136 posts categorized "JOBS Act"

Looking for Mr. 506(c)

"On a relative basis, issuances claiming the new Rule 506(c) exemption have accounted for only 2.1% of the reported capital raised pursuant to Rule 506 since becoming effective in September 2014."

Download (1)So reads a key finding of a report, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014, by Scott Baugess, Rachita Gullapalli and Vladimir Ivanov, staff at the SEC's Divisio of Economic and Risk Analysis. They are speaking about the way Rule 506 under Reg D was reformed by rulemaking pursuant to the JOBS Act, to permit general solicitation while preserving a Rule 506 exemption that is preemptive of state law, as long as all purchasers are verified to be accredited investors.

Rule 506(c) should be a big deal, and we should be seeing more "public" private offerings, like the one from the brewpub chain McMenamins, which my colleague, Jordan Rood, wrote about here.

But we aren't, not yet.

So far, old Rule 506, now re-styled Rule 506(b), is the Donald Trump to Reg D's Jeb Bush. The authors of the SEC staff report have ideas why:

The novelty of the 506(c) provisions after decades on non-permissibility of general solicitation in Regulation D offerings may be one reason why Rule 506(b) continues to dominate the Regulation D market. In particular, issuers with pre-existing sources of financing and/or intermediation channels may not yet have a need for the new flexibility. Other issuers may become more comfortable with market practices as they develop over time, including among other things, certainty over what constitutes general solicitation. There may also be concerns about the added burden or appropriate levels of verification of the accredited investor status of all purchasers, for which efficient market solutions may develop over time.

And might there be a whiff of the taint of adverse selection that one would readily associate with Title III crowdfunded deals. The authors allow that this might be so:

It is possible that some sophisticated investors may perceive the election of the 506(c) exemption as a signal that issuers anticipate difficulties in raising sufficient capital and consequently consider it a less attractive offering, which could also dissuade issuers from utilizing the new exemption for their financing needs.

I yet think this will change. Just not any time tomorrow.

Image: scene from Looking for Mr. Goodbar.

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.

Want to Avoid "General Solicitation?" Focus on Relationships!

The following is adapted from remarks prepared for the Angel Capital Association's 2015 Angel Insights Exchange, held in New Orleans the week of November 9. I am the volunteer chair of an advisory council to the ACA, but the views I express below are personal to me, and not a reflection of ACA views or policy; nor are they a reflection of views of my law firm.

As we all know, Dodd-Frank (2010) and the JOBS Act (2012) brought big changes to the rules that govern what’s okay and what’s not okay in the world of federal exemptions from securities registration requirements.

Couple-by-Paul-Kline-Creative-CommonsOne of the biggest reforms – permitting startups and other private companies to advertise a securities offering, provided that all purchasers are accredited investors – has caused the most consternation, at least in the early implementation. That’s largely because this particular reform – “lifting the ban on general solicitation” in Rule 506, the primary federal exemption on which almost all angel-backed companies rely – came with a catch. The catch is this: if you advertise or otherwise “generally solicit,” you will have a newly-invented1 and heightened burden to verify the accredited investor status of your purchasers.

This has caused many entrepreneurs and angels to shun Rule 506(c). Because the new rules made clear that the old rule (now called Rule 506(b)) remains available on a parallel track, you can still raise your money privately the old way; the heightened verification burden will not apply.2

But still there are gray areas: what about demo days; what about online platforms that restrict access so that only accredited investors can see deals; what about angels syndicating deals with other angels? In the early days of implementation of these reforms, people are worried – even more than they were before the JOBS Act, it seems3 – on whether they might trip accidently into conduct that could be deemed “general solicitation.”

Thankfully, we’ve had new guidance from the SEC this year pertinent to the quandary of “general solicitation” and what we might call the 506(b)/506(c) divide. 2015 has brought us:

  • No fewer than eleven (11) new questions-and-answers on general solicitation, to be added to the Division of Corporation Finance’s ongoing Compliance and Disclosure Interpretations; and
  • A new “No Action” letter, called “Citizen VC,” which tells an online platform how it might avoid slipping into Rule 506(c) territory.

The theme of the new SEC guidance is this: a “pre-existing, substantive relationship” can be a terrific antidote to the virus4 of “general solicitation.”

Now, the concept of the pre-existing, substantive business relationship has been around for a long time. It’s been a way of demonstrating that a given deal is indeed private, and prior guidance from the SEC has long held that an issuer can extend the utility of the concept by including, not only persons the issuer knows, but also the relationships of a broker dealer participating in a given offering.

The new SEC guidance, however, now makes it expressly clear that it’s more than okay for an issuer to be introduced by an angel to other angels the issuer might be meeting for the first time, without tripping into “general solicitation.”5 Here’s an excerpt from the answer to Question 256.27:

[W]e acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members . . . may introduce [the] issuer to other members. Issuers . . . may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Similarly, the new SEC guidance at Question 256.33 states that demo days can be “insulated” by the pre-existing, substantive relationships that a demo day organizer has with attendees:

Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network [of angels] as described in Question 256.27.

Finally, I want to highlight the Citizen VC No Action Letter, because it speaks to what an online angel investing platform might do, should it wish to remain under the ambit of Rule 506(b). Here’s how Dan DeWolfe, a member of the ACA Advisory Council and the attorney who wrote the no-action request on behalf of Citizen VC, summarized in a blog post (co-written with Samuel Asher Effron) his take on the import of this particular guidance:

In essence, the approach under the CVC Letter is to make the online private placement offering similar in policies and procedures to an offline private placement. The pre-existing relationship is not time based nor is it satisfied by answering a mere two questions. Rather, the establishment of a pre-existing relationship depends on the QUALITY of the relationship between the issuer and a potential investor. While the vast majority of online offerings will clearly fall within the new Rule 506(c), the CVC Letter does spell out a way to conduct a true private placement in a password protected web page that does not give rise to a general solicitation.

How can an online platform be sure it is not using general solicitation? That’s right, the answer is in line with the guidance theme for 2015: establish a substantive, pre-existing relationship with prospective investors. In the case of online platforms, establishing such a relationship must occur prior to, and not in the context of, a given offering by an issuer on the platform.

Photo credit: Paul Kline (Creative Commons)


1. On the “newly invented” nature of the verification burden imposed by offerings that are generally solicited pursuant to new Rule 506(c): many securities lawyers might emphasize that Rule 506 has always, always required an issuer to have a reasonable basis on which to conclude that its purchasers were accredited. I myself predict that the distinctions between 506(b) and 506(c), on the point of verification, will inevitably blur over time. But it is certainly fair to say that current industry practices that pass muster as sufficient under 506(b) do not pass muster under 506(c).

2. It’s fair, and probably important, to point out that the verification pitfall is connected with another aspect of Rule 506(c) that is scary to startup and emerging company lawyers, and should be to entrepreneurs and angels as well: if you’re relying on an exemption that expressly stipulates that you have engaged in general solicitation, then, unlike what would be typical in most Rule 506(b) offerings, you will not have other private offering exemptions to fall back on, should your Rule 506 exemption somehow fail. Claiming exemption under 506(c) is like walking a highwire without a net.

3. Anxiety about the meaning of “general solicitation” dates back to the rollout of Rule 506(c) two years ago. See this piece I wrote for the Wall Street Journal: http://blogs.wsj.com/accelerators/2013/09/27/weekend-read-the-trojan-horse-of-accredited-investor-verification/.

4. Is my metaphor over the top, or is it really dangerous and unhealthy for a startup to conduct a Rule 506(c) offering? This is a question I would like to put back to all of you!

5. Technically speaking, it does not appear as though the new guidance is saying that a given angel’s network extends the reach of the issuer’s pre-existing, substantive relationships, at least not in the same way that a broker-dealer’s relationships might. See Question 256.29. Rather, the long-standing practice of introductions via angel networks appears to be a similar but independent method of “neutralizing” general solicitation.

SEC official to angel community: go ahead, develop your own verification methods!

Keith Higgins, the relatively new Director of the Division of Corporation Finance, delivered a speech at the closing session of the 2014 Angel Capital Association Summit - and was it a doozy!

A huge issue for angel investors is the "reasonable steps to verify" accredited status that is part of new Rule 506(c), which permits issuers to engage in "general solicitation." The issue was a focus of at least two breakout sessions at the Summit, including one Thursday moderated by ACA policy chair Mike Eckert that I participated in with the gifted lawyers Peter Rosenblum and Rob Rosenblum (not related), and an excellent breakfast briefing Friday from K&L Gates lawyers Gary Kocher and Kevin Gruben.

1842308438_83cb923365_oThe reason for such attention is the anxiety caused by the non-exclusive verification "safe harbors" set out in Rule 506(c). These verification methods contemplate that, going forward, an issuer is going to have to demand personal financial information from investors, or engage third party verification services to do so. To many readers of the new rule, including a majority of securities lawyers, the safe harbors - in spite of the "non-exclusive" label - feel destined to prove de facto requirement.

But Higgins said that needn't be the case.

In his speech (the full text of which you can access on the SEC's website), Higgins emphasized that if any verification standard might be core under Rule 506(c), it is the flexible, "principles-based" approach laid out in the inital release proposing the new rule:

"These [applications of the principles-based method] are all part of a deliberate effort by the Commission to provide issuers with an alternative to the clear but highly prescriptive list of verification methods included in the rule. In fact, it is ironic that this list of verification methods is being viewed by some as the primary way to verify a purchaser’s accredited investor status when, in fact, the Commission originally proposed the principles-based approach as the way issuers would comply with the rule’s verification requirement and added the list of specific verification methods only in response to address the concerns of commenters who wanted more certainty."

As Gary Kocher explained plainly in his breakfast briefing earlier in the day, lawyers are a conservative bunch, and naturally are going to navigate to the safe harbors. But, Gary stated he believed that the staff meant what they said in the rule and in the release, that the principles-based approach was viable. I think Higgins' speech completely validates Gary's view.

All of this portends well for verification methods based on the Angel Capital Association's Established Angel Group guidance, which would not require the turning over of sensitive financial information to issuers or their vendors.

As for seeking express SEC staff blessing of particular applications of the principles-based method of verification? Higgins seemed to say that was both not likely to be forthcoming anytime soon, and also beside the point:

"On that note, we have had recent inquiries asking whether the staff would provide guidance – presumably on a case-by-case basis – confirming that a specified principles-based verification method constitutes 'reasonable steps' for purposes of the rule’s requirement.  The notion of the staff reviewing and approving specific verification methods seems somewhat contrary to the very purpose of a principles-based rule and I am not yet convinced of the need for this type of staff involvement. Rather, this is an area where issuers and other market participants have the flexibility to think about innovative approaches for complying with the verification requirement of the rule and use the methods that best suit their needs. While the staff may not be in a position at this point to provide guidance on what constitutes 'reasonable steps' under particular circumstances, I also believe the staff will not be quick to second guess decisions that issuers and their advisers make in good faith that appear to be reasonable under the circumstances."

I should note that the angels I spoke to at the Summit, and the questions they posed in the breakout sessions, were more precisely focused on the definition of general solicitation and the activities at pitch events and the like that might push a company from 506(b) territory into 506(c) territory. But let's step back a second and look at the problem from just a story or two higher: to the extent that verification under 506(c) becomes more manageable, then the general solicitation issue becomes somewhat less of an existential distinction. (There may yet be reasons to avoid publicly soliciting investors - but that is another topic.)

Success for principles-based verification approaches will not be self-executing. Angels and their entrepreneurs will have to insist on them, and will have to make sure they have enough rigor to acquire respect. In the right circumstances, lawyers for a given deal might, just might, go along.

Drawing: "Principles Mound" by Paul Downey / Flickr.

What exactly is crowdfunding?

This morning I took part in a panel at the Thompson Reuters 2014 Online Financial Services Symposium.

Moderated by Suzanne Barlyn of Thomson Reuters, the topic was "disruptive alternatives," including crowdfunding and peer-to-peer lending.

Bjkz7mTIQAEPKAkThe audience is made up of financial services professionals who manage online trading and other retail financial services on a massive scale. As I blog this, a panel is getting into the nitty-gritty of trade execution. A later panel will talk about user interface design and new ways to engage both self-directed and managed investors (and how the categories are blurring).

So I hope that lends context. The panel I took part in was to discuss new classes of investing that might be around the bend for the mainstream online financial services industry.

6a01156e3d83cb970c01a3fcde8425970b-580wiSomething big that I learned in the course of the morning is that peer-to-peer lending is something not far off into the future, like Title III non-accredited crowdfunding, but a phenomenon already here and even embraced by policy makers at the Federal Reserve. Ron Suber (pictured) of Prosper, a San Francisco based marketplace matching consumer borrowers with lenders, captured everyone's imagination with his vision of disintermediating banks in the consumer credit space. He calls it an investable asset class, and emphasized the pains taken to qualify would-be borrowers (eighty percent of applicants are turned down, he said).

Closer to the world with which I am more familiar - equity financing provided by accredited investors to startups - Michael Raneri of Venovate, another San Francisco-based company, described a sweet spot for online activity that is post-seed stage (later than AngelList or FundersClub), but still very much emerging growth. His company is part broker, part part portal, part VC fund (or maybe fully all three). He does not appear to like the term "crowdfunding," however, for the connotations it brings of Title III.

BjlGgPNIUAAnRkwTim Baker, Global Head of Content Strategy at Thomson Reuters, reminded all that angel and venture financing is relatively small - only about $25 billion a year. He cited historical precedents which suggest to him that, if crowdfunding on the equity side is going to take off, it will take 5 years or so to catch on.

If Tim is right, I imagine that, in that span of time, people will get comfortable with the idea that some kind of clearinghouse will standardize accreditation. When that happens, the 506(b)/506(c) distinction - so very existentially critical in this moment of transition - won't be as big a deal. 

So debt crowdfunding at a retail level is here already. And accredited crowdfunding (Tito Singh of Thomson Reuters terms it "elite crowdfunding") is finding its footings and will likely impact angel investing as we know it. What about equity crowdfunding for everyone?

I know there are people in the nascent non-accredited crowdfunding industry, who see non-accredited crowdfunding of startups as a asset class. That is a mistake. In fact, part of why I like the state crowdfunding alternatives (alternatives to JOBS Act Title III) is that they seem to take more of the approach that people want to back small companies for reasons that are as compelling or more compelling than the prospect of financial return.

Picture credits: first two, Lauren Young of Thomson Reuters (from her tweet stream); third is picture I took from the dais of Suzanne Barlyn before she took the podium.

The costs of Title III crowdfunding

Kiran Lingam has a deflating post up at the SeedInvest blog this morning.

Kiran and his firm are modeling what costs look like, for pursuing an offering claiming an exemption under the JOBS Act Title III investment crowdfunding rules (caution: these rules are not in effect; they have just been proposed, and I presume Kiran's model is based on the proposed rules).

197742056_c761e25f10_zIt's not pretty.

"A successful $99,999 crowdfunding raise with no audited financials," Kiran writes, "will result in negative CASH FLOW to the company of about $38,000."

So that suggests the sweet spot for Title III fundraising will have to be higher, right? But little comfort there, Kiran says. "A successful $1M raise will actually only net $750,000 in capital, he writes. "This is an astronomical cost of capital."

My suggestion to investment crowdfunding advocates: turn attention away from the prospective federal exemption, and toward analysis of those state crowdfunding exemptions already on the books. Would, say, Wisconsin's investment crowdfunding exemption impose fewer costs?

Thanks to Joe Wallin for the heads up on Kiran's post.

Photo: Mark Jones / Flickr.

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