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The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

The Wealthy Wellthy Podcast: What You Don’t Know About Crowdfunding

2019-06-17_11-54-02

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Our guest on this episode of The Wealthy Wellthy Podcast is Mark Roderick, an attorney who devotes most of his time to crowdfunding. Maybe you are like me in thinking that crowdfunding is pretty straightforward and self-explanatory. I mean, if your friend is looking to start a business and you want to support them, you can donate or invest through their crowdfunding page online and that’s that, right?

Every entrepreneur faces the stage in their business where they need to acquire capital, either from acquaintances, networking, angel investors, venture capitalists, or strategic partners. This process is messy and confusing, filled with regulations and stipulations that may make acquiring the capital more trouble than it is worth. This was partially due to the antiquated laws that were created in the aftermath of The Great Depression and were stifling in the modern economic climate. However, in 2012, the Jobs Act made it legal for entrepreneurs to advertise to raise capital. This opened up a whole new world for small business owners and others who were desperate to be able to connect more easily with potential investors as well as investors who were eager to find new opportunities.

During the interview, Mark distinguishes between the 3 kinds of crowdfunding: (1) to accredited investors only, (2) Regulation A to accredited or non accredited investors, and (3) Title 3 – which is the most common. He also talks about the factors that are most important from a legal perspective when you are determining which crowdfunding site to use to raise capital or to invest capital. It was also interesting to hear Mark spell out the 3 reasons why people invest through crowdfunding: (1) they want to support the company, (2) to do social good, and (3) to make money.

Mark even gave me some advice about a real estate deal I am considering and revealed that 90-95% of the capital exchanged through crowdfunding is for real estate transactions. Finally, he busted a couple of myths regarding the amount of risk involved in crowdfunding and whether money raised from others is subject to securities laws.

What We Covered

  • [2:16] – Who is Mark Roderick?
  • [3:28] – Mark describes the fragmented traditional ways of raising capital.
  • [8:58] – Angel investors and how to present your “deck” to them.
  • [11:08] – Working with venture capitalists and strategic partners.
  • [13:31] – A brief history of the laws affecting capital.
  • [22:34] – What does crowdfunding look like for startup entrepreneurs?
  • [27:20] – How to find a regulated site to post your capital request on.
  • [30:58] – Crowdfunding is the intersection of old and new school.
  • [34:57] – Advice to keep in mind when you are using a crowdfunding site.
  • [38:06] – Mark tells us 3 of the crowdfunding sites he works with.
  • [40:08] – When should an entrepreneur hire an attorney during this process?
  • [42:40]– The prevalence of real estate in the crowdfunding world.
  • [53:24] – What message does Mark want to get out there?
  • [56:17] – Mark busts 2 myths about crowdfunding.

Questions? Let me know.

The Real Estate Syndication Show: How To Do Crowdfunding Legally

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Raising money without begging investors is no easy task for startups. At times, help from a third-party individual is needed to make it happen. But how do you know if you are legally paying brokers to raise capital and not breaking any law or guides set by the Securities and Exchange Commission?

In this interview, Mark Roderick explains what a broker is, and the legal process that raising money entails. He cites examples of the repercussions of hiring an unlicensed broker-dealer, gives advice on the lessons he has learned in the industry, and touches on his blog that tackles crowdfunding.

 

Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

Mark Roderick Explains Restricted Stock VS. Options for Key Employees of a Crowdfunding or Fintech Business

You want to reward and incentivize your CFO and CMO with equity in the company. What’s the best approach?

First, make sure equity provides the right incentives. For the CFO almost certainly, because the CFO shares responsibility for the profitability of the whole company. For the CMO, maybe not. If we want the CMO focused on sales, maybe a cash commission makes more sense. On the other hand, you might decide that owning stock will have a positive psychological effect for your CMO, even if it doesn’t offer a direct incentive.

With that box checked, these are the most common equity-flavored alternatives:

  • Restricted Stock: The CFO might receive a total of 100 shares of stock today, with her right to receive distributions and otherwise enjoy the full benefits of the stock subject to a vesting schedule. The vesting schedule might be based on time (g., 20 shares per year for five years), economic milestones (e.g., 20 shares for each year showing a growth of at least 20% in cash flow or EBITDA), or a combination of the two.
  • Stock Options: The CFO might be granted the option to purchase 100 shares of stock for $0.10 per share (hoping they will someday be worth a lot more), subject to the same vesting schedule. Under section 409A of the tax code, that $0.10 per share exercise price must be the true fair market value at the date of grant, not an artificially low number.
  • Incentive Stock Options: If the company is a corporation (not an LLC) and satisfies lots of special rules, the CFO might be granted a special kind of stock option, with special tax benefits.
  • Phantom Stock: Rather than actual stock, the CFO might receive a contract right intended to achieve the same economic result.

In the world of entrepreneurs generally and the Fintech and Crowdfunding worlds specifically, restricted stock and stock options are the most common choices, so I’m going to focus on those today.

Economically, restricted stock and stock options are almost identical. But the tax consequences can be quite different. For purposes of the discussion below, I’m assuming (i) the CFO’s 100 shares are worth $0.10 per share today and increase in value at the rate of $1.00 per share per year, (ii) the CFO is given 10 years in which to exercise the options, and (iii) the company is sold in 10 years.

Scenario #1: Direct Stock Issuance – General Rule

If the CFO receives 100 shares today, vesting over five years, then she has zero taxable income today because no shares have vested. At the end of the first year she has $22 of taxable income (20 shares vested @$1.10 value per share), at the end of the second year he has $42 of taxable income (20 additional shares vested @$2.10 value per share), and so on. The employee must pay tax on this income each year, while the company can claim a corresponding tax deduction. Thus, over the duration of the vesting period the CFO pays tax on $310 of taxable income and the company obtains a $310 tax deduction.

In this example the CFO will pay roughly $100 of tax on his $310 of taxable income (depending on tax bracket, state of residence, etc.). The exact amount of the tax isn’t important. What’s important is that (i) she will have to fund this cost from her own pocket, and (ii) if the company is very valuable or she owns a lot of stock, her out-of-pocket tax cost could be prohibitively high.

When the company is sold after 10 years, the CFO will receive $1,010 for her shares and have $700 of gain. This $700 would be taxed at long term capital gain rates, and at that point she’ll have the cash to pay her tax.

Scenario #2:  Direct Stock Issuance Followed by §83(b) Election

Where an employee receives stock subject to a vesting schedule, §83(b) of the tax code permits an employee to elect to report as taxable income the entire current value of the stock. Having made the election, the employee does not report any additional taxable income as the stock vests.

In our example, the CFO could make an election and report $10 of taxable income on the date of grant (100 shares of the @ $0.10 per share). She would then have no additional taxable income as the stock vests, and the company would have no tax deductions. Upon the sale of her stock the employee would have $1,000 of income, taxed at long term capital gain rates.

An election under §83(b) must be filed with the Internal Revenue Service within 30 days after the CFO receives the stock.

NOTE:  Suppose the company fails after two years. Now the CFO has paid tax on $10 and has nothing to show for it except a $10 capital loss. That’s the downside of section 83(b).

Scenario #3: Options

The CFO recognizes no current taxable income as a result of receiving options. Instead, she recognizes taxable income as the options are exercised, equal to the difference between the exercise price of $0.10 per share and the value of the stock at the time.

In the simplest scenario, where the CFO exercises options to purchase 20 shares each year, the tax effect would be almost identical to Scenario #1 above. The CFRO would recognize $20 of taxable income in the first year, $40 the next year, and so forth, for a total of $300 of taxable income. No §83(b) election is available with options.

A more likely scenario is that the CFO wouldn’t (or wouldn’t be allowed to) exercise the options each year, but rather waits to exercise until the company is sold. In this case she would recognize no taxable income until sale, and at that point would recognize $1,000 of taxable income, taxed at ordinary income rates rather than capital gain rates. The company would be entitled to a corresponding deduction of $1,000. Again, the CFO would have plenty of money to pay the tax.

Conclusion

Options are simpler than restricted stock, especially if they can’t be exercised until an exit. And the holder of an option, unlike the holder of actual stock, has no right to see confidential information that the company would prefer to keep private.

For that reason, options typically make more sense from the company’s viewpoint, even though the employee might end up paying more tax (ordinary income vs. capital gains) overall. But every company and every situation is different.

Questions? Let me know.

Regulation A Webinar Follow-Up Q&A

A couple weeks ago, Howard Marks of StartEngine and I presented a webinar about Regulation A. Listeners asked far more questions than we were able to answer in the time given, and I promised to post their questions and answers on the blog. Here goes.

First, a few links:

What’s the difference between Regulation A and Regulation A+?

There is no difference. Regulation A has been around for a long time, but was rarely used primarily because issuers could raise only $5 million and were required to register with every state where they offered securities. Title IV of the JOBS Act required the SEC to create a new and improved version of Regulation A, and the new and improved version is sometimes referred to colloquially as Regulation A+. But it’s the same thing legally as Regulation A.

Can I use Regulation A to raise money from non-U.S. investors?

Definitely. Non-U.S. investors may participate in all three flavors of Crowdfunding: Title II, Title III, and Title IV (Regulation A).

But don’t forget, the U.S. isn’t the only country with securities laws. If you raise money from a German citizen, Germany wants you to comply with its laws.

Can non-U.S. companies use Regulation A?

Only companies organized in the U.S. or Canada and having their principal place of business in the U.S. or Canada may use Regulation A.

What about a company with headquarters in the U.S. but manufacturing facilities elsewhere?

That’s fine. What matters is that the issuer’s officers, partners, or managers primarily direct, control and coordinate the issuer’s activities from the U.S (or Canada).

Is Regulation A applicable to use for equity or debt for a real estate development project?

I believe that real estate will play the same dominant role in Regulation A that it plays in Title II. I also believe that real estate development will be more difficult to sell than stable, cash-flowing projects simply because of the different risk profile.

Is there any limit on the amount an accredited investor can invest?

No. An accredited investor may invest an unlimited amount in both Tier 1 and Tier 2 offerings under Regulation A. A non-accredited investor may invest an unlimited amount in Tier 1 offerings, but may invest no more than 10% of her income or 10% of her net worth, whichever is greater, in each Tier 2 offering.

What kinds of securities can be sold using Regulation A?

All kinds: equity, debt, convertible debt, common stock, preferred stock, etc.

But you cannot sell “asset-backed securities” using Regulation A, as that term is defined in SEC Regulation AB. The classic “asset-backed security” is where a hedge fund purchases $1 billion of credit card debt from the credit card issuer, breaks the debt into “tranches” based on credit rating and other factors, and securitizes the tranches to investors. However, the SEC views the term more broadly.

Can I combine a Regulation A offering with other offerings?

In general yes. For example, there’s no problem if an issuer raises money using Rule 506 (Rule 506(b) or Rule 506(c)) while it prepares its Regulation A offering. The legal issues become more cloudy if an issuer wants to combine multiple types of offerings simultaneously. Theoretically just about anything is possible.

Can the same platform list securities under both Regulation A and Title II?

Yes. In fact, the same platform can list securities under all three flavors of Crowdfunding:  Title II, Title III, and Title IV. But on that platform, only licensed “Funding Portals” can offer Title III securities.

Does a platform offering securing under Regulation A have to be a broker-dealer?

The simple answer is No. But a platform that crosses the line into acting like a broker-dealer, or is compensated with commissions or other “transaction based compensation,” would have to register as a broker-dealer or become affiliated with a broker-dealer.

Can a non-profit organization use Regulation A?

Regulation A is one exception to the general rule that all offerings of securities must be registered with the SEC under section 5 of the Securities Act of 1933. Non-profit organizations are allowed to sell securities without registration under a different exception. So the answer is that non-profits don’t have to use Regulation A.

With that said, I represent non-profit organizations that have created for-profit subsidiaries that plan to engage in Regulation A offerings. For example, a non-profit in the business of urban development might create a subsidiary to develop an urban in-fill project, raising money partly from grants and partly from Regulation A.

Can I use Regulation A to create a fund?

If by “fund” you mean a pool of assets, like a pool of 30 multi-family apartment communities, then Yes. You can either buy the apartment communities first and then raise the money, or raise the money first and then deploy it in your discretion. If you want to own each apartment community in a separate limited liability company subsidiary, that’s okay also.

If by “fund” you mean a pool of investments, like a pool of 30 minority interests in limited liability companies that themselves own multi-family apartment communities, then No. Your “fund” would be treated as an “investment company” under the Investment Company Act of 1940, and Regulation A may not be used to raise money for investment companies.

Can a fund be established for craft beverages?

Same idea. You could use Regulation A to raise money for a brewery that will develop multiple craft beverages. You cannot use Regulation A to buy minority interests in multiple craft beverage companies.

For a brand new company, can the audited financial statements required by Tier 2 be dated as of the date of formation, and just show zeroes?

Yes, as long as the date of formation is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date.

How does the $50 million annual limit apply if I have more than one project?

The $20 million annual limit under Tier 1, and the $50 million limit under Tier 2, are per-issuer limits. A developer with, say, three office building projects, each requiring $50 million of equity, can use Regulation A for all three at the same time.

NOTE:  This is different than Title III, where the $1 million annual limit applies to all issuers under common control.

What does “testing the waters” mean?

It means that before your Regulation A offering is approved (“qualified”) by the SEC, and even before you start preparing all the legal documents, you can advertise the offering and accept non-binding commitments from prospective investors. If you don’t find enough interest, you can save yourself the trouble and cost of going through with the offering.

NOTE:  Any materials you use for “testing the waters” must be submitted to the SEC, if the offering proceeds.

Where can Regulation A securities be traded?

Theoretically, Regulation A securities could be registered with the SEC under the Exchange Act and traded on a national market. But I’m sure that’s not what the listener meant. Without being registered under the Exchange Act, a Regulation A security may be traded on the over-the-counter market, sponsored by a broker-dealer.

This sounds expensive! Can you give us an estimate?

Stay tuned! A post about cost is on the way.

Questions? Let me know.

 

 

Why Title II Portals Will Also Become Title III Portals, And Vice-Versa

CF Portal Mall

Why has Home Depot made local hardware stores a thing of the past? Partly price, but mainly selection. And I think the same forces will require most Crowdfunding portals to offer investments under Title II, Title III, and Title IV, all at the same time.

Crowdfunding portals are like retail stores that sell securities. They have suppliers, which we call “sponsors” or “portfolio companies,” and they have customers, which we call “investors.” They pick the market they want to serve – hard money loans, for example – then try to stock their shelves with products from the best suppliers to attract the largest number of customers. Think of DSW, but selling securities rather than shoes.

Now consider these situations:

  • You’re a Title II portal and have established a relationship with Sandra Smith, a real estate developer you’ve learned to trust. She informs you she’d like to raise $30 million to build a shopping center in Chicago and needs to attract investors from the local community. You could tell her you only do Title II and send her across the street, but maybe she’ll find a competitor where she can get Title II and Title IV under one roof. So you’d really like to offering Title IV as well, which means attracting non-accredited investors.
  • You’re a Title II portal raising money for biotech. A company approaches you with a new therapy for cystic fibrosis. They have 117,000 Facebook followers and wide support in the cystic fibrosis community, and have already raised $30,000 in a Kickstarter campaign. They want to raise $800,000 for clinical tests, then come back and raise $5 million if the tests are successful. Sure, you could tell them to go somewhere else for the $800,000 raise and come back for the larger (and more profitable) $5 million round, but once they leave they’re probably not coming back.
  • You’re a Title III portal with lots of investors signed up. Turned away by the portal she’s used to working with, Sandra Smith asks for your help in the $30 million Title IV raise. Any reason to turn her down?

Those of us in the industry see Title II, Title III, and Title IV as separate things, but to the suppliers and customers of the industry they’re all the same thing. The differences between Title II and Title IV are nothing compared to the differences between sneakers and 6-inch heels! Yet DSW sells them both and everything in between because in the eyes of customers, they’re all shoes.

It doesn’t matter to suppliers and customers that Title II and Title III require different technology and business models. It doesn’t matter that one is more profitable than the other. Mercedes might lose money selling its lower-end cars but doesn’t mind doing so because customers who buy the lower-end Mercedes today buy the higher-end Mercedes 10 years from now. The Vanguard Group probably loses money on some of its funds but sells them anyway to keep customers in the fold. As the Crowdfunding market develops, I think the same will be true of the interplay with Title II, Title III, and Title IV.

For portals that have achieved success in Title II, it might be unwelcome news that Title II isn’t enough. But on the positive side, Fundrise has managed to leverage its reputation in Title II into a well-received REIT under Title IV. In any case, I think it’s inevitable.

Questions? Let me know.

Intrastate Crowdfunding After Title III

CF WordclouldOn one hand, the SEC just proposed several changes to Rule 147 that will make intrastate Crowdfunding easier:

  • We used to worry, at least a little, about the language in Rule 147 saying that you couldn’t offer securities to anyone outside the state. How does this work when your offers are made with the Internet, we wondered? The SEC just proposed eliminating that requirement.
  • If you were doing an intrastate offering in Texas, Rule 147 used
    to require using a Texas entity – not Delaware, for example. No more.
  • If you’re doing an intrastate offering in Texas, you have to show you’re doing business in Texas. The new proposals would make that easier.
  • The new proposals would also simplify and rationalize the rules around (1) the “integration” of offerings (combining an intrastate offering with other offerings), (2) verifying that investors are residents of the state, and (3) re-sales of securities purchased in an intrastate offering.

All that is great, and should really help the intrastate Crowdfunding market (although I take to heart Anthony Zeoli’s excellent caveat here.)

On the other hand, the SEC also proposed a $5 million cap on intrastate offerings, which seems very important in light of Title III.

Title III Crowdfunding allows any issuer anywhere to raise up to $1 million from non-accredited investors who live anywhere in the world. With Title III Crowdfunding available, why would an issuer use intrastate Crowdfunding? There are only two possible reasons:

  • You’re allowed to raise more money in the intrastate offering
  • The process of the intrastate offering is faster/cheaper/easier

Once the hi-tech folks get their hands around Title III, I think we’re going to see the process becoming faster, cheaper, and easier than it looks now, making Title III comparable (maybe even superior) to intrastate Crowdfunding from that perspective.

Then it just comes down to how much you can raise. If I am a small issuer – raising less than $1 million, for example – why would I use the intrastate law of my state when I can use Title III instead and appeal to the whole universe of investors? Case in point:  New Jersey enacted an intrastate Crowdfunding law just this week – with a $1 million limit. Why would a New Jersey business use that law, with Title III on the books and the gold and silver of Manhattan right across the Hudson River?

And if I’m a software developer wondering what kind of platform to build, isn’t the scale tipped in favor of Title III?

The scales will tip further that way when Congress increases the limit of Title III from $1 million to something higher. Although the SEC can always raise the limit for intrastate Crowdfunding as well, the future probably belongs to Title III.

Questions? Let me know.

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