Tag: JOBS Act

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

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.

new risk factors for crowdfunding and beyond

Trump II: New Risks Factors for Crowdfunding and Beyond

On By crowdfundattnyIn Crowdfunding, Risk Factor, Tariffs, Trump AdministrationLeave a comment
New risk factors for crowdfunding & beyond

Disclosure is at the heart of the U.S. securities laws, and of all the information that can be disclosed, the most important are the risks associated with the investment. That’s why every disclosure document, from the most humble Private Placement Memorandum to the most extensive S-1, includes a list of risk factors.

Some risks are general: the risk that the business might be affected by another pandemic. Some are technical: the risk that our new technology might not work. Some are legal:  the risk that our product infringes on a patent that belongs to someone else.

Whatever their political persuasion, lawyers who draft disclosure documents should now include risks associated with the new Administration. Different businesses will be subject to different risks, but here is a partial list:

  • Risk of Higher Inflation and Interest Rates:  The new Administration has imposed tariffs on Canada, Mexico, and China, and is threatening tariffs on other allies, including the European Union. According to economists, the cost of tariffs will fall on American consumers, raising prices for a large number of goods and thereby fueling inflation. At the same time, the Administration is proposing large tax cuts funded by higher federal budget deficits, which will also contribute to inflation. The Federal Reserve has struggled to bring inflation down to its 2% target, and these policies will likely lead to interest rates h igher than they would have been otherwise.
  • Risk of Labor Shortages:  The new Administration is cracking down on undocumented immigrants, seeking to deport millions by force. Undocumented immigrants make up approximately 40% of the American agricultural labor market, approximately 15% – 25% of the housing labor market, and approximately 20% of the food services labor market, among others. The absence of these workers would cause acute shortages, leading to higher prices and scarcity.
  • Risk of Future Pandemics:  The COVID-19 pandemic in 2020 was devastating for many industries and for the American economy as a whole. The new Administration is populated by “vaccine skeptics,” chief among them Robert F. Kennedy, Jr., who has propagated misinformation not only about COVID vaccines but about vaccines of all kinds, claiming without evidence that childhood vaccines cause autism and opposing vaccines for illnesses ranging from measles to polio. As the Secretary of Health and Human Services, Mr. Kennedy has already taken action against vaccine research, just as the Administration is defunding scientific research generally. These actions increase the risk of another pandemic.
  • Risks to Agricultural Sector:  The American agricultural sector depends heavily on exports, including exports to China. With China now retaliating against the Administration’s tariffs, and the possible loss of almost half its workforce, the agricultural sector could face severe impacts.
  • Risks to Housing Sector:  The American housing industry contributes approximately $1.2 trillion annually, or about 4.5% of America’s gross domestic product. Tariffs imposed on Canadian exports, retaliation by Canada and other countries, increases in interest rates caused by Administration policies, and the possible loss of approximately 20% of its workforce could damage the housing sector severely.
  • Risks Associated with Government Closures:  The new Administration has slashed some government spending, including spending mandated by Congress, in ways that could disrupt the economy or specific industries. For example, in the weeks that followed a fatal midair collision near Reagan National Airport, the Administration announced a reduction in funding for the Federal Aeronautics Administration, which controls flight safety. These cuts could lead to more travel delays and possibly more fatalities, which would have negative effects on the economy.
  • Risk of Government Action Concerning DEI Initiatives:  The new Administration has moved aggressively against initiatives favoring “diversity, equity, and inclusion.” A project that relies on federal funding for any such initiatives will be affected adversely.
  • Risk of Climate Change:  Climate change (aka “global warming”) caused by human activity is already imposing costs and risks for the American economy, including unusual and unpredictable storms, droughts, and other weather-related events. The new Administration has moved aggressively against initiatives to address climate change, like alternative energy, removing mention of “climate change” from government websites, and defunding the National Oceanic and Atmospheric Administration, in favor of carbon-based energy. These actions will increase the rate of global warming and the associated risks.
  • Risks of Legal and Economic Uncertainty:  The new Administration has announced that it will not enforce laws it does not like, such as the Tik-Tok ban, while also putting in the hands of the White House decisions that have historically been made by administrative agencies like the Securities and Exchange Commission. The Administration has also reversed itself on important issues like tariffs, then reversed the reversals. Economic and legal uncertainty can create a climate where businesses are reluctant to invest, increasing the cost of capital and adding to overall economic risks.
  • Risk of Economic Disruption from Tariffs:  Facing a deepening depression, the administration of Herbert Hoover signed into the law the Smoot-Hawley Tariff Act of 1930, which raised tariffs on imported goods. That statute is widely regarded as having worsened, or even caused, the Great Depression by stifling international trade. The steep tariffs imposed by the new Administration could have a similar effect, or even worse.  World economies are far more connected today than they were in 1930. Everything from iPhones to automobiles are made not just in one country but in many. Canada, Mexico, and China have all announced plans to retaliate against the U.S., and a series of tit-for-tat actions could unravel the free trade networks that have been at the foundation of economic growth for 80 years. Any such disruption increases the risk of recession, if not worse.
  • Risks of Recession:    Consumer sentiment has dropped while expectations for future inflation have risen, even before consumers feel the impact of higher prices caused by tariffs. The yield on the 10-year treasury bill has also fallen on fears of recession. Labor shortages, higher prices, disruptions to supply chains, the possible scarcity of goods, and economic uncertainty could combine to create a recession, which would adversely affect most businesses.

The purpose of the “Risks of Investing” is to alert prospective investors to risks and thereby reduce the chance of a successful investor lawsuit after the fact. Lawyers will have to decide on a project-by-project basis whether these and other policy-related risks should be disclosed. Few, if any, businesses will go unscathed.

Questions? Let me know.

A Radical Proposal For Liquidity In Crowdfunding Investments

A Radical Proposal For Liquidity In Crowdfunding Investments

On By crowdfundattnyIn Uncategorized7 Comments

Many smart people believe the main impediment to Crowdfunding in general and Reg CF in particular is the lack of liquidity. Who wants to invest without the chance to get out?

I don’t agree. I note that:

  • Plenty of money flows into real estate projects with no guaranty of liquidity.
  • Enormous amounts of money has flowed through Silicon Valley over the last 40 years with no guaranty of liquidity.
  • Even before Crowdfunding and outside Silicon Valley, lots of money flowed into private companies with no guaranty of liquidity.

Nevertheless, I agree the lack of liquidity is important and have a proposal to fix it, for those willing to take some risk.

Too often, in my opinion, proposals to allow liquidity focus on the SEC. For example, smart people propose that the SEC should adopt a rule providing that an online marketplace for Reg CF securities won’t be treated as an “exchange.” 

I don’t agree with that, either. One, the SEC probably doesn’t have that authority. Two, and far more important, it wouldn’t help. As described here and here, the absence of vibrant secondary markets for private securities isn’t because of the law. It’s because private securities are really hard to market and sell. The lack of transparency, the reliance on a tiny management team, the lack of the investor protections built into NASDAQ and other national exchanges, the miniscule market cap and public float – all these things and more make private securities illiquid.

Forget about petitioning the SEC or introducing another “Improvements in Crowdfunding” bill in Congress. Trying to create liquidity by legal fiat is like pushing string.

Funding portals can provide liquidity on their own. A funding portal could simply require every issuer to provide for liquidity in its organizational documents. The organizational documents could provide, for example, that within some period of time, say seven years, the issuer would either (i) buy out investors, or (ii) arrange for an exit, either a cash sale or a merger with a company with publicly traded securities. Only with a majority vote of investors (super majority?) could the deadline be extended.

Even an individual issuer could provide such a guaranty, without a mandate from the funding portal.

Think of the marketing campaigns. “Our company guaranties liquidity!” “Every company on our platform guaranties liquidity!”

For those who think seven years is too long, don’t buy private securities if you might need to sell them sooner. For those who think seven years is too short, write your own blog!

Seriously, the proposal has one big flaw, from the perspective of issuers. I’ve recommended before that Crowdfunding investors shouldn’t have the right to vote. My liquidity proposal, in contrast, gives investors the right to force the sale of the company. That might hamstring the company and, more important, it might inhibit the company’s ability to attract future, large investors.

To address that flaw, should we provide that the right of liquidity goes away if the company raises $X in the future? 

Everything is a tradeoff. If you believe a guaranty of liquidity will open the floodgates of investors, you’ll consider taking the plunge. If you doubt that a guaranty of liquidity will attract investors, on the other hand, then the tradeoff might be too high. But that takes us back to the beginning. If you think liquidity is the key, and you acknowledge that no change in the law will get us there, a proposal like this could be an option worth considering. 

Questions? Let me know.

Why I’m Grateful This Thanksgiving

On By crowdfundattnyIn Uncategorized2 Comments
William Bradford leader of the pilgrims

My 10th-great grandfather was William Bradford, the leader of the Pilgrims. I’m grateful that he and his band of religious refugees made the trip and were saved from starvation by the native population.

I’m grateful for the wisdom of the American people and the resilience of their institutions.

I’m thankful for a culture that rewards risk-taking and innovation and that is slowly, haltingly, inexorably freeing itself of the prejudices of our collective past.

I’m grateful for American entrepreneurs who endlessly question the present and invent the future.

I’m grateful I declined an invitation to sit on OpenAI’s Board.

I’m grateful – I’m not joking – to the SEC for providing oversight for the most complex, dynamic, trusted capital markets in the world.

I’m grateful that FINRA. . . .

I’m grateful to my colleagues at Lex Nova Law for helping to build a flexible, modern law firm.

I’m grateful to live in a diverse, changing, sometimes-chaotic country where it often seems we disagree about everything (we don’t). Like others, I worry that so many Americans have chosen alternative realities and conspiracy theories, but I have faith that these afflictions, like others in our history, will prove temporary.

I’m grateful that even while the voices of hate are the loudest, those who yearn for peace – the majority – refuse to be drowned out.

I’m grateful that people can change their minds.

I’m grateful to participate in the fundamental rethinking of capitalism called Crowdfunding, making capital available where it has never been available before and making great investment opportunities available to more and more Americans.

I’m grateful to everyone in the Crowdfunding ecosystem, especially to Doug Ellenoff and others who worked to make the JOBS Act a reality.

I’m grateful for my clients, a diverse, energetic, endlessly-creative group of entrepreneurs who are making America better and in the process making my life infinitely more rewarding.

While complaining that my health insurance premiums went up again, I’m grateful they have not dropped to zero.

Thanks for reading everyone! I hope you enjoy your Thanksgiving as much as I intend to enjoy mine. As always, contact me if you have any questions.

MARK

Republican Dysfunction Could Benefit Crowdfunding

Republican Dysfunction Could Benefit Crowdfunding — REALLY

On By crowdfundattnyIn JOBS ActLeave a comment

During my lifetime we’ve never seen political dysfunction like the dysfunction we’re seeing among House Republicans. Coming just as American leadership could be most helpful, the dysfunction is dangerous, a national embarrassment, all that and much more. Yet it might prove good for Crowdfunding.

An ally of Representative Kevin McCarthy, Representative Patrick T. McHenry of North Carolina was designated “interim Speaker” when McCarthy was dethroned. Nobody knows what “interim Speaker” means or what he or she can do, but now, with Republicans unable to agree on an actual Speaker and no other way out of the cul-de-sac, the idea is circulating to give Rep. McHenry some real power and try to run the place. 

Unprecedented? Sure. But so is the dysfunction among Republicans.

Well, it just so happens that Rep. McHenry was the leading proponent of the JOBS Act, the 2012 law that launched Crowdfunding in all its current forms. Ever since, he has also been a leading proponent of improving the law, making it easier for entrepreneurs to raise capital and for ordinary Americans to participate.

Crowdfunding isn’t exactly high up on the list of priorities for either party. But when you’re Speaker of the House of Representative, or “interim Speaker with special powers,” you get to do stuff. If Rep. McHenry holds his position, I wouldn’t be shocked to see changes to the JOBS Act attached to other legislation, even a bill to help Israel and Ukraine.

To quote someone else, there are two things you never want to see being made:  sausage and law. If the dysfunction among Republicans can help Crowdfunding and the American economy, so be it.

Questions? Let me know.

Advocating for Intellectual Honesty in the Legal Sphere With Mark Roderick

On By crowdfundattnyIn Crowdfunding Interview, Crowdfunding Interviews, PodcastsLeave a comment

In this episode… Why is intellectual honesty important for lawyers? By prioritizing what is morally correct over personal gain, lawyers strengthen the lawyer-client relationship and contribute to a fair and just society. Upholding the integrity of the legal profession and ensuring that justice is served depends on attorneys’ commitment to ethical principles — even when they don’t benefit from what they advocate.

As a math major, Mark Roderick was exposed to the world of math proofs and abstract thinking. Realizing he desired to work with people and help solve problems in the real world, he applied to law school. Unlike other professionals in the industry, Mark has a passion for doing what is right at all times — and seeks out others who value intellectual honesty over financial gain. Respecting your integrity, both in your profession and personal life, strengthens your relationships as individuals grow to trust you have their best interest in mind.

In this episode of 15 Minutes, Chad Franzen sits down with Mark Roderick, Principal Partner at Lex Nova Law, to discuss how sharing the same values impacts your work environment. Mark also talks about what inspired him to pursue a career in law, how his background in math has contributed to his career, and how he started his crowdfunding blog.

Resources mentioned in this episode:

Chad Franzen on LinkedIn – https://www.linkedin.com/in/chadfranzen

Gladiator Law Marketing – https://gladiatorlawmarketing.com

Mark Roderick on LinkedIn – https://www.linkedin.com/in/markroderick/

Lex Nova Law – https://www.lexnovalaw.com/

Crowdfunding & FinTech Law Blog – https://crowdfundingattorney.com/

Watch Out For Oregon’s Securities Laws

On By crowdfundattnyIn Securities LawsLeave a comment

Oregon is a beautiful state and its people among the friendliest and most caffeinated in the country. But watch out for its securities laws.

A New York law firm found out the hard way in a case called Houston v. Seward Kissel, LLP. The firm prepared offering documents for a company that was later sued by an Oregon investor claiming fraud. The unhappy investor sued the law firm under ORS 59.115(3), which imposes liability on anyone who “participates or materially aids” in the sale of a security. The judge allowed the case to go forward without even requiring the plaintiff to show the law firm knew about the alleged fraud. 

In another case under the same statute, Ainslie v. Spolyar, the court granted summary judgment against a junior associate in a law firm that prepared offering documents, where the issuer allegedly violated the terms of the offering documents.

How dare they sue lawyers!

But lawyers aren’t the only ones potentially on the hook. Other potential targets include finders, agents, funding portals, accountants, financial advisors, employees of the issuer, even banks that extend financing to investors. If you touch the offering, you’re potentially liable. And under the statute, everyone is “jointly and severally” liable, meaning everyone, even the lowly associate in Ainslie v. Spolyar is liable for 100% of the damages.

The only defense is to show that you didn’t know of the facts underlying the claim (e.g., the fraud or violations of Oregon’s securities laws) and couldn’t have known of them “in the exercise of reasonable care.” That’s a very tough burden for two reasons:

  • Suppose the issuer has committed fraud. Proving that you didn’t know about it is one thing. Proving that you couldn’t have discovered it is extremely difficult because there it is, in broad daylight today.
  • Because the burden is on the defendant, these cases will rarely be dismissed on summary judgment. That means you’re in for a long, expensive fight.

The Oregon statute doesn’t matter too much for issuers because issuers are always liable for fraud and other wrongdoing and know all the facts. But for third parties, including websites and funding portals, at least consider excluding Oregon investors from your offerings, if possible.

Questions? Let me know. 

WATCH OUT FOR RULE 10b-9 IN CROWDFUNDING OFFERINGS

Watch Out For Rule 10b-9 In Crowdfunding Offerings

On By crowdfundattnyIn Crowdfunding OfferingsLeave a comment

Section 10(b) of the Exchange Act prohibits use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security.

The SEC has issued several regulations under section 10(b), prohibiting deceptive practices in various specific circumstances. By far the best-known and most-feared is 17 CFR §240.10b-5, aka Rule 10b-5, which makes it unlawful:

  • To employ any device, scheme, or artifice to defraud,
  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; and
  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

But Crowdfunding issuers and funding portals should know about another regulation issued by the SEC under section 10(b), Rule 10b-9.

On its face Rule 10b-9 is straightforward. It says (I’m paraphrasing) that if you set a minimum amount for an offering and don’t reach the minimum, you have to return everyone’s money. 

Back in the old days, pre-JOBS Act, when many educated Americans spoke a dialect that rarely included the phrase “100%,” almost every offering had a stated minimum. For example, say a developer wanted to buy a multifamily project for $5M, of which $3.5M would be financed and $1.5M would be raised as equity. In her equity offering the developer would state $1.5M as the minimum raise because without the full $1.5M the deal isn’t viable. If she didn’t raise the full $1.5m by the deadline everyone who had invested would get their money back.

Pretty simple, right?

Now suppose that the developer is three days from her deadline and has raised $1,490,000. To meet the $1.5M minimum she writes a $10,000 check herself. 

Under the language of Rule 10b-9 itself, as well as early SEC interpretations of the rule, that should be fine. The developer has reached the $1.5M minimum, albeit with $10,000 of her own money, so the project is viable and investors are getting the economic deal they thought they were getting.

But in a case called SEC v. Blinder, Robinson & Co., Inc. the court discovered a different rationale for Rule 10b-9. The purpose wasn’t just to ensure an offering was fully funded, but also to assure each investor that others had made the same investment decision:

“Each investor is comforted by the knowledge that unless his judgment to take the risk is shared by enough others to sell out the issue, his money will be returned.”

This language, which implicitly appealed to the “wisdom of the crowd” long before Crowdfunding was a thing, is now cited by the SEC, FINRA, and other courts interpreting Rule 10b-9.

Now we see the developer’s $10,000 investment in a different light. She wrote the $10,000 check not because she’s willing to take the same economic deal as other investors but because she’s entitled to fees from the deal and this is her livelihood. No other investors can take comfort from that!

If this is true for a multifamily real estate project it is true many times over for the local brewery raising money using Reg CF. Although Alfred is unrelated to the founder of the brewery, he invested mainly because he likes getting free beer on Thursday nights – one of the perks – and enjoys the comradery, not because he’s expecting a great financial return. No investor can take comfort from that! 

With little better to do, lawyers worry about this kind of thing. Although I think the risk of enforcement action by the SEC is small, out of an abundance of caution I would consider two disclosures in every offering:

  • A disclosure that investments made by the sponsor and its affiliates will count toward the offering minimum (the “target offering amount” in Reg CF); and
  • A disclosure that investors shouldn’t take comfort from investments made by others.

This is what makes the list of Risk Factors so long:  we keep adding things and rarely take anything out.

100%

Questions? Let me know. 

Think Twice Before Giving Crowdfunding Investors Voting Rights

On By crowdfundattnyIn Crowdfunding, Crowdfunding Investors, Investor, Investor DisclosuresLeave a comment

I attend church and think of myself as a kind person, yet I discourage issuers from giving investors voting rights. Here are a few reasons:

  • Lack of Ability:  Even if they go to church and are kind people, investors know absolutely nothing about running your business. If you assembled 20 representatives in a room and talked about running your business, you would (1) be amazed, and (2) understand why DAOs are such a bad idea.
  • Lack of Interest:  Investors invest because they want to make money and/or believe in you and your vision. They aren’t investing because they want to help run your business.
  • Irrelevant Motives:  Investors will have motives that have nothing to do with your business. For example, an investor who is very old or very ill might want to postpone a sale of the business to avoid paying tax on the appreciation.
  • Bad Motives:  Investors can even have bad motives. An unhappy investor might consciously try to harm your business or, God forbid, a competitor might accumulate shares in your company.
  • Lack of Information:  Investors will never have as much information about your business as you have. Even if they go to church, are kind to animals, and have your best interests at heart, they are unable to make the same good decisions you would.
  • Drain on Resources:  If you allow investors to vote you’ll have to spend lots of time educating them and trying to convince them to do what you think is best. Any time you spend educating investors is time you’re not spending managing your business.
  • Logistics:  Even in the digital age it’s a pain tabulating votes from thousands of people.
  • Mistakes:  When investors have voting rights you have to follow certain formalities. If you forget to follow them you’re cleaning up a mess.

I anticipate two objections:

  • First Objection:  VCs and other investors writing big checks get voting rights, so why shouldn’t Crowdfunding investors?
  • Second Objection:  Even if they don’t help run the business on a day-to-day basis, shouldn’t investors have the right to vote on big things like mergers or issuing new shares?

As to the first objection, the answer is not that Crowdfunding investors should get voting rights but that VCs and other large investors shouldn’t. The only reason we give large investors voting rights is they ask for them, and our system is called “capitalism.”

Before the International Venture Capital Association withdraws its invitation for next year’s keynote, I’m not saying VCs and other large investors don’t bring anything but money to the table. They can bring broad business experience and, perhaps most important, valuable connections. A non-voting Board of Advisors makes a lot of sense.

The second objection is a closer call. On balance, however, I think that for most companies most of the time it will be better for everyone if the founder retains flexibility.

To resolve disputes between the owners of a closely-held business we typically provide that one owner can buy the others out or even force a sale of the company. Likewise, while we don’t give Crowdfunding investors voting rights we should try to give them liquidity in one form or another, at least the right to sell their shares to someone else.

Give investors a good economic deal. Give them something to believe in. But don’t give them voting rights.

Questions? Let me know.