Wednesday, March 16, 2016

Five Myths of Investment Crowdfunding - Part 2

Benji's Blog - By Benji T. Jones

This is part 2 of a 2 part post on the five myths of investment crowdfunding. Part 1 is here.

Myth #3: Will Regulation Crowdfunding make all other paths redundant?  
Benji Jones
No.  There is no one-size-fits-all exemption.  Issuers may have many different objectives that impact which path is best.  Just look at the offering caps – companies can only raise $1 million per year under Regulation Crowdfunding.  That might be too low.  So companies may need to consider alternate paths to raise a larger amount of capital.  Local crowdfunding exemptions may provide access to a larger amount.  Currently, SB481 (NC PACES) would permit companies with reviewed or audited financials to raise up to $2 million in a 12-month period.  Regulation A increases those caps to as much as $50 million in a 12-month period; Rule 506 has no cap.  Despite the lower offering thresholds, some issuers may be drawn to the Regulation Crowdfunding or local crowdfunding statutes for the marketing bonus – harnessing the “crowd” to promote an enterprise can be an extremely powerful tool and added bonus for some issuers.  Alternatively, other companies will require more sophisticated investors, preferring to target only accredited investors through Rule 506 or structure a hybrid offering under Regulation A.  Regulation Crowdfunding simply opened up another avenue for companies to pursue capital, but it is unlikely to become a roadblock for pursuing other options.
Myth #4: Are all investors created equal?
Know your audience
Understand the costs and benefits associated with accepting money from investors who may lack experience in making investments in private companies (where securities have to be held for an indefinite period of time and there is no public market for secondary sales).  Their tolerance for risk or their expectation of how long they should have to wait before they are able to get a return on their investment may be different.  The value they may add to a business enterprise may not be the same as the “super wealthy” experienced investor.  Will your investors be easy to manage and communicate with or will they require extensive hand-holding?  It’s important to understand the pros and cons of taking an investment from anyone – before making the offer. 
Note also --- you may need to verify who is an Accredited Investor.
Rule 501 of Regulation D currently defines “accredited investor” to generally include: (1) banks and other large entities; (2) executive officers and directors of the issuer; and (3) high net worth individuals who have earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or who have a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence)).
You cannot always check the box to confirm this status.  This is of particular importance in Rule 506(c) offerings (which involve general solicitation), when an issuer needs to “verify” that each purchaser is accredited.  There are services issuers can hire to do this, and there are principled approaches to undertaking the verification independently, but the SEC has indicated that just getting an investor to “check the box” isn’t one of them.
You will also need to stay abreast of changes in the accredited investor definition.  The SEC has been actively examining this definition (as required every four years pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act).  In December 2015, the Staff released a detailed report analyzing the current definition and making certain recommendations for modifying it.   The Staff’s recommendations touched on ways to adjust the financial threshold requirements (such as keeping the current thresholds but applying investment limits or creating new inflation-adjusted thresholds) and adding categories of accredited investors based on measures of sophistication not currently contemplated (such as a minimum investment threshold, professional credentials, etc.).  It will be important to monitor these changes and to be prepared to explain to clients how these changes might impact their choices.
Myth #5:  Can companies “go it alone”?  
Maybe.  In many instances an issuer is not allowed to conduct an offering without the use of a portal or intermediary.  Practically speaking, it also might not be prudent to try to conduct the offering without using one.   It just depends on what path or exemption will be used.  In a nutshell: an issuer must use a crowdfunding intermediary (either a registered funding portal or a registered broker-dealer) under Regulation Crowdfunding.  The same may be the case for local crowdfunding exemptions, but it will depend on the rules that apply to a particular jurisdiction.  Although companies are not required to use an intermediary for Regulation A offerings, they may want to engage some kind of listing platform or broker-dealer to help market the deal if they want to raise a significant amount of money (say over $10 million).  Accredited Investor offerings are kind of a hybrid.  Theoretically, companies could advertise their offerings independently under Rule 506(c), but many larger deals are conducted through platforms (AngelList, Equity Shares, Funders Club, CircleUp, etc.) that structure direct investments and syndicated investments in companies and facilitate verification when general solicitation is involved.
But remember . . . not all portals are created equal.
Companies (and their advisors) need to carefully diligence who to use to help with the offering.  Offering portals are potentially regulated as investment advisors and as broker-dealers.  They may also be structuring transactions in a way that implicates the Investment Company Act of 1940.  Portals will need to comply with specific regulations imposed upon their activities (like under Regulation Crowdfunding).  The overlapping nature of these regulations is complex, and it is important to find an operator that understands how these regulations impact what it can and cannot do as well as what it must do.  We are just now finding out who is registered as a funding portal – take a hard look at them.  Understand how platforms charge fees, whether they conduct diligence on offerings, whether they structure transactions or provide form documents.  Do they have experience in other forms of online offerings?  What is their track record?  Can they provide verification of accredited investors or are they simply a bulletin board service?  Are they a registered broker-dealer or working with one?  Read the fine print and the FAQs on the portal’s website. Look for the regulatory disclosures to assess how they operate (or if they even know that there are compliance issues to address).  Use the Internet to assess the reputation and success of different portals.  See what bloggers are saying about the landscape. 

Do the diligence before engaging a partner or commencing an offering and then work with your client to determine what best serves its needs.

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Benji Jones is a partner at the Smith Anderson law firm with extensive experience in representing companies in exempt and non-exempt securities offerings.  Feel free to reach out directly to the author with questions or comments.


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