Potential Pitfalls of Regulation CF – Part I: Practical Concerns for an Issuer
When SEC Commissioner Piwowar lodged his controversial “NO” vote for the final rules implementing Title III Regulation CF last October, he did so with concern that the overcomplicated rules were laden with “traps” that could snare an unassuming company trying to raise funds. Unfortunately, he was right and upon deep analysis of the new regulations, I have found several issues and potential pitfalls, of which the average small business owner or potential funding portal may not be aware. In my tireless effort to “make crowdfunding work” I have embarked on this two part series to highlight these issues and elucidate them, before they ensnare the unwitting entrepreneur. This first partaddresses issuers or those seeking funds through a crowdfunding. Part two will address issues faced by funding portals attempting to facilitate crowdfunding transactions.
For individuals with a net worth or annual income below $100,000, the investment cap is the greater of $2,000 or 5% of the lesser of your net worth or annual income. The annual income and net worth can be combined with one’s spouse – but collectively the spouses can only contribute the maximum amount for an individual. The number of people, including highly trained and experienced securities attorneys, that get this wrong is staggering, and why not? This is a complicated formula with multiple disjunctive clauses that really only differentiates between people making between $40,000 and $100,000 a year or with a net worth in that band – so a scale of investment from $2,000 to $5,000. Do we really need all this complexity and potential for violation to prevent people from investing $3,000? Also, it doesn’t account for the expenses of those individuals. A single professional living alone certainly has a different amount of expendable income than a mother of four, but that is not accounted for. It also doesn’t account for one-time pay increases due to a bonus or other events. Since this cap is ultimately arbitrary, why not at least make it simple to understand and easy to administer like a flat cap of $5,000? Then we do not have to worry about unwary issuers or platforms who take investments from people who lie about their income/net worth, inaccurately calculate their income or net worth (how do you even calculate this – is it at time of investment decision or time of close, assets netted against only liabilities that come due in the current year?) or simply don’t understand the rule because of its complexity. Regardless, hopefully we get some clarity on these issues or develop an industry standard for the calculation of these amounts to provide some comfort when accepting investments.
Understanding the ownership structure is essential to making an informed decision, however, the calculation of the beneficial ownership pursuant to new Regulation CF is no small feat and will definitely take guidance. The beneficial ownership should be calculated based solely on voting power, so you would not take into account holders of non-voting stock. What the release doesn’t say is that the analysis doesn’t end there. In fact, the calculation of Beneficial Ownership (note the capitalization of the term) also includes the owners of any securities convertible into voting securities within the next 60 days, so that includes option holders who may convert their options. Also, the way the SEC has generally required an issuer to calculate the percentage, is by assuming the conversion of the beneficial owner in question’s convertible securities thereby increasing the outstanding amount of voting securities, but not assuming conversion of any other beneficial holders’ convertible securities. However, it is not clear if the traditional method of calculation is what the SEC intended and thus, the calculation methodology is an open issue upon which we await guidance. Pretty complicated right? How is a small business owner supposed to know that?
If during the course of the offering something happens to the business or its prospects that rises to the level of materiality, issuers will need to inform investors and ask for reconfirmations. This requires a level of judgment that issuers should be sensitive to and seek counsel. Materiality is an issue that firms large and small struggle with. I have seen Fortune 100 companies spend days agonizing over whether something was material or not and thus required disclosure. This analysis often costs hundreds of thousands of dollars. Material information is information that would be useful to the average investor when making their investment decision. The issuer needs to think, would I want to know this before making a decision to invest in this company? If the answer is yes, then the Form C should be amended and the investors provided an opportunity to withdraw.
Ownership and Capital Structure
This short section of the release is deceiving. It seems to concisely require only a few items, when in fact it requires extensive and complicated disclosure. In addition to listing and describing each outstanding class of securities of the issuer, the issuer is required to compare and contrast them to the securities being sold in the offering. This is important to investors as they need to understand their place in the capital structure of the company, but this will require detailed analysis and disclosure of risks, which the six bullets do not suggest.
The issuer is required to list “the material factors that make an investment in the issuer speculative or risky.” This is the exact language used in Forms S-1 and 10-K, that also require public companies to provide risk factors, suggesting a similar form of disclosure. In those types of filings, risk factors are basically a term of art and simultaneously formulaic yet highly customized to specific businesses. I have spent months working on a public filer’s risk factors, analyzing comparable company risks and crafting them to the specific business at hand. In addition, to fulfilling a requirement, risk factors also serve the comforting function of providing an insurance policy to the issuer. Unfortunately this is counterintuitive and most small business owners are not going to realize that it behooves them to list these risks, as they protect them from future lawsuits if any of the risks come to fruition. The entire concept of “risk factors” is completely foreign to a typical entrepreneur or small business owner who may not even know where to start. This is an area where I am working to provide a technology solution, but issuer’s need to take this section seriously and take advantage of the protection it can provide.
Related Party Transactions
This is a real potential trap for issuers. The release basically just asks that related party transactions be disclosed and even the Q&A form requests that all “transactions” between a defined set of related parties be disclosed. What the unwary issuer needs to be aware of, is that related party transactions again are basically a term of art and a way to describe transactions between the company and its affiliates or officers, directors, founders and their families. This can range from renting office space, to loans to licensing IP from or to certain entities or individuals that have a relationship with the company or its management. The point of this disclosure is to ferret our self-dealing and conflicts of interest. These are things that all investors want to be made aware of and can raise alarm bells if not provided with sufficient justification. Related party transactions may work to the benefit of the company and thus the investor, but regardless they need to be disclosed to allow the investor to make and informed decision.
In addition to not explaining this concept at all, the rules also establish a false time cutoff. The rules require disclosure of all transactions with a value of 5% or more of the offering amount with a related party that is a related party as of the most recent practicable date but not earlier than 120 days from the date of filing the Form C unless otherwise material. In addition, the Q&A format only mentions transactions that have been conducted in the past year. I find this very confusing. First off, why not just disclose all related party transactions over a certain value as of the date of the offering? The issuer will know if it is intending to conduct such transactions, and therefore, can provide for them in the disclosure. These are private illiquid companies so it isn’t as though some unknown shareholder is going to come in and purchase more than 20% of the company just before the offering and the company won’t be able to determine if any transactions have occurred. Also, it isn’t clear when the cutoff for the actual transactions is – is it one year from the date of the offering? Finally, all of this is a red herring in my opinion, because related party transactions are inherently material. They are in essence self-dealing and conflicts of interest and should thus be disclosed. These arbitrary look-backs will give issuer’s a false sense of security when determining whether or not to disclose a particular transaction. Just because that loan the company made to the CEO took place over a year ago does not mean it doesn’t need to be disclosed. This is one of the most dangerous traps in these regulations in my opinion.
Other Material Information
As I have touched on in other areas, all required disclosures are caveated with the fact that any other material information not specifically called for must be disclosed. This is the regulatory premise of securities law—all disclosures must not contain material misstatements or omissions. Here is another potential trap in that issuers may simply look at all the requisite disclosures or the Q&A form, tick all the boxes and think they are finished. This is not the case and they will be on the hook for any information that they possessed and failed to disclose that an investor would find material in making and investment decision in the company. How can a company be sure that the statements it is making are adequate? This requires a thorough analysis and frankly some soul searching. They must put themselves in the shoes of the investor and think about what information they would like to know. Often the small business owners and entrepreneurs are the major shareholders of the company, so they need to think long and hard as the person wearing that hat and determine what information is necessary to purchase, hold or sell their securities.
Use of a Transfer Agent
The proposed crowdfunding regulations had an important provision that exempted crowdfunded companies from Rule 12(g) of the Securities Exchange Act of 1934. Rule 12(g) requires any private company that has over 500 unaccredited investors or over 2,000 accredited investors to become subject to the public reporting requirements of the Exchange Act. In essence, once a company passes the holder threshold, it will become a defacto public company subject to most of the burdensome reporting requirements but without any of the benefits of a publicly traded company. For a crowdfunded company with potentially vast numbers of holders this would not make sense, as their very success at financing would mean certain disaster due to the public reporting regime. Thus, the initial regulations, wisely excluded companies using Regulation CF from the reach of Rule 12(g). However, in the final rules, there is a catch. In order to receive the reporting exemption, the company must meet two conditions: 1) it must utilize a third party transfer agent and 2) it may not have assets in excess of $25 million. The second is a longer term issue, but this means that crowdfunding issuers must engage a transfer agent. The role of the transfer agent is to maintain the shareholder record and facilitate share transfers; in private companies this is often (wisely or not) handled by the company itself. I am in hopes that transfer agents sensitive to the capital constraints of these issuers will enter the market with their services, but regardless, companies need to add the costs of engaging a transfer agent into the offering cost calculus when contemplating a crowdfunding.
As you can see there are numerous issues that require attention in the final regulations. The devil truly is in the details. It is currently rumored that Congress is working on a bill to amend or fix these and many of the other issues or “traps” in Title III, but in the meantime, we must be aware of and work through these obstacles to make crowdfunding work. Stay tuned for potential funding portal foot faults to come.
Georgia P. Quinn is the CEO and co-founder of iDisclose, an adaptive web-based application that enables entrepreneurs to prepare customized institutional grade private placement documents for a fraction of the time and cost. Heralded by Thomson-Reuters as a Top Female Attorney in New York City, she also serves as of counsel at the leading firm in crowdfunding,Ellenoff, Grossman & Schole, specializing in facilitating financial transactions and compliance with JOBS Act regulations. A foremost expert in corporate finance, she has worked on over $1 billion in business transactions over the course of her legal career. Prior to founding iDisclose, Georgia represented several Fortune 500 companies in financings for six years at Weil, Gotshal & Manges, one of the top ten law firms in the world, and then for over two years at Seyfarth Shaw, a leader in legal technology. As a globally recognized thought leader in the crowdfunding space, she has been a featured speaker at multiple conferences and has presented to such authorities as the Securities and Exchange Commission (SEC) and the American Bar Association (ABA).