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Accredited Investors: Know Your Online Securities Intermediary

Editor’s Note: This is an updated version of an article first published on November 19th, 2014.

The market for online alternative investments has been growing at a steady pace over the past few years. While the use of Rule 506(c) under Regulation D (which allows for general solicitation to reach accredited investors) is still a small segment of the overall market for private placements, companies are beginning to recognize that they have the opportunity to reach a larger number of accredited investors by using online general solicitation. There are three ways in which a company can utilize Rule 506(c) to publicly market its securities to accredited investors over the internet:

  1. On its own
  2. By use of a passive bulletin board
  3. Through a broker-dealer platform.

[Editor’s Note: If you don’t know what Rule 506(c) and Regulation D are then you will benefit from reading Equity Crowdfunding: New Options for Angel Investors.”]

As an accredited investor, it is important to know what distinguishes each method and type of platform, as well as what to watch out for when considering an online alternative investment. While the risk of fraud or business failure is always present, the means by which an offering is conducted creates its own risks as well.

[Editor’s Note: Check out our webinar, “Due Diligence Before Investing”.]

For instance, non-compliance with applicable federal and state laws governing the conduct of an offering may create a right of rescission for investors. So, even if you, as an investor, are happy with the status of your investment, another investor may decide to demand the return of his principal, potentially leading to insufficient capital for the company to continue operations. This is a risk that is not typically disclosed prior to investing.

The Company Going It Alone

Under Rule 506(c), a company may advertise that it is seeking investment through its own website, or a site specifically created for the offering. There is no securities intermediary in the offering and the company is making itself available to investors directly. Since the adoption of Rule 506(c) by the Securities and Exchange Commission (the “SEC”), a handful of technology service providers have created integrated payment processes to facilitate online investment from the company’s website.

Additionally, the company is taking it entirely upon itself to ensure compliance with the exemption from securities registration with the SEC.

For investors, the advantageous aspect of this arrangement is that there is no third-party intermediary that is collecting fees on the investment. Instead, all of the funds will go to the company (minus any processing, escrow costs, etc.).

The disadvantage is that no third-party has reviewed the deal to substantiate the statements and assertions by the company or confirm that the investment is legally valid and binding. Additionally, the company is taking it entirely upon itself to ensure compliance with the exemption from securities registration with the SEC. Failure to comply with its obligations may result in violations of state or federal securities laws that may make it more difficult for the company to raise funds in the future if additional capital is necessary, or could create an obligation to rescind any investments.

Passive Bulletin Boards

Passive bulletin boards are third-parties that assist in the sale of securities by hosting the company’s offering and providing technology-related services but is not selling on behalf of the company. Bulletin boards typically do collect transaction fees and fixed fees for the company’s use of the platform to market its offering.

One benefit of bulletin boards is that investors can review and compare a number of available offerings all in one place. Bulletin boards may also do some of their own marketing to bring deals to investor attention.

However, bulletin boards are constrained in their actions in order to avoid broker registration requirements. One such requirement is that bulletin boards may not offer investment advice. Investment advice is a very broad concept and essentially prohibits passive bulletin boards from vetting or curating companies in order to present investors with “good” deals. As a result, if a passive bulletin board uses any kind of subjective language to talk about the quality of the companies on its site, that bulletin board may have engaged in investment advice and may be required to register as a broker.

One benefit of bulletin boards is that investors can review and compare a number of available offerings all in one place.

Why does this matter for investors? Under some state laws, investors who invest in a company that has used an unregistered broker-dealer may have a private right of rescission, potentially leading to the company facing an obligation to return investment capital that is has received (and may have already spent).

Broker-Dealer Platforms

The third option available to companies to reach investors online are platforms backed by registered broker-dealers. Broker-dealer platforms have a number of obligations that work to the benefit of investors. However, this is not without cost and brokers do take significant fees, often in the form of a fixed posting fee and percentage commissions.

One obligation, in particular, is that brokered platforms must provide investment opportunities that are “suitable” to its investors. This obliges the broker to conduct thorough due diligence on the offering and uncover any problems that could jeopardize the investment.

[Editor’s Note: Continue reading about investing in “Your Wealth is Entropic: Use it (Or Not), You Will Lose It”.]

Broker-dealer platforms are also able to vet deals and solicit investors on behalf of the company—meaning that the deals are more likely to be of better quality. For instance, a common transaction type for broker-dealer platforms is a company with a lead investor in place that has already negotiated the terms of the deal, but the company is seeking to raise capital in addition to that being invested by the lead investor.

With broker-dealer platforms, accredited investors also have a greater amount of publicly available information about the management and prior activities of broker-dealers through FINRA’s BrokerCheck service. This gives you as an investor the opportunity to review the credentials of investment professionals participating in the offering.

In any scenario, for accredited investors, it is important to think critically and determine if you have enough information to make an informed investment decision.

About Andrew Stephenson

Director of Research Operations and Client Services forÊCrowdCheck.

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