Tag: spv

Drafting a Form C in Reg CF

How To Draft A Form C For Regulation Crowdfunding

On By crowdfundattnyIn Crowdfunding Vehicles, Form C, Reg CF, SPVLeave a comment

Form C is the disclosure document used in Reg CF. Because I see so many Form Cs that aren’t done properly, I thought it would be worthwhile to explain how a Form C should be drafted and why too many lawyers go astray.

Rule 201 (17 CFR §227.201) tells us exactly what should be disclosed in a Form C:

  • Rule 201(a) calls for the name, legal status, physical address, and website of the issuer.
  • Rule 201(b) calls for the names and business experience of officers and directors. 
  • Rule 201(c) calls for the name of each person owning 20% or more of the voting stock.
  • All the way through Rule 201(z), which calls for copies of testing the waters materials.

Rule 201 is exhaustive, i.e., there is no disclosure requirement in Reg CF outside Rule 201, other than a short financial summary. 

If you had never prepared a disclosure document, how would you provide the disclosures required by Rule 201? Chances are, you would simply go down the list, from Rule 201(a) to Rule 201(z), and provide answers to all the questions. And that is exactly the right way to do it.

Look at this Form C, for a company called ScienceCast, Inc. Look at the Table of Contents, how it just goes through Rule 201, item-by-item. Look at the body, where each item is labeled with the corresponding rule. Look how the Form C describes the role of the crowdfunding vehicle, or SPV. If you had never prepared a disclosure document and were trying to do things right, I bet this is how you would do it.

Yet look at most of the Form Cs that are filed with the SEC. They don’t follow this format at all or follow it only loosely. In the worst case, of which there are many examples, you can’t even tell it’s a Form C. It looks like a typical Private Placement Memorandum you would see in a Regulation D offering.

And that explains why too many lawyers go off track. A lawyer who has prepared hundreds of Private Placement Memoranda thinks “A Form C is just another type of disclosure document. I’ll start with the form I’m already familiar with rather than create something new from scratch.”

Legal forms can be very useful, but they can also become like an old ship encrusted with barnacles. Over time, lawyers tend to add things to form documents as new cases are decided or new concepts come to mind, but rarely is any of the old stuff scraped away, much less the whole document re-thought.

Using the fresh-out-of-the-box Form C rather than the encrusted Private Placement Memorandum has many benefits:

  • It’s far easier to make sure all the disclosures are there.
  • It’s far easier to check for accuracy.
  • It’s far easier to create an easy-to-understand template.
  • It’s far more efficient, cutting costs.
  • It’s far easier for a lawyer to prepare or review, cutting costs.
  • It’s far easier for the funding portal to explain to the issuer.
  • It avoids all the duplication you see in a typical PPM.
  • It avoids all the state notices and other unnecessary legal boilerplate you see in a typical PPM.
  • It’s far easier for an investor to compare one offering to another.
  • It’s far easier for an investor to read and understand.
  • It uses less energy, reducing the impact of Reg CF on the fragile coral reefs surrounding Australia.

For Reg CF to grow, the industry must standardize. I hope it can at least standardize around a Form C.

Questions? Let me know.

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. 

You Can Use Subsidiaries Without Violating the 100 Investor Rule

On By crowdfundattnyIn 100 Investor Rule, Crowdfunding, Investment Advisers Act of 1940 (IAA), Investor, JOBS Act, LLCsLeave a comment

crowdfunding_investorEveryone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.

The basics of the 100 investor rule:

  • A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
  • A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
  • There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.

Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.

In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?

Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?

Fortunately, the answer is No.

For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.

That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.

Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.

Questions? Let me know.