William Carleton, Counselor @ Law

What Do Angels Think of Crowdfunding?

What do angel investors think of the prospect of a new crowdfunding securities exemption? Good news, or bad?

It depends on the angel you ask.

I wanted to find a way to articulate the range of reactions I've been hearing from angels, in the months since a crowdfunding exemption first gained traction in Congress.

So, late Wednesday afternoon, I emailed a three-question SurveyMonkey poll to fourteen currently active angel investors. Eight have responded as of this writing (Thursday afternoon).

The poll, and the answers, are still very much in the realm of the anecdotal. But the results help me focus a bit better on how any crowdfunding exemption might better overlap with the Reg D Rule 506 paradigm to which serial entrepreneurs, angel investors and startup lawyers are accustomed. (I still think crowdfunding deals, to work, have to be set up in a way that bypasses lawyers.)

The results, and some interspersed commentary, below:

While angels are likely to have a generally positive view of crowdfunding, some feel strongly that crowdfunding should not extend to the sale of stock in startup companies. "In general, I think it’s a bad idea," one of the survey respondents wrote. "These are highly risky assets."

One respondent told me that the the interests of entrepreneurs should come first. "I am in favor of crowdfunding because I think it will help entrepreneurism to flourish. I also realize that it may create competition for the angel investors however."

Last comment from another of the respondents, who is generally okay with the idea but not convinced of the need: "I really don't think there's a shortage today for funding good ideas."

Crowdfunding a Crowdsourced Ad for Crowdfunding

A group of really cool, hardworking people have put together a campaign to draw the attention of the political class to the crowdfunding exemption legislation currently before the Senate.

The objective is to raise money to place a very nicely designed ad in Politico, the paper all the politicos read. Here's an early version of the ad:

As usual, Paul Spinrad's Change Crowdfunding Law blog has the details. See his February 12 post for background on the strategy, who is behind the campaign, the fundraising plan, and the target date for publication (assuming the funds can be raised).

Okay, I know I have been railing on Facebook for perverting social distribution, chiding Twitter for polluting the timeline with fake tweets, and otherwise advocating for an ad-free commercial web. But this ad is for that offline, political class in DC!

NASAA's Model Crowdfunding Exemption - the Internal Draft

Today's the day by which the NASAA requested that its members - state securities regulators - give it feedback on the model crowdfunding exemption it circulated last month.

The model exemption had been posted to NASAA's site, at least for a time, but was taken down, possibly due to the fact that it had been disccovered and was being accessed outside the membership (I am speculating; I do not really know why it was taken down).

Since NASAA circulated its draft, the crowdfunding movement has gotten a lift from the announcement of White House support.

The President, as far as I know, has not announced support for any one of the three crowdfunding bills before Congress; nor has he, as far as I know, expressly excluded that idea that state regulators might control the policing of a crowdfunding exemption. But the NASAA's sense of urgency about pulling together a viable, state-run alternative - "in light of the speed with which Congress may proceed on these issue" - would appear to have been validated by the White House announcement.

For future reference, here is the initial NASAA model crowdfunding exemption, as submitted to member regulators for comment:

Rule XXX. Model Crowdfunding Exemption.

(a)  Definitions.  For purposes of this rule, the following definitions shall apply:

(1)  “Executive officer” shall mean the president; any vice president in charge of a 
principal business unit, division or function (such as sales, administration or finance); any 
other officer who performs a policy making function; or, any other person who performs 
similar policy making functions for the issuer.

(2) “Institutional investors” shall have the same meaning as provided in Section XXX 
[Section 102(11) of USA 2002].

(3)  “Intermediary” shall mean an entity that facilitates the offer and sale of securities by 
issuers to investors through an internet-based system that is open to and accessible by the 
general public.

(4)  “Management” shall mean the issuer’s directors, executive officers, or the persons 
that perform such functions for the issuer.

(5) “Qualified custodian” shall mean one of the following entities that is not affiliated 
with the issuer by any direct or indirect common control and has not had a material 
business relationship with the issuer in the previous two years:

(A)  A bank or savings association that has deposits insured by the Federal 
Deposit Insurance Corporation; or

(B)  A registered broker-dealer other than the intermediary.

(b)  Transactional exemption from securities registration requirements.  The offer or sale of a 
security by an issuer in a transaction that meets the requirements of this rule is exempted from 
Sections XXX through XXX [Sections 301 through 306 of USA 2002] and Section XXX 
[Section 504 of USA 2002] and is subject to the limitations contained herein. 

(1)  Aggregate sales limit.  The aggregate amount of securities sold to all investors by the
issuer during the 12-month period preceding the date of the offer or sale, including any
amount sold in reliance upon this exemption, shall not exceed $500,000, other than: 

(A)  Securities sold to institutional investors; and 

(B)  Securities sold to the issuer’s management.

(2)  Individual investment limitation.  The aggregate amount sold to any investor in
reliance upon this exemption within the previous 12-month period shall not exceed $1,000.
For purposes of this individual investment limitation, the following investors shall be
treated as one investor:

(A)  Any relative, spouse or relative of the spouse of an investor who
has the same principal residence as the investor; 

(B) Any trust or estate in which an investor and any related person as specified in 
paragraph (b)(2)(A) or (b)(2)(C) collectively have more than 50 percent of the 
beneficial interest (excluding contingent interests); and

(C)  Any corporation or other organization of which an investor and any related 
person as specified in paragraph (b)(2)(A) or (b)(2)(C) collectively are beneficial 
owners of more than 50 percent of the equity securities (excluding directors' 
qualifying shares) or equity interests. 

(3)  Use of an intermediary.  All offers and sales of securities in reliance upon this 
exemption shall be made through an intermediary’s website in compliance with the 
provisions of this rule.

(4)  Notice to home state Administrator.  Prior to the offer of any security in this state in 
reliance upon this exemption, the issuer shall file a notice electronically or in writing on 
Form CF.  The notice shall be filed with the Securities Administrator of the state in which 
the issuer maintains its principal place of business, and an amended notice shall be filed 
within 30 days of any change in the information provided on the Form CF.

(5)  Disclosure to investors.  Prior to any offer of securities, the issuer shall provide the 
following materials to the intermediary, and these materials shall be made available to 
each offeree through the intermediary’s website:

(A)  The information required in Parts 2 and 3 of Form CF; and

(B)  Information describing the financial condition of the issuer, including, at a 
minimum, unaudited financial statements prepared in accordance with generally 
accepted accounting principles in the United States.

(6)  Restrictions on advertising and communications.  The issuer shall not advertise the 
specific details of the offering, except for notices which direct investors to the 
intermediary’s website.  Potential investors that have reviewed the information 
maintained on the intermediary’s website shall have the opportunity to ask questions and 
receive answers concerning the terms and conditions of the offering and to obtain any 
additional information which the issuer possesses or can acquire without unreasonable 
effort or expense that is necessary to verify the accuracy or clarify the information 
provided on the intermediary’s website.  If such additional information is material, the 
issuer and the intermediary shall immediately amend the information contained on the 
intermediary’s website to provide such information.  The intermediary may also maintain 
a forum on its website whereby potential investors may ask questions of and receive 
answers from the issuer.  Such forum shall be available to all potential investors as well 
as state securities regulators as provided in paragraph (c)(5).

(7)  Target amount, offering period, and escrow requirements.  The issuer shall establish 
a target offering amount and an offering period of not more than 12 months from the date 
of filing the notice as set forth in paragraph (b)(4).  All offering proceeds shall be held in 
an escrow account maintained by a qualified custodian until offering proceeds (less any 
offering proceeds from the issuer, its management or affiliates) totaling at least the target 
offering amount are received.  If the target offering amount is not received by the end of 
the offering period, the proceeds shall be returned to the investors within thirty days.  All 
investors shall have the right to withdraw their investment, without deduction of any 
kind, until such time as offering proceeds (less any offering proceeds from the issuer, its 
management or affiliates) totaling at least the target offering amount are received and the 
offering proceeds are released by the qualified custodian from the escrow account to the 
issuer.

(8)  Compensation restrictions. Neither the issuer nor the intermediary may employ or 
compensate promoters, finders, lead generators, or other persons to attract or provide the 
personal information of any potential investor.

(9)  Disqualification.  This exemption shall not be available if any of the following 
persons is subject to a disqualifying event as described in the regulations adopted in 
accordance with section 926 of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act:

(A)  The issuer or its management; or

(B)  The intermediary or any of its executive officers or directors, or persons 
occupying similar roles.

(10)  Restricted securities.  A security issued in a transaction that is exempt under this 
rule may not be sold by the purchaser during the 12 month period beginning on the date 
of purchase, unless the security is sold:

(A)  to the issuer, an institutional investor, or a family member of the purchaser;

(B)  as part of a registered offering; or

(C)  in connection with the death of the purchaser.

(11)  Exclusions.  This exemption shall be available only to business organizations duly 
organized and registered under the laws of a state. This exemption shall not be available 
to any of the following:

(A)  A foreign issuer;

(B)  An investment company, as defined in Section 3 of the Investment Company 
Act of 1940;

(C)  A development stage company that either has no specific business plan or 
purpose or has indicated that its business plan is to engage in a merger or 
acquisition with an unidentified company or companies, or other entity or person; 
or

(D)  A company with a class of securities registered under the Securities 
Exchange Act of 1934.

(12)  Sales Reports.  Upon request from the Administrator, the issuer shall provide a sales 
report detailing the amount of securities sold in this state from the beginning of the 
offering to the most recently completed fiscal quarter, unless the issuer has already 
provided this information to the Securities Administrator in the state in which the issuer 
filed its notice under paragraph (b)(4).

(13)  Offering Price.  The offering price of the securities offered and sold pursuant to this 
exemption shall be the same for all investors, and shall not be increased during the 
offering period.  The offering price may be lowered, but only if all previous investors in 
the particular offering are notified of the change and allowed to rescind their previous 
investment and participate at the lower offering price.

(c)  Requirements for intermediaries in connection with offerings of securities pursuant to this 
exemption.  An intermediary shall comply with each of the following requirements.

(1)  Investor screening.  Before a security is sold through the intermediary, the 
intermediary shall ensure that the investor does all of the following:

(A)  Reviews the information provided in Part 3 of Form CF; and

(B)  Positively affirms that the investor understands that the investor is risking the 
loss of the entire investment, and that the investor has the capacity to bear such a 
loss.

(2)  Reduction of fraud risk.  The intermediary shall take reasonable measures to reduce 
the risk of fraud in connection with the offer or sale of the securities.  Such measures 
shall include obtaining a criminal background check and securities enforcement 
regulatory check on the issuer and the issuer’s management, and notifying the issuer of 
any information that may disqualify the issuer from using this exemption pursuant to 
paragraph (b)(9).  Upon request from the Administrator, the intermediary shall provide 
the results of the background check and securities enforcement regulatory check, unless 
the intermediary has already provided this information to the Securities Administrator in 
the state in which the issuer filed its notice under paragraph (b)(4).

(3)  Enforcement of investment limits.  The intermediary shall take reasonable measures 
to ensure that no investor exceeds the investment limits set forth in subsection (b)(2).  In 
addition, the intermediary shall take reasonable measures to ensure that no investor has 
purchased securities in multiple offerings conducted in reliance upon this exemption that, 
in the aggregate, would exceed the greater of: 

(A)  $2,000, if the investor has an annual income of less than $50,000;

(B)  Four percent of the annual income of the investor, if the investor has an 
annual income of at least $50,000 but less than $100,000; or

(C)  Eight percent of the annual income of the investor, if the investor has an 
annual income of at least $100,000.

(4)  Conflicts of interest.  The intermediary and its management shall have no ownership 
or other financial interest in the issuer.

(5)  Administrator access.  The intermediary shall provide the Administrator with 
continuous investor-level access to the intermediary’s website.

(d)  Registration requirements for intermediaries.  An intermediary is a broker-dealer that is 
subject to the registration requirements of [Section 401 of the 2002 USA], but if an 
intermediary’s activity as a broker-dealer is limited to offerings conducted in accordance with 
this rule, the intermediary is exempt from the requirements of the following rules: 

(1)  Rule XXX [any rule that incorporates by reference or is the substantial equivalent of 
section 15(b)(8) of the Securities Exchange Act of 1934, which pertains to membership in 
a self-regulatory organization];

(2)  Rule XXX [any rule that incorporates by reference or is the substantial equivalent of 
section 15(e) of the Securities Exchange Act of 1934, which pertains to customer notices 
regarding short sales];

(3)  Rule XXX [any rule that incorporates by reference or is the substantial equivalent of 
section 15(h) of the Securities Exchange Act of 1934, which pertains to sales of penny 
stocks];

(4)  Rule XXX [paragraph 1.c. of the NASAA Model Rule on Dishonest or Unethical 
Business Practices of Broker-Dealers and Agents, which requires a determination of 
suitability]; and

(5)  Rule XXX [paragraph 1.j. of the NASAA Model Rule on Dishonest or Unethical 
Business Practices of Broker-Dealers and Agents, which requires prospectus delivery].

Picture: Jarek Tuszynsk/Wikimedia Commons.

Crowdfunding Without a Platform?

Good exchange yesterday between Steve Reaser and Joe Wallin over whether the optimal crowdfunding exemption should require an intermediary. ("Intermediary" is the term used in proposed legislation to mean "crowdfunding platform.")

Joe says no. Offerings under Rule 506 of Reg D don't require an intermediary or broker. If issuers may sell directly to investors under that exemption, Joe reasons, why shouldn't the would-be crowdfunded be so permitted?

But Steve Reaser makes a case for why use of a (regulated) intermediary should be built into a crowdfunding exemption:

"I don't understand the opposition to requiring an intermediary; it seems like the only way to create a system with the accountability, transparency,and reliability needed. Some agency will need to provide industry oversight (at a minimum they'll need to follow up on any complaints). The task is manageable if they are working through a few dozen licensed and sophisticated intermediaries,but is far more difficult and costly if they have to deal directly with thousands of issuers. Further: most individual issuers would be doing an offering once or twice in their lives. It's very reasonable to assume that lots of mistakes would be made -- mistakes which could hurt either the investors or the issuers... and these mistakes could so easily be minimized by requiring an intermediary."

As I mentioned last week, Paul Spinrad's recent crowdfunding post on BoingBoing got me rethinking my own position on the mandatory-intermediary question. Paul prefers the lower individual investment caps of the Brown bill (protecting investors, indirectly, by limiting how much they may put at risk in any given crowdfunded deal - or spreading the risk among a crowd that thus has collectively more resources to monitor the integrity of the deal?); but he thinks the McHenry bill (which has passed one house of the Congress already) gets it right to conceive of crowdfunding deals being done sometimes with, and sometimes without, intermediaries.

The old school way of thinking about what's different about 506 (at least as it is relied upon in most startup offerings) is that acredited investors can "fend for themselves" (that is the diction used). If you buy that (and for the most part, I do), one answer to Joe is that crowdfunded deals will be targeted at investors who are not so good at "fending."

The new school way of thinking - or, at least, the position of many advocates of a crowdfunding exemption - is that the wisdom of the crowd will stand in for investor "sophistication" and "suitability" (two other buzz words associated with offerings exempt by virtue of being directed to accredited investors - though it's often acknowledged that wealth alone is sometimes a poor proxy for sophistication). That may suggest either (a) Joe is right and we don't need intermediaries, or (b) Steve is right and we need intermediaries, formal or informal, for the exchanging and compiling of crowd wisdom, though the intermediaries might perform just as well or better for not being regulated.

Whichever way, platform or not, do it without lawyers!

Photo by WIlliam Warbly/Flickr.

Pick a crowdfunding exemption. Any crowdfunding exemption?

The AP reports that President Obama will endorse or propose a package of pro-startup legislation. Today.

The package will draw upon, among other elements, the Startup Act and the American Growth, Recovery, Empowerment and Entrepreneurship (AGREE) Act. Those Senate bills are grab bags of tax incentives, regulatory reforms, and new visas for immigrant entrepreneurs. (The Startup Act would make permanent a 100% exclusion on captial gains from qualified small business stock held for at least five years; it's a great idea, though query how the President is going to square it with electioneering against Mitt Romney's tax bracket.)

It will be interesting to see how granular the White House will get, when it comes to a crowdfunding exemption.

There are at least three crowdfunding exemptions to choose from. Four, if you include a proposal that state securities regulators may be conducting a two-minute drill to pull together.

The Congressional bills are H.R. 2930, S. 1791, and S. 1970.

In many respects, H.R. 2930 (hereinafter, the "McHenry bill"), passed by the House with unseemly unanimity, is the best and most obvious choice. Back in November, the President lent timely support to the McHenry bill with this statement.

S. 1791, introduced by Senator Scott Brown, is also viable. This is the bill being supported by the Wefunders petition (which came to my attention because it drove a ton of traffic to my site yesterday). Wefunders appears to be in the business of being a platform, so it may make sense that they support the Brown bill, which requires use of an intermediary.

S. 1970, introduced by Senator Merkley, is the crowdfunding bill that represents no crowdfunding exemption at all.

The optimum crowdfunding exemption may be a mix of the McHenry bill and the Brown bill. I like what Paul Spinrad said in a responsive comment under his own post on BoingBoing last night:

"I think H.R.2930 is right to not require an intermediary-- that's important, a small local non-tech savvy business shouldn't have to go online.  But I like the lower individual investment cap of $1000 better in S.1791 -- I think $10K / 10% of income (H.R.2930) is way too high to start this new legislation out with."

I'll have to do some more thinking before I give up on the idea that a platform is the best way to bring accountability to the issuers, but I hadn't before appreciated the point that some businesses may not know how to deal with the internet.

Note as I'm just about to hit "publish" at 7:02 AM Pacific: Check out this post by Instagram co-founder Mike Krieger on the White House blog. Among other things, Krieger talks about progress toward making it easier for immigrant entrepreneurs to establish themselves in the US.

Update 10:44 AM Pacific: The White House has issued a press release, stating that "The President is calling for a national framework that allows entrepreneurs and small businesses to raise capital through 'crowdfunding.'”

Federal / State Crowdfunding Coordination

When testifying before the Senate Banking Committee early last month, NASAA (North American Securities Administrators Association) President Jack Herstein asserted that states, not the federal government, should be in charge of crowdfunded securities offerings.

"Congress should allow the states to take a leading role," Herstein said. "The states should be the primary regulator . . . of a crowfunding offering."

What's more, Herstein anticipated the objection that it would take too long for 50 states to put a crowdfunding proposal forward. "The states are working on it, and the states can do it," he testified then.

Clearly he meant that. Last week, Jim Hamilton's blog broke the news that a NASAA committee has submitted a draft to member regulators for comment. And as further discussed on this blog yesterday, the NASAA crowdfunding proposal takes us into details the the federal legislative proposals, so far, have not.

Now, NASAA appears to have thought better of putting its draft crowdfunding rule on the open web (the pdf was taken down from the NASAA site by the time I hit "publish" on yesterday's post), but we do know Herstein is following through. The NASAA document requests that member regulators submit responsive comments by February 7, 2012.

Why so fast? In part, the document says, because of "the speed with which Congress may proceed on these issues." Some proponents of a federal crowdfunding exemption worry that momentum may have stalled over the holiday break, but NASAA's sense still seems to be that the train is leaving the station.

But we don't know for sure that the states really will pull together to endorse an effective exemption. The draft proposed rule is cumbersome enough, and reflects a committment to a "theology," as SM Turner put it in the comments yesterday, of old school, blue sky law. Will the regulators' internal review process take the state crowdfunding prototype closer to the McHenry bill, or, as seems more likely, further from it?

As reassuring as Herstein was in his Congressional testimonry last month, the NASAA document reveals that the organization may still be trying to pin down how many states may be on board. One of the questions put out for response:

"If the federal exemption preserves state authority to regulate in this area, is your state unwilling to consider the adoption of a uniform crowdfunding exemption?"

Some Thoughts on the NASAA Crowdfunding Exemption

"NASAA" stands for the North American Securities Administrators Association, an organization of state and provincial securities regulators. NASAA and its member regulators have been paying attention to the crowdfunding bills in the current US Congress.

Careful attention.

NASAA does not like the fact that the McHenry bill, which passed the House with very broad, bi-partisan support, would preempt the jurisdiction of state regulators over stock offerings that would qualify for the contemplated federal exemption. NASAA is making efforts to persuade the Senate that the Senate's version of a crowdfunding exemption (there are at least two bills to be chosen from or reconciled) should preserve prescriptive state regulatory authority, or at least some state role in a federally conceived exemption.

Turf battle? That's part of it. But it's more than that. In many ways, the bills the federal legislators are drafting don't take a realistic view of the SEC's culture, or its lack of bandwidth to administer a crowdfunding exemption.

In other words, it actually makes some sense that a crowdfunding offering might be administered by a relevant state agency, IF the crowdfunding exemption was uniform in all 50 states and IF one state only had the lead and IF there was no merit review or other up front impediment (something like the McHenry design, if you will, but administered by a single, chosen state regulator, rather than the SEC).

I shudder as I slip from the prior paragraph, because, in interacting with entrepreneurs (non-laywers) in recent months who are proponents of a crowdfunding exemption, I've gotten the sense that entrepreneurs don't appreciate what a tangle of complication, cost and delay can be entailed when you try to conduct a securities offering across several states, and you are not using the federal Reg D regime. There's a reason that almost all startup financing today takes advantage of Reg D. It preempts state regulation and it doesn't involve any prescriptive SEC review. Crowdfunding proponents who are securities lawyers by and large are inclined to want Congress to pass a federal crowdfunding exemption that preempts state law in the same ways Reg D today preempts state law.

NASAA is making the pitch that it can keep jurisdiction over a crowdfunding exemption that is uniform across the country and that won't require issuers (fancy term for startups that issue stock) and intermediaries (the crowdfunding platforms or sites) to deal with 50 different state agencies. That is reflected in their proposal with even more sensitivity than I saw from the NASAA representative in a Senate hearing on crowdfunding late last year.

As I mentioned yesterday, Jim Hamilton's blog provides a good overview of the NASAA proposal. (By the way, I credited the post to Jim, but I see now that the byline credits John Jascob. My apologies to Jim and John for that mistake.) At some point I'll probably try to update the chart I've been iterating which compares the McHenry, Brown, Merkley bills and the NASAA concept (now the NASAA draft rule). In the meantime, I would direct you to the post on the Hamilton blog, or to the NASAA document itself [clarification: as I get ready to hit "publish," I see that the NASAA document appears to have been taken off the NASAA site], for the key thresholds set by the NASAA exemption on offering amounts and individual investments, and on other structural points.

What I want to call out in this post are certain features of the NASAA proposal that reflect a mindset different from that animating the McHenry bill. These features happen also to raise details of implementation that we supporters of a crowdfunding exemption ought to be talking about, but which haven't been forced to the fore in discussion of the federal exemptions, so far.

(I'm going to skip the NASAA proposal's requirement that the crowdfunding intermediary, or platform, be a registered broker dealer. That is probably the biggest difference of the NASAA proposal, though that approach is also reflected in the mess that is the Merkely bill.)

1. The NASAA crowdfunding exemption proposes that all advertising and promotion of a crowdfunded take place on the crowdfunding platform's site.

Some background here: NASAA is not on the bandwagon to repeal the prohibition on "general solicitation." To the contrary, state regulators, who do battle with fraudsters who dress up scams as "Reg D offerings," don't like public promotion of offerings that are not regulated.

When it comes to crowdfunding, one might assume offhand that you have to make peace with the fact that the crowdfunding investors are going to be "generally solicited," on the internet - that the very nature of the activity is public.

But NASAA doesn't assume that. It's draft exemption provides that companies seeking crowdfunding must not promote the offering outside the regulated platform site. Tweets about the offering? Those should do nothing other than link the public to the platform's site. In a sense, the state regulators have the crowdfunding site acting as the offering circular or prospectus for the deal.

Here's pertinent language from the NASAA draft:

"(6) Restrictions on advertising and communications. The issuer shall not advertise the specific details of the offering, except for notices which direct investors to the intermediary’s website. Potential investors that have reviewed the information maintained on the intermediary’s website shall have the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy or clarify the information provided on the intermediary’s website.  If such additional information is material, the issuer and the intermediary shall immediately amend the information contained on the intermediary’s website to provide such information. The intermediary may also maintain a forum on its website whereby potential investors may ask questions of and receive answers from the issuer. Such forum shall be available to all potential investors as well as state securities regulators as provided in paragraph (c)(5)."

2. The NASAA crowdfunding exemption contemplates that crowfunding startups and crowdfunding platforms will be continually updating disclosure about the deal, based on investor questions.

This second point restates what you just read in the block quote above.

It's obvious to me right away that what NASAA is saying about continuous investor feedback and updating of the offering materials is not practical. The second sentence above ("Potential investors that have reviewed the information maintained on the intermediary’s website shall have the opportunity to ask questions and receive answers concerning the terms and conditions of the offering . . .") draws on process that is both prudent and feasible for an all-accredited offering, but query how the issuer and platform will deal with the unrestricted comments of hundreds of investors?

And yet, a process for identifying how changes to the offering terms might be made, and for how those might be communicated to investors already in escrow, is something any actually viable crowdfunding exemption is going to have to address.

3. The NASAA crowdfunding exemption contemplates that crowdfunding platforms will enforce, not only individual investment limits per deal, but also aggregate caps on each individual investor's activity across all crowdfunding deals.

Also in the draft NASAA rule:

"(3) Enforcement of investment limits. The intermediary shall take reasonable measuresto ensure that no investor exceeds the investment limits set forth in subsection (b)(2). In addition, the intermediary shall take reasonable measures to ensure that no investor has purchased securities in multiple offerings conducted in reliance upon this exemption that,in the aggregate, would exceed the greater of: (A) $2,000, if the investor has an annual income of less than $50,000; (B) Four percent of the annual income of the investor, if the investor has an annual income of at least $50,000 but less than $100,000; or (C) Eight percent of the annual income of the investor, if the investor has an annual income of at least $100,000."

The individual limits referenced are $1,000 per year. Assuming an investor maxes out her individual limit on each deal, that means she can do between two and eight crowdfunding deals per year, depending on her income.

Will different crowdfunding platforms have to share information with each other about crowdfunding investors? Will a platform be able to rely on information given by the investor?

4. The NASAA crowdfunding exemption contemplates that crowdfunding investors can demand their money back, at any time until escrow is broken.

Here's the provision in the draft NASAA rule concerning escrow:

"(7) Target amount, offering period, and escrow requirements. The issuer shall establish a target offering amount and an offering period of not more than 12 months from the date of filing the notice as set forth in paragraph (b)(4). All offering proceeds shall be held in an escrow account maintained by a qualified custodian until offering proceeds (less any offering proceeds from the issuer, its management or affiliates) totaling at least the target offering amount are received. If the target offering amount is not received by the end of the offering period, the proceeds shall be returned to the investors within thirty days. All investors shall have the right to withdraw their investment, without deduction of any kind, until such time as offering proceeds (less any offering proceeds from the issuer, its management or affiliates) totaling at least the target offering amount are received and the offering proceeds are released by the qualified custodian from the escrow account to the issuer."

If investors can ask for their money back at any time until escrow is broken, that could make it a challenge for the platform and the startup raising money to keep track of where it is on the amount in escrow, and how far away it is from breaking escrow. It certainly renders the escrow threshold a moving target.

Also note the investments by insiders do not count toward the minimum escrow threshold.

5. The NASAA crowdfunding exemption gets a bit more granular on what platforms will have to do to check out the startups whose offerings they list.

NASAA wants the platforms to do background checks, that the platform must share with regulators on request:

"(2) Reduction of fraud risk. The intermediary shall take reasonable measures to reducethe risk of fraud in connection with the offer or sale of the securities. Such measures shall include obtaining a criminal background check and securities enforcement regulatory check on the issuer and the issuer’s management, and notifying the issuer ofany information that may disqualify the issuer from using this exemption pursuant toparagraph (b)(9). Upon request from the Administrator, the intermediary shall provide the results of the background check and securities enforcement regulatory check, unless the intermediary has already provided this information to the Securities Administrator in the state in which the issuer filed its notice under paragraph (b)(4)."

Concluding thought: The NASAA proposal was directed to its member securities regulators in the form of a "request for comment." Email addresses and contact information are provided in the document. While comments from the public were not invited, why don't we provide some, anyway?

Flickr photo by sethoscope.

More on the Merkley Bill

If you missed it over the holiday weekend, be sure to read Joe Wallin's guest post on an alternative to crowdfunding here. Joe challenges crowdfunding proponents to ask Congress to democratize startup financing in a more fundamental way. I don't agree with Joe's approach, but he's a leading thinker on securities law reform and I think crowdfunding advocates would be smart to confront and assess his view.

Yesterday, Adam Gering left a comment on Joe's post about the 500 shareholder threshold, and that made me look again at the Merkley crowdfunding bill.

Quick recap: there are at least three different crowdfunding bills in the current Congress: one that has passed the House, the McHenry bill, H.R. 2930; one introduced by Senator Scott Brown, S. 1791; and one introduced by Senator Jeff Merkley, S. 1970.

In a prior post, "Third #crowdfunding bill is no charm," I dissed the Merkley bill and suggested Sen. Merkley is no real fan of crowdfunding. 

Adam's comment raises a point I didn't cover in that "third bill" post, and that has to do with whether or not the "crowdfunders," those shareholders who are shareholders by virtue of owning shares issued under the crowdfunding exemption, count toward the 500 shareholder limit (or 1,000, or greater, shareholder limit, assuming legislative efforts backed by Second Market succeed).

As Adam puts it,

"If they just increase the number to 1000 shareholders (as has been proposed), I think a company would still severely regret in the future having sacrificed half their shareholder limit for only $500K of seed funding."

The McHenry and Brown bills cover this, by providing that "holders of securities issued pursuant to" the crowdfunding exemption shall not count as shareholders of record for purposes of the numerical cap. (See Section 3 of each bill.)

But the Merkley bill lays down no such solution. Instead, it kicks the subject over to the SEC, stating that "The Commission may, "as appropriate," exempt from" the shareholder count "securities acquired pursuant to an offering made under" the crowdfunding exemption.

Merkley's language is discretionary: the SEC may decide, as appropriate, to issue rules to exempt crowdfunders from the shareholder cap. If there's no rulemaking on this point, then crowdfunders count against the limit, and Adam's objection applies. Even if there is rulemaking on this point and it ends up at the same place the McHenry and Brown bills start at, Merkley's crowdfunding exemption will have entailed more delay, more uncertainty, and less utility for at least a year.

Flickr photo by Preconscious Eye.

Hey Crowdfunding Fans: Get Congress to Democratize the Existing Laws!

Note from Bill: This is a guest post from Joe Wallin. I really appreciate Joe sharing his views here because he's bringing ideas to the debate that I think crowdfunding advocates should hear, think through, debate, and fold into their advocacy.

Dear Crowdfunding Advocates & Enthusiasts:

It is great that you are excited about the crowdfunding proposals being kicked around Congress. I too am excited about the prospect of crowdfunding becoming legal in the new year.

Making Crowdfunding Legal Is A Great Idea

Crowdfunding is a great idea. It would be great for companies to be able to easily raise small amounts of money from hundreds or even thousands of small investors over the Internet or through other public means, legally, and without having to spend fortunes in legal and accounting fees complying with legal and regulatory mandates at both the federal and state level.

Today, companies don't need to raise huge sums of money to build what could be the next great mobile game or software or other product, resulting in a company that could employ many people. Our laws should be changed to allow entrepreneurs to democratize the funding of these enterprises.

The Trouble With Current Crowdfunding Proposals

The trouble with the current crowdfunding proposals? I don’t think Congress is going about making crowdfunding legal in the right way. And I think that it is wasting precious time fuddling with various and competing proposals that ultimately won’t work when it could easily and should be able to quickly change existing law to achieve the goals we all share.

What Existing Laws Could Easily Be Slightly Changed To Achieve Our Goals?

What existing laws could be changed to achieve our goals? All we need to do is amend Rule 506 of Regulation D to do the following:

• allow general solicitation;
• allow non-accredited investors to investors in Rule 506 offerings without triggering Rule 506’s onerous information sharing provisions even if non-accredited investors are involved--so long as the non-accredited investors invest less than $1,000 (or pick your number) a piece and the total raised from non-accredited investors is less than $1M (or pick your number).

Why is this better than what is currently being proposed? Because it is simpler. Simpler is not always but is frequently better. Let's look at what is currently happening with crowdfunding proposals in Congress. There are multiple, competing crowdfunding legislative proposals proposed. Each is complex. It is unclear which one will emerge as the consensus appraoch. And even if one of them passes, it will likely be years before the regulations are adopted and everything is in place to allow them to be used readily. The likely outcome of all this effort is that nothing will get passed (or that that what will pass will be unusable), and us crowdfunding advoicates will have nothing to celebrate.

What Could Congress Do Instead?

Instead of trying to pass a new, complex law, Congress should just improve upon what is already on the books. I am referring to Rule 506 of Regulation D, the securities law exemption most widely used by startups.

Rule 506 works. And one of the reasons it is so widely used is because of federal preemption. It is unclear how new crowd funding rules and regulations will work with state law. They very well may give state regulators significant authority over crowd funding financings. This may make crowd funding just impractical--look at how well Rule 504 doesn’t work (and how rarely it is used because of the lack of federal premption). In other words, the new proposals may not work as well with state law as Rule 506 does--which could render them not nearly as usable as we all hope them to be.

What Should Congress Do?

Congress should just fix the laws currently has in place. That would actually work. And it could work immediately. Specifically, Congress should make Rule 506 usable in the crowd funding context. How?

1. Remove the ban on general solicitation--period; for all offerings. Allow companies to advertise for funds on their web sites. On the Internet. Everywhere.
2. Reduce the financial threshholds to qualify as an accredited investor. Consider reducing them to really, really low threshold amounts.
3. Allow non-accredited investors to invest in Rule 506 offerings as long as non-accredited investors don’t invest more than $1,000 per offering or $1M in the aggregate.
4. Repeal the ridiculous and onerous new bad actors rules and regulations.
5. Allow “sophisticated” investors to qualify as “accredited investors.” What do I mean by this? Perhaps a test administered by the SEC, or NASAA, that once investors pass allows them to check the box that they are accredited. This “test” would essentially educate potential investors about the risks and the likelihood that they are going to lose money.

I hope that in the new year Congress will see fit to pass laws which actually make life easier for entrpreneurs and startup companies. I have a long list of suggestions I have made in this regard, that you can read about on Quora here. 

Photo by S.S.K.

Joe Wallin is a startup and emerging company attorney who practises law at the Davis Wright firm. He blogs at Startuplawblog.com and is Bill's fellow Seattle Dude behind the Startup Trivia app.

Final Rule on Change to "Accredited Investor" Net Worth Standard

A final rule was published yesterday, to bring SEC rules in line with the change Dodd-Frank made in July 2010 to the "accredited investor" definition.

The accredited investor definition is critical for angel investing and therefore for the startup financing ecosystem. Though some feel that an effective crowdfunding exemption could greatly democratize seed financing, the facts are (a) there is as of yet no such thing as a crowdfunding securities exemption, and (b) angel financing is far and away the means by which most startups are financed today. (Topic for further exploration under the crowdfunding category on this blog: will select crowdfunded deals, assuming an exemption is passed and that it works, funnel back into the angel and VC financing system we recognize today; see the comments from Charles Higgins on this post and my replies, a thread that just begins to pry at that manhole cover.)

Dodd-Frank changed the net worth standard of the accredited definition, laying down a law that one must exclude "the value of the primary residence" from the $1,000,000 net worth calculation. (The effect was that some angel investors were taken out of the startup financing ecosystem. Query whether the great recession was the right time to do such a thing, but it was a compromise and a huge improvement from changes MPAA Chairman and CEO Christopher Dodd, then Senator Dodd, had first proposed.)

And a practical problem was presented by this change: how deal with underwater mortgages?

If, before Dodd-Frank, you owned a principal residence worth $700,000 but had a $1,000,000 mortgage on it, and that mortgage was full recourse (just trying to make my example simple!), then that house but you in a $300,000 hole on your balance sheet; you would have had to have at least $1.3 million in other assets to climb out of that hole to meet the $1,000,000 net worth prong of the accredited investor definition.

But once you exclude "the value of a person’s primary residence," should you change the analysis in the preceding hypothetical? If the equity in your principal residence can't help you in meeting the $1,000,000 accredited investor standard, can you take your negative equity off the table, as well?

The SEC final rule says, no, if you are underwater, your net worth gets dinged. Equity in your principal residence can't help you meet the net worth standard. But having debt on the property in excess of the value of that residence, that hurts you. There are some complicated provisos, of course, that we'll all have to read a million times before we can say we're truly comfortable with the new rule.

The new rule also includes a transitional rules for investors who may have gotten into deals while they were accredited under the old standard, but who fail to meet the new standards.  The idea is to grandfather those investors into an ability to participate in rights offerings, going forward.

Below is a screenshot from the SEC final release of yesterday. If you need to cut and paste the text of the rule, here is a link to the release itself (pdf). The release has commentary on how to read the new rule. Here is a link to an earlier post prognosticating how stable the accredited investor definition should otherwise be over the next few years.

Photo, "etsy hat," found on Kelly Ryan O'Brien's blog.