Tag: Reg CF

SPVs in Crowdfunding

SPVs in Crowdfunding

On By crowdfundattnyIn Investment Advisers Act of 1940 (IAA), Investment Company Act, SPVLeave a comment

When you’re raising money for a company, it’s tempting to group all your investors in an entity and have that entity, rather than the individual investors, invest in the company. We often refer to an entity like this as a special purpose vehicle, or SPV. 

The Cursed Investment Company Act

Because the SPV is in the business of owning a security – even if it’s only one security – it’s an “investment company” within the meaning of section 3(a)(1)(A) and/or section 3(a)(1)(C) of the Investment Company Act of 1940. That means, among other things, that the SPV can’t use Reg CF or Regulation A to raise capital.

NOTE:  In 17 CFR §270.3a-9, the SEC created a special kind of SPV called a “crowdfunding vehicle” that can be used to raised capital in Reg CF. I’ve written about those here and here and here but am not writing about them today. Today I’m talking about SPVs formed to raise money under an exemption other than Reg CF, e.g., Rule 506(b) or Rule 506(c).

Because of the prohibitive regulatory burden, we don’t want our SPV to be an investment company. Therefore, having concluded that the SPV is an investment company within the meaning of section 3(a)(1) of the ICA, we look for an exemption.

If you’re raising money only from very wealthy people you find an exemption in section 3(c)(7) of the ICA, which allows an unlimited number of investors as long as each owns at least $5 million of investable assets. All the big hedge funds and private equity funds in Manhattan and Merchantville rely on this exemption. 

The Section 3(c)(1) Exception – 100 Security Holders

For the unwashed masses, the most common exemption – actually, the only other viable exemption for SPVs – is section 3(c)(1) of the ICA. The section 3(c)(1) exemption applies if the outstanding securities of the SPV are held by no more than 100 persons. A few points about the 100-investor limit:

  • The limit refers to the total number of security-holders, not the number of investors in a particular offering. If you’ve conducted one offering and admitted 72 investors, you can’t conduct another offering and admit 87 more.
  • “Securities” include equity, debt, and everything in between. An investor holding a promissory note or a SAFE counts.
  • In general, if an entity invests in the SPV the entity counts as only one security-holder, even if the entity itself has multiple owners. But the law will “look through” the entity, treating its owners as owners of the SPV, if either:
    • You formed the entity to get around the 100-security holder limit; or
    • The entity owns 10% or more of the voting power of the SPV and is itself an investment company.
  • Suppose your SPV has 98 security holders and P.J. Jankara is one of them. She dies and leaves her 100 shares of common stock to her five children, 20 shares each. Is your SPV now an investment company? No, the law provides latitude for involuntary transfers like death.
  • As long as you have no more than 100 security holders in one SPV, you’re allowed to have a separate SPV relying on the section 3(c)(7) exemption. In legal jargon, the two SPVs won’t be “integrated.”

Qualifying Venture Capital Funds – 250 Security Holders

The 100 limit is increased to 250 for a “qualifying venture capital fund.” That means a fund satisfying all six of the following conditions:

  1. The fund represents to investors and potential investors that it pursues a venture capital strategy;
  2. Other than short-term holdings, at least 80% of the fund’s assets must consist of equity interests in portfolio companies;
  3. Investors in the fund do not have the right to withdraw or have their interests redeemed;
  4. All investors in the fund must have the right to receive pro rata distributions;
  5. The fund may have no more than $10,000,000 in aggregate capital contributions and uncalled committed capital, indexed for inflation; and
  6. The fund’s borrowing does not exceed 15% of its aggregate capital contributions and uncalled committed capital.

The regulations don’t define the term “venture capital strategy,” but the SEC provided this explanation:

Under the rule, a qualifying fund must represent itself as pursuing a venture capital strategy to its investors and potential investors. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in our rule (because for example it only invests in short-term holdings, does not borrow, does not offer investors redemption rights, and is not a registered investment company). We believe that only funds that do not significantly differ from the common understanding of what a venture capital fund is, and that are actually offered to investors as funds that pursue a venture capital strategy, should qualify for the exemption.

Whether or not a fund represents itself as pursuing a venture capital strategy, however, will depend on the particular facts and circumstances. Statements made by a fund to its investors and prospective investors, not just what the fund calls itself, are important to an investor’s understanding of the fund and its investment strategy.

When asked to define pornography, former Supreme Court Justice Potter Stewart famously responded: “I know it when I see it.” (Contrary to some critics, he did NOT continue “. . . .and I see it a lot.”) The definition of “venture capital strategy” is like that.

Now, one of the high-volume Reg CF portals says this about using SPVs for Rule 506(c) offerings:

If you wish to consolidate all the investors into a single SPV or fund, the law places a limit of 249 investors if the offering is under $10M in investments. If the offering has more than $10M in investments, there is a 99 investor limit.

This is 100% wrong. By referring to a $10M limit, the portal clearly believes that an SPV can be a “qualifying venture capital funds.” But an entity formed to “consolidate all the investors into a single SPV” couldn’t be a qualifying venture capital fund because it doesn’t pursue a “venture capital strategy.” In fact, the SPV has no investment strategy at all. Investors themselves make the one and only investment decision at the time they invest. The SPV is simply a conduit between the investors and the team, used to simplify the team’s cap table.

This is the same high-volume Reg CF portal that uses a series LLC as crowdfunding vehicles, despite this. 

Whether the exception for qualifying venture capital funds is flexible enough for a bona fide venture capital fund is a different story. But unless you live in Manhattan or Merchantville, assume that your SPV can have only 100 security holders.

Questions? Let me know. 

Escrow account crowdfunding portals

By Itself, An Escrow Account Won’t Stop Sponsors From Stealing Investor Money

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Real Estate, Portals, Real Estate2 Comments

As reported everywhere, CrowdStreet investors recently suffered very large losses when a sponsor apparently absconded with their money. It’s a very bad thing, not only for those investors but for the real estate crowdfunding industry. You’d almost think this were crypto! 

In the aftermath, many have called for crowdfunding sites to use escrow accounts. My point today is that escrow accounts by themselves aren’t enough.

CrowdStreet hosts offerings under Rule 506(c), where escrow accounts aren’t required. On the other side of the street, in the Reg CF world, funding portals must use an escrow agent. Rule 303(e) even specifies who can serve as the escrow agent (a broker-dealer, a bank, or a credit union) and directs which instructions the funding portal is required to give to the escrow agent under what circumstances. If and when the issuer reaches its target amount the funding portal must instruct the escrow agent to release the funds to the issuer, while if the investor cancels his, her, or its investment commitment or the offering is terminated, the funding portal must instruct the escrow agent to return the funds to the investor.

Now let’s assume exactly such an arrangement had been in place for the doomed offering on CrowdStreet.

The offering would have stipulated a “target amount” of $63 million, with the money held securely in escrow. With the target amount raised, CrowdStreet would have given the escrow agent instructions to release the money to the sponsor, following the regulations to the letter. And the sponsor would have stolen it.

By itself the escrow account wouldn’t have prevented the theft. Extrapolating to Reg CF, the escrow accounts used by funding portals do not prevent theft. They just make the unscrupulous sponsor wait until reaching the target amount to steal the money.

To prevent the theft you have to layer something on top of the escrow agent. In the CrowdStreet offering you could have prevented the theft by wiring the money not to the sponsor but to the title company conducting the closing, with instructions that it would be used only to acquire the property. In a typical Reg CF offering, where the money is being used by the issuer for marketing or other general business purposes, it’s much harder.

This is another reason why the “bad actor” rules are odd. They catch people who have violated the securities laws but not people who have robbed strangers at gunpoint. 

Questions? Let me know. 

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 Vehicles2 Comments

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. 

Three Ways To Improve Reg CF

On By crowdfundattnyIn Reg CF, Title III Crowdfunding11 Comments

Reg CF is off and running, on its way to becoming the way most American companies raise capital. Still, there are three things that would improve the Reg CF market significantly.

Revise Financial Statement Requirements

Financial disclosures are at the heart of American securities laws, I understand. The best way to understand an established company is often to pore over its audited financial statements, footnotes and all.

But that’s just not true of most small companies, whether the micro-brewery on the corner or a new social media platform. For these companies, reviewed or audited statements yield almost no worthwhile information to prospective investors. Yet the cost of the statements and the time needed to create them are significant impediments in Reg CF.

In my opinion, the following financial disclosures would be more than adequate:

  • Copies of the issuer’s tax returns for the last two years;
  • Interim financial statements (profit and loss and balance sheet) from Quickbooks or other financial software, through the last day of the month before the offering is launched;
  • A separate statement of the issuers’ assets and liabilities in Form C;
  • An attestation from the Chief Executive Officer;
  • A statement in Form C describing where and how the issuer expects to derive revenue during the next 12 months (e.g., subscription fees, advertisements, rents, etc.);
  • Reviewed financial statements for offerings in excess of $1,235,000; and
  • No requirement for audited statements.

Conversely, I believe annual audited financial statements should be required after a successful raise.

Address Artificially Low Target Amounts

Artificially low target amounts are the worst thing about Reg CF, by a long shot.

In the common approach, a company that needs $750,000 to execute its business plan sets a target amount of $25,000.

The artificially low target works for both the platform and the company. If the company raises, say $38,000, then the platform receives a small commission and advertises a “successful” offering, while the company can at least defray its costs.

But investors have thrown their money away.

Artificially low target amounts are terrible for investors and terrible for the industry, in a vicious cycle. Nobody wants to throw money away, and with so many Reg CF offerings using artificially low target amounts many serious investors will simply stay away from the industry.

Speaking of the Vietnam war, John Kerry asked “Who wants to be the last man to die for a lie?” Here, the question is “Who wants to be the first to invest in a company that needs a lot more?”

The fix is pretty simple. Issuers should be required to disclose what significant business goal can be accomplished if the offering yields only the minimum offering amount or, if no significant business goal can be achieved, should be required to say so.

In the meantime, it’s pretty shocking that while many offerings use an artificially low target amount, very few disclose the enormous additional risk to early investors. That’s a lot of lawsuits waiting to happen.

More Automation for Issuers

Speaking of lawsuits waiting to happen. . .

Most platforms do a pretty good job automating the process with investors. With issuers not so much.

Instead, platforms interact with issuers through people. Theoretically the role of these people is simply to guide the issuer through a semi-automated process. In practice, however, they end up as all-purpose advisors, giving issuers advice about everything from the type of security the issuer should offer to the issuer’s corporate structure to whether an SPV should be used.

As nice and well-meaning as these people may be, they aren’t qualified to give all that advice. Too often they end up giving advice that is either incomplete or wrong, doing a disservice to issuers and creating an enormous potential liability for the platform.

It’s unrealistic to think the platform will staff a team of investment bankers and securities lawyers giving individual advice to each issuer. Instead, in my opinion, the solution is to do a much better job automating the issuer side of the platform. That’s easier said than done, I realize. I hope and expect that the software providers active in Reg CF can provide some industry-wide solutions.

Questions? Let me know.

Using Reg CF To Raise Money For A Non-U.S. Business

On By crowdfundattnyIn Title III, Title III Crowdfunding2 Comments

To use Reg CF (aka Title III Crowdfunding), an issuer must be “organized under, and subject to, the laws of a State or territory of the United States or the District of Columbia.” That means a Spanish entity cannot issue securities using Reg CF. But it doesn’t mean a Spanish business can’t use Reg CF.

First, here’s how not to do it.

A Spanish entity wants to raise money using Reg CF. Reading the regulation, the Spanish entity forms a shell Delaware corporation. All other things being equal, as an entity “organized under, and subject to, the laws of a State or territory of the United States,” the Delaware corporation is allowed to raise capital using Reg CF. But all other things are not equal. If the Delaware corporation is a shell, with no assets or business, then (i) no funding portal should allow the securities of the Delaware corporation to be listed, and (ii) even if a funding portal did allow the securities to be listed, nobody in her right mind would buy them.

Here are two structures that work:

  • The Spanish business could move its entire business and all its assets into a Delaware corporation. Even with no assets, employees, or business in the U.S., the Delaware corporation could raise capital using Reg CF, giving investors an interest in the entire business.
  • Suppose the Spanish company is in the business of developing, owning, and operating health clubs. Today all its locations are in Spain but it sees an opportunity in the U.S. The Spanish entity creates a Delaware corporation to develop, own, and operate health clubs in the U.S. The Delaware corporation could raise capital using Reg CF, giving investors an interest in the U.S. business only.

NOTE:  Those familiar with Regulation A may be excused for feeling confused. An issuer may raise capital using Regulation A only if the issuer is managed in the U.S. or Canada. For reasons that are above my pay grade, the rules for Reg CF and the rules for Regulation A are just different.

Questions? Let me know.

Crow of people wearing masks

PODCAST: Is Coronavirus Impacting Crowdfunding?

On By crowdfundattnyIn PodcastsLeave a comment

Coronavirus is the epitome of what a “risk factor” is in any crowdfunding or real estate deal. As such, whatever the deal, issuers are required to warn potential investors about the riskiness of such an investment. If they don’t, then these businesses can get into serious trouble. Coronavirus compounds that issue even more. In this podcast, attorney Mark Roderick of Lex Nova Law provides some real world examples of what Covid19 disclosures are required in crowdfunding offerings and goes over some of the emergency rules that the SEC issued to facilitate Title III crowdfunding during the coronavirus crisis.

How Coronavirus is Impacting Crowdfunding

The COVID-19 pandemic illustrates exactly why a list of “risk factors” should be included in offering documents when companies issue and sell securities. As Mr. Roderick notes on the podcast, crowdfunding itself can be the catalyst of what may actually restart the economy, but the proper disclosures are a must!

For example, if a company issued stock before the pandemic began, its duty to tell investors about the pandemic would depend on which version of Crowdfunding it used.

Are you aware of these specifics? If not, listening to this podcast will get you up to speed on important items you may not know about, yet are crucial to your crowdfunding efforts (especially if something goes wrong). In addition, are you aware of the temporary rules that the SEC has adopted to make Title III crowdfunding a bit easier in the short term in four major ways? You’d be wise to get a pen and paper and take notes regarding the significant points Mr. Roderick explains in detail in this episode.

Questions? Let me know.

My Comments To The SEC’s Crowdfunding Proposals

On By crowdfundattnyIn Accredited Investor, FINRA, Regulation A3 Comments

Gentlemen and Ladies—

The following are comments to the proposed rules published in the Federal Register on March 31, 2020 relating to offerings under §4(a)(6) of the Securities Act of 1933 and related matters.

Before commenting, I would like to applaud the Commission not only for these proposals but for its approach to the JOBS Act generally. I have practiced in this space extensively since 2012, representing funding portals, issuers, and other industry participants. Time after time I have been impressed with how the Commission has sought to achieve two complimentary goals:  on one hand, protecting investors and ensuring that American capital markets remain the most transparent and robust in the world; and on the other hand, facilitating capital formation by small, job-creating enterprises and giving ordinary Americans the opportunity to invest in businesses historically available only to the wealthy.

Among many examples I will mention just one. On May 4, 2020 the Commission adopted temporary rules to facilitate capital formation under §4(a)(6) In response to the COVID-19 pandemic. No one knows how many jobs the temporary rules will save or create, but the willingness of the Commission to draft and issue the temporary rules in the midst of a crisis, taking the time to help very small businesses while overseeing a complex, multi-trillion dollar securities market, speaks volumes. The Commission clearly believes that Crowdfunding has an important role to play in our capital markets, and all Americans, not just those of us in the industry, should be grateful.

Speaking from the ground floor, so to speak, I have just a few comments, all geared toward making the industry more robust while protecting investors.

Raised Offering Limit and Elimination of Limit for Accredited Investors

To my mind, the two most important and welcome proposals are (i) to increase the limit set forth in 17 CFR §227.100(a)(1) from $1,070,000 to $5,000,000, and (ii) to eliminate the limit in 17 CFR §227.100(a)(2) for accredited investors. Either change would have been welcome, but together I believe they will change the Title III market significantly for the better, improving both the quality of the offerings and the level of compliance.

With offerings limited to $1,070,000 and very low per-investor limits, even for accredited investors, funding portals have had a very hard time making money, plain and simple. Struggling to make ends meet, they lack resources to spend on compliance or on other business practices that would attract more promising issuers and, especially, a larger number of prospective investors. In fact, the difficulty in turning a profit has led some funding portals to adopt practices that may provide some benefit in the short term but drive away rather than attract issuers and investors.

With larger offerings and unlimited investments from accredited investors, I believe that the proposed changes to 17 CFR §227.100(a)(1) and 17 CFR §227.100(a)(2) will reverse that cycle. A profitable funding portal can hire compliance officers, exercise more discretion in the presentation of disclosure materials, provide better documents, insist on quality in all aspects of its business. These steps will in turn attract more investors, which will attract more and better issuers, in a virtuous cycle. With the promise of potential profits, I expect the number, sophistication, and expertise of funding portals to grow rapidly, helping to deliver on the promises with which Title III was launched.

Hence, I strongly support these proposals.

Artificially Low Target Offering Amounts

Too often, we see Title III issuers launch offerings with an artificially low target offering amount, typically $10,000. I believe the artificially-low target amounts are unfair to investors and poisonous to the Title III Crowdfunding market.

The concept of offering “minimums” has always been part of private investments with sophisticated investors. For example, a company seeking to raise as much as $750,000 to obtain three patents and hire a Chief Operating Officer and Chief Marketing Officer might set a minimum offering amount of $450,000, which would allow it to at least obtain two patents and hire the COO. But if the company could raise only $150,000 the company was obligated to give the money back, because sophisticated understand that anything less than $450,000 wouldn’t move the needle for the business.

I believe the concept of target offering amounts in Title III should follow that model, i.e., that the target offering amount should represent an amount of money that would allow the issuer to achieve a significant business goal.

Too often we see on funding portals a company that seeks to raise, say, $350,000 setting a target offering amount as low as $10,000. The artificially low target amount serves the short-term interests of the funding portal and the issuer:  if the company raises, say, $38,000, the issuer receives some cash while the funding portal receives a commission on $38,000 and includes the issuer in its list of “successful” offerings, skewing its statistics as well as the statistics of the industry as a whole. Meanwhile, investors have put $38,000 into a company that needed a lot more and have thereby made an investment fundamentally different and riskier than the investment promised. In the larger picture, I believe sophisticated investors see the game and stay away from the funding portal – and perhaps all of Title III – altogether.

I believe the Commission should amend 17 CFR §227.201(g) to provide as follows:

The target offering amount, the deadline to reach the target offering amount, a statement of the significant business goal the issuer expects to achieve if it can raise the target amount or, if there is no such significant goal, a statement to that effect, and a statement that if the sum of the investment commitments does not equal or exceed the target offering amount at the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned;

In addition, I believe the Commission should caution issuers and funding portals that if raising the target offering amount will not allow the issuer to achieve any significant business goal, a risk factor should be added to that effect.

Revenue-Sharing Notes

The Commission proposes to add 17 CFR §227.100(b)(7), making Title III Crowdfunding unavailable for securities that “Are not equity securities, debt securities, and securities convertible or exchangeable to equity interests, including any guarantees of such securities.”

It is unclear to me whether this new rule would allow securities commonly referred to as “revenue-sharing notes.” I believe these securities should be allowed.

A typical revenue-sharing note has the following features:

  • Investors are entitled to receive a specified percentage of the issuer’s gross revenues, or gross revenues from specified sources (e.g., from sales of a new product).
  • The note specifies a maximum amount investors may receive, often a multiple of the amount invested. For example, investors might be entitled to receive a maximum of twice the amount invested.
  • The note also specifies a maturity date – for example, three years from the date of issue.
  • Payments continue until the sooner of the maturity date or the date investors have received the specified maximum amount.
  • If investors have not received the specified maximum amount by the maturity date, they are entitled to receive the balance (the difference between the maximum amount and the amount they have received to date) on the maturity date.
  • Sometimes, but not always, the revenue-sharing is convertible into equity.

Revenue-sharing notes are especially attractive for small companies and less-experienced investors:

  • They are extremely easy to understand. For less-experienced investors a revenue-sharing note is much easier to understand than a share of common stock, for example.
  • The payments on a revenue-sharing note depend on only one thing:  sales. They do not depend on any expense items. For example, they do not depend on how much compensation is paid to the principals of the company. As a result, the potential for misunderstandings and disputes is reduced substantially.
  • They provide investors with built-in liquidity.
  • They allow issuers to maintain a “cleaner” cap table, possibly facilitating future financing rounds.
  • All those benefits are also available with straight debt securities. For many small businesses, however, and especially for true startups, there is no interest rate – short of usury, that is – that would compensate investors adequately for the risk. As of this morning, the one-year return of the S&P 500 BB High Yield Corporate Bond Index is almost 9%. To compensate investors adequately for the risk of investing in a startup the potential return must be far higher. The revenue-sharing note provides that potential.

Revenue-sharing notes shares features of equity securities in the sense of providing a significant potential for profit, and also share features of debt securities in the sense of providing a date certain for payment. Sharing features of both equity securities and debt securities, it is hard to say a revenue-sharing note is only an equity security or only a debt security. Hence, it would be helpful if the Commission would clarify that revenue-sharing notes may be offered and sold under §4(a)(6).

Accountant Review

In the context of large companies, reviews and audits of financial information by independent accountants is an unmitigated positive, indeed a cornerstone of transparency and integrity in the American capital markets. In the context of very small companies, however, the positives are less apparent and can be outweighed by the cost.

Currently, 17 CFR §227.201(t)(2) requires companies seeking to raise between $107,000 and $535,000 to provide financial statements reviewed by an independent accountant. The cost of such a review varies by region but can certainly amount to between $5,000 and $10,000. For a company seeking to raise, say, $150,000, the cost of the accountant review by itself represents between 3% and 7% of the capital raise, an enormous cost and far more as a percentage than the audit costs of large issuers.

In my opinion, the cost of these reviews is not justified by the value of the additional information they provide to investors. For companies raising no more than $107,000, 17 CFR §227.201(t)(2) requires only information from the company’s Federal tax certified by the principal executive officer, who is typically the founder of the company. My experience in representing hundreds of small companies over more than 30 years suggests that a certification for which a CEO and/or founder takes personal responsibility is much more likely to be accurate than a reviewed financial statement. Although I am confident that every small company files tax returns that are accurate in every respect, out of patriotic obligation, I also note that CEOs and founders are, if anything, incentivized to understate a company’s income on a tax return.

In short, I believe investors get very little, if anything, in terms of the accuracy of a company’s financial disclosures in exchange for the added cost to the company. To bring the cost and the benefit closer into line, I recommend raising the threshold in 17 CFR §227.201(t)(2) to at least $350,000, and possibly eliminating 17 CFR §227.201(t)(2) altogether and raising the threshold in 17 CFR §227.201(t)(1) to $500,000.

I will make two further points in this regard:

  • It is possible that as the market becomes more robust investors will reward companies that provide reviewed financial statements and punish those who don’t. If so, the market will impose its own discipline.
  • Although financial statements are extremely important in evaluating established companies, they are far less important in evaluating small companies and startups. For example, the financial statements of Facebook and Amazon and Microsoft were essentially irrelevant to the earliest investors. I believe that investors in the Title III market make investment decisions almost wholly without regard to historical financial statements and will continue to do so. In this sense the paradigm for large companies simply doesn’t fit the small company market.

Advertising

Section 4A(b)(2) of the Securities Act provides that issuers relying on the exemption of §4(a)(6) “shall not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.” That rule is implemented in 17 CFR §227.204, which defines the “terms of the offering” to mean (i) the amount of securities offered, (ii) the nature of the securities, (iii) the price of the securities, and (iv) the closing date of the offering period.

In practice this rule has created a great deal of confusion and many inadvertent violations. It has also kept issuers from communicating effectively with prospective investors. I do not believe it has protected investors in any meaningful way.

A small company will reasonably wonder why it is allowed to say “We’re raising capital!” on its Facebook page but might not be allowed to say “We’re trying to raise $250,000 of capital!” I say “might not” because even with this simple example the rule is not clear. If “We’re trying to raise $250,000 of capital!” were the only item the company ever posted on Facebook, that would be okay. But of course the company’s Facebook page is filled with all sorts of other information, including information about the company’s founders and history and products – that’s the point of having a Facebook page. In this situation the statement “We’re trying to raise $250,000 of capital!” might be illegal, while the statement “We’re raising capital!” is fine.

In today’s digital, social-media-driven world that creates a mess, impossible for small companies to untangle.

The problems arise from applying the paradigm of large, public companies to the world of small companies and startups. If I want to buy stock of Google I don’t call Google, I call my broker. At some point in the future funding portals might play the role for small companies that brokers play for large companies today. For the present, however, the reality is that Title III issuers have primary and sometimes exclusive responsibility for marketing their own offerings. To hamstring advertising by Title III issuers is to hamstring Title III.

I do understand and support the goal of directing investors back to the portal and thus ensuring that all investors receive exactly the same information. However, I believe that goal can be accomplished, with no harm to investors, through a slightly different approach.

In a Title III offering, I understand the “terms of the offering” to mean all the information contained in Form C. Thus, I would interpret section 4A(b)(2) to mean only that if an issuer provides to prospective investors all or substantially all of the information provided in its Form C, it must direct them to the portal. Otherwise, issuers should be allowed to advertise their offerings, including the four terms enumerated in current 17 CFR §227.204, with three caveats:

  • I would require every advertisement, no matter its contents, to direct potential investors to the funding portal. For these purposes I would define the term “advertisement” very broadly, even more broadly than the term “offer” is defined under current law. Thus, I would consider requiring even notices permitted by 17 CFR §230.169 to include a link back to the funding portal, if made while the offering is open.
  • I would prohibit any advertisement containing information that is not in the issuer’s Form C.
  • In the text of 17 CFR §227.204 I would remind issuers and their principals of their potential liability for material misstatements and omissions.

Those changes would provide clear rules for issuers and funding portals and, I believe, would unleash a torrent of creativity and energy in the Title III market, with no harm to investors.

The Role of FINRA

Under section 4A(a)(2) of the Securities Act, every funding portal must register with any applicable self-regulatory organization. Because there is only one such organization in the United States, all funding portals must become members of the Financial Industry Regulatory Authority, or FINRA. Consequently, although not directly germane to the Commission’s proposals published on March 31, 2020, any discussion of Title III must include at least a reference to FINRA and its regulation of funding portals.

Like everyone else involved in Title III, lawyers and the Commission included, FINRA was starting from scratch in 2016, its two point of reference being the Commission’s regulations on one hand and its own experience regulating broker-dealers on the other hand. In my view FINRA has leaned too heavily on its institutional experience regulating large broker-dealers without taking into account the unique aspects of Title III Crowdfunding.

The Commission’s proposals, and my comments to the proposals, are focused on the economic realities of raising capital for very small companies. One of those economic realities is that most funding portals, like most startups, are owned and operated by just a few people. Too often, the FINRA regulatory paradigm seems to ignore this reality and assume that the funding portal is a much larger enterprise, an enterprise with multiple layers of management – an enterprise like a national broker-dealer.

For example, FINRA requires funding portals to adopt and adhere to an extensive manual of policies and procedures addressing every aspect of its operations. Theoretically such a manual is unobjectionable, and in a large organization absolutely necessary, but in the real world of funding portals the manual typically has the effect of requiring Ms. Smith to supervise herself and maintain a meticulous log proving she did so, and how.

Just as the Commission itself seeks to regulate Title III Crowdfunding based on economic realities, understanding that the rules applicable to public filers might not always apply to very small issuers, I would like to see the Commission encourage FINRA to review its approach to funding portals.

****

Thank you for your consideration.

Questions? Let me know.