Category Archives: Crowdfunding

Simultaneous Offerings Under Rule 506(c) And Regulation S

Co-Authored By: Bernard Devieux & Mark Roderick

If you ask one of my partners whether he wants beer or hard liquor, he says “Yes.” That’s the same answer most entrepreneurs give when asked whether they want to raise money from U.S. investors or investors who live somewhere else. Fortunately, if you’re reasonably careful, you can raise money from U.S. investors under Rule 506(c) – otherwise known as Title II Crowdfunding – while simultaneously raising money from non-U.S. investors under Regulation S.

You don’t have to use Regulation S to raise money from non-U.S. investors. You can use Rule 506(c) instead, as long as you take reasonable steps to verify that they’re accredited, just as with U.S. investors. But verification can be difficult with non-U.S. investors. You use Regulation S either because you want to include non-U.S. investors who are non-accredited or because you just don’t want the hassle of verification.

The concept behind Regulation S is simple:  the U.S. government doesn’t care about protecting non-U.S. people. That sounds harsh but think about it this way. If an American citizen is taken hostage in Albania, boom, the U.S. military comes to the rescue. But if a Russian citizen is taken hostage in Albania. . . .well, maybe that’s a bad example these days, but you get the picture.

To implement this concept, Regulation S provides that:

For purposes of section 5 of the Securities Act of 1933 [the law that usually requires the registration of securities offerings], the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed . . . not to include offers and sales that occur outside the United States.

An offer or sale by an issuer of securities will be treated as occurring “outside the United States” only if all of the following requirements are satisfied:

  • The buyer is a non-U.S. person.
  • The issuer follows designated guidelines with legends on the securities, restrictions on resales, etc.
  • The offer is not made to a person in the United States.
  • No “directed selling efforts” are made in the United States.

The first two are relatively easy:  you make sure the investor isn’t a U.S. resident and you put the right words on stock certificates, promissory notes, and other legal documents.

The second two become tricky in Crowdfunding, where everything is done on the Internet.

For example, suppose an issuer maintains a single website advertising its offering of common stock, equally accessible to prospective investors in Iowa and in Spain. The website undoubtedly constitutes an “offer” to investors in Iowa, and is undoubtedly part of a “directed selling effort” in Iowa, no less than if the offering had been advertised in the Des Moines Gazette. Does this ruin the Regulation S offering?

The SEC’s definition of “directed selling efforts,” written in the early 1990s, doesn’t address this situation. And other than confirming that issuers are legally permitted to conduct simultaneous offerings under Rule 506(c) (to U.S. investors) and Regulation S (to non-U.S. persons) so long as each offering complies with its applicable rules, the SEC has not provided specific guidance on how to avoid the “cross-contamination” issue involving websites.

Fortunately, the SEC addressed a very similar issue with intrastate Crowdfunding just last year. Technically, an intrastate offering is allowed only if “offers” are limited to the citizens of one state. Does posting an offering on a website violate that rule, given that the website is visible to everyone? The SEC chose the position more favorable to Crowdfunding (as it almost always does), announcing that an intrastate offering could be advertised on a website as long as the issuer accepts investments only from residents of the state in question.

The SEC’s position on intrastate offerings suggests that it would take a similar position on Regulation S, finding that the use of a single website would not violate either (1) the requirement that no “offers” be made in the U.S., and (2) the requirement that “no directed selling efforts” be made in the U.S. But we don’t know for sure.

To be on the safe(er) side, an issuer would create separate websites, one for the Rule 506(c) offering and the other for the Regulation S offering, and use IP addresses to ensure that the Regulation S website is not visible within the United States. On the Regulation S website, you would also:

  • Have each visitor (and potential investor) verify his, her, or its legal residence before being permitted to see the details of the offering; and
  • Feature prominent disclaimers that U.S. persons are not welcome.

Finally, bear in mind that Regulation S is an exemption from U.S. securities laws. If you’re offering and selling securities to the citizens of another country, you should think about the laws of that country, too.

CROWDFUNDING AND CRYPTOCURRENCIES

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Cryptocurrencies are hot. And often the sale of cryptocurrencies is referred to as Crowdfunding. Unfortunately, the use of “cryptocurrencies” and “Crowdfunding” together creates confusion about both, along with some pretty serious legal risks.

We use “Crowdfunding” to mean raising money for a business or other venture online. We say “donation-based Crowdfunding” when we’re talking about Kickstarter, where people ask for donations. We say “equity-based Crowdfunding” when we’re talking about raising money from investors, who receive a stock certificate or some other security.

A cryptocurrency is, well, hard to pin down. It’s a transaction registered in a distributed, secure database. Because it exists in limited quantities and is secure, it has value. Like anything of value, it can be used as a currency. For purposes of this post, the key feature of a true cryptocurrency is that is has value of itself, like a nugget of gold.

You use Crowdfunding to sell shares of stock. Obviously, the paper certificates representing the shares of stock have no value by themselves, they have value only to evidence ownership in the business that issued the certificates or, more exactly, in the cash flow the business is expected to generate. So it wouldn’t make sense to say “I’m selling nuggets of gold using Crowdfunding.” The nuggets of gold have an intrinsic value without reference to the cash flow of anything else, or at least you hope they do. I can go shopping with a cryptocurrency like Bitcoin or Ethereum, just as I can shop with US dollars or, historically, with gold.

This is where things get tricky and words matter. The blockchain – the technology underlying all cryptocurrencies – can be used for a lot of things other than cryptocurrencies. As it happens, one of the things the blockchain can be used for is to keep track of stock certificates. In fact, the blockchain works so well keeping track of stock certificates that it will undoubtedly be used by (or replace) all public stock transfer agents within the next five years.

What’s happening today is that companies are selling what they call “cryptocurrencies” that are really just interests in the future operations of a business, i.e., really just hi-tech stock certificates. Cool, they’re using blockchain technology to keep track of who owns the company! But that doesn’t mean what you’re buying is really a cryptocurrency and that you’re going to get rich like the early buyers of Ethereum.

Words are powerful, and the confusion around cryptocurrencies is deepened by the nomenclature. Sales of cryptocurrencies are often referred to as “initial coin offerings,” or ICOs, which implies a similarity to “initial public offerings,” or IPOs. Yet if we’re being careful, the two have nothing in common. In an IPO a company sells its own securities, which have value only based on the success of the company. In an ICO somebody sells a product that has intrinsic value of itself.

Ignoring the difference is going to land someone in hot water, probably sooner rather than later. A company that sells something it calls a cryptocurrency but is really just a share of stock is selling a security, even if that company has an address near Palo Alto. And a company that sells a security is subject to all those pesky laws from the 1930s. If you sell a cryptocurrency that is really just a hi-tech stock certificate, then not only do you risk penalties from the SEC and state securities regulators, you’ll also face lawsuits from your investors if things don’t go as planned.

How to know whether you’re selling a true cryptocurrency or a hi-tech stock certificate? Here are some tips:

  • If the value of the cryptocurrency depends on the success of the business, it’s a security.
  • If the value of the cryptocurrency depends on, or is backed by, real estate or other property, it’s a security.
  • If the cryptocurrency is marketed as an investment, it’s probably a security.
  • If the value of the cryptocurrency depends what the buyer does with it, rather than the success of the business, it’s probably not a security.
  • If the cryptocurrency merely gives the holder the right to participate in a group effort (g., the development of software), it’s probably not a security.
  • If you’re selling the cryptocurrency in lieu of issuing stock, it’s probably a security.

Filing Financial Statements and Other Reports Under Regulation A

“I know I have to include financial statements when I file an Offering Statement under Regulation A. When should these statements be dated and what periods should they cover?”

“What ongoing reports do I have to file with the SEC after my Regulation A offering is qualified, and when do I have to file them?”

We hope to answer these questions below.

Types of Financial Statements in the Offering Statement

A Regulation A Offering Statement can require four kinds of financial statement:

  • A balance sheet as of the end of a fiscal year
  • An interim balance sheet
  • A statement of income, cash flows, and changes in stockholders’ equity
  • Interim statements of income, cash flows, and changes in stockholders’ equity

Requirements for Financial Statements

In general, the financial statements must be audited in a Tier 2 offering, but not in a Tier 1 offering. However, interim financial statements – balance sheets and statements of income and cash flows – never have to be audited, even in Tier 2.

Audits in Regulation A may be performed using U.S. Generally Accepted Audited Standards or the standards of the Public Company Accounting Oversight Board. The accounting firm that prepares the audit does not have to be registered with the PCAOB.

When Should the Financial Statements in the Offering Statement Be Dated?

This is tricky, because there are not one, but two important dates:  the date the Offering Statement is filed with the SEC, and the date it is qualified by the SEC. By definition, the date of qualification is always after the date of filing, by a month in the best of circumstances and often by many months. That means that a financial statement that was timely when the Offering Statement was filed might be “stale” by the time it’s qualified. In that case, you’ll need to submit updated financial statements before qualification.

Thus, read the term “Reference Date” in the chart below to mean the date of filing, when you’re preparing your Offering Statement. But bear in mind that eventually the “Reference Date” will mean the date of qualification. So if you’re close, you might as well use a later date.

Click here to view the printable chart.

Ongoing Reporting under Regulation A

Click here to view the printable chart.

 

Questions? Let me know.

Raising Capital Online: An Introduction For Real Estate Developers

If you’re a real estate developer accustomed to raising capital through traditional channels, you’re probably wondering about Crowdfunding. In this post, I’m going to provide some basic information, then try to answer the questions I hear most.

Basics of Crowdfunding

  • It’s Not Kickstarter. On Kickstarter, people make gifts, often to strangers. You’re not going to ask for gifts. Instead, you’re looking for investors, and in exchange for their money you’re going to give them the same kinds of legal instruments you’d give an investor in the offline world: an interest in an LLC, a convertible note, or something else.
  • It’s Just the Internet. For better or worse, a certain mystique has developed around Crowdfunding, if only because it’s so new. But Crowdfunding is just the Internet, finally come to the capital formation industry. We buy airline tickets online, we call a cab online, we search for significant others online, now we can search for capital online. If you’re comfortable buying socks on Amazon, you’ll be comfortable raising money using Crowdfunding.
  • Why Crowdfunding? How many investors do you know? Twelve? Seventy-two? With Crowdfunding, you can put your project in front of every investor in the world. And you’ll probably get better terms.
  • The Market Is Small But Growing Quickly. Title II Crowdfunding became legal in September 2013, Title IV in June 2015, and Title III in May 2016. The amounts being raised are in the billions of dollars per year, small in terms of the overall U.S. capital markets but growing quickly.
  • There Are Three Flavors of Crowdfunding. Crowdfunding was created by the JOBS Act of 2012. The three flavors of Crowdfunding are named for three of the sections, or “Titles,” of the JOBS Act:
    • Title II, which allows only accredited investors (in general, those with $200,000 of income or $1 million of net worth, not counting a principal residence) but is otherwise largely unregulated.
    • Title III, which allows issuers to raise up to $1 million per year, through a highly-regulated online process.
    • Title IV, which allows issuers to raise up to $50 million per year in what amounts to a mini-public offering.

For more information, take a look at this chart. But first, read the next bullet point.

  • You Don’t Have to Learn the Legal Rules. You’re a real estate developer, not a lawyer. You don’t have to become a lawyer to raise money using Crowdfunding, and in terms of lifestyle I wouldn’t recommend it.
  • You Don’t Have to Write Computer Code. You’re a real estate developer, not an IT professional. You don’t have to know or learn anything about technology to raise money through Crowdfunding.
  • Crowdfunding is About Marketing. It’s not a technology business, it’s not even a real estate business. Crowdfunding is all about marketing. You create a product that investors will want, and you market both the product and your track record. Just as you rely on your lawyer for legal advice and your IT folks for technology, you rely on marketing professionals to sell yourself and the product.

Common Questions

  • Will I Have More Liability? Here’s a long and technical blog post, listing all the ways that an issuer of securities in Crowdfunding can be liable. By all means share this with your regular lawyer and ask for his or her opinion. But the bottom line is that if you do it right, raising money through Crowdfunding creates no more liability than raising money through traditional channels. It’s just the Internet.
  • Will Banks Lend Money for Crowdfunded Deals? In the earliest stages of Crowdfunding, some lenders balked at deals that involved a bunch of passive investors. But we crossed that bridge long ago. Today, banks and other institutional lenders routinely finance Crowdfunding deals.
  • Isn’t It a Hassle Dealing with All Those Investors? It can be, but doesn’t have to be. For one thing, investors in the Crowdfunding world get no voting or management rights. If you’re used to the private equity guys looking over your shoulder, you’ll be thrilled with Crowdfunding. For another thing, if you use one of the existing Crowdfunding portals (see below), you can outsource a large part of the initial investor relations.
  • I’ve Heard That Investors Must Be Verified – How Does That Work? In Title II Crowdfunding, the issuer – you – must verify that every investor is accredited. In theoretical terms that could mean asking for tax returns, brokerage statements, and other confidential information. But in practical terms it just means engaging a third party like VerifyInvestor. Most verification is done with a simple letter from the investor’s lawyer or accountant.
  • How Much Money Can I Raise? In a typical Title II offering, developers typically raise $1M to $3M of equity.
  • If Crowdfunding is Still Small, Why Start Now? One, you can raise capital for smaller deals. Two, it’s about building a brand in the online market. In a few years, when developers are raising $30M rather than $3M, the developer who built his brand early is more likely to be funded.
  • Is Crowdfunding All or Nothing? No, not at all. You can raise part of the capital stack through Crowdfunding and the balance through traditional channels.
  • Will I Need a PPM? You’ll generally provide the same information to prospective investors in the online world as you’re accustomed to providing in the offline world.
  • Why Am I Seeing All These REITs in Crowdfunding? Three reasons:
    • Most retail investors have neither the skill nor the desire to select individual real estate projects. Just as retail investors prefer mutual funds to picking individual stocks, retail investors will prefer to invest in pools of assets that have been chosen by a professional.
    • Theoretically, thousands of retail investors could invest in a traditional limited liability company. But when you own equity in an LLC you receive a K-1 each year. For someone who’s invested $1,000, the cost of adding a K-1 to her tax return at H&R Block could be prohibitive. In a REIT you receive a 1099, not a K-1.
    • Privately-traded REITs have a very bad reputation, plagued by high fees and sales commissions. But if light is the best disinfectant, the Internet is like a spotlight, relentlessly driving down costs and providing investors with instantly-accessible information.
  • What Kind of Yields Do Investors Expect? That’s a tough question, obviously. But here are two data points. For an equity investment in a high-quality, cash-flowing garden apartment complex, investors might expect a 7% preferred return and 70% on the back end (e., a 30% promote for you). For a debt investment in a single-family fix-and-flip, with a 65% LTV, they might expect a 9% interest rate on a one-year investment.
  • Should I Use Rule 506(b) or Rule 506(c)? If you’re asking that question, you probably shouldn’t be reading this blog post. Try this one.
  • Do I Need a Broker-Dealer? Two answers:
    • As a general rule, you are not legally required to be registered as a broker-dealer, or to be affiliated with a broker-dealer, if you’re offering your own deals. For a more technical legal answer, you can read this blog post.
    • To sell your deal, you might want to use a broker-dealer, or a broker-dealer network.
  • How Can I Get Started? You have two choices:
    • You can establish your own website and list your own deals. But there are millions of websites in the world, many featuring photographs of naked people. Against that competition you might find it difficult to attract eyeballs.
    • You can get your feet wet by listing projects on an existing real estate Crowdfunding portal, one with a good reputation and a large pool of registered investors. If that goes well, you can think about establishing your own website later. The portal will take the mystery out of the online process, making it look and feel like any other offering from your perspective.

Questions? Let me know.

If I Raise Money Using Crowdfunding, Will I Be Able To Raise More Money Later?

 

I have rarely attended a Crowdfunding conference where this question wasn’t asked. Maybe those of us in the industry haven’t done a good enough job answering it.

Before getting into details, I’ll note that it is no longer a hypothetical question, as it was when the JOBS Act was signed into law in 2012. Today, many companies have indeed graduated from Crowdfunding to venture rounds, to angel rounds, to Regulation A offerings, and even to IPOs.

But judging from the look on the faces of the audience, that answer never seems completely satisfying. Isn’t there something about Crowdfunding that sophisticated investors don’t like?

The answer is “Only if the Crowdfunding round is done wrong!” So:

  • Institutional investors don’t want anyone else participating in their round. If you give your Crowdfunding investors preemptive rights, or the equivalent of preemptive rights, the institutional investors won’t like it. That’s why you don’t give your Crowdfunding investors preemptive rights.
  • Institutional investors don’t want anyone but you managing the company. That’s why you keep your Crowdfunding investors (and friends & family investors) out of management. Ideally, you issue non-voting stock (or its equivalent) to the Crowdfunding investors, and don’t permit representation on your Board.
  • Institutional investors want to know what they’re getting into. If you conduct your Crowdfunding round carefully, with clear legal documents, that’s not a problem.
  • Institutional investors don’t like surprises. They don’t want to learn afterward that your Crowdfunding investors, or anyone else, have rights they didn’t know about. That’s why you form your entity in Delaware, which gives the parties to a business transaction more or less unlimited freedom of contract.
  • Institutional investors don’t like a messy cap table. There’s no reason to have a messy cap table in Crowdfunding. Often, we bring in Crowdfunding investors through a special-purpose vehicle, or SPV. We can also issue to Crowdfunding investors a separate class of stock. One way or another, we keep the cap table clean.
  • Institutional investors worry about legal claims brought by Crowdfunding investors. Of course they do! That’s why we conduct the Crowdfunding offering correctly, just as we conduct the institutional round.
  • Institutional investors don’t like sharing information with all those investors. With today’s technology tools, communicating with investors isn’t difficult, and Delaware law allows us to limit who gets what. But it’s certainly true that the more investors you have, the more people get the information.
  • Institutional investors just don’t like hanging out with the riffraff. That’s never stated outright, but implied. If we address all the real issues, I have never found it to be true.

As Crowdfunding gains traction, I expect institutional investors to embrace it fully, as another facet of their own business models. In the meantime, be assured that if done right, raising money through Crowdfunding today will not keep you from raising more money in the future.

Questions? Let me know.

Targeted IRRs in Crowdfunding

Targeted internal rate of return, or IRR, is used widely to advertise deals on Crowdfunding sites, real estate and otherwise. While target IRR means something to sophisticated sponsors and investors, its widespread and uncritical use makes me a little uneasy, for the following reasons:

  • If pressed, many people don’t know what IRR really means. Investors assume that a higher IRR is better than a lower IRR, but many couldn’t explain exactly why or how.
  • IRR can be misleading. For example, a bond purchased for $100 that pays interest of $10 at the end of each of the first four years and $110 at the end of the fifth year has an IRR of 10%. A bond purchased for $68.30 that pays nothing for four years and $110 at the end of the fifth year also has an IRR of 10%. But those two investments are very different. The IRR calculation assumes that the $10 interest payments on the first bond can be reinvested at 10%, which is probably not true.
  • The IRR of a real estate deal (or any deal) increases when the asset is refinanced and the proceeds distributed to investors. But refinancing the asset doesn’t necessarily make for a better investment.
  • There being no such thing as a free lunch in capitalism, a higher IRR generally coincides with higher risk. For example, I can usually increase my IRR by borrowing more money. That relationship is not typically highlighted.
  • For a typical startup outside the real estate industry, IRR has no meaning. Or to put it differently, a 28% target IRR for a startup plus $2.75 gets you on the New York subway.
  • The term “target IRR” tends to mask what’s really important:  the factual assumptions concerning sales and asset appreciation. To say “We expect a target IRR of 18%” is somehow easier to sell than “We expect the property to appreciate at 6% per year.”
  • Under FINRA Rule 2210, offerings conducted through a broker-dealer may not advertise target IRRs. FINRA also prohibits Title III Funding Portals from advertising target IRRs, and the SEC prohibits new issuers from advertising a target IRR in Regulation A offerings, even for sponsors with extensive track records. Hence, target IRR cannot be used to compare offerings across all platforms and all deal types.

What can we do better as an industry? Here are a few ideas:

  • We can explain internal rate of return better, maybe with examples and a standardized presentation and graphics.
  • We can develop other apples-to-apples metrics for comparing deals.
  • We can make clear that higher IRRs generally come with higher risks.
  • In Regulation A offerings, and even in Rule 506(b) offerings where non-accredited investors are involved, the issuer is required to provide extensive information about the sponsor’s track record. Some version of that concept, applied consistently and allowing for side-by-side comparison, might be the most valuable information for investors.

Questions? Let me know.

Assembling the Team for a Regulation A Offering (and how much it costs)

The two most frequently asked questions about Regulation A are: How long does it take? and How much does it cost?

I tried to answer the first question with this Regulation A Timeline.

To answer the second question, I’ve created a chart called Assembling the Regulation A Team. The chart identifies the services required for a successful Regulation A offering (legal, accounting, etc.) and estimates how much each service will cost. At the end, I’ve included a pro forma chart for issuers to estimate the cost of their own offerings.

I find that many would-be Regulation A issuers find the process opaque and somewhat intimidating. I hope these two tools – the Regulation A Timeline and Assembling the Regulation A Team – can make it simpler, more transparent, and more predictable.

Questions? Let me know.

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