Category Archives: Investor

You Can Use Subsidiaries Without Violating the 100 Investor Rule

crowdfunding_investorEveryone knows the “100 investor rule” is a thorn in the side of Crowdfunding portals. The good news is you can still use subsidiaries to protect yourself from liability.

The basics of the 100 investor rule:

  • A company engaged in the business of investing in securities is an “investment company” and subject to burdensome regulation under the Investment Act of 1940.
  • A “special purpose vehicle” formed by a portal to invest in a portfolio company is engaged in the business of investing in securities.
  • There’s an exception: if the SPV has no more than 100 investors, it’s not an investment company.

Today, most deals on Crowdfunding portals are funded with fewer than 100 investors and qualify for the exception. But that’s because most Crowdfunding deals are still small, i.e., less than $2 million. As the deals get bigger and, most important, as we start to see pools of assets rather than individual assets, SPVs will no longer be available. Already, they’re not available for Regulation A+ deals.

In the absence of an SPV, investors will be admitted directly to the issuer’s cap table. But what if the issuer owns one or more subsidiaries? Will the issuer itself be disqualified as an investment company?

Here’s an example. Suppose NewCo is raising $25 million to acquire 10 properties, and we expect 1,000 investors. We’d like to put each property in a separate subsidiary because (1) we might want to finance them separately, and (2) we don’t want the liabilities arising from one property to leak into another property. But would that make NewCo an investment company, holding the stock (securities) of 10 subsidiaries?

Fortunately, the answer is No.

For purposes of deciding whether NewCo is an investment company, the rule is that you ignore securities issued by any company that NewCo controls, as long as the company itself is not an investment company.

That means NewCo can put Business #1 in Subsidiary #1, Business #2 in Subsidiary #2, and so on and so forth, without becoming an investment company. Most likely, NewCo will hold each property in a separate limited liability company, serving as the manager of each.

Don’t fool around with investment company issues. A company that becomes an investment company without knowing it can face a world of trouble, including having all its contracts invalidated.

Questions? Let me know.

 

C Corp vs. LLC: What’s the Right Choice?

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an online pamphlet describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Contact Mark Roderick.

How Much of My Company Should I Give Away?

Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?

One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.

Suppose you’re raising $500,000. To calculate how much your investor should receive:

  • Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
  • Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
  • Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
  • Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
  • Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
  • Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).

Very elegant and simple.

But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.

money treeThat’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.

The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.

In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

CFGE CROWDFUND BANKING AND LENDING SUMMIT IN SAN FRANCISCO

Roderick CFGE

Since Labor Day, I’ve spoken at half a dozen events: for entrepreneurs, for intellectual property lawyers, for finance professionals, for digital marketing groups. This week I’ll be speaking at one of the premier Crowdfunding events in country, the CFGE Crowdfund Banking and Lending Summit on the 16th and 17th in San Francisco.

The conference features some of the leaders in the industry, including:

  • Richard Swart, Director of Research for Innovation in Entrepreneur and Social Finance, Colman Fung Institute for Engineering Leadership at UC Berkeley.
  • Ron Suber, the President of Prosper.
  • Jason Fritton, the Founder and CEO of Patch of Land.
  • Tom Lockard, the Vice President for Real Estate Investment and Institutional Sales of Fundrise.
  • Nikul Patel, the Chief Lending Officer of LendingTree.
  • Jesse Clem, the Co-Founder of LOQUIDITY, LLC.
  • Joy Schoffler, the CEO of Leverage PR.

Whether you’re new to Crowdfunding or an industry veteran, I’d strongly suggest you attend. I’m always amazed how much more there is to learn.

To register, click here. Make sure to use my promo code and receive a 25% discount! Promo code: Roderick

And while you’re there, please stop by and say hello. Crowdfunding and skiing – those are my two favorite topics.

ENCOURAGING LOCAL INVESTMENT IN CROWDFUNDING

Crowdfunding provides deep pools of capital to entrepreneurs and makes high-quality investments available to individuals for the first time. Those things are great, transformative.

But Crowdfunding achieves its greatest potential at the local level, where communities invest in themselves. An entrepreneur needs capital to start a local business. Her customers are her neighbors. They help design her business to respond to their needs, and they invest in her business to share in the financial rewards and to improve their own neighborhood. There’s a lot more going on there than finance.

I once served on a panel with David Paterson, the former Governor of New York. Governor Paterson spoke about the usefulness of Crowdfunding for community development and community redevelopment, and now works as the Director of Community for iFunding, one of the leading portals.

I have spoken with and represent others thinking along the same lines, putting local money back into local economies.

We should think about ways to encourage localized Crowdfunding investment. When we’re talking about revising Title III, or crafting better state Crowdfunding laws, we should include community development folks in the conversation. They’re going to have better ideas than I have, but I can think of one small step in the right direction.

Why not provide some economic incentive? For example, suppose State X allows a $5,000 maximum investment from non-accredited investors. Why not raise that limit to $7,500 or $10,000 if the project is in the same county as the investor?

That works for two reasons. One, it encourages investing locally. Two, the investor is likely to know more about the project in his neighborhood than he knows about a project on the other side of the state, so he can make a more informed decision. For that matter, as a consumer he might be in a position to help the project after it’s built.

It’s a small step. Crowdfunding is global, but it works even better when it’s local.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

THE iFUNDING MOBILE APP: AN INTERVIEW WITH SOHIN SHAH

Sohin at desk croppedSohin Shah is the COO and co-founder of iFunding, and created iFunding’s mobile app, the first in the Crowdfunding market. Sohin also created Valuation App, which allows finance professionals to analyze businesses and start-ups. His prior experience is at New York investment banks and he holds a Masters in Finance & Risk Engineering from NYU.

Q:        Before getting to the iFunding mobile app, what’s your sense of technology innovation in real estate overall?

A:        Impressive but uneven. There is a lot of technology for the consumer looking for a home or apartment – the Zillow/Trulia merger is an example of scale in that segment. Also, developers looking to purchase properties wholesale have sites like Auction.com, and larger institutions are increasing their data and automation for deal assessment through services like Compstak and Reonomy. But there’s been surprisingly little innovation available to the individual investor who wants to participate in real estate projects and profits.

Q:        What can an individual investor do with your mobile app?

A:        Anything she could do on our website, from browse opportunities to review documents to actually invest. We can also send an alert to your app to let you know when deals are available.

Q:        Can I switch back and forth from mobile to website?

A:        Absolutely. We made it as seamless as possible going both ways.

Q:        I have to ask you: was the mobile app really necessary? Do your investors log in from mobile devices? Or is this a gimmick?

A:        You would be amazed. Already, about 25% of the visits to ifunding.co come from mobile devices, roughly two-thirds of these from smart phones and one-third from tablets. We realized our customers want to get information and make investments when it is convenient to them, from the couch to the hair stylist.

Q:        But are people really moving tens of thousands of dollars into investments via smartphone?

A:        Yes, definitely. Although we don’t have hard data, those completing the entire investment process by mobile device have probably invested with us before. They know what they want and are looking to roll their money into the next deal before someone else fills that slot. Keep in mind that some of our deals fund with a day or hours, so mobile access at any time is valuable to top investors.

Q:        Why do you think people might be skeptical investing significant dollars by phone?

A:        Sometimes people have a tendency to underestimate the individual investor and what they become comfortable with. Think about banking by phone, or sending funds by PayPal. What we’re learning in Crowdfunding is that individuals really do want the power to control their own destinies. Our mobile app is just one more tool helping them do that.

Q:        Can you use the app to just browse properties and learn about investing?

A:        You sure can. Many people do. We provide a lot of educational content and try to help investors make smart decisions. When you’re traveling or have idle time, instead of playing a game on your phone, why not learn more about real estate and empower yourself financially?

Q:        Did you build the app yourselves?

A:        Yes, our technology team built it. I had the experience of building Valuation App and we had all the industry knowledge in house, so that made sense for us to design and program it.

Q:        Is the mobile app secure? As secure as your website?

A:        Yes, definitely. In fact, no user information is stored on the mobile device – you could drop your phone in Grand Central Station and have no worry about compromised information. All information is on our secure servers and downloaded to the mobile device through an encrypted connection only when you use the app, then erased when you quit.

Q:        Do you plan to add more functionality in the future?

A:        We update the app several times a month based mainly on customer suggestions. The future will see more eye-catching features, though you can imagine we haven’t planned an “Apple Watch” version just yet.

Q:        So what’s it called and where can I get it?

A:        It’s called “iFunding – Real Estate Investing through Crowdfunding.” It’s available on iOS and Android devices. You can download it for free at bitly.com/ifundappios and bitly.com/ifundappandroid.

CHOOSING AND PROTECTING A NAME FOR YOUR CROWDFUNDING BUSINESS

Names matter, even for a local business, but they matter a great deal for a Crowdfunding business, where your customers know you only from a distance.

Generally speaking you can choose three kinds of names:

  • A name that describes what you do, e.g., Real Estate Crowdfunding Portal, LLC.
  • A name with no inherent meaning, e.g., Xeta, LLC.
  • A name somewhere in between, e.g., Lifelong Investments, LLC.

Each category has advantages and disadvantages:

  • A name that describes what you do…well, it describes what you do. When a consumer sees the name she knows what you’re selling. On the other hand, a name that describes what you do is often not very memorable.
  • The strongest names are those that start out with no inherent meaning. Amazon, Starbucks, E-Bay. When consumers think of Amazon they think about the gigantic online retailer, nothing else. The name is worth a billion dollars! On the other hand, Amazon had to spend more than a billion marketing dollars to give meaning to a name that otherwise belonged to a river.
  • A name somewhere in between is somewhere in between. It might be sexier than a name that is merely descriptive and require a lot less marketing fuel than a name with no meaning, but with the associated disadvantages as well.

In the Crowdfunding industry to date, most portals have chosen the more descriptive over the more powerful. Poliwogg is an exception. Fundrise might be another.

With two well-known Crowdfunding companies – Crowdentials and VerifyInvestors – we see two different approaches to choosing a name. And we can’t say for certain whether one is better than the other. That will depend on what each company does with its name.

Having chosen a name, how do you protect it?

To start with, a business acquires “common law” rights to a name merely by using it, without filing anything with the government and without involving lawyers. If another real estate Crowdfunding portal tried to use the Fundrise name today they couldn’t do it, even if the Miller brothers had never done anything to protect their name (they have).

Contrary to common belief, merely registering a company name with the state by forming a corporation or other entity provides no real protection. State filings are simply a matter of bureaucracy – the state wants to make sure that no two names are confusingly similar on its own records.

For the best protection, however, the business owner should obtain a Federal trademark from the U.S. Patent and Trademark Office. A Federal registration provides important benefits, including:

  • The registration constitutes “constructive notice” to all later users in all locations.
  • The registration permits the owner to get an injunction against a trademark infringer and sue for damages, including profits, costs, treble damages and attorneys fees.
  • The registration can strengthen the value of the name as a corporate asset.
  • The registration demonstrates your right to use the name to the owners of other websites, such as Google, Facebook, and Twitter, which are often called on to “officiate” disputes over names.

The trademark application process normally takes about a year, assuming no significant problems. Once granted, a trademark registration can last forever if continuously used and renewed.

NOTE: Not every name can be trademarked. A name like “Real Estate Crowdfunding Portal,” which merely describes the product or service, probably cannot be registered by itself. But it might be registered with a distinctive logo.

Finally, don’t forget to acquire the domain name.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

WHAT CAN I SHOW ON MY SITE, TO WHOM, AND WHEN?

The SEC no-action letters issued to FundersClub and AngelList early in 2013 created some confusion around the deal-specific information that can be shown to prospective investors. Let’s try to clear that up.

Rule 506(b) Deals

You cannot show your Rule 506(b) deals to just anyone browsing the Internet, because that would be “general solicitation and advertising,” which is permitted under Rule 506(c) but still prohibited under Rule 506(b). If you’re a real estate portal, you can say “We have great real estate deals on our site,” but you can’t say “Look at this multi-family rental project in Austin.”

Both FundersClub and AngelList hid their deals behind a firewall. A user couldn’t see the deals until he registered at the site and promised he was accredited. In the 2013 no-action letters the SEC approved this arrangement, sort of.

I say “sort of” for three reasons:

  • The two no-action letters weren’t actually about registering users. They were about whether FundersClub and AngelList had to register as broker-dealers. Nowhere do the no-action letters say “We agree that, because you hide your deals behind firewalls, you’re not engaged in prohibited general solicitation and advertising.”
  • The no-action letters were issued by the Division of Trading and Markets within the SEC, not the Division of Corporation Finance. Typically, the Division of Corporation Finance would deal with so-called “exempt offerings” (offerings that are exempt from the general registration requirements of the Securities Act of 1933), of which general solicitation is a part.
  • Most intriguingly, the no-action letters aren’t exactly consistent with prior SEC rulings dealing with the online solicitation of customers, specifically the IPONET rulings in 2000. Those rulings assumed that the person doing the online solicitation was a registered broker-dealer; by definition, FundersClub and AngelList were not broker-dealers.

As a result, we can’t be 100% certain that the SEC, if asked point blank, would approve those arrangements from the perspective of general solicitation and advertising.

Nevertheless, the no-action letters were issued and the Crowdfunding industry has adopted the FundersClub and AngelList model: if you’re doing Rule 506(b) deals, you put the actual deals behind a registration firewall.

Once an investor registers at your site he can see the deals, but he can’t invest in them. In a series of no-action letters issued long before the JOBS Act, the SEC established that once an investor has become a customer, he has to wait before investing – the so-called “cooling off period.”

Some sites today are using a 21 day cooling off period, presumably because Title III incorporates a 21 day cooling off period. But the Title III rule is irrelevant to Rule 506(b). Thirty days is probably better, although, again, the notion of a cooling off period comes from SEC rulings, not a statute.

One more twist: at the end of the cooling off period, your investor can invest only in new deals, not deals that were on the site when he registered.

Rule 506(c) Deals

Rule 506(c) is far simpler. If you are doing only Rule 506(c) deals, you can show anything to anyone anytime.

Using Rule 506(c), you can show every detail of every deal to every casual viewer, even before the viewer has registered at your site. If you think that’s a bad idea from a marketing perspective or because you’re trying to protect confidential information, no problem. You don’t have to show all the details on your home page, but you can.

You can also make users register before they can see deals, just like Rule 506(b). If you take that route, you can ask users whether they’re accredited when they register, as you would under Rule 506(b), but you don’t have to ask. You can let everyone see the deals, accredited and non-accredited alike.

If you ask whether users are accredited – because you think it’s a good idea from a marketing perspective – that doesn’t mean you have to stop non-accredited investors at the door. Non-accredited investors can see the deals, too. Maybe they’ll tell their accredited friends.

Suppose a user tells you she’s accredited when she registers. Can you take her word for it? At that point in the process, absolutely! We don’t want to spend money or time on verification yet, and we don’t want to create transactional friction where we don’t have to.

With Rule 506(c), there is only one critical moment: when your investor is ready to write a check. At that point you must verify that she’s accredited, not merely by asking her but by looking at her tax returns, or getting a letter from her lawyer, or, most likely, having her verified by a third party service like VerifyInvestors or Crowdentials.

There’s no cooling off period with Rule 506(c), either. Your investors can see all the deals and invest right away.

Have I mentioned before that Rule 506(c) is better for Crowdfunding?

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

UPDATE ON ACCREDITED INVESTOR DEFINITION

I wrote to my close friend Mary Jo White, the Chair of the SEC, urging that the SEC expand, rather than restrict, the definition of accredited investor. My letter is here.

SEC letter_Roderick

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

 

 

 

 

INVESTOR VERIFICATION: QUESTIONS AND ANSWERS FROM THE SEC

The SEC recently issued four questions and answers dealing with investor verification.

Question #1

If a purchaser’s annual income is not reported in U.S. dollars, what exchange rate should an issuer use to determine whether the purchaser’s income meets the income test for qualifying as an accredited investor?

Answer: The issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

Question #2

Can assets in an account or property held jointly with another person who is not the purchaser’s spouse be included in determining whether the purchaser satisfies the net worth test in Rule 501(a)(5)?

Answer: Yes, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the net worth test, but only to the extent of his or her percentage ownership of the account or property. [July 3, 2014]

Question #3

Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser’s income for the “two most recent years.” If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?

Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:

  • Reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
  • Obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

Where the issuer has reason to question the purchaser’s claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser’s income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary.

Question #4

A purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income. Can an issuer review comparable tax forms from a foreign jurisdiction in order to rely on the verification method provided in Rule 506(c)(2)(ii)(A)?

Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. In adopting this safe harbor, the Commission noted that there are “numerous penalties for falsely reporting information” in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013). Although the safe harbor is not available for tax forms from foreign jurisdictions, we believe that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information.

Where the issuer has reason to question the reliability of the information about the purchaser’s income after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor.

The Takeaway

The lesson is that issuers and portals should not try to verify investors on their own. Leave that to a third party service like Crowdentials or VerifyInvestor – they keep track of these rules so you won’t have to.

Questions? Contact Mark Roderick

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