You just raised $1 million in your crowdfunding offering under Title III/Regulation CF. That’s the good news. The bad news? You now have over a thousand shareholders on your cap table, making it unwieldy, an administrative nightmare and likely to impede future funding. It means a huge challenge seeking consents for such things as director elections, strategic decisions and later funding rounds. And later rounds in turn will become more difficult to achieve as the company is perceived to be less attractive.
One way to avoid the messy cap table problem would be to conduct the raise through a special purpose vehicle whose sole purpose is to recruit investors and invest the proceeds in an identified operating company. The investors receive interests in the SPV, and the operating company adds only one new shareholder to its cap table. Unfortunately, SPVs have not been eligible under Regulation Crowdfunding.
Until now. As part of the reform package adopted by the SEC last November to facilitate capital formation (see my previous posts here, here and here), the SEC lifted the prohibition on the use of special purpose vehicles in Regulation Crowdfunding offerings. The crowdfunding ecosystem has been clamoring for this change for years, primarily because it would alleviate the messy cap table problem. But the SPVs that will be allowed to recruit investors into Regulation CF deals must meet several stringent requirements not present in typical venture SPVs many of us are familiar with. This is not your father’s SPV.
Technically, the reason SPVs were ineligible to offer securities under Title III of the JOBS Act is because of Regulation CF’s exclusion of “investment companies” and even companies excluded from the investment company definition because of having fewer than 100 investors or only “qualified purchasers”. Since an “investment company” is defined generally as a company in the business of holding the securities of other companies, issuers were not allowed to conduct Regulation CF offerings through SPVs.
In addition to contributing to the messy cap table problem, the ineligibility of SPVs also increased the likelihood of prematurely triggering Securities Exchange Act registration due to the number of overall shareholders or the number of non-accredited investors. Section 12(g) of the Exchange Act requires an issuer with total assets of more than $10 million and a class of securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, to register that class of securities with the SEC. Most companies seek to avoid Exchange Act registration until a time of their choosing. Regulation Crowdfunding, however, does conditionally exempt securities issued under Regulation Crowdfunding from the shareholder number registration trigger under Section 12(g) if certain conditions are met, including having total assets of $25 million or less. The $25 million asset threshold, combined with the 2,000/500 shareholder cap, could be a real trap for crowdfunding issuers.
New Conditional Crowdfunding Vehicles
The new SPV rules exclude from the definition of “investment company” crowdfunding vehicles that meet specific conditions designed to require that they function purely as conduits for investors to invest in a company seeking to raise capital through a crowdfunding vehicle. To be excluded from the definition of “investment company” and thus be eligible to participate in an offering under Regulation Crowdfunding, a crowdfunding vehicle must:
- be organized and operated for the sole purpose of acquiring, holding, and disposing of securities issued by a single crowdfunding issuer and raising capital under Regulation Crowdfunding;
- not be permitted to borrow money;
- be required to use the proceeds solely to purchase a single class of securities of a single crowdfunding issuer;
- be permitted to issue only one class of securities in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers under the Securities Act;
- maintain the same fiscal year-end as the crowdfunding issuer;
- maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding;
- vote the crowdfunding issuer securities, and participate in tender or exchange offers or similar transactions, only in accordance with instructions from the investors in the crowdfunding vehicle;
- provide to each investor the right to direct the crowdfunding vehicle to assert such rights under state and federal law that the investor would have if he or she had invested directly in the crowdfunding issuer; and
- promptly provide each investor any information that it receives from the crowdfunding issuer as a shareholder of record of the crowdfunding issuer.
The requirement that the crowdfunding vehicle issue only one class of securities in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers means that each of the issuer and the vehicle would be deemed to be the maker of any statements by the crowdfunding vehicle and any material misstatements or omissions with respect to the offering. The two entities (issuer and vehicle) would also be required to file jointly a Form C providing all of the required Form C disclosures with respect to (i) the offer and sale of the crowdfunding issuer’s securities to the crowdfunding vehicle and (ii) the offer and sale of the crowdfunding vehicle’s securities to the investors.
The crowdfunding issuer, for its part, must file its own Form C if it is separately offering securities both through a crowdfunding vehicle and directly to investors, and fund or reimburse the expenses associated with the crowdfunding vehicle’s formation, operation, or winding up.
The SEC also provided some Section 12(g) registration relief in the new crowdfunding vehicle rules. A crowdfunding vehicle will constitute a single record holder in the crowdfunding issuer for purposes of Section 12(g) of the Exchange Act, but only to the extent that all investors in the crowdfunding vehicle are natural persons. An issuer must include in the Section 12(g) calculation securities issued by a crowdfunding vehicle that are held by investors that are not natural persons.
Interesting to note that the SEC considered, but ultimately did not require, that a registered investment adviser manage the crowdfunding vehicle. The SEC explained that doing so would have made the SPV more than just a conduit, let alone that the RIA requirement would not be economically feasible for startups.
The restrictions on the use of crowdfunding vehicles in Regulation Crowdfunding offerings are intended to provide investors in the crowdfunding vehicle the same economic exposure, voting power and disclosures as if the investors had invested directly in the crowdfunding issuer. The crowdfunding vehicle must act merely as a conduit for the crowdfunding issuer and not an independent investment entity like a fund or other similar investment vehicle.
For those crowdfunding issuers that choose to use crowdfunding vehicles, the new rules will ease cap table burdens and remove a potential deal breaker for future investors. It will provide smaller investors with more leverage to negotiate better terms and protections, making crowdfunding safer and more profitable for them, and attract more capital and higher profile investors.
Also, a crowdfunding offering resulting in only one new shareholder for Exchange Act registration purposes under Section 12(g) (assuming all crowdfunding vehicle investors are natural persons) will be enormously helpful for issuers with assets of $25 million or above.
Nevertheless, because of the onerous conditions, each issuer will need to make its own cost-benefit analysis prior to implementing a crowdfunding vehicle strategy, which should take into consideration the issuer’s offering experience, potential for raising follow-on financing from a large investor, costs associated with the creation and administration of the crowdfunding vehicle and the number of small investors likely to participate in the crowdfunding offering.
The new crowdfunding vehicle rules won’t be effective until 60 days after publication in the Federal Register. I anticipate the new rules will be published in the Federal Register soon and be effective sometime in March of this year.