If you’re a real estate developer accustomed to raising capital through traditional channels, you’re probably wondering about Crowdfunding. In this post, I’m going to provide some basic information, then try to answer the questions I hear most.
Basics of Crowdfunding
It’s Not Kickstarter. On Kickstarter, people make gifts, often to strangers. You’re not going to ask for gifts. Instead, you’re looking for investors, and in exchange for their money you’re going to give them the same kinds of legal instruments you’d give an investor in the offline world: an interest in an LLC, a convertible note, or something else.
It’s Just the Internet. For better or worse, a certain mystique has developed around Crowdfunding, if only because it’s so new. But Crowdfunding is just the Internet, finally come to the capital formation industry. We buy airline tickets online, we call a cab online, we search for significant others online, now we can search for capital online. If you’re comfortable buying socks on Amazon, you’ll be comfortable raising money using Crowdfunding.
Why Crowdfunding? How many investors do you know? Twelve? Seventy-two? With Crowdfunding, you can put your project in front of every investor in the world. And you’ll probably get better terms.
The Market Is Small But Growing Quickly. Title II Crowdfunding became legal in September 2013, Title IV in June 2015, and Title III in May 2016. The amounts being raised are in the billions of dollars per year, small in terms of the overall U.S. capital markets but growing quickly.
There Are Three Flavors of Crowdfunding. Crowdfunding was created by the JOBS Act of 2012. The three flavors of Crowdfunding are named for three of the sections, or “Titles,” of the JOBS Act:
Title II, which allows only accredited investors (in general, those with $200,000 of income or $1 million of net worth, not counting a principal residence) but is otherwise largely unregulated.
Title III, which allows issuers to raise up to $1 million per year, through a highly-regulated online process.
Title IV, which allows issuers to raise up to $50 million per year in what amounts to a mini-public offering.
For more information, take a look at this chart. But first, read the next bullet point.
You Don’t Have to Learn the Legal Rules. You’re a real estate developer, not a lawyer. You don’t have to become a lawyer to raise money using Crowdfunding, and in terms of lifestyle I wouldn’t recommend it.
You Don’t Have to Write Computer Code. You’re a real estate developer, not an IT professional. You don’t have to know or learn anything about technology to raise money through Crowdfunding.
Crowdfunding is About Marketing. It’s not a technology business, it’s not even a real estate business. Crowdfunding is all about marketing. You create a product that investors will want, and you market both the product and your track record. Just as you rely on your lawyer for legal advice and your IT folks for technology, you rely on marketing professionals to sell yourself and the product.
Common Questions
Will I Have More Liability? Here’s a long and technical blog post, listing all the ways that an issuer of securities in Crowdfunding can be liable. By all means share this with your regular lawyer and ask for his or her opinion. But the bottom line is that if you do it right, raising money through Crowdfunding creates no more liability than raising money through traditional channels. It’s just the Internet.
Will Banks Lend Money for Crowdfunded Deals? In the earliest stages of Crowdfunding, some lenders balked at deals that involved a bunch of passive investors. But we crossed that bridge long ago. Today, banks and other institutional lenders routinely finance Crowdfunding deals.
Isn’t It a Hassle Dealing with All Those Investors? It can be, but doesn’t have to be. For one thing, investors in the Crowdfunding world get no voting or management rights. If you’re used to the private equity guys looking over your shoulder, you’ll be thrilled with Crowdfunding. For another thing, if you use one of the existing Crowdfunding portals (see below), you can outsource a large part of the initial investor relations.
I’ve Heard That Investors Must Be Verified – How Does That Work? In Title II Crowdfunding, the issuer – you – must verify that every investor is accredited. In theoretical terms that could mean asking for tax returns, brokerage statements, and other confidential information. But in practical terms it just means engaging a third party like VerifyInvestor. Most verification is done with a simple letter from the investor’s lawyer or accountant.
How Much Money Can I Raise? In a typical Title II offering, developers typically raise $1M to $3M of equity.
If Crowdfunding is Still Small, Why Start Now? One, you can raise capital for smaller deals. Two, it’s about building a brand in the online market. In a few years, when developers are raising $30M rather than $3M, the developer who built his brand early is more likely to be funded.
Is Crowdfunding All or Nothing? No, not at all. You can raise part of the capital stack through Crowdfunding and the balance through traditional channels.
Will I Need a PPM? You’ll generally provide the same information to prospective investors in the online world as you’re accustomed to providing in the offline world.
Why Am I Seeing All These REITs in Crowdfunding? Three reasons:
Most retail investors have neither the skill nor the desire to select individual real estate projects. Just as retail investors prefer mutual funds to picking individual stocks, retail investors will prefer to invest in pools of assets that have been chosen by a professional.
Theoretically, thousands of retail investors could invest in a traditional limited liability company. But when you own equity in an LLC you receive a K-1 each year. For someone who’s invested $1,000, the cost of adding a K-1 to her tax return at H&R Block could be prohibitive. In a REIT you receive a 1099, not a K-1.
Privately-traded REITs have a very bad reputation, plagued by high fees and sales commissions. But if light is the best disinfectant, the Internet is like a spotlight, relentlessly driving down costs and providing investors with instantly-accessible information.
What Kind of Yields Do Investors Expect? That’s a tough question, obviously. But here are two data points. For an equity investment in a high-quality, cash-flowing garden apartment complex, investors might expect a 7% preferred return and 70% on the back end (e., a 30% promote for you). For a debt investment in a single-family fix-and-flip, with a 65% LTV, they might expect a 9% interest rate on a one-year investment.
Should I Use Rule 506(b) or Rule 506(c)? If you’re asking that question, you probably shouldn’t be reading this blog post. Try this one.
Do I Need a Broker-Dealer? Two answers:
As a general rule, you are not legally required to be registered as a broker-dealer, or to be affiliated with a broker-dealer, if you’re offering your own deals. For a more technical legal answer, you can read this blog post.
To sell your deal, you might want to use a broker-dealer, or a broker-dealer network.
How Can I Get Started? You have two choices:
You can establish your own website and list your own deals. But there are millions of websites in the world, many featuring photographs of naked people. Against that competition you might find it difficult to attract eyeballs.
You can get your feet wet by listing projects on an existing real estate Crowdfunding portal, one with a good reputation and a large pool of registered investors. If that goes well, you can think about establishing your own website later. The portal will take the mystery out of the online process, making it look and feel like any other offering from your perspective.
I see lots of offering documents like this, with pages of state “legends.” The good news is that in Crowdfunding offerings – Title II (Rule 506(c)), Title III (Regulation Crowdfunding), and Title IV (Regulation A) – you can and should get rid of them.
The legal case is pretty simple:
Before 1996, states were allowed to regulate private offerings. Every state allowed exemptions, but these exemptions often required legends, differing from state to state.
The National Securities Market Improvement Act of 1996 added section 18 to the Securities Act of 1933. Section 18 provides that no state shall “impose any conditions upon the use of. . . .any offering document that is prepared by or on behalf of the issuer. . . .” in connection with the sale of “covered securities.”
The securities sold under Title II, Title III, and Title IV are all “covered securities.”
Hence, section 18 prohibits states from imposing any conditions regarding the issuer’s offering documents, including a condition that requires the use of a state legend.
If the capitalized legends just take up space, why not include them anyway just to be safe? Take Pennsylvania’s legend as an example:
These securities have not been registered under the Pennsylvania Securities Act of 1972 in reliance upon an exemption therefrom. any sale made pursuant to such exemption is voidable by a Pennsylvania purchaser within two business days from the date of receipt by the issuer of his or her written binding contract of purchase or, in the case of a transaction in which there is not a written binding contract of purchase, within two business days after he or she makes the initial payment for the shares being offered.
If you include the Pennsylvania legend “just to be safe,” you’ve given Pennsylvania investors a right of rescission they wouldn’t have had otherwise!
Two qualifications.
First, the North American Securities Administrators Association –the trade group of state securities regulators – suggests including uniform legend on offering documents. I include this or something similar as a matter of course:
IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN EXAMINATION OF THE COMPANY AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND RISKS INVOLVED. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT, AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS SHOULD BE AWARE THAT THEY WILL BE REQUIRED TO BEAR THE FINANCIAL RISKS OF THIS INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.
Second, some states, including Florida, require a legend to appear on the face of the offering document to avoid broker-dealer registration. Because Section 18 of the Securities Act doesn’t prohibit states from regulating broker-dealers, some lawyers recommend including those legends, while others believe those requirements are an improper “back door” way for states to avoid the Federal rule. I come out in the latter camp, but opinions differ.
Title III includes two definitions about related parties, similar but not identical.
The first definition dictates who is subject to the $1 million-per-year limit on raising money. There, the regulations provide that the limit applies not only to the issuer itself (the company raising money), but also to “all entities controlled by or under common control with the issuer and any predecessors of the issuer.” To determine who controls whom, the regulations borrow the definition from SEC Rule 405:
The term ‘control’ means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of the entity, whether through the ownership of voting securities, by contract or otherwise.
This means, for example, that if Company X is raising money using Title III, then Company X and all members of the same corporate family are subject to the same $1 million cap, even if other members of the corporate family are engaged in very different businesses.
(Don’t even think about having your husband or girlfriend or best friend from college own the other businesses get around the rule. It doesn’t work.)
This is a very broad rule and, like so much of Title III, very different than anything we’ve seen before in the U.S. securities laws. For example, while Issuer X may include only 35 investors in an offering under Rule 506(b), Issuer X is allowed to have multiple offerings – an apartment building in this offering, an oil and gas development in this offering, a social media app in a third offering – and include 35 non-accredited investors in each.
Similarly, in Title IV an issuer can raise up to $50 million for a mortgage REIT. Nothing stops a company under common control with the issuer from raising another $50 million for a REIT that buys office buildings.
Why the stricter rule for Title III? I would say that, consistent with the whole Title III paradigm, the goal was to reserve Title III for little guys, the neighborhood businesses, while keeping the professional financiers from Wall Street and Silicon Valley out. It’s part of the big compromise that allowed enactment of Title III in the first place.
The second definition around related parties in Title III dictates who on the portal side may own securities of the issuer. The rule is that:
The portal itself may own a financial interest in the issuer only if (1) the portal received the financial interest as compensation for the services provided to or for the benefit of the issuer, and (2) the financial interest consists of the same securities that are being offered to investors on the portal’s platform.
No director, officer, or partner of the portal, or any person occupying a similar status or performing a similar function, may own a financial interest in an issuer.
The term “financial interest in an issuer” means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.
This rule means, for example, that:
A portal may not raise money for itself on its own platform.
Neither the portal nor any of its directors, officers, or partners may invest in an issuer before it raises money on the portal (they could invest afterward).
Purely contractual arrangements, not relating to the securities of the issuer, are okay.
The rule about financial interests doesn’t use the words “common control” but, because a portal is controlled by its directors, officers, and partners, the result is nearly the same. But not identical. In a typical Crowdfunding structure, for example, the Title III portal is owned in a separate company. Key contributors to other parts of the corporate family who are not directors, officers, or partners of the portal itself should be allowed to invest without violating the rule, even where all the companies are under common control.
Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?
For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.
For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.
Section 18(a)(1) of Securities Act
Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:
Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.
Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?
Here’s the statute again, with extra words removed:
No law requiring registration or qualification of securities transactions shall apply to a covered security.
A sale of a security is definitely a “securities transaction.” So here’s the question: does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.
But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.
For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.
What’s At Stake
If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.
The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.
I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.
And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.
What To Do
The simplest solution is to sell through a clearing broker licensed in every state.
Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).
If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.
Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.
Lending Club and Prosper are going through a rough patch. Renaud Laplanche, the CEO and founder of Lending Club, just resignedamid allegations of financial irregularities, while Prosper recently laid off more than a quarter of its employees.
But those are only the ripples on the pond’s surface. What’s going on underneath is that Wall Street is losing faith in the business model – that is, losing faith in the quality of the loans made on the Lending Club and Prosper platforms.
Not long ago, Wall Street financial institutions couldn’t get enough of Lending Club and Prosper loans. Now the same institutions are cutting back and the effect is severe.
To me, there are two lessons.
This is a Brand New Business Model, and It’s Going to be a Bumpy Ride
Marketplace lending started with the observation that banks pay much less interest to depositors than they charged to borrowers, and that technology should allow someone to decrease that spread, making a profit in the bargain. Lending Club and Prosper grew by substituting proprietary algorithms for traditional bank due diligence. The algorithms seem to work,and institutional investors rushed in.
But marketplace lending has been around for less than 10 years and nobody knows how the algorithms will perform during a down cycle. It’s not a big surprise that Wall Street money managers, aware that the economy might be due for a downturn, are hedging their bets.
The fickleness of Wall Street money managers doesn’t mean the business model of Lending Club and Prosper is broken. To me, there is little doubt that algorithms and big data will replace traditional bank due diligence – not only in consumer lending, but in other parts of the Crowdfunding ecosystem as well. But the algorithms and business models might well have to be adjusted, and nobody should expect a straight line from A to Z.
The fickleness of Wall Street money managers leads to the second lesson.
Wall Street is Fickle
Soon after launching a Crowdfunding platform, you realize there’s a choice where you look for investment capital. You might have begun with the idea of raising money from the public – that is, from retail investors – but you realize quickly that you can also raise money from institutions.
Raising money from institutions is often much easier because, well, institutions have more money. But there are a couple downsides:
You started off hoping to become a household brand, but if most of your money comes from institutions you risk becoming merely a deal originator for institutions, with far less clout and long-term brand value.
You started off idealistically hoping to bring high-quality investments to the public, but if most of your money comes from institutions, you aren’t.
The experience of Lending Club and Prosper reveals another downside: Wall Street is fickle. If you build your Crowdfunding business based on large investments from a handful of institutional investors it’s a lot of fun on the way up, but when the institutions pull the plug it’s a hard fall.
Ideally, a Crowdfunding platform can have it both ways, using institutional money to build the business while building its brand with the retail public, to the point where the business can survive and prosper even if institutional tastes change. I don’t know whether that’s possible, but I hope so.
Crowdfunding is a marketing business. But when it comes to marketing an offering of securities by a Title III issuer, things get complicated. That’s why this is three times longer than any blog post should be.
Why It Matters
Section 5(c) of the Securities Act provides that an issuer may not make an “offer” of securities unless a full-blown registration statement is in effect, of the kind you would prepare for a public offering.
There are lots of exceptions to the general rule and Title III is one of them: you can make “offers” of securities without having a full-blown registration in effect, if you comply with the requirements of Title III.
On one hand that’s good, because if you market your offering as allowed by Title III, you’re in the clear. On the other hand, if you make “offer” of securities without meaning to, or without complying with the intricacies of Title III, you could be in trouble in two ways:
You might have violated section 5(c), putting yourself in jeopardy of enforcement action by the SEC and other liability.
By making an illegal offer, you might have jeopardized your ability to use Title III at all.
What is an “Offer” of Securities?
Section 2(a)(3) of the Securities Act defines “offer” very broadly, to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” And the SEC has defined “offer” even more broadly than those words suggest. Going back to 1957, the SEC said that any publicity that could “contribute to conditioning the public mind or arousing public interest” could be treated as an “offer.”
These examples illustrate the spectrum:
A company continues to advertise its services as usual, keeping its plans for an offering under wraps, then files an S-1 registration statement.
A company steps up its public relations efforts before a new product announcement, which happens to coincide with a new public offering.
For six months before it files a registration statement, a company triples its advertising budget, trying to build brand recognition specifically with the investing public.
A company puts up a website announcing “Please buy our common stock!”
The SEC has adopted a number of rules describing behavior that will not be treated as an “offer” for purposes of section 5(c). For example, Rule 135 allows so-called “tombstone” advertisements of registered offerings, Rule 135c allows notices of private offerings by publicly-reporting companies, and Rule 169 allows factual business information released by an issuer that has filed or intends to file a registration statement. But all these rules apply only to companies that are or intend to become public or publicly-reporting. There are no equivalent rules dealing with the behavior of small companies.
A Different Definition for Small Companies?
With that background, advice given by the SEC in 2015 catches your attention:
Question: Does a demo day or venture fair necessarily constitute a general solicitation for purposes of Rule 502(c)?
SEC Answer: No. Whether a demo day or venture fair constitutes a general solicitation for purposes of Rule 502(c) is a facts and circumstances determination. Of course, if a presentation by the issuer does not involve an offer of a security, then the requirements of the Securities Act are not implicated.
The italicized statement is true, by definition. If there is no “offer,” the securities laws don’t apply. Even so, it’s hard to reconcile with the SEC guidance for public companies. A “demo day” is, by any definition, an event where companies make presentations to investors. Not to customers, to investors. If merely “conditioning the public mind” can be an offer, it is very hard to understand how presenting to a roomful of investors could not be an offer.
Trying to reconcile the two, you might conclude that the SEC is, in effect, using different definitions of “offer” depending on the circumstances. During the period surrounding a public offering of securities a stringent definition applies (the 1957 ruling involved the period immediately following the filing of a registration statement) while outside that period a more lenient definition applies. If that were true, those of us trying to advise Title III issuers would sleep better.
There are two glitches with the theory, however:
Maybe the SEC will view the period surrounding a Title III listing in the same way it views the period surrounding a public registration statement.
The preamble to the final Title III regulations actually cites Rule 169 and cautions that “The Commission has interpreted the term ‘offer” broadly. . . .and has explained that ‘the publication of information and publicity efforts, made in advance of a proposed financing which have the effect of conditioning the public mind or arousing public interest in the issuer or in its securities constitutes an offer. . . .’” That sure doesn’t sound like a more lenient rule for Title III.
The Title III Rule for Advertising
Title III is about Crowdfunding, right? Doesn’t that mean Title III issuers are allowed to advertise anywhere and say anything, just like Title II issuers?
Not exactly.
A core principle of Title III is that everything happens on the portal, where everyone can see it, so nobody has better access to information than anyone else. A corollary is that that Title III issuers aren’t allowed to advertise freely. If a Title III issuer put information about its offering in the New York Times, for example, maybe readers of the New York Post (are there any?) wouldn’t see it.
A Title III issuer can advertise any where it wants – Twitter, newspapers, radio, web, etc. – but it can’t say any thing it wants. All it can do is provide a link to the Funding Portal with an ad that’s limited to:
A statement that the issuer is conducting an offering
The terms of the offering
Brief factual information about the issuer, e.g., name, address, and URL
In the public company world, those are referred to as “tombstone” ads and look just about that appealing. In the online world issuers can do much better. A colorful post on the issuer’s Twitter or Facebook pages saying “We’re raising money! Come join us at www.FundingPortal.com!” is just fine.
Insignificant Deviations From The Rules
Recognizing that Title III is very complicated and new, section 502 of the Title III regulations provides:
A failure to comply with a term, condition, or requirement. . . .will not result in the loss of the exemption. . . .if the issuer shows. . . .the failure to comply was insignificant with respect to the offering as a whole and the issuer made a good faith and reasonable attempt to comply. . . .”
The language is vague, as it has to be, but it certainly suggests that Title III issuers can make mistakes without losing the exemption. And there’s no reason why mistakes in advertising an offering should be treated more harshly than other mistakes.
The purpose of the advertising rule, as we’ve seen, is to ensure that every investor has access to the same information. If a Title III issuer mistakenly provides more information about its offering in a Facebook post than it should have, the infraction could be cured easily – for example, by ensuring that any information in the Facebook post appeared on the Funding Portal for at least 21 days before the offering goes live, or by correcting the Facebook post and directing Facebook friends to the Funding Portal.
Where Does That Leave Us?
Ideally, a company thinking about raising money using Title III would follow these simple rules:
Don’t attend demo days.
In fact, don’t mention your plan to raise money to any potential investors until you register with a Title III Funding Portal.
The minute you want to talk about raising money, register with a Title III Funding Portal.
After registering with a Title III Funding Portal, don’t mention your offering except in “tombstone” advertising.
After registering with a Title III Funding Portal, don’t meet, speak, or even exchange emails with investors, except through the chat room on the Funding Portal.
A company that follows those rules shouldn’t have problems.
That’s ideal, but what about a company that didn’t speak to a lawyer before attending a demo day? What about a company that posted about its offering on Facebook before registering with a Funding Portal, and included too much information? What about a company that’s spoken with some potential investors already? What about a real company?
Nobody knows for sure, but unless the SEC takes a very different position with regard to Title III than it has taken with regard to Regulation D, I think a company that has engaged in any of those activities, or even all of those activities, can still qualify for a successful Title III offering.
Let’s not forget, the SEC has been very accommodating toward Crowdfunding, from the no-action letters in March 2013 to taking on state securities regulators in Regulation A. With section 502 in its toolbox, it’s hard to believe that the SEC is going to smother Title III in its cradle by imposing on startups the same rules it imposes on public companies.
It’s instructive to look at the way the SEC has treated the concept of “general solicitation and advertising” under Regulation D.
By the letter of the law, any contact with potential investors with whom the issuer does not have a “pre-existing, substantive relationship” is treated “general solicitation,” disqualifying the issuer from an offering under Rule 506(b) (and all of Rule 506, before the JOBS Act). But the SEC has taken a much more pragmatic approach based on what it refers to as “long-standing practice” in the startup industry. In fact, in a 1995 no-action letter the SEC concluded that there had been no “general solicitation” for a demo day event even when investors had been invited through newspaper advertisements.
I think the SEC will recognize “long-standing practice” in interpreting Title III also.
Bearing in mind the language of section 502, I think the key will be that an issuer tried to comply with the rules once it knew about them, i.e., that a company didn’t violate the rules flagrantly or intentionally. If you’re a small company reading this post and start following the rules carefully today, I think you’ll end up with a viable offering. Yes, there might be some legal doubt, at least until the SEC issues clarifications, but entrepreneurs live with all kinds of doubt, legal and otherwise, all the time.
It’s Not Just the Issuer
The issuer isn’t the only party with a stake in the advertising rules. The Funding Portal might have even more on the line.
Here’s the challenge:
Before allowing an issuer on its platform, a Funding Portal is required to have a ”reasonable basis” for believing that the issuer has complied with all the requirements of Title III.
We’ve seen that one of the requirements of Title III is that all advertising must point back to the Funding Portal.
Before the issuer registered with a Funding Portal, advertising by the issuer couldn’t have pointed back to the Funding Portal.
Therefore, if a would-be issuer has engaged in advertising before registering with the Funding Portal, including any activity that could be construed as an “offer” for purposes of section 5(c), the Funding Portal might be required legally to turn the issuer away.
With their legal obligations in mind, dozens of Funding Portals are preparing questionnaires for would-be issuers as I write this, asking questions like “Have you made any offers of securities during the last 90 days? Have you participated in demo days?”
If the Funding Portal denies access to any issuer that answers “I don’t know” or “Yes,” it might end up with very few issuers on its platform. On the other hand, if it doesn’t ask the questions, or ignores the answers, it’s probably not satisfying its legal obligation, risking its SEC license as well as lawsuits from investors.
The Funding Portal will have to make some tough calls. But its answer doesn’t have to be limited to “Yes” or “No.” For one thing, using its own judgment, the Funding Portal might suggest ways for the issuer to “fix” any previous indiscretions. For another, rather than make the call itself, the Funding Portal might ask for an opinion from the issuer’s lawyer to the effect that the issuer is eligible to raise money using Title III.
Advertising Products and Services
We’ve seen that product advertisements by a company that has filed, or is about to file, a public registration statement can be viewed as an “offer” of securities for purposes of section 5(c) if the company uses the product advertisement to “arouse interest” in the offering. However, I don’t believe this will be a concern with Title III:
A company that has registered with a Funding Portal should be free to advertise its products and services however it pleases. There’s no “quiet period” or similar concept with Title III the way there is with a public registration.
A company that has not yet registered with a Funding Portal and is not otherwise offering its securities should also be free to advertise its products or services. Just not at a demo day!
Many companies in the Title III world will be looking to their customers as potential investors. For those companies it makes perfect sense to advertise an offering of securities in conjunction with an advertisement of products or services. Sign up with a Funding Portal, follow the rules for advertising, and “joint” advertisements of product and offering should be fine.
Will a Legend Do the Trick?
Suppose a company thinking about raising money using Title III Crowdfunding makes a presentation to a roomful of investors at a demo day, but includes on each slide of its deck the disclaimer: “This is Not An Offering Of Securities.”
The disclaimer doesn’t hurt and might tip the balance in a close case, but don’t rely on it.
An Issuer With A Past: Using Rule 506(c) to Clean Up
Photo Credit: Fast Company editor Jason Feifer
In Scott Fitzgerald’s TheGreat Gatsby, the main character reaches for a new future but, in the end, finds himself rowing “against the current, borne back ceaselessly into the past.” In this final section I’ll suggest a way that an issuer might raise money using Title III notwithstanding a troubled past, succeeding where Jay Gatsby could not.
Suppose an issuer registers with a Funding Portal, raises money using Title III, then fails. Looking for a basis to sue, investors learn that the issuer attended a demo day three weeks before registering with the Funding Portal. An illegal offer! Gotcha!
“No,” says the issuer, calmly. “You’re right that we attended a demo day and made an offer of securities, but that’s when we were thinking about a Rule 506(c) offering. As you know, offers made under Rule 506(c) are perfectly legal. It was only afterward that we started to think about Title III.”
As long as the record – emails, promotional materials, investor decks, and so forth – demonstrates that any “offers” were made in contemplation of Regulation D rather than Title III, I think the issuer wins that case. The case would be even stronger if the issuer actually sold securities using Rule 506(c) and filed a Form D to that effect, before registering with the Funding Portal.
An issuer with a troubled past – one that has attended lots of demo days, posted lots of information on Facebook and met with a bunch of different investors – might go so far as to engage in and complete a Rule 506(c) offering before registering on a Funding Portal. With the copy of the Form D in their files, the issuer and the Funding Portal might feel more comfortable that the troubled past is behind.
Title III requires all these disclosures, reported on the new Form C:
The name, legal status, physical address, and website of the issuer
The names of the directors and officers of the issuer and their employment history over the last three years
The name of each person owning 20% or more of the issuer’s stock
The issuer’s business and business plans
The number of employees of the issuer
A statement of risks
How much money the issuer is trying to raise
How the money will be used
The price of the shares or the method for determining the price
The capital structure of the issuer, including the rights of all security-holders, restrictions on transfer, and how the securities are being valued
A description of the portal’s financial interests
A description of the issuer’s liabilities
A description of other offerings conducted within the past three years
A description of “insider” transactions
A discussion of the issuer’s financial condition
Financial statements or their equivalent
Any other information necessary in order to make the statements made not misleading
As I write this, a lot of very smart entrepreneurs and software engineers are working to automate these disclosures. They have to: to make money running a Title III portals, you’re going to have to automate everything that can be automated.
Now look at Title II. As a write this, the disclosures for almost all Title II deals are prepared the old-fashioned way, with a lawyer writing an old-fashioned Private Placement Memorandum. The PPM for Deal 1 on Portal X might or might not include the same information as the PPM for Deal 2 on Portal X, and almost certainly doesn’t include the same information or look the same as the PPM for deals on Portal Y. An investor trying to compare apples to apples would go, well, bananas.
That situation is ripe (sorry) for change and I think it will change as Title III comes online, for three reasons:
As someone argued recently, investors couldn’t care less about the distinction between Title II and Title III. They are going to want to see the same information in the same format.
Using the tools developed for Title III, Title II portals will be able to provide more information than they are currently providing, cheaper and more effectively.
There is no law that dictates what information must be provided in a Title II offering. But we still think about 17 CFR §240.10b-5, which makes it unlawful 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. . . .not misleading. . . .” As the industry develops, it seems at least possible, if not likely, that the disclosures required by Title III could be viewed as the standard for avoiding Rule 10b-5 liability.
Most Title II and Title IV portals will also want to operate Title III portals, and vice versa. Can they do it?
The Title III regulations issued by the SEC appear to contemplate that a Title III portal – a “funding portal” – will do more than operate a Title III portal. For example, 17 CFR §227.401 provides that “A funding portal. . . .is exempt from the broker registration requirements of section 15(a)(1) of the Exchange Act in connection with its activities as a funding portal.” If a Title III portal couldn’t do anything else, that extra language at the end wouldn’t be necessary.
The same is true for of the regulations issued by FINRA. FINRA prohibits Funding Portals from making false or exaggerated claims, implying that past performance will recur, claiming that FINRA itself has blessed an offering, or engaging in other misconduct, but a well-behaved Title II or Title IV portal would have no trouble meeting those standards.
What about the platform itself? The Title III regulations (17 CFR §227.300(c)(4)) define “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 in a transaction involving the offer or sale of securities in reliance on section 4(a)(6) of the Securities Act.
Nothing there would prohibit Title II, Title III, and title IV securities from appearing on the same website.
The fly in the ointment is 17 CFR §227.300(c)(2)(ii), which provides that a Title III portal may not:
Offer investment advice or recommendations; OR
Solicit purchases, sales or offers to buy the securities displayed on its platform.
What does that mean, in the context of a portal offering both Title II and Title III securities? What it should mean is that a Title III portal cannot offer investment advice or recommendations concerning Title III securities, and cannot solicit purchases, sales, or offers of Title III securities. The idea of Title III is to protect Title III investors. Why should the SEC care whether the portal is offering investment advice concerning Title II or Title IV securities?
But we can’t be 100% sure that’s what it means. If it means that a Title III portal can’t offer investment advice about any securities and can’t solicit offers to buy any securities, then we need to steer clear.
I’ve spoken informally with the SEC and they’re not sure how to interpret 17 CFR §227.300(c)(2)(ii). They suggested I submit a request for a no-action ruling and I guess I will, unless one of my Crowdfunding colleagues already has.
Pending that guidance, there are several ways to operate a Title II portal, a Title III portal, and a Title IV portal on the same platform:
Operate the portals through a single legal entity. Avoid giving investment advice to anybody or soliciting purchases, sales, or offers of any securities.
Operate the portals through one legal entity. If you want to offer investment advice and/or actively solicit, do it through or more additional legal entities. For now, limit the investment advice and active solicitation to Title II and Title IV securities.
Create a separate legal entity to hold the Title III license. Create an arm’s length license agreement between that entity and the entity that owns the platform (a simple downloadable form is here). List all the deals on the same platform, but make sure that when an investor clicks on a Title III deal the Title III portal handles the investment process.
Finally, FINRA is a wonderful organization, but I’m not necessarily eager to have FINRA looking at everything my clients do. All other things being equal, I might choose option #3 just to keep a degree of separation between the regulated entity and my non-regulated activities. But that’s not necessarily the end of it – FINRA will want to explore the relationship between the funding portal and its affiliates.
Why has Home Depot made local hardware stores a thing of the past? Partly price, but mainly selection. And I think the same forces will require most Crowdfunding portals to offer investments under Title II, Title III, and Title IV, all at the same time.
Crowdfunding portals are like retail stores that sell securities. They have suppliers, which we call “sponsors” or “portfolio companies,” and they have customers, which we call “investors.” They pick the market they want to serve – hard money loans, for example – then try to stock their shelves with products from the best suppliers to attract the largest number of customers. Think of DSW, but selling securities rather than shoes.
Now consider these situations:
You’re a Title II portal and have established a relationship with Sandra Smith, a real estate developer you’ve learned to trust. She informs you she’d like to raise $30 million to build a shopping center in Chicago and needs to attract investors from the local community. You could tell her you only do Title II and send her across the street, but maybe she’ll find a competitor where she can get Title II and Title IV under one roof. So you’d really like to offering Title IV as well, which means attracting non-accredited investors.
You’re a Title II portal raising money for biotech. A company approaches you with a new therapy for cystic fibrosis. They have 117,000 Facebook followers and wide support in the cystic fibrosis community, and have already raised $30,000 in a Kickstarter campaign. They want to raise $800,000 for clinical tests, then come back and raise $5 million if the tests are successful. Sure, you could tell them to go somewhere else for the $800,000 raise and come back for the larger (and more profitable) $5 million round, but once they leave they’re probably not coming back.
You’re a Title III portal with lots of investors signed up. Turned away by the portal she’s used to working with, Sandra Smith asks for your help in the $30 million Title IV raise. Any reason to turn her down?
Those of us in the industry see Title II, Title III, and Title IV as separate things, but to the suppliers and customers of the industry they’re all the same thing. The differences between Title II and Title IV are nothing compared to the differences between sneakers and 6-inch heels! Yet DSW sells them both and everything in between because in the eyes of customers, they’re all shoes.
It doesn’t matter to suppliers and customers that Title II and Title III require different technology and business models. It doesn’t matter that one is more profitable than the other. Mercedes might lose money selling its lower-end cars but doesn’t mind doing so because customers who buy the lower-end Mercedes today buy the higher-end Mercedes 10 years from now. The Vanguard Group probably loses money on some of its funds but sells them anyway to keep customers in the fold. As the Crowdfunding market develops, I think the same will be true of the interplay with Title II, Title III, and Title IV.
For portals that have achieved success in Title II, it might be unwelcome news that Title II isn’t enough. But on the positive side, Fundrise has managed to leverage its reputation in Title II into a well-received REIT under Title IV. In any case, I think it’s inevitable.
Last Thursday I joined Jack Miller, the host of “Down to Business” on 880 AM The Biz in Miami, for a discussion about Crowdfunding and what it means for entrepreneurs and investors. Jack is a terrific interviewer and an entrepreneur himself, and brings a great perspective to the subject.
We had a lot of fun and might have even shed some light on this brave new world for Jack’s listeners.
