Expert Q&A on Accredited Crowdfunding

Transcription

1 PLC Corporate & Securities An expert Q&A with William Carleton and Kimberly Walker of McNaul Ebel Nawrot & Helgren PLLC on the recent proliferation of accredited crowdfunding platforms, also known as online venture capital firms or angel investing platforms. This is just one example of the many online resources Practical Law Company offers. To access this resource and others, visit practicallaw.com. Congress passed the JOBS Act in 2012 with the stated purpose of increasing smaller and emerging companies access to capital. One year on from enactment, these companies are still awaiting SEC rulemaking that would permit them to take advantage of two of the JOBS Act s most heralded reforms: General solicitation in private placements. Title II of the JOBS Act instructs the SEC to amend Regulation D under the Securities Act of 1933 (Securities Act) to allow general solicitation and advertising to be used to market certain private placements sold only to accredited investors (AIs). Crowdfunding. Title III of the JOBS Act creates a framework for permissible crowdfunding offerings. Crowdfunding offerings are unregistered securities offerings marketed via the internet or social media involving a large number of investors, including non-ais, where each invests a small amount. Title III crowdfunding offerings are not permitted until the SEC adopts enabling rules. Despite the SEC s delay in implementing these reforms, in the past year platforms connecting growth companies with capital have been proliferating. Some of these platforms are preparing to begin operations after the SEC adopts rules under Titles II and III. Others are already operating within the bounds of the existing securities laws. A sleeper provision of Title II of the JOBS Act, Section 201(c) (codified as Section 4(b)(1)-(3) of the Securities Act) creates a new exemption from broker-dealer registration under Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) for platforms that provide certain services in the context of offerings conducted under Rule 506 of Regulation D. The Section 4(b) exemption has garnered increased attention following the SEC staff s release in February 2013 of a series of frequently asked questions that: Confirm the exemption is currently available, even before Title II rulemaking allowing general solicitation is adopted. Articulate the staff s views on several ambiguities in Section 4(b) regarding the conditions of the exemption. Give examples of how the staff interprets the prohibition on compensation under the Section 4(b) exemption in connection with the purchase and sale of securities using the platforms. (See Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act (February FAQs).) Following the release of the February FAQs, the staff issued back-to-back no-action letters to two high-profile accredited crowdfunding portals, FundersClub (issued March 26, 2013) and AngelList (issued March 28, 2013). These no-action letters provide alternative models, outside of the JOBS Act, for accredited crowdfunding platforms that plan to earn incentive compensation that would not be permitted under the Section 4(b) exemption. This Expert Q&A deals with platforms that are currently connecting growth companies with AIs. Some of these platforms refer to themselves as online venture capital firms or angel investing platforms. This resource refers to them as accredited crowdfunding platforms. PLC Corporate & Securities discussed accredited crowdfunding platforms with William Carleton. Mr. Carleton is a member of Seattle-based McNaul Ebel Nawrot & Helgren PLLC where he leads a group that works with emerging companies in technology and media. He frequently writes about crowdfunding and other topics relevant to emerging companies, including on his popular securities law blog Law. He also frequently speaks on these issues across the country. Contributions to this article were made by Kimberly Walker, an associate of the McNaul firm who works closely with Mr. Carleton on accredited crowdfunding issues and the firm s clients in this area. For an overview of the JOBS Act and links to continuously maintained summaries of each of its key sections and related rulemaking, see Practice Note, Road Map to the Jumpstart Our Business Startups (JOBS) Act of 2012 ( com/ ). Learn more about Practical Law Company practicallaw.com

2 Generally speaking, how do accredited crowdfunding platforms work? While it is difficult to generalize about this fast-growing and diverse area, generally speaking these platforms offer one or both of the following: Access to a network of growth companies, on the one hand, and investors on the other. They provide an online forum through which companies seeking funding and AIs seeking to invest in growth companies can connect. Curation services. The platforms have quality control measures in place for selecting the capital-seekers they allow to join. Some platforms source growth companies only within their existing professional networks. Others have different vetting processes. Some platforms select from among the companies on the platform particular ones that seem to offer a particularly interesting investment opportunity and flag them for increased attention. Generally speaking, transactions are not executed on or through the accredited crowdfunding platform itself unless the platform has associated itself with a registered broker-dealer. So, for example, in one model, when an investor and company connect and decide to pursue a relationship, the platform does not play any role in the negotiations and resulting transaction. In another model, the investor co-invests with the platform operator through a separate fund that is managed by the platform operator but is separate from the platform. Crucially, information about companies seeking funding is accessible on the platform only to individuals and entities that the platform has confirmed are AIs. Effectively, information on capitalseekers is walled off and protected by a password so only AIs can access it. To be granted access, investors typically must attest to and submit documentary evidence of their AI status. Under current law, this is a necessary step for the platform operator and the sales of securities resulting from contacts made on the platform to be exempt from registration requirements under the federal securities laws (for more information on this, see Practice Note, JOBS Act: Regulation D and Rule 144A General Solicitation Summary ( Hence the term accredited crowdfunding, because the crowd is limited to AIs. What size are the capital-raises typically conducted on accredited crowdfunding platforms? Can you describe the typical profile of a company raising money on them? What about the investor base? While there is no central database that provides information on the typical size of capital-raises across all platforms, certain filings made to state and federal securities authorities provide some insight. For example, the Form ADV filed by FundersClub for its investment adviser registration shows that the average gross asset value of the platform s six disclosed investment funds is $307,776. The average number of owners (meaning investors) of each fund is 53. The minimum investment required is generally $1,000, although the average number of investors and average gross asset value suggest that the average investment is significantly more than $1,000. The percentage of these funds owned by non-us persons is approximately 11.8%. Similarly, there is no comprehensive data regarding the companies raising money on the platforms. The platforms generally restrict the names and details of the companies raising money to members that have been qualified as AIs. Some platforms, such as AngelList, do allow companies to post general information about themselves (although not about specific fund raising opportunities), and this information is publicly available on the website. Generally speaking, companies seeking to raise capital on the platforms are early-stage startups across a variety of industries and geographic locations. Some platforms are geared toward targeted industries, consumer categories or community businesses. For example, a review of the markets represented by companies listed on AngelList, which is focused on early-stage startups, shows that nearly 80% of these companies are in the information technology and consumers sectors. Geographically, approximately 43% of the companies listed on AngelList are located in the US, nearly 12% in Europe and just over 6% in Asia. Can you briefly explain how a funding platform can use the Section 4(b) exemption to avoid the broker-dealer registration requirement of Section 15 of the Exchange Act? Section 4(b) of the Securities Act became available immediately when the JOBS Act was enacted. It provides an exemption from broker-dealer registration under Section 15(b) of the Exchange Act. The exemption is available to persons that would be required to register as a broker-dealer solely because of the following activities related to securities sold under Rule 506: Maintaining a platform or mechanism (including online) permitting offers, sales, purchases, negotiations, general solicitation or similar activities by issuers of the securities. Co-investing in the securities. Providing ancillary services, including: certain due diligence services related to the securities, if the services do not include, for separate compensation, investment advice or recommendations to issuers or investors; standardized documentation services, if the person or entity does not negotiate the terms of the issuance or require that issuers use these documents. 2

3 There are additional conditions to the exemption, including that: The person relying on it does not have possession of customer funds or of the securities in the purchase and sale process. Neither the person relying on it nor any of its associated persons receives compensation in connection with the purchase or sale of the securities. Even though this exemption is currently available, until the SEC fulfills its JOBS Act mandate to amend Rule 506 to allow general solicitation in certain Rule 506 offerings, the ban on general solicitation remains in place. Therefore, currently, issuers using these platforms may not engage in general solicitation (see February FAQs, Question 1). In its February FAQs on Section 4(b), the SEC staff took the position that accredited crowdfunding platforms relying on that provision are subject to strict limits on compensation. What is the business model of these platforms? The Section 4(b) exemption is only available if neither the person relying on it nor any of its associated persons receives compensation in connection with the purchase or sale of the securities. In the February FAQs, the SEC staff expressed a view that the statutory language prohibits a platform operator that is relying on Section 4(b) from receiving any compensation (meaning any direct or indirect benefits), not just transaction-based compensation. Under a conservative reading of the staff s position in the FAQs, arguably the only compensation a platform operator relying on Section 4(b) may receive is any eventual profit from coinvestment in the offered securities. At the same time, the statute itself clearly contemplates that an operator may charge for ancillary services. Ancillary services are not defined in Section 4(b), but the statute gives two examples: Due diligence services. Standardized documents. In my view, both angel groups and other platforms seeking to make a business in accredited crowdfunding will further explore the limits of the ancillary services concept. What if an accredited crowdfunding platform wishes to target types of compensation not permitted under the Section 4(b) exemption? Are there alternative models? Yes, the FundersClub no-action letter and the AngelList no-action letter present alternative venture fund models for accredited crowdfunding platforms. These alternative models may prove more flexible than Section 4(b) on the issue of permissible compensation. The no-action letters lay out business models for an accredited crowdfunding platform that may not trigger, at least not currently, enforcement action under Section 15(a) of the Exchange Act for failure to register as a broker or dealer in accordance with Section 15(b) of the Exchange Act. At a high level, both no-action letters can be said to bless business models in which accredited crowdfunding platforms receive compensation contingently, in the form of a carried interest. Often referred to simply as a carry, carried interest means a percentage interest in any profits made by the fund. In other words, an accredited crowdfunding portal may legitimately rely on the kind of legal exemptions that permit venture capital (VC) firms to set up and manage VC funds, all while conducting business online and crowdfunding the investment dollars. Because, however, both no-action requests indicated that neither platform intended to charge annual management fees expressed as a percentage of funds under management, it is not clear that all aspects of a VC fund business model will be fully extendable into the accredited crowdfunding space. Focusing on the FundersClub no-action request as an example, we can identify ways in which FundersClub is and ways in which it is not conducting its business like a typical VC firm. Unlike a typical VC firm, FundersClub indicated that it will not charge a management fee for the investment funds its management arm will operate. Typically VC firms follow a 2 and 20 model, under which they charge an annual fee equal to 2% of funds under management and take a 20% carried interest when a fund is wound down (known as a back-end carry). In its noaction request, FundersClub indicated that it will take only the back-end carry as compensation (it may also be reimbursed for documented expenses paid to third parties, such as legal costs for fund formation). In addition, FundersClub indicated that it may increase the size of the back-end carry, on a case-by-case basis, to as much as 30% of a given fund s profits. For more information on VC funds, see Practice Note, Private Equity Fund Formation ( If FundersClub sees itself as taking the VC fund model online, why would it dispense with the industry-standard annual management fee? There are probably multiple reasons, not the least of which may include signaling from the SEC staff that this kind of compensation might be deemed transaction-based or would otherwise be disfavored. It may also be fair to consider that FundersClub itself is financed. According to CrunchBase, FundersClub has raised $7 million in angel and venture capital. It may be fair to think of that money as the FundersClub management fee, pre-paid, if indirectly, on investment funds to be specified later. In essence, venture investors in a for-profit accredited crowdfunding platform business might be said to be pre-funding management fees in exchange for a beneficial interest in the platform s carry (though such platform investors assume, of course, the risk that there may be no eventual profits to share). 3

4 It is also important to note that FundersClub indicated that it is a venture capital fund adviser subject to state and other regulation as an exempt reporting investment adviser. In AngelList s no-action request, it indicated that it anticipated some kind of investment adviser registration. For more information on private fund adviser registration, see Practice Note, Summary of the Dodd-Frank Act: Private Equity and Hedge Funds ( us.practicallaw.com/ ). Should issuers care whether an accredited crowdfunding platform is relying on the Section 4(b) exemption or on one of the venture fund models described in the no-action requests? Perhaps. There may be a key additional benefit to issuers seeking to raise capital in a venture fund model accredited crowdfunding platform. In its no-action letters, the SEC staff did not express concern that issuers were evading the current Regulation D prohibition against general solicitation by using the venture fund platforms. This may seem incongruous with the February FAQs, which highlighted that issuers may not engage in general solicitation in connection with sales of securities through accredited crowdfunding platforms relying on the Section 4(b) exemption, at least until the ban on general solicitation is lifted (February FAQs, Question 1). It may be that other aspects of the fund models presented in the no-action letters allayed concern about general solicitation. On the other hand, one can imagine a given platform relying on Section 4(b) being just as vigorous about policing the AI-status of its participants. Are there any state blue sky law issues raised by these platforms? Yes. State securities laws governing broker-dealers and investment advisors may apply to the platforms themselves. Depending on the state, these platforms may be exposed to state securities laws governing the registration and licensing of investment advisors and broker-dealers. Issuers offering securities on accredited crowdfunding platforms are exempt from the substantive registration and qualification requirements of state securities regulations (blue sky laws), as long as they otherwise meet the requirements of Rule 506 of Regulation D. However, as with Rule 506 offerings conducted offline, individual states may require notice filings and filing fees in securities transactions exempt from substantive blue sky requirements. You have predicted that, even after Title III crowdfunding rules are adopted, accredited crowdfunding platforms will continue to dominate. Can you elaborate? Once the SEC adopts rules under Title III of the JOBS Act, in theory crowdfunding portals not limited to AIs can begin operations. However, Title III crowdfunding, or crowdfunding for everyone, is unlikely to replace the accredited crowdfunding platforms already in operation. This will not be the SEC s fault. It will be because Title III is too much of a grab bag of conflicting imperatives. To understand why the Title III framework is so unworkable, it helps to understand the statute s history. The bill that eventually became Title III originated as a simple, limited exemption from Securities Act registration for very small offerings. Sponsored by Congressman Patrick McHenry, the bill was supported by the White House and had broad bipartisan support when it first passed the House. However, months later, as the JOBS Act was being cobbled together from disparate bills, Senators threw into Title III several investor protection measures that effectively make Title III crowdfunding unworkable as a practical matter. Examples of these measures include requirements that companies raising money in crowdfunding offerings: Do not advertise the offering, other than to direct people to the funding portal. Provide investors with financial statements (which must be audited if the issuer is raising more than $500,000). File a business plan with the SEC. The company and its officers, directors and any selling stockholders face potential liability for the business plan. Annually file with the SEC and provide to investors financial statements and other information. Title III crowdfunding portals are subject to the following requirements, among others: They may not solicit purchases, sales or offers to buy securities displayed or offered on the portal. They must ensure that no investor has exceeded its annual per-investor crowdfunding limit, across all platforms. This limit varies depending on an investor s annual income or net worth. A requirement to educate and test investors. A requirement to obtain background checks and securities enforcement regulatory history checks on an issuer s officers, directors and over 20% owners. A requirement to ensure offering proceeds are not distributed before the offering target is reached. They are prohibited from having an interest in any issuer raising money through the portal. For a full description of these requirements, see Practice Note, JOBS Act: Crowdfunding Summary ( 4

5 By contrast, none of these requirements apply to crowdfunding on accredited crowdfunding platforms. Many of the capital raising transactions currently taking place as a result of accredited crowdfunding platforms would: Exceed the Title III $1 million limit. Exceed Title III s per-investor limit. Trigger Title III s requirement that the issuer provide investors with audited financial statements (this applies to offerings of over $500,000). Despite this, a nascent investment crowdfunding industry is eagerly awaiting Title III rules. Promoters of would-be Title III crowdfunding sites are meeting with the SEC and FINRA. Some are reconciling themselves to becoming registered broker-dealers, as the sense emerges that the constraints Title III imposes on funding portals are too restrictive. Contributor Profiles: WILLIAM CARLETON McNaul Ebel Nawrot & Helgren PLLC KIMBERLY WALKER McNaul Ebel Nawrot & Helgren PLLC T F E wcarleton@mcnaul.com W Professional qualifications. Washington, US Areas of practice. At McNaul, Bill leads a boutique group that serves a range of legal needs for emerging companies in Web, IT, Gaming, Custom Software Development, Digital Media and other software-related industries. These needs include: private financings; outbound and inbound licensing agreements; IP spinouts; and M&A events. T F E kwalker@mcnaul.com W Professional qualifications. Washington, US New York, US Areas of practice. Ms. Walker's corporate practice is concentrated in the area of privately held and emerging growth companies. She focuses on representing clients in connection with stock and asset acquisitions and divestitures, mergers, and similar transactions. She has worked on complex M&A transactions in multiple industries, including technology, retail, healthcare, and aircraft sectors. Ms. Walker's experience extends to other corporate matters and transactions, including debt and equity financings, licensing and other commercial agreements, securities offerings, private equity investments, fund formation, and corporate governance. 5

6 For more information, search for the following resources on our website. Topics Market Regulation ( Private Equity ( Unregistered Offerings ( Practice Note: Overview Road Map to the Jumpstart Our Business Startups (JOBS) Act of 2012 ( Summary of the Dodd-Frank Act: Private Equity and Hedge Funds ( Practice Notes JOBS Act: Crowdfunding Summary ( JOBS Act: Regulation D and Rule 144A General Solicitation Summary ( Private Equity Fund Formation ( Checklists Emerging Growth Company Status and Smaller Reporting Company Status: Comparison Chart ( JOBS Act and FPIs: How the JOBS Act Applies to Foreign Companies Chart ( JOBS Act: Effective Dates of Provisions Chart ( Article Crowdfunding Right Now: Alternatives to Title III of the JOBS Act ( For the links to the documents referenced in this note, please visit our online version at Practical Law Company provides practical legal know-how for law firms, law departments and law schools. Our online resources help lawyers practice efficiently, get up to speed quickly and spend more time on the work that matters most. This resource is just one example of the many resources Practical Law Company offers. Discover for yourself what the world s leading law firms and law departments use to enhance their practices. To request a complimentary trial of Practical Law Company s online services, visit practicallaw.com or call Use of PLC websites and services is subject to the Terms of Use ( and Privacy Policy (