3 posts categorized "December 2015"

$20k Soon to Be the New Standard Minimum Angel Investment?

$25,000 is a common minimum investment in startup financings, at least for those conducted offline (not through an accredited crowdfunding platform).

I wonder if that will change, if new SEC staff recommendations for the accredited investor definition are adopted. 
 
CaptureThe SEC staff recommendations are broad and potentially positive for the startup financing ecosystem: they call for expansion of the means by which an investor may qualify as accredited, which may mean more individuals may eventually be eligible to participate as angels.
 
However, on preserving the existing financial thresholds for natural persons to qualify as accredited, the recommendations are muddy. Granted, the staff state that the existing thresholds should stay in place; but they also recommend that the current standards should be indexed to inflation, going forward, and that investors be limited in how much they can invest, unless they meet significantly higher financial qualification thresholds.
 
Here's a quote from the report on the concept for limiting how much the typical angel may invest:
"The Commission could consider leaving the current income and net worth thresholds in the accredited investor definition in place, but limiting investments for individuals who qualify as accredited investors solely based on those thresholds to a percentage of their income or net worth (e.g., 10% of prior year income or 10% of net worth, as applicable, per issuer, in any 12-month period)."
If the investment cap for the majority of angels ends up being 10% per issuer per year, then I'd predict we'll see downward pressure on the $25,000 minimum rule of thumb, and possibly find $20,000 will become a new de facto standard minimum.
 
I derive that figure from the $200,000 income threshold. Ten percent of that minimum threshold is $20,000. Though if you go with the $1M net worth standard (as refined by Dodd-Frank), you get $10,000.
 
What will happen is, the issuer will ask the angel, "unless you are super accredited, what is the maximum you can invest, under either the income or net worth tests?" And the investor will say, "none of your business; I meet the standard, that's all you need to know, here's $20k (or $10k) accordingly - don't ask what my income (net worth) is." This reaction hurts startups insofar as it lowers the average investment, but helps in terms of transaction costs insofar as it bypasses (presumably?) any verification requirement that new rules might impose to enforce individual angel investing limits.

NW Brewpub Chain McMenamins Uses Own Site to Openly Solicit Accredited Investors

Those of you that enjoy beer or securities laws (or both), may have recently seen news articles from various Puget Sound media outlets amorphously mentioning “crowdfunding” when reporting on the development and grand opening of the new McMenamins Anderson School entertainment complex in Bothell. In developing the Anderson School project, McMenamins applied its expertise in creating funky, yet accessible, recreation properties to transform an old, empty middle school building into a complex with a hotel, brewery, restaurants, bars, music and event space and a public swimming pool, in partnership with the City of Bothell.

CaptureThe project has a successful precedent in the McMenamins Kennedy School complex in Portland, and the early reviews on the Anderson School have been quite positive, so much so, that McMenamins recently announced that it would be moving forward with a similar project at the old Elks Lodge in Tacoma.

However, beyond applying its tried and true aesthetic to transform the Anderson School, McMenamins broke new financing ground by using the Rule 506(c) private offering exemption to generally solicit accredited investors via the internet. The company raised approximately $6.3 million (with $250K as the minimum investment) in four months to obtain the initial equity for kickstarting development in the property. This experiment worked so well, the Company intends to use it again in connection with financing the forthcoming Tacoma project.

For those curious about the completed Anderson School deal terms, the offering website is still up, and you can still access all the LLC unit offering documents here. Additionally, a similar site is now up for the Elks Lodge project with initial information about the project and investment terms, however, the offering documents appear to be forthcoming, and no securities appear to be offered yet. Though it does appear similar to the Anderson School project, in that investors will receive a preferred return of 8% flowing from the proceeds of the long-term lease of the property to a McMenamins entity, among other terms.

Conducting private offerings publicly over the internet may sound like a contradiction in terms, and until recently that was the case. However, as part of the federal JOBS Act of 2012, Congress instructed the Securities and Exchange Commission to implement rules allowing general solicitation in a private offering if securities are sold only to accredited investors. As a result, the SEC amended Rule 506 to create Rule 506(c), which allows for general solicitation in a private offering, so long as the issuer takes reasonable steps to verify that sales are made only to accredited investors.

This “verification” standard is a heightened requirement in comparison to the “old-fashioned” Rule 506(b) exemption, which only requires issuers to have a “reasonable belief” that investors are accredited, which may include self-certification by the investor. Although the SEC has provided a set of non-exclusive safe harbors for 506(c) verification, including by bank/brokerage statements, tax returns or statement by a third-party attorney or accountant, this requirement has had a chilling effect on the use of Rule 506(c), as the admission of even one unaccredited investor will disqualify the issuer from use of the exemption, and if any general solicitation has occurred, the issuer will be disqualified from relying on any other exemptions from registration, which could result in significant civil and administrative penalties. As such, using Rule 506(c) has been described as similar to walking on a tightrope without a net.

But back to McMenamins, who rather than worry about the lack of net, just followed the clear rules set forth by the SEC to make sure they didn’t lose their balance. In particular, even though all of the offering information was publicly available on the internet, each prospective investor had to fill out a questionnaire, and submit it to the company counsel with supporting documentation to meet the aforementioned verification steps. Only once the company had “verified” a prospective investor’s accredited status, would any subscription be accepted.

Although some investors may not wish to undergo such scrutiny, this did not seem to be an obstacle for McMenamins, a brand with significant brand and consumer cachet. The Tacoma News Tribune reported that the company raised the $6.3 million from 23 investors (in an offering up to $8 million, per the SEC filing and company offering documents), and now intends to raise up to $10 million for the Elks Lodge project (with a $150K minimum investment), with preliminary indications of interest already received from prior investors.

The use of Rule 506(c) by a company like McMenamins is instructive. By working with competent counsel to safely stay within the investor verification guidance set forth by the SEC, the company was able to broadly reach out to its natural constituency of fans as prospective investors. Simultaneously, it was also able to avail itself of the broad benefits of the Rule 506 exemption, including the ability to raise an unlimited amount of money from an unlimited number of accredited investors, blue sky preemption and “relaxed” disclosure standards, as sales were only made to accredited investors (that said, the company did provide fulsome disclosure materials to prospective investors).

Accredited “crowdfunding” as a concept is generally associated with technology startups and angel investors, but the success McMenamins has had demonstrates that Rule 506(c) is a viable and potentially attractive, offering alternative for companies across a range of industries that may be able to draw widely upon accredited investor interest, rather than being subject to the limited personal networks required by the “substantive, pre-existing relationship” standard of Rule 506(b).

In addition to monitoring the development of these projects, I intend to personally kick the tires at the Anderson School soon by enjoying a McMenamins Terminator Stout, and the always delicious Cajun tater tots.

Image: detail from McMenamins webpage.

Comparing the Federal Crowdfunding Rules with Washington State's

Note from Bill: Before returning to private practice, my colleague, Jordan Rood, worked as a state securities regulator. What's more, Jordan was directly involved in the implementation of the crowdfunding law my friend Joe Wallin was so instrumental in driving into law in the State of Washington. I asked Jordan to give us his perspective on how the new federal Regulation Crowdfunding, promulgated by the SEC pursuant to Title III of the JOBS Act, compares with Washington State's crowdfunding law. Here are his thoughts, in Q&A format.

JordanRood-WebQ: Jordan, before you re-entered private practice, you worked for a few years as a state securities regulator for Washington State. During your time there, I understand you were the person tasked with writing and implementing the Washington crowdfunding rules, which is based on the legislation Joe Wallin proposed and got passed through the sponsorship of Cyrus Habib. So you presumably know the Washington crowdfunding law well. Based on that knowledge base, how do you rate the new federal crowdfunding rules, by comparison?

Great question, Bill. There are actually many similarities between the Washington and federal crowdfunding rules, as certain provisions of the Washington state bill and administrative rules draw from the federal rules. However, there are also some very key differences to consider between the two that make the particular circumstances of an issuer a dispositive factor in determining whether the federal or Washington crowdfunding exemption makes the most sense. For locally-oriented issuers, the Washington exemption may prove feasible, whereas an issuer with greater horizons may find the federal exemption, or another exemption, a better fit.

First, some of the similarities include:

  • Disclosure Requirements: The Washington state rules require that issuers provide prospective investors with material disclosures about the Company, its business and the offering via the “Washington Crowdfunding Form” which is available on the Washington Securities Division’s website, and acts as a short form disclosure document for the issuer. These disclosures include information such as the minimum offering amount, use of offering proceeds, a description of the business and management of the company and risk factors. The federal rules will require similar types of information to be filed on a proposed “Form C” that will be used to provide such information to investors. A significant difference here is that the Washington Crowdfunding Form must be submitted to the Washington Securities Division for review, and potential commentary, prior to the exemption being acknowledged by the Division, whereas the federal Form C must be notice filed with the SEC. However, the information in Form C must be provided to investors by the broker-dealer or crowdfunding intermediary used to offer the securities under the federal rules (more on this below), so it is seems likely that these intermediaries may play a role in setting standards for the information contained in the issuer disclosure materials.
  • Investment Limitations: Both the Washington and federal rules limit the amount of money individuals may invest in offerings conducting under the crowdfunding offerings in a 12-month period. Both exemptions state that  such investment may not exceed:  (1) $2,000 or 5% of the investor’s annual income or net worth, whichever is greater, if either annual income or net worth is less than $100,000; or (2) 10% of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more. A key difference here is that observance of these limitations must be performed by the broker-dealer or crowdfunding intermediary under the federal rules, whereas the Washington rules require the Company to make such determination (however, each set of rules allows this to be done by investor self-certification, absent the issuer’s knowledge the contrary).
  • Ongoing Reporting: Both the Washington and federal rules require the Company to maintain ongoing reports so long as the securities sold pursuant to the exemption are outstanding. The federal rules require the issuer to post on its website an annual report on Form C-AR, containing an updated version of the information required in the Form C offering statement, as well as financial statements of the issuer certified by its principal executive officer.The Washington rules require quarterly reports to be posted on the issuer’s website, which must contain officer and director compensation, the names of directors, officers, managing members or similar persons and major securityholders (20% or more of the outstanding securities), as well as a brief analysis by the issuer of its business operations and financial conditions.

However, as noted above, there are some significant differences between the federal and the Washington State crowdfunding exemptions:

  • Rule 147 v. Rule 4(a)(6): Perhaps the greatest difference between the two exemptions is that the federal exemption relies on Rule 4(a)(6) of the federal Securities Act, which preempts state blue sky laws in connection with such offerings (with the exception of anti-fraud enforcement authority), and the Washington act relies of federal Rule 147 which allows certain “intrastate” offerings to be exempt under the federal Securities Act. What this means, is that the federal exemption will allow for sales to a nationwide audience, whereas to comply with Rule 147, the Washington exemption is subject to significant restrictions limiting both who may be offered securities, and the operations of the Company itself, to Washington state. Specifically, issuers relying on the Washington exemption may only offer securities to Washington state residents (merely offering securities to out of state parties could jeopardize the offering). Further, for an offering to qualify as “intrastate” to the Securities and Exchange Commission, the activities of the issuer and its use of investment proceeds must be substantially within Washington. In particular, the issuer must be organized in Washington, the principal office must be located in Washington, the issuer must derive at least 80% of its gross revenues from operations within Washington, 80% of the issuer’s assets must be located in Washington and 80% of the proceeds of the offering must be used for operations within Washington. The SEC just recently proposed prospective amendments to Rule 147 that would loosen some of these 80% restrictions, however, until such rules are adopted, the intrastate constraints of Rule 147 make the Washington exemption much more restrictive than an offering conducted pursuant to the federal exemption.
  • Financial Statements: The Washington rules require that the Company’s financial statements be GAAP-compliant, with applicable footnote disclosure, but does not require the statements be reviewed or audited by an independent public accountant. The federal rules have heightened requirements for financial reporting that phase as the size of the offering increases, as follows: (1) if the offering is $100,000 or less, the financial statements must be certified by a principal executive officer of the Company, or if reviewed or audited financial statements are already available for the Company, they must be disclosed; (2) if the offering is between $100,000-$500,000, the financial statements must be reviewed by an independent public accountant, unless audited financial statements are already available, then they must be disclosed; and (3) for offerings greater than $500,000, audited financial statements must be provided, with an exception for first-time issuers, which may have their financial statements reviewed by an independent public accountant.
  • Eligible Issuers: The Washington crowdfunding exemptions prohibits many types of issuers from relying on the crowdfunding exemption, including companies involved in petroleum exploration or production, mining or other extractive industries, real estate programs, “blind pools,”  development stage companies with no specific business plan or purpose, equipment leasing companies, and investment companies subject to the Investment Company Act of 1940, among others. The federal rules only exclude investment companies under the Investment Company Act, while retaining the authority to exclude any issuer the SEC, by rule or regulation, determines appropriate.
  • Eligible Securities: The federal exemption does not provide a limitation on the types of securities that may be offered, and note that debt securities may be offered, though it does not provide a specific exemption from the Trust Indenture Act of 1939. The Washington crowdfunding exemption only allows the sale of equity securities by the issuer, with a prohibition on debt securities and resales. An issuer may issue preferred stock under the exemption, as long as the investors receive the protections called for in WAC 460-99C-030(5) (e.g. liquidation preference, anti-dilution protection, voting rights on the creation of senior securities, among other protective provisions, among others).
  • Intermediaries: A significant difference between the two exemptions is that the federal rules require the offering be conducted online via a single broker-dealer or a crowdfunding intermediary, which will allow the “crowd” to assess the offering through review of the disclosed issuer information, and a public forum for prospective investors to exchange information about the issuer and offering. The Washington exemption has no requirement that the offering be conducted by a broker-dealer or intermediary (though use of a broker-dealer is permitted), and contemplates that the issuer will be marketing the offering itself. However, due to the constraints of federal Rule 147 that the Washington exemption relies on, the issuer is limited in its ability to directly offer the securities on the internet, which is global by nature, or other public forums, as Rule 147 requires all offers of securities be to Washington state residents. The Securities and Exchange Commission has provided Rule 147 C&DI guidance (Questions 141.03-141.05) noting that while Rule 147 doesn’t prohibit general advertising or general solicitation, direct marketing on a Company’s website or social media would likely cause offers to be made to out of state residents, jeopardizing the Rule 147 exemption. The SEC does state in 141.05 that it believes issuers may be able to implement technological measures to limit communications constituting an offer of securities to in-state residents, such as limited communications to those with IP addresses originating from zip codes with the state, but does not provide specific guidance on how to address this issue. As such, although the Washington exemption does not require the use of an online intermediary or broker-dealer, the restrictions of Rule 147 may make it difficult for an issuer to conduct web advertising of its securities without running afoul of the strict intrastate offering requirements called for in Rule 147. However, under the federal exemption, requiring the use of an intermediary or broker-dealer will almost certainly add substantial cost to any offering conducted, as compared to an offering run directly by the issuer under the Washington exemption.

Q: Should a startup based in Washington use the Washington crowdfunding rules, or should it use the federal rules?

As noted above, there are key differences between the two that may make one more attractive than the other based on the specific circumstances of the issuer. For a locally-oriented issuer (e.g. a microbrewery), the Washington exemption may make the most sense, as the Rule 147 restrictions may be less burdensome, the offering cost is likely lower as the issuer may market the offering directly and there is no requirement that financial statements be audited or reviewed by an independent accountant.However, for an issuer that intends to generate substantial business outside Washington, the federal exemption would be the vehicle of choice, as the Rule 147 restrictions would not apply. Although some of the offering and accounting costs may be higher, the issuer will be able to reach a wider, national audience for its offering, potentially increasing its chances of meeting its funding goals, and enhancing its exposure to customers. The issuer may also be able to issuer convertible debt, or other preferred securities that aren’t subject to the requirements of the Washington exemption, as well.

Q: In what ways might Reg A+ make more sense?

Regulation A+ may make more sense for issuers that will need to raise additional proceeds and/or reach a wider investor base, as the issuer may raise up to $50 million (as opposed to the $1 million allowed under the Washington and federal crowdfunding exemptions), and the offering may be advertised in up to all 50 states. Particularly for an issuer that is relying on the federal exemption, Regulation A+ may be a more attractive option as the issuer will already be required to spend a significant amount of money on the offering due to the legal costs of organizing the offering, preparing the offering circular and incurring the costs of a broker-dealer or crowdfunding intermediary to market the offering. As it is conceivable that these costs may rise into the realm of tens, if not hundreds of thousands of dollars, it may make more sense for the issuer to spend the additional money required to prepare a Form 1-A offering circular, and continued reporting requirement, if it is able to raise a significantly higher amount of money under Regulation A+. However, Regulation A+ does have higher regulatory hurdles to clear before the offering may become effective. “Tier 1” offerings, which may include offerings under $20 million, are subject to review and commentary by the SEC and each state securities division where the securities will be sold, and “Tier 2” offerings, which may be up to $50 million, are subject to continuing federal reporting requirements after the conclusion of the offering, as long as there are securities from the offering outstanding.

Q: Gosh, lots of strings and conditions and requirements and expenses. Any other alternatives?

Another “crowdfunding” vehicle arising from the federal JOBS Act of 2012, was the creation of Rule 506(c) which allowed for “accredited crowdfunding” as an alternative to the “old-fashioned” Rule 506 private placement exemption that accounts for the vast majority of private securities offerings. Rule 506(c) allows an issuer to raise an unlimited amount of money, from an unlimited number of investors, through “generally solicitation” (i.e. publicly advertising) its private securities offering, which historically has been prohibited under federal and state securities laws. A key condition, however, is that the issuer must verify that each investor is accredited.  This means that the issuer must actually verify the issuer is “accredited” by obtaining tax returns, bank statements, the opinion of counsel or an accountant or other method by which the issuer can actually establish accredited status. The SEC Rule 501 definition of “accredited investor” includes individuals who have made $200,000 over the prior two years ($300,000 with spouse), or have a net worth of $1 million, excluding the value of the individual’s primary residence. The definition also sets forth multiple institutional investors who will meet the definition, as well. While this is a new area of the law that has been showing promise, the risk involved is that the admission of even one unaccredited investor will disqualify the issuer from relying on Rule 506(c), but will leave it without another private offering exemption to claim if it has engaged in any general solicitation in connection with the offering

Q: You can always do it the old fashioned way, right?

In creating these new crowdfunding exemptions (crowdfunding rules, Regulation A+, Rule 506(c)), Congress and the SEC have left in place the “old-fashioned” 506(b) exemption, which remains the primary way by which issuers conduct private securities offerings. Rule 506(b) allows for issuer’s to raise an unlimited amount of money, from an unlimited number of accredited investors, so long as no “general solicitation” is conducted in connection with the offering, and that each investor has a substantive, pre-existing relationship with the issuer or person offering the securities of its behalf. A key feature here (and in 506(c)) is that the disclosure required to be provided about the issuer in connection with the offering is relaxed for sales to accredited investors. As such, most 506(b) offerings are only sold to accredited investors (even though the Rule allows for the sale of up to 35 non-accredited investors), as the sale to any unaccredited investors requires significantly heightened disclosure to such investors, which can be costly and burdensome to provide, and may increase the exposure of an issuer to liability under federal and state securities acts.

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