Tag: Crowdfunding

SEC Clears the Way For Intra-State Crowdfunding

Most states have passed crowdfunding laws. One of the barriers has been the breadth of the federal preemption of interstate securities transactions. To be intra-state, and therefore out of the jurisdiction of the Securities and Exchange Commission, the investors and the company doing the fundraising needed to all be in the same state. The problem is the widespread use of Delaware as a state of organization. That puts the company in Delaware, while the operations and investors are in another state.

Crowdfunding

It was good to see states experimenting with crowdfunding. The SEC regulations of equity crowdfunding have proven to be difficult. Now the SEC has cleared the way for a broader definition of intra-state.

For example, the Massachusetts crowdfunding regulation, 950 CMR 14.402(B)(13)(o), required the issuer to have its principal place of business in Massachusetts and to be formed in Massachusetts.

The adopted a new Rule 147A  and amendments to Rule 147 to address the crowdfunding limitations. The SEC had adopted Rule 147 in 1974 as a safe harbor to a statutory intrastate exemption under Section 3(a)(11) of the Securities Act of 1933.

The new Rule 147A has changed the requirement so that the issuer merely has to have its “principal place of business” in that state and satisfy at least one “doing business” requirement to demonstrate the in-state nature of the issuer’s business.

Of course, the SEC does not make intra-state crowdfunding legal. It’s subject to state regulatory requirements. Massachusetts, and most states, will need to revise their crowdfunding laws to open up to these broader rules.

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Crowdfunding is by Rocio Lara
CC BY SA

Massachusetts Adopts Crowdfunding

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Add Massachusetts to the growing list of states that are sidestepping the unusable federal crowdfunding alternative.

“The Crowdfunding Exemption is designed to foster job creation by helping small and early-stage Massachusetts companies find investors and gain greater access to capital with fewer restrictions. The exemption is also intended to provide necessary investor protections by requiring key disclosures, and by making the exemption unavailable to bad actors that have violated the securities laws or committed financial fraud.”

The federal crowdfunding provisions in the Jumpstart Our Business Startups Act of 2012 was supposed to be a panacea for crowdfunding. But the final language of the law was amended at the last minute. The Securities and Exchange Commission was vocally opposed to it, but issued proposed regulations in October 2013 to implement the exemption. The SEC received about 300 written comments to the proposed regulations, but there is no sign that the final regulations will come out any time soon. The Federal crowdfunding regime will not be effective until the SEC issues those regulations. Even then, the regime is likely to be unwieldy.

A May 1, 2014 Wall Street Journal article, entitled “Frustration Rises Over Crowdfunding Rules,” describes efforts in the U.S. Congress to amend the JOBS Act even before the federal regime takes effect. However, many states have decided that crowdfunding is worth trying and are not waiting for the SEC.

The new Massachusetts crowdfunding regime is limited to $1 million a year, which can be increased to $2 million with audited financial statements. The company must set a fundraising minimum and must keep funds in escrow at a Massachusetts bank until it reaches the target.

The investment amount limitations are a bit messy. For those with net worth and income of less than $100,000, an investment is limited to the greater of $2000 or 5% of annual income or net worth. For the wealthier, it can go up to 10% of income or net worth. The Massachusetts regulation looks to the SEC accredited investor standard for calculating those amounts (i.e. exclude the home).

There is a limitation on form. The business must be formed under Massachusetts law, have its principal place of business in Massachusetts and authorized to do business in Massachusetts. It’s too bad the regime excludes the Delaware formed organizations from crowdfunding. That limits future growth of the company. Bigger money investors will want a Delaware entity for the certainty under the Delaware corporate laws for protection of their shareholder rights.

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Real Estate Crowdfunding

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Real estate investing has a long history of crowdfunding. Prior to the 1986 changes to the tax code, there was a large syndication business for getting investors into real estate. Although the investment was usually more for the tax breaks involved instead of income and capital appreciation.

With the surge of product crowdfunding through sites like Kickstarter, the regulatory changes for equity crowdfunding from the SEC, and state-level implementation of crowdfunding, investors and sponsors are once again looking to crowdfunding for real estate. Currently, it’s largely limited to accredited investors due to SEC limits or limited to state specific projects and investors.

Goodwin Procter put together a publication full of real estate crowdfunding articles: A Guide to Real Estate Crowdfunding Today.

The guide hits one major theme: crowdfunding is new and there are few success stories. No one site has been very successful at pulling investors and meaningful projects together.

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees. The crowdfunding platforms I’ve looked at are expensive. It’s expensive for the sponsor and its expensive for the investor.

The other concern is execution. To purchase or sell real estate, you need to decide quickly on the best deals and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. You would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a real estate seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the crowdfunded real estate is already warehoused with the sponsor and is looking to lay off some of the equity or fund capital improvements. The sponsor is looking to crowdfunding as a cheaper source of capital or a quicker source of capital. So far, crowdfunding does not seem cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication of the investment’s quality.

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The SEC Shuts Down Another Illegal Crowdfunding Site

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Kickstarter has shown the world that crowdfunding is a viable option for funding great ideas. Because of US securities laws, the funding arrangement on that platform cannot be for an equity interest. That’s selling securities and that practice is subject to decades of protections built to protect consumers.  The JOBS Act opened the possibility of equity crowdfunding sites for the masses, but the implementation is still hung up in SEC rulemaking.

That has not stopped internet entrepreneurs from firing up crowdfunding sites. There are ways to do so legally, but there are lots of regulatory and operational landmines that need to be navigated.

Of course, it’s very easy to set up an illegal crowdfunding site. Eureeca.com did that and subjected itself to the wrath of the SEC.

Eureeca.com’s approach was to make international investments available for crowdfunding. From looking at the funding proposals on the site, most seem to be coming out of the Middle East and North Africa. Since I see the proposals and can seemingly participate, Eureeca.com subjected itself to the jurisdiction of the SEC.

The website is a general solicitation for securities purchases. None of the securities are registered. Eureeca.com is not making any attempt to limit participants to accredited investors and is not taking steps to verify that investors are accredited investors. That would allow it to use the new Rule 506(c) exemption for public private placements.

The SEC wrath was a charge of failing to register as a broker-dealer.

According to the SEC order, three US investors put $20,000 into four offerings. That resulted in a $25,000 fine and new big disclaimer on the site:

The securities and services on the Eureeca platform are not being offered in the USA or to U.S. persons. For further information please read our FAQs.

If the offerings were in the US, the SEC would also be able to interfere with the private placements as violations, but the issuers are outside the reach of the SEC. I’m not familiar with the securities laws in the foreign jurisdictions, but I would guess that Eureeca.com is violating the securities laws in many other countries.

The SEC will continue to bring the hammer down on crowdfunding sites. The SEC worried about consumer protection and fraud in this area. I think they are right to concerned.

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The SEC Still Hates Intrastate Crowdfunding

Icon of Money in the Hand on Rusty Warning Sign.

One of the exemptions from registering a securities offering is if the offering is limited to one state. Some crowdfunding advocates latched onto this exemption and have been pushing for single state crowdfunding at the state legislatures. On April 10, 2014, the SEC issued a Compliance and Disclosure Interpretation on intrastate crowdfunding offerings. The interpretation was overly restrictive.

The SEC said at the time that you can’t use a third-party portal website for an intrastate securities offerings. “Use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory.” In reading that, the SEC waved a big regulatory “NO” finger at using third party sites.

The SEC just retreated slightly from that position, but proved that the SEC does not understand how the internet works. In Question 141.05, published on October 2, the SEC seems to be a bit more lenient when it comes a company using its own website. The SEC acknowledges that a website advertises the company, but could also advertise a securities offering. “Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances…”

If the company does make the existence of an investment opportunity available on an unrestricted website, that could be considered a violation of the intrastate exemption. The SEC offers up the solution that a company “could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. ”

The location of an IP address does not necessarily equate to your state of residence.  It may not even equate to where you at the moment you are accessing the internet. One of the great values of the internet is that is defies and defeats physical borders.

 The SEC’s solution is short-sighted and poorly thought out.

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Real Estate Investing and Crowdfunding

crowdfunding real estate

Real estate investing is capital-intensive. It should be a natural area for crowdfunding. The big concern is fees and conflicts.

With a tech startup, you are investing in an idea and the people with the idea. It may grow exponentially or blow up, leaving little behind. Part of the investment is paying the people to run the business. With real estate, the cost of managing the investment may be an additional expense beyond the investment. The people managing the investment may be connected with the people selling the investment. That can work well, or be a conflict.

The Wall Street Journal highlighted crowdfunding opportunities in real estate: Real-Estate Crowdfunding Finds Its Footing. The Securities and Exchange Commission has not enacted crowdfunding regulations yet, so the investments will have to be limited at accredited investors, or otherwise exempt from securities registration. Of course, if the investor has enough rights, it’s possible that the investment might not be a security.

The stories highlights three real estate crowdfunding platforms:

  • RealtyMogul
  • Fundrise
  • Prodigy Network

So I decided to take a closer look.

Realty Mogul

After logging in, the site asks for self-reporting of income and net worth to determine if the user is an accredited investor. The final step is a click wrap agreement that:

“By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of this investment, and you are able to bear the economic risk of this investment including the risk of complete loss.”

Then the site imposes a 21 day delay. I presume that this is set up to distance the site registration from a general solicitation. By coming back 21 days later, I assume the firm is trying say that there is now a relationship.

Even with the delay, you can browse available investments. There were 5 available when I viewed the site, ranging from $510,000 to $760,000 of equity sought. Each sets up a Realty Mogul subsidiary to invest alongside a property operator/co-investor. The site discloses the operator’s compensation and Realty Mogul’s compensation.  The available assets all had a $10,000 minimum investment.

Fundrise

This site also has you self-certify as an accredited investor. I was surprised to see the no option as “No – most people choose this option”. I chose this first, then went back to switch it to accredited investor.

Apparently, Fundrise has seen the SEC rule on general advertising and requires verification that you are accredited. The site requires a verification letter from a broker-dealer, registered investment adviser, attorney, or CPA before granting you status as an accredited investor.

The platform has regulation A offerings available for non-accredited investors, but limited by state. The documentation is substantial. The offering document for one investment was over 100 pages.

Fundrise is less transparent about fees than Realty Mogul. The Reg A investment allowed an investment as little as $100. The private placements required a minimum of $5000.

Fundrise has a social network aspect, allowing you to see the investors in an investment and to join investment network within the platform.

Prodigy Network

Offered little detail behind its introductory pages.

Summary

Here is the big problem with real estate crowdfunding. To purchase or sell real estate, you need to act and convince the other side that you can close. If you are buying a property and sourcing the capital with crowdfunding, there is the possibility that you won’t raise the money and not be able to close. Presumably you would have to include the successful crowdfunding as a closing condition, or have a backup source of more expensive capital to cover the failed crowdfunding. As a seller, why would you accept an offer contingent on crowdfunding?

The alternative is that the real estate is already warehoused with a party and is looking to lay off some of the equity or fund capital improvements.  Then you are looking to crowdfunding as a cheaper source of capital or a quicker source of capital. I have a hard time believing that crowdfunding is cheaper or faster than other sources of capital. And if other sources of capital are not interested in the investment, perhaps that is an indication.

However, I applaud the efforts of these sites and think they offer an interesting opportunity to make an alternative investment.  I had only a short opportunity to see what these platforms have to offer and how they go about offering their investments. There is lots more to see and learn.

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The Monsters of Compliance – Frankenstein’s Monster

Frankenstein and compliance

The pumpkins and garish Halloween decorations are out on my front lawn. With the Halloween season upon us, my mind has become stuck on movie monsters and been mixed with compliance. This is the terrible result.

Victor Frankenstein builds a creature in his laboratory with a mixture of surgery, chemistry, and alchemy. His creation horrifies Dr. Frankenstein and he disavows the experiment. The abandoned monster wanders through the wilderness searching for kindness and acceptance, unaware of his own identity.

I expect we will see this metaphor in the crowdfunding rules expected to be released today. The rules will likely be a mess of cobbled together parts. That’s because the Doctor designed the framework that way. In this case, the Doctor is Congress.

The SEC will be stuck wandering the wilderness being chased by pitchfork-wielding entrepreneurs who wanted a simple platform for getting equity funding from the masses. The problem was not of the monster’s creation, but of its master’s doing. Congress created an unworkable framework and the SEC is stuck with its design, trying to get its pieces to work together.

In many ways, the ills of the Securities and Exchange Commission can be blamed on its master. Congress limits its budget. The SEC is not self-funded like the Federal Reserve, the bank regulators, or FINRA. As Robert Kaiser points out in his book, Act of Congress:

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

The SEC must heed the mandates of Congress and the cobbled together pieces of legislation that make up our securities laws.

UPDATE:

The proposed rules were published shortly after the post was published. Although I have not read it, the release proposal is 585 pages long. The text of the regulations is 50 pages long and includes several additional pages of proposed forms. That makes it a big monster.

Action Against a Crowdfunding Platform

somoLend

SoMoLend – which stands for Social Mobile Local Lending – is a crowdfunding platform that allows small businesses to borrow money from a network of lender. The State of Ohio claims that SoMoLend failed to meet the regulatory hurdles currently in place for crowdfunding. It’s also claiming that SoMoLend acting fraudulently when seeking its own investment capital.

There are many entrepreneurs and wantapreneurs trying to jump on the crowdfunding bandwagon. For those willing to take the time to understand the securities laws, there are ways to enter the field. For some, the upcoming gate opening on general solicitation and advertising will allow them to jump on board. Others are looking to the Securities and Exchange Commission to issue rules on crowdfunding under the JOBS Act.

Just by looking at that web of requirements, the regulatory landscape for crowdfunding is complicated and currently in flux. That likely means that fraudsters are circling for easy targets and well intentioned businesses can easily make a mistake.

The State of Ohio says that SoMoLend made a mistake when working for lending sources and crossed the line when soliciting its own investors.

The Ohio action is not against the crowfunding aspect, it’s against the way SoMoLend raised its own capital and its business model. Ohio has an exemption from registration for securities offerings that comply with the SEC’s Regulation D. Until September 23, 2013 that means the securities can’t be offered through general solicitation and advertising. Ohio is claiming that SoMoLend violated that ban and therefore does not qualify for the exemption from registration under Ohio law.

On top of that violation, Ohio is also claiming fraud for SoMoLend using financial projections in investor pitches that depicted a more profitable company. The company projected millions in revenue and profits. Those projections lacked any meaningful disclosure about the assumptions that went into the projections and lacked cautionary risk factors for investors.

In a March 2013 article, SoMoLend claimed:

Since the beta site launched in May 2012, SoMoLend has facilitated some 100 small-business loans totaling nearly $3.5 million. Loans range from $500 to $1 million, with interest rates ranging from 3 to 22 percent and terms spanning six weeks to five years, depending on a business’s needs and creditworthiness. SoMoLend also charges a 4 percent transaction fee on funds borrowed.

Ohio claims the true amount of lending activity was 13 loans to 9 businesses for $94,000. According to the Ohio filing, the company has brought in only $3404 in revenue.

On top of that, SoMoLend met with the Ohio regulators who pointed out that the firm would need to be registered as broker-dealer if it was going to collect transaction-based fee for selling notes through the platform. That 4% transaction fee is effectively a commission on the sales of securities. You can compare that to Funder’s Club that took a different approach to crowdfunding by taking a promote on the back-end. Funder’s Club even obtained a No Action letter from the SEC validating its business model.

Finally, the state gets to the crowdfunding piece and alleges that some, or all, of the promissory notes offered through SoMoLend were not registered or exempt from registration. Ohio seems a bit sympathetic to the note issuers when it says SoMoLend “exposed approximately 200 small business issuer to potential liability”.

I decided to take a look at the platform. To start, I saw this warning:

If you are an accredited investor, we require you attest to your status prior to viewing borrowers on the platform.

I still have not gotten any more for verification and am still blocked from seeing any investment opportunities. I assume the business has come to grinding halt, even though the hearing on the order is not until October. SoMoLend’s CEO, Candace Klein recently resigned because of the regulatory action.

According to a story on Cincinnati.com:

Klein is a passionate entrepreneur who was honest about the company’s finances with investors and board members, but consistently lacked discipline and precision when discussing and presenting the company’s actual performance.

A combination of those missteps and the state’s apparent concerns about crowdfunding, lead to trouble.

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Fund Investing and Crowdfunding

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As the Securities and Exchange Commission has been dragging its feet on new crowdfunding regulations, companies are finding a way to crowdfund using the current rules. The biggest challenge is dealing with the broker-dealer registration requirements. If you sell securities on a transaction basis, you are likelya broker-dealer and need to deal with the registration requirements.  The other limitation is dealing with the current ban on general solicitation and advertising.

One company that appears to be successfully employing a crowdfunding  strategy is Solar Mosaic. The company is selling interests directly in its own projects so it avoids the broker-dealer requirements. It uses a Rule 504 exemption instead of Rule 506 exemption under Regulation D. Rule 504 exempt offerings are not subject to the ban on advertising that impedes Rule 506 offerings, but are subject to a $1 million limit on capital raised. I even invested a small amount of cash in a Solar Mosaic project.

I have seen a few other platforms, like Circle Up, that partner with a broker-dealer. Effectively, the web crowdfunding platform sits on top of the broker-dealer’s regulatory platform.

The latest crowdfunding approach to catch my eye is FundersClub. They even obtained a no-action letter from the Securities and Exchange Commission blessing their approach. (I should disclose that Mrs. Doug works at the law firm that requested the no-action letter.)

FundersClub acts as a venture capital fund manager and registered as a venture capital fund manager with California. It starts a separate private fund for each company that it funds.

The compensation it tricky. According to the SEC no-action letter and the FundersClub FAQ, the company charges an administrative fee to cover out of pocket costs. None of that fee goes to salaries or personnel. That lack of transaction compensation and operations was enough to keep the company away from broker-dealer registration.

FundersClub does take a promote on the performance of the investment fund. It has a long road ahead for compensation to come in, but is aligned with the investors.

I decided to try out the platform. Signing up is straightforward.

As for vetting users as accredited investors, the platform does a better job than others. It asks for your income, joint income and net worth. Other platforms just have a check button exactly tied to the right answers for those questions. With FundersClub, you need to know your income or know the right answers to be accredited.

It does have one simple check for knowledge:

By checking this box, you represent that you have such knowledge and experience in financial and business matters that you are capable of evaluating the merits and risks of investment opportunities in private companies generally, and you are able to bear the economic risk of such investments including the risk of complete loss.

After passing the entrance hurdle, there are several investment opportunities in the works.

The current regulatory environment for crowdfunding is tricky, but navigable for accredited investors. Non-accredited investors are left out, so maybe crowdfunding is not the right term. I’m skeptical that the JOBS Act mandate for new crowdfunding regulations is going to truly open the floodgates to non-accredited investors.

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UPDATED: To clean up more than my usual collection of typos.

Crowdfunding and the Ban on General Solicitation

18 Rabbits Bars

While entrepreneurs are looking to create crowdfunding portals under Title III of the JOBS Act, small business owners looking to raise capital should keep an eye on the regulatory changes under Title II of the JOBS Act. That may do a better job of opening the spigot for capital than the avalanche of crowdfunding portals likely to appear.

Look at the case of Alison Bailey Vercruysse, a maker of granola-based foods, and her company 18 Rabbits. According to a story in yesterday’s Washington Post, her products attracted a loyal following, but she could not tap those fans for capital as she tried to grow her firm.

“People would come up to me in different places and say: ‘I’m interested in investing in your company. How can I do that?’ ” Vercruysse said. “I couldn’t say we were trying to raise money. I’d end up saying things like; ‘Buy our granola. That would help us.’ ”

Without the ban on general solicitation, the company could put a message on its packaging or its website for accredited investors interested in investing.

Currently, the Securities and Exchange Commission has a ban on the use of general advertising and solicitation for raising private capital under the most popular exemption, Rule 506. Title II of the JOBS Act requires the SEC to remove that ban for offering where all investors are accredited. The agency tried to rush the rules last summer to meet the Congressional deadline, but investor advocates demanded that the SEC slow down. The SEC is gathering public comment before finalizing the rule.

Two SEC commissioners, Dan Gallagher and Troy Paredes, were in favor of immediately lifting the ban. SEC Commissioner Luis Aguilar did not like the rule, saying it lacked adequate investor protections. The fourth SEC Commissioner, Elise Walter voted for the proposal, but expressed concerns. She has stated the SEC must consider ways to mitigate potential harm to investors. The fifth and presumably deciding Commissioner’s seat is vacant with the departure of Mary Shapiro. Looking into my crystal ball, it would seem that the rule is not going to be finalized anytime soon. At least not until the vacancy is filled.

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