We continue our discussion of crowdfunding. In our last installment, we discussed the rewards-based origins of crowdfunding from ArtistShare to Kickstarter to GoFundMe. In this installment we move on to the development of equity crowdfunding.
[Editor’s Note: This is the sixth installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. Read Installments #1, #2, #3, #4 and #5.]
Given the success of donation- and rewards-based crowdfunding in the decade up to 2010, it was inevitable that intermediaries in the angel capital profession would try to accomplish similar objectives—matching startups with angel investors using the power of the Internet, disclosing information and deal terms, and facilitating the investment transaction, all online. It is a streamlined process compared with the old version. It typically took eight to 12 months for an entrepreneur to find angels who were interested in the offer and to negotiate a deal. Today on Regulation D platforms it typically takes as little as two to eight weeks from the time an issuer lists its offer to closing a deal with investors and in some cases less than a week. Further, Reg D platforms attract investors (especially strategic investors) to deals from across the country, whereas before, it was frequently a matter of promoting a deal through a network of personal relationships that mainly spanned a metropolitan area or narrow region of the country.
The first Regulation D equity offering platforms, which emerged around 2011, were governed by Rule 506 of Regulation D. We refer to these as “traditional” Reg D platforms. They continue today under Rule 506(b) and Rule 506(c) and are open only to accredited investors. Among the most prominent and successful of those early traditional Reg D platforms are MicroVentures, which launched in 2011, and CircleUp (launched in 2012, focusing on consumer products and retail).
Under traditional Reg D platforms, private companies can sell equity through online platforms only to accredited investors, not to “the crowd.” Thus many “crowd finance” professionals do not refer to traditional Reg D platform offerings as crowdfunding. Rule 506 permitted an unlimited number of accredited investors to participate in an offering, and up to 35 sophisticated non-accredited investors. Rule 506 did not allow general solicitation, which means announcing or advertising the offering outside of the platform where it was listed was prohibited. For online offering platforms, Rule 506 allowed investors to “self-certify” their accredited status (usually by checking a single box on the platform’s registration form).
Rule 506 did not limit the size of an offering in terms of dollars. Rule 506 deals typically involve small businesses making offers of less than $2 million, but the offering amounts varied from much less than $1 million to well over $50 million. Nor did Rule 506 limit the amount a single investor could invest in each deal. (Note: this is a major distinction from Title III equity crowdfunding offerings, which will have a $1 million maximum.)
Significantly, Rule 506 offerings are exempt from registration under state “blue sky” laws, making them ideal for online offerings, whose offerings reach investors in all 50 states.
The regulations implementing Title II of the JOBS Act became effective in September 2013, and in compliance with the statutory requirements the SEC split Rule 506 into two parts:
General solicitation includes advertising the price, equity percentage, terms, and other details of an offer of securities to the general public—through the media, seminars, meetings, etc.—even if sales of those securities can be made only to accredited investors.
People in the private finance industry started referring to 506(b) offerings as “quiet deals.” Some with an excessive fondness for acronyms started to call 506(c) offerings PIPRs—private issuers publicly raising, though the term is misleading because these offerings are not public offerings. (They haven’t yet referred to 506(c) offerings as “loud deals.”)
Title II went into effect on September 23, 2013, and some (but not all) Reg D platforms permitted their issuers to engage in general solicitation if they chose to make 506(c) offerings. One disadvantage of opening up a Reg D platform to 506(c) offerings is that investors might be spooked by the need to submit documentation or engage their professional advisor, to verify their accredited status. Platforms that stuck with the 506(b) “quiet deal” structure could still let their investors “one-click certify.”
|Comparing Rules 506(b) and 506(c) of Regulation D*|
|“Traditional” Rule 506(b)||“New” Rule 506(c)|
|Raise limit for issuers ($)||No limit||No limit|
|Investor status||Unlimited number of accredited investors, self-certification allowed on Reg D platform; up to 35 sophisticated non-accredited investors||Accredited investors only; issuer/Reg D platform must take reasonable steps to verify AI status|
|Investment limit ($)||No limit||No limit|
|Registration under state ”blue sky” laws||Exempt||Exempt|
|* This table summarizes important provisions of the two rules from the investor’s point of view. It is not meant to include all provisions or to be comprehensive. Adapted from © 2014 David M. Freedman and Matthew R. Nutting. Reprinted with permission.|
Companies that decide to offer securities through a Reg D platform must choose whether they want to use Rule 506(b) or Rule 506(c). If they chose the 506(b) exemption, where general solicitation is not permitted, investors can register to see the amount being raised, share price, terms, principals’ backgrounds, financials, disclosures, and other details of the offer, and make a purchase. If they choose Rule 506(c), they can announce and advertise many details of the offer to the public (including raise, price, equity, etc.), and direct investors to the platform where they can find more information and disclosures, and make the purchase.
A Reg D platform that operates strictly under the Rule 506(b) exemption may present general descriptions of issuing companies on its home page and other pages that are visible to the public, but must post the offering details behind a “gate” that is accessible only to accredited investors who register (and self-certify) on the site.
Regulation D offering platforms fall into a number of categories, depending on:
Regarding the second-to-last item on the bullet list above: One of the features that distinguishes MicroVentures from CircleUp and many other Reg D platforms is that for each deal it pools investor money into a single entity, a limited liability company, which then executes the private placement memorandum. In this arrangement, investors buy membership units in the LLC rather than investing directly in the issuer. That way, the issuer adds only one entity to its capitalization table—a spreadsheet that lists all the company’s investors, showing when each one invested, the amount of each investment, and how much equity each investor holds, among other data.
Most issuing companies prefer to keep the capitalization table as simple as possible, especially if they are obligated to respond to questions and comments from, as well as provide regular reports to, each and every investor. Small issuing companies that do not have full-time investor relations staff may prefer to avoid having to respond to inquiries from many investors so they can focus on building the business and earning a profit. Thus the platform-created LLC provides a “buffer” between the company and its investors. More importantly, such a structure, depending on its internal organizational documents, can also alter individual investors’ information and control rights. For example, individual investors may not be able to access a company’s books and records, a basic shareholder right under state corporate law (because the LLC, rather than the LLC’s owners, is the investor in the company). In an instance where a company has to hold a shareholder vote to approve some corporate action, rather than solicit approval from the individual investors it would simply deal with the LLC and the individual investors may have very limited or no involvement in the process. Note that we keep saying “LLC” here but the “buffer” entity does not have to be an LLC.
However, the buffer is a disadvantage for investors who want to communicate with company executives. They may be able to do so only through MicroVentures, which manages the LLC.
It is important to distinguish the fund-like LLC entity from a venture capital fund. VC funds are typically blind pools where individual investors do not select portfolio companies in which to invest. Each MicroVentures LLC, by contrast, invests in only one issuer, and the investors who buy LLC units have selected that particular issuer in which to invest. As an aside, and as discussed later in this book, a “pledge fund” is a type of fund that does enable its investors to participate in opportunities on a deal-by-deal basis.
The last item on the bullet list above is whether or not the offering platform qualifies as a registered broker-dealer. Being a broker permits the platform to participate in and effect transactions in securities for the account of its clients and others, and being a dealer allows the platform to buy and sell securities for its own account or through another broker (underwriters and market-makers are examples of dealers).
Broker-dealers are regulated by the SEC and FINRA and as such may be held to a stricter standard of due diligence than other intermediaries. For example, a broker-dealer must take reasonable steps to ensure that the information and disclosures that issuers post on its platform are materially accurate and complete, or risk facing disciplinary action (including regulatory fines and civil enforcement actions) by the SEC, FINRA or both regulators. This means that, among other measures, the platform’s staff will need to implement procedures for examining carefully and in-depth an applicant’s financial disclosures, perform criminal background checks on its executives, etc.
Platforms that are not registered broker-dealers may be selective about the issuers that they accept, but you should not assume that they conduct the same depth of due diligence as registered broker-dealer platforms. Keep in mind that you need to conduct your own due diligence in any case before you invest.
Registered broker-dealers are subject not only to the general anti-fraud and anti-manipulation provisions of federal securities laws and regulations but also to additional anti-fraud and anti-money laundering requirements specific to broker-dealers.
Reg D platforms that are not themselves broker-dealers must effect securities transactions through outside firms that are (e.g., banks or brokerage firms), and in most cases must share fees with those outside firms.
In certain circumstances, the investor-facing staff of a Reg D platform who are registered representatives affiliated with a registered broker-dealer or registered investment advisers may advise investors regarding investment suitability. Intermediaries and advisors who are not registered representatives affiliated with a registered broker-dealer or registered investment advisers are generally prohibited from offering investment advice.
[Editor’s Note: This series is based on Jonathan Friedland’s book The Investor’s Guide to Alternative Assets: The JOBS Act, “Accredited” Investing, and You.]
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David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…
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