Tag: Reg CF offerings

Self-hosted Reg CF offerings legal analysis SEC crowdfunding rules

Self-Hosted Reg CF Offerings

On By crowdfundattnyIn Crowdfunding Offerings, FINRA1 Comment

Are self-hosted Reg CF Offerings legal? I think so, but FINRA might differ.

NOTE: Self-hosted offerings are not legal for funding portals. If they are legal, it’s only for broker-dealers.

What Is A Self-Hosted Offering?

We call a Reg CF offering “self-hosted” if it appears on the website of the issuer rather than the website of a funding portal or broker-dealer.

We are accustomed to seeing multiple offerings listed side-by-side on sites like WeFunder. You click one and see the details. A self-hosted offering, accessible only on the issuer’s website, has one obvious benefit for the issuer:  the offering isn’t competing for attention with all the other offerings. Most investments in Reg CF come through the marketing efforts of the issuer, not the marketing efforts of the portal. Why spend money bringing investors to WeFunder’s site when some of them might invest in something else?

The flip side, of course, is that when an issuer self-hosts, its offering isn’t seen by anyone browsing the other offerings. Statistics show that very few of those browsers end up investing, but still.

The Law

Rule 100(a)(3) provides that a Reg CF offering must be “conducted exclusively through the intermediary’s platform.”

Rule 300(c)(4) defines “platform” as “a program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary.”

Applying the Law to Self-Hosted Offerings

When you read Rule 100(a)(3), you might say “Ah-ha! The issuer’s website isn’t the intermediary’s platform! Therefore, the self-hosted offering is illegal.”

But then read Rule 300(c)(4) carefully. It doesn’t define “platform” as a website, as you might expect. Instead, it defines “platform” as a “program or application accessible via the Internet.”

When an issuer self-hosts a Reg CF offering, it uses software provided by the broker-dealer. The software handles the investment process from beginning to end. I believe this software – a “program” – is the broker-dealer’s “platform” for purposes of these rules. Hence, I think the offering satisfies Rule 100(a)(3) and is legal.

The history of the regulations is also on our side. Originally, the regulations (in Rule 100(d)) defined “platform” as “an Internet website or other similar electronic medium.” That language might have inhibited self-hosted offerings. But the rule was changed to read as it does today in Rule 300(c)(4), talking about “programs or applications.”

The Policy Also Lines Up

Why aren’t funding portals allowed to provide self-hosting? The answer is in Rule 402, which prohibits funding portals from “highlighting” any individual issuer, except by using criteria “reasonably designed to highlight a broad selection of issuers.” By definition, a self-hosted offering highlights only one issuer.

Rule 402 doesn’t apply to broker-dealers. Even if it listed three dozen Reg CF offerings on its own website, a broker-dealer could highlight as many or as few as it liked. If it may highlight a single issuer on its own website, there’s no reason why it shouldn’t be allowed to allow self-hosting by issuers.

FINRA Begs to Disagree

FINRA issued the following FAQ:

Q3. Is it permissible for an issuer to conduct a Regulation Crowdfunding offering on its own website? What if the issuer’s website says that my firm is the intermediary for the offering?

A3.  No. An issuer may not conduct a Regulation Crowdfunding offering on its own website. As discussed above, a transaction involving the offer or sale of securities under Regulation Crowdfunding must be conducted exclusively through the platform of a single intermediary. The platform must display in such manner that it is clear to viewers and users that the platform is that of the intermediary. Posting a statement on the issuer’s website that your firm is the intermediary for the offering would not suffice to make this activity consistent with Regulation Crowdfunding.

In my opinion, FINRA is ignoring the definition of “platform” in Rule 300(c)(4). FINRA says, “[A] transaction involving the offer or sale of securities under Regulation Crowdfunding must be conducted exclusively through the platform of a single intermediary,” as if that statement answered the question. But if “platform” just means software, there should be no problem.

FINRA also says, “The platform must display in such manner that it is clear to viewers and users that the platform is that of the intermediary.” The regulations say no such thing. But if the software is branded with the broker-dealer’s name and logo, that might be good enough anyway.

Does it Matter?

I would like to see statistics demonstrating whether self-hosted offerings are more or less successful. To be meaningful, these statistics would have to account for differences in the marketing spend. My sense is that we wouldn’t see much difference, but that’s just a guess.

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

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

On By crowdfundattnyIn Crowdfunding, Crowdfunding VehiclesLeave a comment

Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.

Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through  successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.

A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.

For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.

But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law. 

A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:

Seek instructions from the holders of its securities with regard to:

  • The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
  • Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.

So let’s think of two scenarios.

In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.

Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.

The first scenario clearly complies with Rule 3a-9. Does the second?

To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.

Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.

When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.

Questions? Let me know. 

Using A SAFE In Reg CF Offerings

On By crowdfundattnyIn Crowdfunding, Reg CF, Regulation CF, SAFE, Title III, Title III CrowdfundingLeave a comment

The SEC once wanted to prohibit the Simple Agreement for Future Equity, or SAFE, in Reg CF offerings. After a minor uproar the SEC changed its mind, and SAFEs are now used frequently. I think prohibiting SAFEs would be a mistake. Nevertheless, funding portals, issuers, and investors should think twice about using (or buying) a SAFE in a given offering.

Some have argued that SAFEs are too complicated for Reg CF investors. That’s both patronizing and wrong, in my opinion. Between a SAFE on one hand and common stock on the other, the common stock really is the more difficult concept. As long as you tell investors what they’re getting – especially that SAFEs have no “due date” – I think you’re fine.

The reason to think twice is not that SAFEs are complicated but that a SAFE might not be the right tool for the job. You wouldn’t use a hammer to shovel snow, and you shouldn’t use a SAFE in circumstances for which it wasn’t designed.

The SAFE was designed as the first stop on the Silicon Valley assembly line. First comes the SAFE, then the Series A, then the Series B, and eventually the IPO or other exit. Like other parts on the assembly line, the SAFE was designed to minimize friction and increase volume. And it works great for that purpose.

But the Silicon Valley ecosystem is very unusual, not representative of the broader private capital market. These are a few of its critical features:

  • Silicon Valley is an old boys’ network in the sense that it operates largely on trust, not legal documents. Investors don’t sue founders or other investors for fear of being frozen out of future deals, and founders don’t sue anybody for fear their next startup won’t get funded. Theranos and the lawsuits it spawned were the exceptions that prove the rule.
  • The Silicon Valley ecosystem focuses on only one kind of company: the kind that will grow very quickly, gobbling up capital, then be sold.
  • Those adding the SAFE at the front end of the assembly line know the people adding the Series A and Series B toward the back end of the assembly line — in fact, they might be the same people. And using standardized documents like those offered by the National Venture Capital Association ensures most deals will look the same. Thus, while SAFE investors in Silicon Valley don’t know exactly what they’ll end up with, they have a good idea.

The point is that SAFEs don’t exist in a vacuum. They were created to serve a particular purpose in a particular ecosystem. To name just a couple obvious examples, a company that won’t need to raise more money or a company that plans to stay private indefinitely probably wouldn’t be good candidates for a SAFE. If it’s snowing outside, don’t reach for the hammer.

If you do use a SAFE, which one? The Y Combinator forms are the most common starting points, but in a Reg CF offering, you should make at least three changes:

  1. The Y Combinator form provides for conversion of the SAFE only upon a later sale of preferred stock. That makes sense in the Silicon Valley ecosystem because of course the next stop on the assembly line will involve preferred stock. Outside Silicon Valley, the next step could be common stock.
  2. The Y Combinator form provides for conversion of the SAFE no matter how little capital is raised, as long as it’s priced. That makes sense because on the Silicon Valley assembly line of course the next step will involve a substantial amount of capital from sophisticated investors. Outside Silicon Valley you should provide that conversion requires a substantial capital raise to make it more likely that the raise reflects the arm’s-length value of the company.
  3. The Y Combinator form includes a handful of representations by the issuer and two or three by the investor. That makes sense because nobody is relying on representations in Silicon Valley and nobody sues anyone anyway. In Reg CF, the issuer is already making lots of representations —Form C is really a long list of representations — so you don’t need any issuer representations in the SAFE. And dealing with potentially thousands of strangers, the issuer needs all the representations from investors typical in a Subscription Agreement.

The founder of a Reg CF funding portal might have come from the Silicon Valley ecosystem. In fact, her company might have been funded by SAFEs. Still, she should understand where SAFEs are appropriate and where they are not and make sure investors understand as well.

Questions? Let me know.