Eliminating Rule 204 would invigorate the Reg CF market without hurting investors.

Eliminate Rule 204 and stop issuers and portals from using artificially low minimums. That’s my platform for 2026.

In the meantime, I’m afraid a Shark Tank for Reg CF isn’t going to work.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com


Perks of crowdfunding in Delaware state

Another Reason To Use Delaware for Crowdfunding

On By crowdfundattnyIn Delaware, Delaware Crowdfunding, IDCsLeave a comment

Long ago, I posted about the advantages of using a Delaware entity. If you’re Crowdfunding in the oil and gas industry, there’s another.

The U.S. tax code provides for special treatment of expenses associated with drilling wells, things like labor costs and site preparation, known as “intangible drilling costs,” or “IDCs.” Under general tax principles, a taxpayer would be required to capitalize IDCs and amortize them over time, just as you would depreciate the costs of building an industrial complex. But §263(c) of the code allows taxpayers to deduct IDCs right away, rather than amortize them over time. That’s a significant economic advantage.

Section 469 of the code goes one step farther. In general, §469 prevents investors from deducting losses incurred in a “passive activity,” like investing in an industrial complex, against wages or other income from other sources. But §469(c)(3)(A) provides:

The term “passive activity” shall not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest.

Thus, §263(c) allows taxpayers to deduct IDCs immediately, and §469(c)(3)(A) allows even passive Crowdfunding investors to deduct their share provided they hold their interest through an entity that does not limit their liability.

This is where Delaware has the advantage.

In Delaware, as in every other state, the general rule is that the members of a limited liability company are not personally liable for obligations of the entity. Section 303(a) of the Delaware statute provides:

Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.

Unlike other states, however, Delaware adds another statute immediately afterward, §303(b):

Notwithstanding the provisions of subsection (a) of this section, under a limited liability company agreement or under another agreement, a member or manager may agree to be obligated personally for any or all of the debts, obligations and liabilities of the limited liability company.

By contrast, Texas (where many oil and gas firms operate) includes a statute providing for the limited liability of members (§114) but does not explicitly allow that rule to be changed by an Operating Agreement. 

In my opinion, Delaware §303(b) makes it much easier to conclude that, with the right provisions in the Operating Agreement, a Delaware LLC can be “an entity which does not limit the liability of the taxpayer.” Under the Texas statute, it is probably possible to provide for personal liability, but the absence of an explicit statutory exception makes the argument under §469(c)(3)(A) much more difficult.

Let me know if you’d like to see the appropriate Operating Agreement provisions.

Questions? Let me know.

title III crowdfunding outline for portals and issuers

The Crowdfunding Bad Actors Rule: Applying For A Waiver

On By crowdfundattnyIn Applying For A Waiver, Bad Actors Rule, Reg CF, Regulation A, Regulation CFLeave a comment

Reg CF, Rule 506(c), and Regulation A all include what have come to be known as “bad actor” rules, codified in 17 CFR §227.503, 17 CFR §230.506(d), and 17 CFR §230.262. In each case, the rule provides that the company can’t use the exemption in question to raise capital if the company itself or certain people affiliated with the company (directors, officers, etc.) have violated certain securities-related laws.

(The bad actor rules don’t apply to investors!)

In each case, the rule allows a company to apply for a waiver. The waiver provisions are codified in 17 CFR §227.503(b)(2), 17 CFR §230.506(d)(2)(ii), and 17 CFR §230.262(b)(2). Each provides for waiver “Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied.”

The SEC Has Complete Discretion

The SEC has identified some factors it will consider but, in truth, whether it is “necessary under the circumstances that an exemption be denied” is highly ambiguous and therefore highly subjective. As a result, the SEC has enormous discretion whether to grant waivers. Faced with two waiver requests with similar facts, the SEC might reach different conclusions. 

What Factors Matter

With that said, the SEC has identified the following factors, for now:

  • Did the Violation Involve the Sale of Securities?  An individual can become a bad actor without violating securities laws – for example, if a state regulator prohibits her from being associated with savings and loan associations. The SEC might be more inclined to give her a waiver, as compared to a person found guilty of having violated federal securities laws.
  • Did the Violation Involve Bad Intent?  Some violations involve bad intent (in legalese, “scienter”), like the intentional failure to disclose important information to investors. The SEC is less likely to grant waivers in those cases than where the violation was technical and unintentional, like the inadvertent failure to file a report.
  • Who Was Responsible for the Misconduct?  Suppose that while Mr. X was its Managing Partner, Company Y engaged in conduct causing it to become a bad actor, and that Mr. X was responsible. Two years later, Mr. X is no longer with Company Y. The SEC is more likely grant Company Y a waiver than if Mr. X were still at the helm. 
  • Is the Culture of the Company Good or Bad?  Underlining that waiver requests are highly subjective, the SEC believes that, where the bad actor is an entity rather than individual, it should take into account the culture, or “tone at the top,” of the entity. If the C-suite executives are trying to comply, the SEC would be more likely to grant a waiver than if they have obstructed the SEC’s investigations.
  • How Long did the Misconduct Last?  If the misconduct was brief, even an isolated event, the SEC would be more inclined to rule favorably than if it occurred over an extended period.
  • What Remedial Steps Have Been Taken?  The SEC will consider “what remedial measures the party seeking the waiver has taken to address the misconduct, when those remedial measures began, and whether those measures are likely to prevent a recurrence of the misconduct and mitigate the possibility of future violations.” Remedial steps could include (i) improving internal training, (ii) adopting or revising policies and procedures, (iii) improving internal controls, (iv) terminating employees responsible for the misconduct, and (v) completing educational courses. I believe the most effective remedial action, from the SEC’s perspective, would be to hire an outside compliance consultant, take her recommendations seriously, and implement as many as possible. 
  • Will Bad Things Happen if the Waiver is Denied?  The SEC will consider who will be hurt if the waiver is denied, and how badly. For example, suppose Company XYZ has already raised $50 million from 2,700 investors for a real estate development, using Regulation A. It needs to raise $5 million more using Rule 506(b) but has been designated a bad actor. If it is unable to raise the additional capital all the existing investors will lose their money. The SEC would take the potential harm to existing investors into account, along with other factors.

The SEC has also stated that it might develop a longer and more objective list in the future, based on its experience with actual waiver requests.

Waivers Are Not Black and White

The SEC can say No. It can also say Yes, but with conditions. For example, it might require additional disclosure. It might require additional notices to investors. It might limit the scope or term of the offering(s) for which a waiver is requested. In one instance, the SEC granted the waiver provided that (i) the applicant would retain an independent consultant and submit a written report, (ii) the applicant would implement all the consultant’s recommendations or obtain the SEC’s consent to alternatives, and (iii) the initial waiver would last for only 30 months, with the opportunity to request an extension.

You Might Not Need a Waiver

The bad actor rules apply to offerings under Rule 506, Regulation A, and Reg CF (they also apply to offerings under Rule 505, but that’s not Crowdfunding). Rule 506, Regulation A, and Reg CF are exemptions to the general rule, set forth in section 5 of the Securities Act of 1933, that every time you raise money from investors you have to conduct a full-blown IPO. 

But they are not the only exemptions. Section 4(a)(2) of the Securities Act still provides an exemption for “transactions by an issuer not involving any public offering.” In the early days of our securities laws, the ambiguity of the italicized language led to an enormous amount of litigation, which in turn led the SEC to create some of the exemptions, or “safe harbors,” used regularly today.

But the language is still there and, despite the ambiguity, there is no doubt that exempt offerings can be conducted without relying on Rule 506, Regulation A, or Reg CF. Consider Company XYZ above, which needs $5 million to complete its real estate development. If Company XYZ knows (has an existing relationship with) five wealthy investors each willing to write a $1 million check, it can forego the waiver request.

How to Apply 

Written requests for waivers should explain in detail (i) how the person came to be treated as a bad actor, (ii) her background in the securities industry and otherwise, and (iii) the nature of the offering(s) for which the waiver is sought. Is it a single real estate syndication under Rule 506? A large fund raising capital using Regulation A? A private equity fund raising capital from only qualified purchasers, i.e., people with more than $5 million of investable assets?

Most importantly, the request should explain why disqualification is not necessary. A request that amounts to “He’s a really great person and promises to do better this time” will be denied. A request should correlate with the factors identified by the SEC and identify any other objective factors showing that what happened in the past has little or no bearing on the new offerings. 

Waiver requests should be sent to:

Sebastian Gomez Abero, Chief
Office of Small Business Policy
Division of Corporation Finance
U.S. Securities and Exchange Commission
100 F Street, N.E.
Washington, DC 20549-3628

Confidentiality

Requests for waivers become public documents, just like requests for no-action letters. If you want parts of your waiver request to be treated as confidential, you can ask for confidential treatment separately. Be prepared for the SEC to say No, whereupon you will decide whether to withdraw the request.

Questions? Let me know.

Title III Crowdfunding

Crowdfunding And The Investment Company Act

On By crowdfundattnyIn Crowdfunding, ICA, Investment Company Act, JOBS ActLeave a comment

I speak with lots of people about Crowdfunding and write this blog to answer questions they ask. I’ve had hundreds of conversations that start with Crowdfunding and end up with the Investment Company Act. I hope this post will help clarify the relationship between the two.

The Investment Company Act of 1940

Many entrepreneurs have never heard of the Investment Company Act, or ICA, so that part of my conversations begins with a short primer.

Think of a mutual fund, a company that exists only to invest in stock of other companies. That’s an investment company.  Unfortunately, the definition of “investment company” in the ICA is so broad it sweeps in many companies that would never think of themselves as mutual funds. Any company holding stock in another company can be treated as an investment company. 

Investment companies are subject to so many rules and expensive regulations, unless you’re a mutual fund you don’t want to be treated as an investment company.

Suppose a real estate sponsor forms ABC LLC to collect 87 investors, and ABC  LLC invests in the entity that owns the real estate, i.e., owns stock of one company. ABC LLC is an investment company and must comply with all the rules and regulations!  Suppose you and three friends form STU LLC to invest in the stock market together. You have an investment company and must comply with all the rules and regulations! Suppose XYZ LLC raises money from 220 people to invest in startups. XYZ LLC is an investment company and must comply with all the rules and regulations!

Unless, that is, ABC LLC, STU LLC, and XYZ LLC qualify for one of the exemptions describe below.

Common Exemptions

A Company with No More Than 100 Owners

A company with no more than 100 owners is exempt from the ICA. ABC LLC and STU LLC fall within this exemption.

A Venture Capital Fund with No More Than 250 Owners

A venture capital fund with no more than 250 owners is exempt from the ICA. A “venture capital fund” means a fund that holds itself out as a venture capital fund and:

  • Raises no more than $10,000,000;
  • Invests no more than 20% of its capital contributions in any single investments;
  • Doesn’t borrow money; and
  • Doesn’t give investors the right to withdraw, redeem or require the repurchase of their ownership interests.

Depending on its terms, XYZ LLC might fall within this exemption.

A Company with Only Wealthy Investors

A company where each investor is a “qualified purchaser” is exempt from the ICA. A qualified purchaser is, in general, an individual with at least $5,000,000 of investments.

ABC LLC, STU LLC, and XYZ LLC could be eligible for this exemption.

NOTE:  American securities laws have always distinguished between people who are wealthy and people who are not. The theory is that wealthy people, who can hire lawyers and accountants and possibly are smarter, don’t need the protection of the government while other people do. We see the theory in practice most commonly with the different treatment of accredited vs. non-accredited investors. With this exemption to the ICA, we see the theory taken one step farther. 

Intersection with Crowdfunding

These are the key points of intersection between Crowdfunding and the ICA:

The ICA Prohibits Many Good Investment Ideas 

I can’t count how many entrepreneurs have proposed a great idea, only to have me say it can’t be done because of the ICA. For example, suppose you believe in startup culture and want to give more Americans the chance to participate. You know that investing in just one startup is very risky, so you propose to raise money from hundreds of people and invest in 20 startups, a million dollars each.

You call me and I tell you that you can’t. Or more exactly, you can, but only if your hundreds of people are wealthy, which defeats the purpose. 

Neither Reg CF nor Regulation A can be Used by Investment Companies

Alright, you say, suppose I’m willing to limit the number of investors to 250, all non-accredited, raise $10 million rather than $20 million, and otherwise meet the requirements of a venture capital fund. Can I do that?

Yes! Or rather, No! 

Under that structure, your entity would fit within the ICA exemption described above. But to raise the $10 million, you have to find an offering exemption. The general rule, set forth in section 5 of the Securities Act of 1933, is that every time you raise money from investors you have to conduct a full-blown IPO. The most common offering types –Rule 506, Reg CF, and so forth – are exemptions from that rule. Which will you use for your new fund?

You can’t use Rule 506(c) because it doesn’t allow non-accredited investors. You can’t use Rule 506(b) because (i) it allows only 35 non-accredited investors, and (ii) it doesn’t allow advertising. And you can’t use Reg CF or Regulation A because they can’t be used by investment companies. With no offering exemptions available, the answer is No, you can’t do it. 

Hold on, you say. I understand that Reg CF and Regulation A can’t be used by an investment company, but didn’t you tell me five minutes ago that my venture fund won’t be treated as an investment company if I follow the rules? Are you experiencing dementia at such an early age, with such youthful features?

Possibly, but that’s not what’s going on here. Unfortunately, neither Reg CF nor Regulation A can be used by a company that would be an investment company if not for the three exemptions I described above. I didn’t say your fund wouldn’t be an investment company, I said it wouldn’t be subject to all the expensive rules and regulations of the ICA.  

It’s like a trick the law plays on you. ABC LLC STU LLC, and XYZ LLC will have “IC” emblazoned on their chests forever. 

The ICA Exemptions and the Offering Exemptions are Apples and Oranges 

People will say “I know I can’t have more than 100 non-accredited investors” or “Am I still subject to the Investment Company Act if I use Rule 506(c)?” 

Those are non-sequiturs. On one side of the fence sits the Investment Company Act of 1940 and its exemptions. On the other side of the fence sits the Securities Act of 1933 and its exemptions. The exemptions for one having nothing to do with the exemptions for the other. They aren’t friends.

Thus:

  • The ICA exemptions apply no matter how you raise the money. If you’re relying on the 100-owner exemption, for example, you can raise the money from 100 qualified purchasers, from 100 accredited investors, from 100 non-accredited investors, or a mix of investors. But you must qualify under one of the offering exemptions separately.
  • Of the offering exemptions commonly used, you can use Rule 506(b) (no advertising, up to 35 non-accredited investors) or Rule 506(c) (no non-accredited investors, unlimited advertising) without thinking about the ICA. But if you want to use Reg CF or Regulation A, you have to think about the ICA a lot.

Every conversation about Crowdfunding should include time for the Investment Company Act. Beware!

Questions? Let me know.

Non-Competes Are Back

On By crowdfundattnyIn Non-Compete Agreements1 Comment

On April 23, 2024, the Federal Trade Commission issued a final rule that would prohibit restrictive covenants (non-compete agreements) for most employees, effective on September 4, 2024.

Last Monday, I was about to write a blog post predicting that FTC’s rule couldn’t survive. A Supreme Court that struck down major environmental rules, eliminated the 40-year-old Chevron doctrine, and created from scratch a shocking new doctrine of presidential immunity that has Washington, Jefferson, Hamilton, et al rolling in their graves, all in one week, was not going to tolerate a national rule opposed by most businesses.

Two days later, on July 3rd, in Ryan v. FTC, a federal District Court judge in Texas saved the Supreme Court the trouble, issuing an injunction against the FTC’s rule. For the time being the injunction applies only to the plaintiff in the case. However, there is a very high probability that the injunction will become national when the District Court issues its final opinion at the end of August. With several other cases pending and the position of the Supreme Court so clear, it’s also possible that another court will issue a national injunction first.

For practical purposes, it is reasonable to assume that the FTC’s rule will never come into effect.

Questions? Let me know.

blind pool offerings in crowdfunding

Does Reg CF Allow Blind Pool Offerings?

On By crowdfundattnyIn Reg CF, Regulation CF4 Comments

It’s a trick question.

It’s a trick question because the term “blind pool offering” doesn’t appear in Reg CF. If you try to figure out whether Reg CF allows “blind pool offerings” you’ll drive yourself crazy and/or reach the wrong answer. 

To illustrate the point, suppose NewCo was formed to buy Class B multi-family projects in the southeastern United States but has not yet identified any such properties. If you focus on the term “blind pool offering” you might decide that NewCo can’t use Reg CF. But if you read Reg CF instead, you’ll reach the opposite – and correct – conclusion. 

To see whether NewCo is eligible for Reg CF, we look at the eligibility rules in 17 CFR §227.100(b). NewCo is a Delaware entity, so we’re good under section 100(b)(1). NewCo isn’t subject to the reporting requirements of the Exchange Act, so we’re good under section 100(b)(2). And we keep going through the list until we get to section 100(b)(6), which provides that Reg CF may not be used if the issuer:

Has no specific business plan or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies.

Does that describe NewCo? Well, no. NewCo does have a specific business plan and it’s not about merging with anyone. 

Thus, having gone through the whole list of section 100(b), we conclude that NewCo is eligible to use Reg CF, 100%.

I’ll add two epilogues.

First, Regulation A uses exactly the same language as Reg CF, in 17 CFR §230.251(b)(3). And even a cursory review of the Regulation A offerings reviewed and qualified by the SEC reveals many, many companies like NewCo.

Second, Industry Guide 5, issued by the SEC to provide disclosure guidelines for real estate offerings, specifically contemplates issuers like NewCo. Item 20D provides for certain disclosures in offerings where “a material portion of the maximum net proceeds (allowing for reasonable reserves) is not committed (i.e., subject to a binding purchase agreement) to specific properties. . . .” 

During my first year of law school in 1838, a partnership tax guru named Bill McKee insisted that we read the statute first. It has turned out to be excellent advice.

Questions? Let me know.

Artificial Intelligencer and crowdfunding

Artificial Intelligence And Crowdfunding Law

On By crowdfundattnyIn AI1 Comment

Like everyone else, I was shocked by the launch of ChatGPT. And like everyone else, I believed lawyers would be first on the chopping block. But I now have a far more optimistic view. I think AI will have a far more nuanced and ultimately beneficial effect for lawyers and their clients, including but not limited to Crowdfunding clients.

At first, I thought lawyers (or non-lawyers, gasp!) could type a question into ChatGPT and get a fully-formed legal product, whether a brief, a memo, a contract, or an obnoxious letter. But it turned out that neither ChatGPT nor its imitators is close to that, and I doubt they ever will be. 

Rather than crashing down the walls, AI is entering the legal profession through the front door. Lawyers are not interfacing with AI directly, by typing prompts into ChatGPT. Instead, the AI is being intermediated by existing legal resources. Through subscription, lawyers have access to extremely powerful online resources like the research tools at Westlaw and the high-quality legal forms at Practical Law. These services are themselves incorporating AI into their products, the same way Microsoft is incorporating AI into Office.

Today, for example, I can upload an Asset Purchase Agreement and get back all sorts of comments – what provisions are missing, as compared to a complete Asset Purchase Agreement, what provisions I should consider adding or deleting depending on whether I represent the buyer or seller, what’s “normal” for a given issue, correcting cross-references, letting me know which capitalized terms haven’t been defined, lots of other things. And I know that these comments and suggestions are coming, ultimately, from some of the best M&A lawyers in the country.

The AI is being intermediated by experts, who are using their experience and brains. In this way AI is not so much revolutionary as another step, if a large step, in the continuing evolution of legal resources.

Lawyers are using AI without even knowing it’s AI. And that’s perfectly normal. How many of us, flipping a light switch, think about electrons?

The result should be to make it easier for lawyers to produce a better product. Or to put it differently, to make high-quality legal work cheaper per hour.

I remember when lawyers thought email and fax machines would give them more leisure time and were shocked when they had the opposite effect. Email and fax machines allowed – actually, forced – lawyers to do more work. Rather than send a document overnight (itself an innovation) and wait for a response, the response was immediate.

The same will be true for AI, in my opinion. AI isn’t going to make lawyers redundant. Instead, with AI driving down the cost of a high-quality contract, existing clients will have more of their work done by lawyers, rather than trying to piece something together themselves, and people who have never used a lawyer will be able to afford one. The overall quality of legal work will rise, benefiting everyone.

Ever seen Apple’s original license agreement with Microsoft? The agreement was so awful, it basically allowed Microsoft to steal the GUI and launch Windows. And I am 100% sure the contract was so awful because a business guy at Apple wasn’t allowed to spend money on a lawyer.

You can see how this will translate to Crowdfunding. Upload a Form C and the AI will tell you what’s missing and suggest corrections and replacements. Upload the Y Combinator SAFE and the AI will tell you “Please read Mark Roderick’s blog post explaining why the Y Combinator form has to be changed for Reg CF.” Unfortunately, the Form Cs and other legal documents used for most Reg CF campaigns today are awful, like the Apple license agreement. I think AI will improve the quality of those documents and at the same time make Reg CF more accessible to more people. 

That’s a huge win.

Questions? Let me know.

financial statements in crowdfunding

Whose Financial Statements?

On By crowdfundattnyIn Filing Financial Statements & Other Reports, Reg CF4 Comments

Reg CF requires financial statements. To refresh your memory:

Those thresholds are based on the maximum you’re trying to raise. So if your “target amount” is $600,000 but you’re trying to raise up to $900,000, and this is your second Reg CF offering, you need audited statements. 

Now suppose you conducted your business as a sole proprietorship or an LLC until six months ago, when someone in Silicon Valley told you to convert to a C corporation. Your sole proprietorship or your LLC is a “predecessor” of your C corporation within the meaning of 17 CFR §230.405. Hence, under the Reg CF rules, your financial statements should include the results of the sole proprietorship or LLC. Which makes sense, given the purpose of the disclosure rules.

The same is true if your company intends to acquire another company. If you’re raising money to buy TargetCo Inc. then TargetCo Inc. is a “predecessor” of your company for purposes of Reg CF. Hence, you should include the financial statements of TargetCo Inc. Which also makes sense.

Especially for small companies, financial statements represent one of the biggest impediments to Reg CF. The rules around predecessors make the impediment that much higher.

Questions? Let me know.