Tag Archives: Title IV Crowdfunding

Non-U.S. Investors and Companies in U.S. Crowdfunding

Non-US Investors and Companies in US Crowdfunding

When I was a kid, back in the 1840s, we referred to people who live outside the United States as “foreigners.” Using the more globalist and clinical term “non-U.S. persons,” I’m going to summarize how people and companies outside the U.S. fit into the U.S. Crowdfunding and Fintech picture.

Can Non-U.S. Investors Participate in U.S. Crowdfunding Offerings?

Yes. No matter where he or she lives, anyone can invest in a U.S. Crowdfunding offering, whether under Title II, Title III, or Title IV.

The Crowdfunding laws don’t distinguish U.S. investors from non-U.S. investors. Thus:

  • To invest in an offering under Title II (SEC Rule 506(c)), a non-U.S. investor must be “accredited.”
  • If a non-U.S. investor invests in an offering under Title III (aka “Regulation CF”), he or she is subject to the same investment limitations as U.S. investors.
  • If a non-U.S. investor who is also non-accredited invests in an offering under Tier 2 of Title IV (aka “Regulation A”), he or she is subject to the same limitations as non-accredited U.S. investors, e., 10% of the greater of income or net worth.

What About Regulation S?

SEC Regulation S provides that an offering limited to non-U.S. investors is exempt from U.S. securities laws. Mysterious on its face, the law makes perfect sense from a national, jurisdictional point of view. The idea is that the U.S. government cares about protecting U.S. citizens, but nobody else.

EXAMPLE:  If a U.S. citizen is abducted in France, the U.S. military sends Delta Force. If a German citizen is abducted in France, Delta Force gets the day off to play volleyball.

Regulation S is relevant to U.S. Crowdfunding because a company raising money using Title II, Title III, or Title may simultaneously raise money from non-U.S. investors using Regulation S. Why would a company do that, given that non-U.S. investors may participate in Title II, Title III, or Title IV? To avoid the limits of U.S. law. Thus:

  • A company raising money using Title II can raise money from non-accredited investors outside the United States using Regulation S.
  • A company raising money using Title III can raise money from investors outside the United States without regard to income levels.
  • A company raising money using Tier 2 of Title IV can raise money from non-accredited investors outside the United States without regard to income or net worth.

Thus, a company raising money in the U.S. using the U.S. Crowdfunding laws can either (1) raise money from non-U.S. investors applying the same rules to everybody, or (2) place non-U.S. investors in a simultaneous offering under Regulation S.

What’s the Catch?

The catch is that the U.S. is not the only country with securities laws. If a company in the U.S. is soliciting investors from Canada, it can satisfy U.S. law by either (1) treating the Canadian investors the same way it treats U.S. investors (for example, accepting investments only from accredited Canadian investors in a Rule 506(c) offering), or (2) bringing in the Canadian investors under Regulation S. But to solicit Canadian investors, the company must comply with Canadian securities laws, too.

Raising Money for Non-U.S. Companies

Whether a non-U.S. company is allowed to raise money using U.S. Crowdfunding laws depends on the kind of Crowdfunding.

Title II Crowdfunding

A non-U.S. company is allowed to raise money using Title II (Rule 506(c)).

Title III Crowdfunding

Only a U.S. entity is allowed to raise money using Title III (aka “Regulation CF”). An entity organized under the laws of Germany may not use Title III.

But that’s not necessarily the end of the story. If a German company wants to raise money in the U.S. using Title III, it has a couple choices:

  • It can create a U.S. subsidiary to raise money using Title III. The key is that the U.S. subsidiary can’t be a shell, raising the money and then passing it up to the parent, because nobody wants to invest in a company with no assets. The U.S. subsidiary should be operating a real business. For example, a German automobile manufacturer might conduct its U.S. operations through a U.S. subsidiary.
  • The stockholders of the German company could transfer their stock to a U.S. entity, making the German company a wholly-owned subsidiary of the U.S. entity. The U.S. entity could then use Title III.

Title IV Crowdfunding

Title IV (aka “Regulation A”) may be used only by U.S. or Canadian entities with a “principal place of business” in the U.S. or Canada.

(I have never understood why Canada is included, but whatever.)

If we cut through the legalese, whether a company has its “principal place of business” in the U.S. depends on what the people who run the company see when they wake up in the morning and look out the window. If see the U.S., then the company has it’s “principal place of business” in the U.S. If they see a different country, it doesn’t. (Which country they see when they turn on Skype doesn’t matter.)

Offshore Offerings

Regulation S allows U.S. companies to raise money from non-U.S. investors without worrying about U.S. securities laws. But once those non-U.S. investors own the securities of the U.S. company, they have to think about U.S. tax laws. Often non-U.S. investors, especially wealthy non-U.S. investors, are unenthusiastic about registering with the Internal Revenue Service.

The alternative, especially for larger deals, is for the U.S. entity to form a “feeder” vehicle offshore, typically in the Cayman Islands because of its favorable business and tax climate. Non-U.S. investors invest in the Cayman entity, and the Cayman entity in turn invests in the U.S. entity.

These days, it has become a little fashionable for U.S. token issuers to incorporate in the Cayman Islands and raise money only from non-U.S. investors, to avoid U.S. securities laws. Because the U.S. capital markets are so deep and the cost of complying with U.S. securities laws is so low, this strikes me as foolish. Or viewed from a different angle, if a company turns its back on trillions of dollars of capital to avoid U.S. law, I’d wonder what they’re hiding.

What About the Caravan from Honduras?

Yes, all those people can invest.

Questions? Let me know.

A Summary of the Investment Company Act for Crowdfunding

Hardly a day goes by without someone asking a question that involves the Investment Company Act of 1940. Although the Act is hugely long and complicated, I’m going to try to summarize in a single blog post the parts that are most important to Crowdfunding.

Why the Fuss?

If you’re in the Crowdfunding space, you don’t want to be an “investment company” within the meaning of the Act:

  • As an investment company, you’re not allowed to raise money using either Title III (Regulation Crowdfunding) or Title IV (Regulation A).
  • Investment companies are subject to huge levels of cost and regulation.

What is an Investment Company?

An investment company is company in the business of holding the securities of other companies. That statement raises many interesting and technical legal issues that have consumed many volumes of legal treatises and conferences at the Waldorf. But almost none of it matters to understand the basics.

All that matters from a practical perspective is that stock in corporations, interests in limited liability companies, and interests in limited partnerships are all generally “securities” within the meaning of the Act.

And that means, in turn, that if you hold stock in corporations, interests in limited liability companies, and/or interests in limited partnerships, then assume you’re an “investment company” within the meaning of the Act, unless you can identify and qualify for an exception.

How Much is Too Much?

Holding some securities doesn’t make you an investment company. Under one of the many technical rules in the Act, a company won’t be considered an investment company if:

  • No more than 45% of its assets are invested in securities, as of the end of the most recent fiscal quarter; and
  • No more than 45% of its income is derived from investment securities, as of the end of the most recent four fiscal quarters.

Does That Mean a Typical SPV is an Investment Company?

Unless the SPV can find an exception, yes.

Many Crowdfunded investments use a “special purpose vehicle,” typically a Delaware limited liability company. Investors acquire interests in the SPV, and the SPV invests – as a single investor – in the actual operating company. Because the only asset of the SPV is the interest in the operating company, which is a “security,” the SPV is indeed an investment company, unless it qualifies for one of the exceptions below.

Simple Exceptions

The definition of “investment company” is so broad, most of the action is in the exceptions. I’m not going to talk about all of them, only those that are most relevant to Crowdfunding.

  • No More Than 100 Investors – A company with no more than 100 investors (who do not have to be accredited) isn’t an investment company. That’s the exception used by SPVs in Crowdfunding. Which means that as the size of deals in Crowdfunding grows, SPVs will no longer be used.
  • All Qualified Investors – A company with only “qualified investors” isn’t an investment company. A “qualified investor” is generally a person with more than $5 million of investable assets. Many hedge funds rely on this exception, but it’s not going to be used widely in Crowdfunding.

NOTE:  A company that would be an investment company but for either of those two exceptions is still not allowed to use Title III or Title IV.

  • Companies That Invest In Mortgages – A company that invests in or originates mortgages is usually not an investment company.
  • Wholly-Owned Subsidiaries – A company that conducts its business through wholly-owned subsidiaries isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “wholly-owned” means the parent owns at least 95% of the voting power.
  • Majority-Owned Subsidiaries – A company that conducts its business through majority-owned subsidiaries usually isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “majority-owned” means the parent owns at least 50% of the voting power.

The 45% Exception

Some companies, including some REITs, own interests in subsidiaries that are not wholly-owned or even majority-owned. To avoid being treated as investment companies, those companies typically rely on an exception that requires more complicated calculations. Under this exception, a company is excluded from the definition of “investment company” if it satisfies both of the followings tests:

  • No more than 45% of the value of its assets (exclusive of government securities and cash items) consist of securities other than what I will refer to as “allowable securities.”
  • No more than 45% of its after-tax income is derived from securities other than those same “allowable securities.”

For these purposes, the securities I am calling “allowable securities” include a number of different kinds of securities, but the two most important to us are:

  • Securities issued by majority-owned subsidiaries of the parent; and
  • Securities issued by companies that are controlled primarily by the parent.

So think of those securities as being in the “good” basket and other kinds of securities as being in the “bad” basket.

In determining whether a security – such as an interest in a limited liability company – is an “allowable security,” and therefore in the “good” basket, the following definitions apply:

  • A subsidiary is a “majority-owned subsidiary” if the parent owns at least 50% of the voting securities of the subsidiary.
  • A parent is deemed to “control” a subsidiary if it has the power to exercise a controlling influence of the management or policies of the subsidiary.
  • A parent is deemed to “control primarily” a subsidiary if (1) it has the power to exercise a controlling influence of the management or policies of the subsidiary, and (2) this power is greater than the power of any other person.

Summary

If your business model involves investing in other companies and you plan to raise money from other people, the Investment Company Act of 1940 should be on your To Do List.

As a rule of thumb, you can feel comfortable investing in wholly-owned subsidiaries, majority-owned subsidiaries, and subsidiaries where you have exclusive or at least primary control. If you find other investments making up, say, more than 25% of your portfolio, measured by asset value or income, look harder.

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.

Improving Legal Documents in Crowdfunding: Get Rid of the State Legends!

I see lots of offering documents like this, with pages of state “legends.” The good news is that in Crowdfunding offerings – Title II (Rule 506(c)), Title III (Regulation Crowdfunding), and Title IV (Regulation A) – you can and should get rid of them.

The legal case is pretty simple:

  • Before 1996, states were allowed to regulate private offerings. Every state allowed exemptions, but these exemptions often required legends, differing from state to state.
  • The National Securities Market Improvement Act of 1996 added section 18 to the Securities Act of 1933. Section 18 provides that no state shall “impose any conditions upon the use of. . . .any offering document that is prepared by or on behalf of the issuer. . . .” in connection with the sale of “covered securities.”
  • The securities sold under Title II, Title III, and Title IV are all “covered securities.”
  • Hence, section 18 prohibits states from imposing any conditions regarding the issuer’s offering documents, including a condition that requires the use of a state legend.

If the capitalized legends just take up space, why not include them anyway just to be safe? Take Pennsylvania’s legend as an example:

These securities have not been registered under the Pennsylvania Securities Act of 1972 in reliance upon an exemption therefrom. any sale made pursuant to such exemption is voidable by a Pennsylvania purchaser within two business days from the date of receipt by the issuer of his or her written binding contract of purchase or, in the case of a transaction in which there is not a written binding contract of purchase, within two business days after he or she makes the initial payment for the shares being offered.

If you include the Pennsylvania legend “just to be safe,” you’ve given Pennsylvania investors a right of rescission they wouldn’t have had otherwise!

Two qualifications.

First, the North American Securities Administrators Association –the trade group of state securities regulators – suggests including uniform legend on offering documents. I include this or something similar as a matter of course:

IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN EXAMINATION OF THE COMPANY AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND RISKS INVOLVED. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT, AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS SHOULD BE AWARE THAT THEY WILL BE REQUIRED TO BEAR THE FINANCIAL RISKS OF THIS INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.

Second, some states, including Florida, require a legend to appear on the face of the offering document to avoid broker-dealer registration. Because Section 18 of the Securities Act doesn’t prohibit states from regulating broker-dealers, some lawyers recommend including those legends, while others believe those requirements are an improper “back door” way for states to avoid the Federal rule. I come out in the latter camp, but opinions differ.

Questions? Let me know.

A Regulation A+ Primer

Regulation A Plus Women GossipingNo disrespect to Kim Kardashian, but I think the SEC’s proposals for Regulation A+ have come closer to breaking the Internet than the photos I heard about last year – although that could be a function of the circles I travel in.

My contribution started as a blog post but got too long for a blog post. Hence, I’m providing this Regulation A+ Primer as a separate link. Within the Primer are links to:

I am trying to provide not just technical details in the Primer – which are important – but also practical advice about the cost of Regulation A+ offerings, the advantages and disadvantages, and examples.

If you have thoughts, as many of you will, I am eager to hear them and plan to supplement the Primer.

Questions? Let me know.

Crowdfunding Is Just the Internet

red mouse with money and comment

Fortunately for me, there are a lot of complicated legal issues around Crowdfunding, including:

  • The differences among Title II, Title III, and Title IV
  • The differences between Rule 506(b) offerings and Rule 506(c) offerings
  • The differences between accredited investors and non-accredited investors
  • The Trust Indenture Act of 1939
  • The Investment Company Act of 1940
  • Applying broker-dealer and investment adviser laws to Crowdfunding portals

But at a higher level Crowdfunding isn’t complicated at all. Crowdfunding is just the Internet coming to the capital formation industry.

What happens when the Internet comes to an industry? Look at the publishing industry and the travel industry and the music industry and, increasingly, the entire retail industry:

  • Buyer and sellers connect directly
  • Middlemen are displaced
  • Prices decrease as the industry becomes more efficient
  • The middlemen being displaced are sure it won’t happen as it’s happening
  • In the end, the industry looks completely different and we all take it for granted

In Crowdfunding, the “sellers” are entrepreneurs and real estate developers seeking capital and the “buyers” are investors. The middlemen are the lawyers, bankers, finders, brokers, venture capital funds, investment advisors, and all the others who for the last 80 years have played an indispensable part in connecting entrepreneurs with investors. Today, for the first time, entrepreneurs and investors can connect directly, via the Internet. The middlemen have already started to be pushed to the side. The picture in my mind is an ice field slowly breaking apart as temperatures warm.

People sometimes ask whether Crowdfunding will last. I respond “When was the last time you planned a vacation through a bricks-and-mortar agency?” The Internet is here to stay!

The capital formation industry is enormous – far, far bigger than the book selling industry or the travel industry. And the middlemen in the capital formation industry enjoy far greater political power than Barnes & Noble. But in the end, resistance is futile.

As you’re planning and managing your own portal, or any other Crowdfunding business, pause every now and then and remember that for all the legal complexity, for all the nuts-and-bolts, day-to-day grind of generating cash flow, Crowdfunding is nothing more or less than the Internet come to the capital formation industry.

Questions? Contact Mark Roderick.

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