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Does a Successful Kickstarter Campaign Establish ‘Pre-existing Substantive Relationships’ with Backers, for the Purpose of a Later Securities Offering under Rule 506(b)?

 

DaveFreedmanIt is becoming more common for entrepreneurs to raise capital on Kickstarter or another rewards-based crowdfunding platform, and then raise another round of capital through a Regulation D offering of securities. This later Reg D equity raise could be a Rule 506(b) offering, which prohibits general solicitation, or a Rule 506(c) offering, which allows general solicitation. Rule 506(b) is still the predominant exemption in Reg D offerings.

In a Rule 506(b) offering, one way for an issuer to demonstrate compliance with the rule (i.e., prove the absence of general solicitation) is to demonstrate that is has a “pre-existing substantive relationship” with the investor whom it solicits.

It seems natural for such an issuer to invite its earlier Kickstarter backers, with whom it has maintained communication over a number of months—and to whom it has largely kept its promises (and in most cases apologized for minor delays)—to invest in its equity raise. In fact, that is one of the advantages of running a rewards-based campaign first: there is a handy list of enthusiastic supporters, fans, brand evangelists and/or satisfied customers who are comfortable with the crowdfunding environment.

Keep in mind that for an off-platform equity offering—that is, not through a crowdfunding website—Rule 506(b) allows up to 35 non-accredited investors to participate in the offering. On-platform, however, only accredited investors can register to invest in an offering. So for an off-platform offering, the issuer does not need to determine which of its Kickstarter backers, if any, are accredited investors.

But can a Rule 506(b) issuer specifically solicit its Kickstarter backers in an equity raise, individually or as a group, without violating the ban on general solicitation? In other words, did the issuer establish a pre-existing substantive relationship with its Kickstarter backers?

“It is certainly possible that a relationship could be created as a result of a rewards-based campaign,” says Sara Hanks, a securities lawyer and CEO of CrowdCheck, a Virginia-based compliance and due diligence firm. “It’s important to remember that a pre-existing relationship is not required under federal law. It’s just one way of establishing that there was no general solicitation for 506(b). That principle underlies the no-action letter and the Compliance and Disclosure Interpretation (CDI) notice that the SEC issued [in August 2015]. So, although it’s always going to be a facts-and-circumstances analysis, I don’t see why a rewards campaign couldn’t form the foundation for a relationship.”

You should not consider your relationship with a Kickstarter backer substantive until you build it beyond the superficial level, through ongoing one-on-one communications. Ted Yu, a mergers & acquisitions lawyer in the Washington, D.C., office of Skadden Arps, clarifies: “To have a pre-existing substantive relationship, you must have a relationship that is substantive enough for you to know that the person is an accredited investor [in the event of an equity crowdfunding offering] or is a sophisticated investor [in the event an off-platform offering],” says Yu. “This means having sufficient information about the person’s financial situation to make this determination (e.g., information about the person’s income, net worth, investments etc.). It is unclear whether Kickstarter and other rewards-based crowdfunding sites collect this type of detailed financial information; if they don’t, then I don’t think you can rely on pre-existing substantive relationships.”

Yu is a coauthor of Skadden’s Corporate Finance Alert dated August 13, 2015 [pdf], which highlighted the SEC’s CDI notice on general solicitation.

An issuer under Rule 506(b) must do more than simply maintain a list of Kickstarter backers. It should conduct regular follow-up communications with those backers to establish more “substantive” relationships that will help the issuer learn about backers’ financial status and/or sophistication. Then perhaps it can prove that its relationship with backers is pre-existing and substantive, and its solicitation is specific rather than general.

 

— David M. Freedman has worked as a financial and legal journalist since 1978. He is a coauthor of Equity Crowdfunding for Investors (Wiley & Sons, June 2015). 

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