The SEC has released a set of proposed rules for implementation of Title III of the JOBS Act, FINRA has released proposed forms and rules for the required registration by funding portals and new rules on general solicitation and general advertising have been put into effect.
But where does that leave the market now? Despite the proposals, the Title III crowdfunding market is not open and won’t be for another few months. Furthermore, questions remain as to how navigable that market will be for newcomers and how profitable it will be in the short to medium term.
But where does that leave the market now? Despite the proposals, the Title III crowdfunding market is not open and won’t be for another few months. Furthermore, questions remain as to how navigable that market will be for newcomers and how profitable it will be in the short to medium term.
There are other options for issuers, sophisticated investors wishing to invest in start-ups and young companies and entities that want to facilitate such transactions. Some of these options are set out briefly below.
But before any of that, please consult legal counsel before entering this market in any way. The information below is not legal advice, it is only provided as an introduction. A little knowledge is a dangerous thing and if you make a mistake, even if it is inadvertent, there may be serious legal consequences. Go talk to a lawyer.
Accredited Crowdfunding Platforms
Investment Fund Model
As I discussed previously, the SEC issued no action letters to FundersClub and AngelList in March 2013 which, for all intents and purposes, signed off on the business models proposed by each group.
FundersClub and AngelList are online platforms that are seeking startup companies with a large upside that are good candidates for traditional venture capital funding. Both groups will be open to accredited investors only and will provide such investors with opportunities to invest in unregistered offerings pursuant to Rule 506 under Regulation D of the Securities Act.
Significantly, both AngelList and FundersClub either have or will register as “investment advisers” under the Investment Advisers Act of 1940 and both groups have confirmed that they will not pursue transaction-based compensation (thus avoiding registration as a broker-dealer). These platforms will therefore only look to receiving carried interest from the funds they advise, which will not be immediately remunerative.
Broker-dealer Model
This structure requires an accredited investor-only platform (i.e. deals offered pursuant to Rule 506, as above) that has itself registered as, or has partnered up with, a registered broker dealer.
This option figures to become more attractive as the rules that lifted the prohibition on general solicitation and advertising become better understood and utilized by the market and once the rules implementing Title III crowdfunding are adopted.
This model allows the broker-dealer to receive transaction-based compensation while the platform is able to provide ancillary services in an environment that has the ability to generate deal flow. The broker-dealer model can serve any type of market, company or fund, just as broker-dealers do in the non-online version of the securities world.
Rewards-based Platforms
Think Kickstarter and Indiegogo.
Rewards-based crowdfunding has grown dramatically in recent years and has, until recently, been the only type of crowdfunding that was possible. Kickstarter has reportedly funded tens of thousands of creative projects with hundreds of millions of dollars.
In order to sell a security in the United States, the security must either be registered with the SEC or exempt from the requirements to register that are set out in the Securities Act of 1933, as amended. This rewards-based model avoids the registration issue because it does not involve an offer or sale of “securities”. Instead, investors “donate” funds in return for which they are promised a “reward” of some sort by the person or company that is raising the funds. This model is essentially the pre-sale of goods and services. For example, a music group that raises funds in order to record their new CD might promise each person that donates at least $10 a free copy of the CD.
The platform takes a transaction fee based on a percentage of the amount raised once the target funding amount is met.
Although this type of transaction is attractive for a number of reasons (test the market, avoid shareholder dilution), it does raise a number of often thorny issues, including tax issues for the “donors” and state securities laws (including California) that might consider the transaction as an investment in securities.
Peer-to-Peer Lending Platforms
Although they don’t call themselves crowdfundings, peer-to-peer platforms like Prosper Marketplace and LendingClub do facilitate online deals in which a large number of people (a crowd) to fund a single person or entity. Depending on what you read, these sites may have moved billions of dollars.
These businesses usually enable unsecured interest-bearing loans (maturity of 3-5 years) to borrowers in amounts up to $35,000 that may be used to fund small business initiatives. The platform tales a transaction-based fee when the loan is initially funded and servicing fees as payments are made to lenders.
The model isn’t quite a clean end-run around registration with the SEC, however, as both Prosper Marketplace and LendingClub have shelf registrations on file with the SEC (Form S-1) that allow them to engage in continuous offerings of this nature. Note that this does not address the securities laws of individual states, which usually apply as well.
Yields are relatively high for lenders, but there is very little liquidity for those holding the investment and personal liability for the borrowers (because the loans aren’t corporate loans). Also, the loan size is usually not large enough to mean much to anything but the smallest businesses.
Intrastate Offerings and Crowdfunding
Intrastate offering is registered with a US state securities regulator, only offered to investors in that state and is exempt from registration with the SEC under Section 3(a)(11) of the Securities Act. We won’t get into the specifics here, given the complexity of these types of deals and the fact that they will necessarily be different from state to state, but there has been some success with this type of transaction recently.
For example, Solar Mosaic, a California-based solar finance company, launched a $100 million intrastate debt offering in California to fund solar power projects. The notes correspond to an underlying solar projects is secured by the assets of the solar project. Mosaic takes management fees from investors.
Intrastate offerings can be attractive because, subject to state law, they can be marketed and sold to retail (i.e. non-sophisticated investors), whereas Rule 506 offerings can only access funds from “accredited investors” (although sales can be made to up to 35 non-accredited investors, Rule 506 offerings are often restricted to accredited investors only). However, liquidity is an issuer (resales to investors out of state are usually prohibited for a period of time) and interaction with the state regulator can be problematic as the regulator may be more or less involved in reviewing the offer.
This is an area that is particularly fluid at the moment as state legislators are attempting to address the new market and passing laws related to intrastate offerings.
Conclusion
As the crowdfunding world waits for the SEC to adopt the new rules and regulations it has proposed recently, the crowdfunding market continues to grow and evolve. Companies need money, investors are excited about getting involved and there are business models that can (legally) enable crowdfunding now. It will be interesting to see how the options set out above, which in many instances are gaining momentum, will be impacted when the rest of the market opens up.
Photo Credit: https://bit.ly/p/76vkzm
But before any of that, please consult legal counsel before entering this market in any way. The information below is not legal advice, it is only provided as an introduction. A little knowledge is a dangerous thing and if you make a mistake, even if it is inadvertent, there may be serious legal consequences. Go talk to a lawyer.
Accredited Crowdfunding Platforms
Investment Fund Model
As I discussed previously, the SEC issued no action letters to FundersClub and AngelList in March 2013 which, for all intents and purposes, signed off on the business models proposed by each group.
FundersClub and AngelList are online platforms that are seeking startup companies with a large upside that are good candidates for traditional venture capital funding. Both groups will be open to accredited investors only and will provide such investors with opportunities to invest in unregistered offerings pursuant to Rule 506 under Regulation D of the Securities Act.
Significantly, both AngelList and FundersClub either have or will register as “investment advisers” under the Investment Advisers Act of 1940 and both groups have confirmed that they will not pursue transaction-based compensation (thus avoiding registration as a broker-dealer). These platforms will therefore only look to receiving carried interest from the funds they advise, which will not be immediately remunerative.
Broker-dealer Model
This structure requires an accredited investor-only platform (i.e. deals offered pursuant to Rule 506, as above) that has itself registered as, or has partnered up with, a registered broker dealer.
This option figures to become more attractive as the rules that lifted the prohibition on general solicitation and advertising become better understood and utilized by the market and once the rules implementing Title III crowdfunding are adopted.
This model allows the broker-dealer to receive transaction-based compensation while the platform is able to provide ancillary services in an environment that has the ability to generate deal flow. The broker-dealer model can serve any type of market, company or fund, just as broker-dealers do in the non-online version of the securities world.
Rewards-based Platforms
Think Kickstarter and Indiegogo.
Rewards-based crowdfunding has grown dramatically in recent years and has, until recently, been the only type of crowdfunding that was possible. Kickstarter has reportedly funded tens of thousands of creative projects with hundreds of millions of dollars.
In order to sell a security in the United States, the security must either be registered with the SEC or exempt from the requirements to register that are set out in the Securities Act of 1933, as amended. This rewards-based model avoids the registration issue because it does not involve an offer or sale of “securities”. Instead, investors “donate” funds in return for which they are promised a “reward” of some sort by the person or company that is raising the funds. This model is essentially the pre-sale of goods and services. For example, a music group that raises funds in order to record their new CD might promise each person that donates at least $10 a free copy of the CD.
The platform takes a transaction fee based on a percentage of the amount raised once the target funding amount is met.
Although this type of transaction is attractive for a number of reasons (test the market, avoid shareholder dilution), it does raise a number of often thorny issues, including tax issues for the “donors” and state securities laws (including California) that might consider the transaction as an investment in securities.
Peer-to-Peer Lending Platforms
Although they don’t call themselves crowdfundings, peer-to-peer platforms like Prosper Marketplace and LendingClub do facilitate online deals in which a large number of people (a crowd) to fund a single person or entity. Depending on what you read, these sites may have moved billions of dollars.
These businesses usually enable unsecured interest-bearing loans (maturity of 3-5 years) to borrowers in amounts up to $35,000 that may be used to fund small business initiatives. The platform tales a transaction-based fee when the loan is initially funded and servicing fees as payments are made to lenders.
The model isn’t quite a clean end-run around registration with the SEC, however, as both Prosper Marketplace and LendingClub have shelf registrations on file with the SEC (Form S-1) that allow them to engage in continuous offerings of this nature. Note that this does not address the securities laws of individual states, which usually apply as well.
Yields are relatively high for lenders, but there is very little liquidity for those holding the investment and personal liability for the borrowers (because the loans aren’t corporate loans). Also, the loan size is usually not large enough to mean much to anything but the smallest businesses.
Intrastate Offerings and Crowdfunding
Intrastate offering is registered with a US state securities regulator, only offered to investors in that state and is exempt from registration with the SEC under Section 3(a)(11) of the Securities Act. We won’t get into the specifics here, given the complexity of these types of deals and the fact that they will necessarily be different from state to state, but there has been some success with this type of transaction recently.
For example, Solar Mosaic, a California-based solar finance company, launched a $100 million intrastate debt offering in California to fund solar power projects. The notes correspond to an underlying solar projects is secured by the assets of the solar project. Mosaic takes management fees from investors.
Intrastate offerings can be attractive because, subject to state law, they can be marketed and sold to retail (i.e. non-sophisticated investors), whereas Rule 506 offerings can only access funds from “accredited investors” (although sales can be made to up to 35 non-accredited investors, Rule 506 offerings are often restricted to accredited investors only). However, liquidity is an issuer (resales to investors out of state are usually prohibited for a period of time) and interaction with the state regulator can be problematic as the regulator may be more or less involved in reviewing the offer.
This is an area that is particularly fluid at the moment as state legislators are attempting to address the new market and passing laws related to intrastate offerings.
Conclusion
As the crowdfunding world waits for the SEC to adopt the new rules and regulations it has proposed recently, the crowdfunding market continues to grow and evolve. Companies need money, investors are excited about getting involved and there are business models that can (legally) enable crowdfunding now. It will be interesting to see how the options set out above, which in many instances are gaining momentum, will be impacted when the rest of the market opens up.
Photo Credit: https://bit.ly/p/76vkzm
About the author - Dan McNamee
Dan is a U.S. trained and qualified lawyer (New York) with extensive experience in capital markets and M&A transactions in the United States, Europe, Asia and Africa. This background has provided extensive exposure to rules, regulations and regulators (including the SEC and FINRA) governing many forms of capital raising in the United States. With this foundation in the traditional capital markets space, Dan is seeking to help grow the crowdfunding market in the United States in a manner that encourages capital formation, protects investors and meets the extensive requirements of the nation’s regulators.
Born and raised in Cleveland, Ohio, Dan has worked and lived throughout the United States, in London and elsewhere in Europe. In his spare time, Dan has contributed a significant amount of pro bono work to a number of organizations, including the Clinton Health Access Initiative, and enjoys suffering as he watches Cleveland’s consistently terrible sports teams lose.
Dan is a U.S. trained and qualified lawyer (New York) with extensive experience in capital markets and M&A transactions in the United States, Europe, Asia and Africa. This background has provided extensive exposure to rules, regulations and regulators (including the SEC and FINRA) governing many forms of capital raising in the United States. With this foundation in the traditional capital markets space, Dan is seeking to help grow the crowdfunding market in the United States in a manner that encourages capital formation, protects investors and meets the extensive requirements of the nation’s regulators.
Born and raised in Cleveland, Ohio, Dan has worked and lived throughout the United States, in London and elsewhere in Europe. In his spare time, Dan has contributed a significant amount of pro bono work to a number of organizations, including the Clinton Health Access Initiative, and enjoys suffering as he watches Cleveland’s consistently terrible sports teams lose.
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