Crowdfunding Not Quite As Open As Recent Reports May Suggest

by Gray Reed & McGraw

My friends in the start-up community are excited about recent headlines suggesting the SEC has greenlighted crowdfunding.  Leave it to the lawyer in the crowd to suggest they temper their excitement.  As lawyers, we are used to telling people to be careful.

The News

The headlines come from two SEC actions that appear to allow AngelList and the the ability to operate as crowdfunding sites.   The SEC no action letters are linked here for and here for AngelList.

Technically, the SEC authorized AngelList and the fundersclub to receive a carried interest in the companies without having to comply with rigorous broker-dealer rules.   These sites are not simply taking 3-10% of whatever is raised by the company like some broker-dealers registered with FINRA might.  Instead, they are now allowed to take a carried interest in the companies to compensate them for raising money in what are essentially investment vehicles or funds to invest in start-ups.  This costs the founders much more out of the profits (anywhere between 20-30%) and the carried interest takes it out of the broker-dealer rules.  To read more, check out this blog post from Stephen Quinlivan of Leonard, Street and Dienard.

Both sites pre-screen and approve the companies seeking funds (although AngelList appears to have a lot of start-up that you can peruse without registering).  The investors don’t invest directly into the companies, but into investment vehicles (like a separate limited partnership or fund) which then manages the investment on behalf of all of the investors.  Therefore, it is not likely the individual investors get to vote their stock or impact management, other than through the collective investment vehicle.  Finally, both sites only allow accredited investors to participate.

What does it mean?

This is big news.  It does not mean, however, you can post your idea on Facebook and start asking for small contributions from your 2,000 Facebook “friends” of $100 each in exchange for stock in your company.

While the ruling focused on the broker-dealer exemption, it did not provide any guidance or loosen the restrictions against general solicitations of equity which is still against the law.  Importantly, the SEC’s tepid authorization of these sites was conditioned on the representation that all of the investors using the site would be accredited investors, registered and pre-screened.   Finding accredited investors interested in start-ups is easier said than done.

With regard to individuals, to be an accredited investor, the individual must:

  • Have a net worth that exceeds $1 million at the time of the purchase, excluding the value of the primary residence; or
  • Have an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Both sites claim to abide by Rule 506 of Regulation D which still prohibits “general solicitations.”  Rather than a true crowdfunding site that allows you to peruse various companies, you agree to invest in certain funds to be sued on start-ups and then state your interest in certain pre-screened startups.  

In the letter to the SEC, AngelList says it does not engaged in general solicitation because:

AngelList Advisors’ activities with respect to the qualification and approval of Investors should not be deemed a solicitation for any securities transaction. In particular, AngelList Advisors is proposing to impose a thirty day waiting period from the time a potential Investor submits an RFI and questionnaire until he or she closes on an investment. Consistent with the Staff’s guidance in Lamp Technologies Inc., this waiting period is designed to ensure that Investors do not join the AngelList Advisors platform to invest in a particular Investment Vehicle, and accordingly is sufficient to ensure that AngelList Advisors’ qualification of the potential Investor is not deemed to be a solicitation of an investment in the applicable Investment Vehicle.

The website is silent on the solicitation issue, but explains their process as follows:

FC Inc. and FC Management collectively identify and perform due diligence on start-up companies for which FC Management may wish to form investment funds. Once they have identified such a company, FC Management enters into a non-binding term-sheet agreement with that company on a target amount of capital which a limited liability investment fund managed by FC Management would invest in that company. FC Inc. then posts information about that start-up company, provided by the start-up company, on its website. The name of and information about a start-up company is available online only to FundersClub members who have already been qualified as accredited investors. FC Inc. makes available the investment fund which will invest in that company for its members to offer non-binding indications of interest. FC Inc. provides those members who express indications of interest in an investment fund with standardized legal documentation through which they will invest in that investment fund. When an investment fund reaches indications of interest sufficient to fund the target amount originally agreed upon between FC Inc. and the start-up company (or if the company agrees to increase the target level of capital), then FC Inc. closes the indication of interest process. FC Inc. then reconfirms the indication of interest with each member who has offered the indication of interest and reconfirms the accredited investor status of each of those members. Simultaneously, FC Inc. negotiates the final terms of the investment fund’s investment with the start-up company. That negotiation may include the management rights that FC Management will have in the start-up company after the completion of the investment fund’s investment in the start-up company.

Yes, this is a big step.  It may even be the first step toward loosening general solicitation restrictions.  It does give guidance on broker-dealer requirements, but almost no guidance or even clearance of where the line is on general solicitation restrictions.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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