When considering an investment in a direct public offering, potential investors may want to understand how they can get their investment back, i.e. their exit strategy. Organizations raising capital via a DPO should expect questions from potential investors on this subject.
An investor’s sale of their investment is itself regulated by securities laws, so in addition to the pragmatic question of finding a buyer, the investor needs a strategy for compliance with these securities laws.
The following summarizes a number of exit strategies that may be available to investors in a DPO, depending on the type of security and other circumstances. The discussion is organized into four sections: i) exit strategies that are built in to the security itself, ii) those that may arise based on future events, iii) those that may be available on an investor’s initiative, and iv) trading mechanisms that may be available.
I. Exit strategies designed into the security
These strategies are built right into the investment from the beginning and don’t generally raise additional securities compliance issues at the time of the exit.
Debt: Many of our DPO clients offer investment notes, which are debt instruments with a specific maturity date. Of course, an issuer offering debt needs to think about how it will repay the principal at maturity. Some may establish a sinking fund, or will make annual principal payments rather than a balloon payment at maturity.
Revenue share: Also known as revenue-based financing (or RBF), this is an increasingly popular investment model in which payments to investors is a function of the issuer’s top-line revenue, so that the issuer pays less during lean times and more when it’s flush with cash. There are several variations on the theme, but in the most common variations the investor’s rights expire when the investor has received a pre-set multiple of their original investment (typically 2x to 3x).
Preferred stock with redemption feature: Preferred stock can be designed with a built-in redemption feature. There is a lot of flexibility in how to do this. Key decisions for issuers who want to go this route are:
– Who has the right to initiate a redemption? In other words, does the issuer have a call right or do the investors have a put right? Or should it be automatic upon some triggering event?
– When does the redemption right arise? Often it arises after some period of years, say five or seven years.
– How should the redemption price be calculated? To avoid having to pay for a professional appraisal, it could simply be the original purchase price (which means those investors won’t share in any appreciation), or it could be based on some formula based on revenue, profit, or other metrics.
– How should the redemption price be paid out? If it is at the investor’s election, the issuer should have the option of paying in installments over, say, five years.
II. Exit strategies based on future events
These exit strategies involve someone other than the investor taking the lead – someone who typically handles securities compliance issues.
IPO: An initial public offering (IPO) entails a full registration with the US Securities and Exchange Commission (SEC), usually accompanied by a listing on a national trading market, either over-the-counter (OTC) or on a stock exchange (like NASDAQ or the NYSE). This usually allows existing investors to buy and sell their shares freely. For example, Annie’s Homegrown raised capital through a DPO in 1995 and then went public with an IPO in 2012.
Merger or Acquisition: A number of companies that have done a DPO have subsequently been acquired by a larger company. Perhaps the most prominent example of this is Ben & Jerry’s, which completed their a DPO in 1984 and was later acquired by Unilever in 2000. Annie’s Homegrown, following its IPO, was acquired by General Mills in 2014. When an acquisition happens, the acquiring company makes a tender offer to all shareholders to purchase their shares, often in cash at a premium over what investors paid. Sometimes, if the acquiring company’s stock is publicly traded, it may offer to exchange the shares of the acquired company for its own shares, which can then be sold.
Listing on the OTC Market, or stock exchange: Even without going public via a full IPO, a company that has raised capital via a direct public offering may decide to register its shares to trade on a national market such as NASDAQ or the NYSE. Since doing so does not raise capital and can be expensive to accomplish, however, there may be little incentive for the company to go this route.
Issuer’s Tender Offer: Even if an investment has no built-in redemption feature, an issuer can still redeem investments by making a tender offer. This typically occurs in conjunction with a new investment into the issuer — so the new investment proceeds are used to redeem the earlier investors. This new investment can be in the form of a private placement, or it could be a subsequent (or renewed) DPO. The issuer has some flexibility as to which classes of investment and which investors it will redeem; and it can structure the transactions so only a portion of the new investment will be used to redeem earlier investors, so as to have a net new infusion of capital. As with other types of securities transactions, tender offers must comply with a set of rules that govern them.
III. Exit strategies at the investor’s initiative
If none of the strategies above are available to an investor who wants an exit, there are other ways to sell an investment, as long as the investor is careful to comply with securities laws. These laws generally forbid an offer or sale of an investment unless it is either registered or exempt from registration; and this is true at both the state and federal level.
Federal law provides an exemption from registration for sales by someone other than the issuer, an underwriter or a dealer. While that would appear to allow secondary sales by an investor, there is an important nuance: A selling investor might inadvertently be deemed an underwriter. In other words, if an investor buys shares of stock in a DPO and then later turns around and sells them (a “secondary sale”), the investor could be deemed to have participated in a distribution on behalf of the issuer. In that case, the exemption is not available.
However, there are three strategies an investor can use to ensure that a sale of their investment complies with federal law:
Rule 144 sales: Under Rule 144, if an investor that is not an affiliate of the issuer (that is, not an officer, director, or 10% shareholder of the issuer) holds the investment for one full year, they can’t be deemed an underwriter and can sell the investment. However, the investor would also need to comply with their state’s securities laws.
Private sales: Another way to ensure the investor is not deemed an underwriter, even if a full year has not elapsed, is to offer and sell the investment privately. This requires that the investor have an established relationship with someone before offering the investment to them. As with Rule 144, the investor would also need to comply with state securities laws.
Section 4(a)(7) sales to accredited investors: Section 4(a)(7), which was added in 2015 to the 1933 Securities Act, provides a new exemption from registration for secondary sales to accredited investors, as long as there is no advertising and as long as the issuer provides disclosure of key information about the company. This is a federal exemption that preempts state law, so investors don’t need to be concerned about their specific state rules. An individual is accredited if they have either $1 million in net assets excluding their primary residence, or $200,000 in annual income (or $300,000 together with their spouse).
With secondary sale strategies that also require compliance with state law, the selling investor is responsible for understanding what their particular state requires. In California, for example, Corporations Code section 25104(a) provides an exemption for secondary sales if there is no advertising and the sale is not conducted through a broker-dealer in a public offering. Many states have a similar exemption.
An investor looking to sell their investment should be aware of other restrictions that may be imposed due to the nature of the original offering. Perhaps most prominently, if the investment was made in an intrastate offering (a common DPO strategy), the investment may not be resold to a resident of another state for at least nine months after the date of the last sale by the issuer in the intrastate offering.
IV. Secondary Sales Mechanisms
The above strategies are the legal compliance strategies. Some practical mechanisms for secondary sales under these legal strategies include:
Broker-managed trading platform: Companies like NASDAQ Private Market (which acquired SecondMarket), OpenShares, and SharesPost operate platforms on which securities acquired in a DPO can be sold. Since they receive compensation for their services, these platforms need to be licensed as a securities broker-dealer.
Trading bulletin board hosted by issuer: This may be similar to a broker-managed platform; but as long as the issuer is not receiving any compensation for facilitating securities transactions, it does not need a securities broker-dealer license.
Privately negotiated sales: An investor can sell their investment in a private transaction to a buyer in their network, as long as they follow the rules, such as not advertising or announcing the potential sale in any public way.
While there are a number of exit strategies available, each has its limitations, and an investor in a particular situation may very well find that none of them is feasible. One of our goals at Cutting Edge Capital is to eliminate barriers to a vibrant and efficient community capital market. Therefore, we are exploring two possible strategies that could help alleviate investor concerns about a future exit from a DPO investment:
– A nonprofit market participant that can purchase securities that were acquired in a DPO, hence creating a kind of market appetite. It could raise capital via a debt offering (like other nonprofit investment funds).
– A for-profit investment fund that would invest in DPOs, as well as in privately offered securities of social enterprises. As an open-ended fund, it would itself issue shares to investors and redeem them as needed.
Foundations, Families and Funds can play a very important role in helping to redirect capitalism toward a more fair and just application, while also finding the right social enterprises to support.
By playing a more comprehensive role in the creation and support of Community Capital Markets, these funding sources can build impact into a systemic approach. In addition to investments they make into the social enterprises either directly or through other intermediaries, they can also facilitate opportunities for the 90% of households that are prevented from participating in the private capital markets by investing in the structures that form alternative capital markets open to everyone.
We are better informed today than ever before about the rapidly expanding wealth and income gaps. Many recent studies show the top 10% of U.S. households now have over 75% of all the wealth in America. The next 24% of American households make up almost all the rest of all the wealth, leaving the bottom 40% with 0% wealth, and the bottom 60% with a whopping 3%! And the gap is growing fast, not shrinking, which portends many new challenges to our society.
Clearly we need to think about whether the current approaches are working, and if not, shift the paradigm.
As economists like Thomas Piketty have thoughtfully surmised, this growing gap will not improve without either government intervention or opportunities similar to what the wealthy have had – i.e. the same chances to invest and to begin to grow some wealth of their own. For anyone out there who follows the current dysfunctional state of our government, I would not hold out much hope for the first option anytime soon.
Regardless of the causes, our current state of affairs seems to point toward us having to right this very serious problem ourselves, and right it we must.
In the U.S., our government actually limits 90% of households from having any access to the private capital markets, leaving their investment options only in either the public capital markets, or alternatives that I’ve written about here, via Direct Public Offerings, or perhaps through the new state and federal crowdfunding options.
The irony is that, in the interests of protecting the 90%, only the very wealthy 10% continue growing their wealth. They have access to opportunities that far surpass anything found in the public capital markets. The 10%er’s may also use the public capital markets to hedge, speculate, or even arbitrage if they like, but their real wealth generation comes mostly from those private markets. But neither of these kinds of markets helps us to form the systemic structure we need to build healthier communities.
Which leads me back to how Foundations, Families and Funds can help.
The list of impact investors is growing every day, and we will all continue to work toward better identification of who is truly acting as a social enterprise, e.g. companies building business models to tackle some of the most difficult and seemingly intractable social and environmental problems, including climate change, poverty, water, energy and real estate, etc.
I refer to the entrepreneurs above as our new community of social enterprises, which includes those with a clearly defined mission, who are focusing on achieving impact at scale for all stakeholders (workers, customers, community, environment), but who also understand the importance of connecting via deep impact into their local populations. These kinds of entrepreneurs place a high degree of importance on the generation of mission aligned revenues (from clients or others who’s mission is aligned), and tracking/publicly reporting on their impact on a regular basis (transparency).
It’s encouraging to know that many investing organizations are now looking to make real impact via their investments by seeking out these entrepreneurs, even if we’re still in the nascent stages of trying to square that with the goal of getting back “market rate returns.” Leslie Christian just posted a great blog on this conflict here.
However, supporting those entrepreneurs with an investment is only one of two key components we need to have a healthy Community Capital Market. Focus also needs to be provided to the 90% of households so they can participate as well, even if half or more of them currently have no wealth to employ as investments into a market. These households need opportunity, which they are now starting to see with the alternative investment vehicles mentioned above, but even more important, they need experience, education and understanding in terms of what it means to be an impact investor – one that may not need those “market based returns,” whatever that means.
We need a whole system approach in place for community investors and community entrepreneurs to be able to find each other, which is what a Community Capital Market can be.
10 years ago, my good friend Don Shaffer (now at RSF Social Finance) and I embarked on a project to develop Local Stock Exchanges. I wrote about the need for these in several publications and even took a position at the Boston Stock Exchange to mirror a national exchange at a local level. But looking back, there is one critical element I got wrong. We don’t need to replicate the public capital markets with a lively secondary trading component that fosters speculation and arbitrage (using the need for liquidity to justify the madness they have become). We need a much more simple system in place that allows for the efficient transfer of individual’s savings into socially responsible companies, allowing for modest healthy returns, and some reasonable offerings of an exit if necessary. We need to power it with the right tools, education and mentors to help guide the ones that have not had access until now. We also need to reconsider what a capital market needs to be today, and not fall for the trap of manic returns and unlimited growth.
Foundations, Families and Funds can get behind this new kind of capital market by funding the system that can facilitate the Impact we need, and if they desire, they can also play a member-based role in how we operate it – much like exchanges used to be structured, before they turned into the same shareholder primacy driven entities that list on them today.
The Securities and Exchange Commission has recently estimated that approximately 10% of all U.S. Households are now in the “Accredited Investor“ category (for individuals, that means $1m in net worth not counting primary residence, or $200k of income). Assuming that’s accurate, there are now over 12 million households in the U.S. that meet the definition of Accredited Investor (“AI”).
The SEC defines the AI to determine their eligibility to invest in Private Placement offerings (i.e. funding rounds of securities that are sold not through a public offering (IPO), but rather through a private offering, and mostly to a small number of chosen investors). And as the private placement market edges toward $60 billion of deals a year, that may seem to most people as a sizable amount to participate in, with lots of opportunities to get in on the next big home run deal.
Some of those AIs, however, have begun to look for more than just a company swinging for the fences, but rather companies that look out for profits, people andthe planet. The rise of socially responsible or impact investing has now begun to take hold. And there are now more financial advisors becoming familiar with these kinds of investments, and helping their clients to find such deals.
Unfortunately, financial advisors feels constrained (for good reasons) to only show their clients deal opportunities of a certain size and nature. Many even limit their scope to only companies traded on public markets so that they reduce the risk of breaching their fiduciary duty to their clients. Other more adventurous advisors will brave the private investment landscape, where, with the right amount of due diligence, they can recommend impact deals to their clients that will also provide something close to market returns (whatever that really means).
But there’s another opportunity for AIs to make a significant impact. They can invest AND play an essential role in the stabilization, growth and resilience of the communities they live in or relate to. They can do this by participating alongside of the rest of the non-accredited investor community into investments offered by community entrepreneurs.
The kinds of investments I refer to here are Direct Public Offerings and certain state securities crowdfunding opportunities, both of which allow for investors to directly interact and engage with the entrepreneur/issuer. I wrote recently about this in previous blogs here, and also earlier today in a Locavesting article. As these crowdfunding offerings and the platforms they list on become more populated, investors will begin to find it easier to find offerings. Also, as we help clients obtain their approvals for DPOs, we post the offerings up on our CEX site so that investors can more easily find the issues and link to their sites.
The role AIs can play to support these much needed community enterprises cannot be emphasized enough. For one thing, as companies begin to turn more to using tools like DPOs to raise their funds, the size of the raise is going to increase well above the $1 million limit that the state or federal crowdfunding laws impose. DPOs, if done via the Intrastate exemption, are typically unlimited, as long as the state regulators approve them, and we are starting to see many more offerings in the $5-10 million range. Companies offering stock will want to limit the number of non-accredited investors to 500, and the total number of investors to 2,000, or face becoming “publicly reporting,” which is expensive to maintain. This means the offerings truly need the AIs to meet their targets.
Another key reason is the experience AIs may be bringing to these offerings. Clearly just because one is an AI does not mean one has the financial expertise of a typical VC or Angel who do this for a living or hobby. But there is no doubt that many AIs have some experience with investments, and likely more than their non-accredited counterparts. This can be very important when a company is even considering how to structure their offering, if they can learn beforehand what an AI will want to see before they participate.
And then there is, of course, the leverage an AI can bring to the offering, just by signing on and showing up. Some AIs provide the “prime to the pump“ so that the offering can take hold. Some even offer a matching approach. It can be an important signal to the non-accredited investors that they don’t have to shoulder the offering alone. Also, regardless of the wealth divide that exists, every member of the community can come together to make an offering successful. AIs can be an important kind of hero to this movement, while still obtaining enough of a return. Their participation can also lend the right kind of pressure to the entrepreneur to keep them on their toes, and striving to meet their mark.
AIs might do their own homework (due diligence), as they look at these investments, or they may be able to find a new breed of financial advisor who are willing to help analyze the offering, even if they stop short of making recommendations and risk their duty. And there are also new pioneers, like Marco Vangelisti, who has taken it upon himself to begin offering daylong workshops for community investors.
Marco is a veteran of global finance who walked away from the industry in 2009 after a 25-year career, and is now helping communities around the country understand the role investors can play in support of community. He created Essential Knowledge for Transition – an initiative to empower communities with a basic understanding of the large systems affecting our lives. Marco’s next workshop will be in Irvine CA the 7th of May, and after that, we intend to try cloning him so that we can help ALL kinds of investors, AIs and non-accrediteds alike, everywhere, to align their investments with their values, and create the world we want, and need.
Most people don’t have the ability, flexibility or funds to invest like a professional, and a more common approach for ‘investing in what you know’ takes the form of how well you can follow a company, mainly by looking at what you (or others who you trust) know about the company, or what the company has disclosed or reported about itself.
In the public markets, this means what a company publicly reports, and we (or the analysts) will read their “Form 10-Qs” and “10-Ks,” which publicly reporting companies must file with the SEC every quarter and year, respectively. We might also listen in on their webcasts, track their progress in the news, and even monitor their competition as a comparison.
The SEC reporting is still based mainly around financial information, with much less attention devoted to other material actions and impacts, but this is starting to change. There’s a lot of great work underway by organizations such as the Global Reporting Initiative (GRI), and Sustainable Accounting Standards Board (SASB), who are creating sustainability performance measures for these publicly reporting companies, and then monitoring and reporting on them separately. The largest database of corporate sustainability reports is still the UN Global Compact Initiative, which they publish on their website.
For private companies, there are also some new approaches, such as the GIIRS rating system for companies or funds, allowing companies to voluntarily report measurements on social and environmental impacts. B-Lab’s “B Corporation” label allows a company to do a self-assessment, which they claim leads to “B Analytics to help investors consider whether a company is properly managing its socially responsible impacts, with as much rigor as their profits.”
While these new reporting approaches try to help investors assess whether companies are meeting certain “sustainability” standards, trying to define these standards are can be a daunting task, especially as the definitions are too murky or continue to change and new reporting tools are created.
We first saw screening tools applied to companies (e.g. no oil, weapons or bad actor sovereignties) in an attempt to label the good ones as “socially responsible investments.” Then came the dawn of “sustainability,” which sounds good, but has many different definitions. Nor has “triple bottom line,” “ESG” (environmental, social, governance), or even “Impact” given us clarity in terms of a definitive metrics-based idea for understanding whether a company is really contributing to our world in a positive and replenishing way, or simply another extractor of resources leading us closer to the demise of our species.
Even if the definitions or surveys are well thought out, is a company’s reporting enough for us to rely on to know that they are really making the kind of “impact” we want to see? When a company receives a “good company” sort of label, in whatever new socially responsible format we like, does that mean that the label was strict enough to ferret out all of its behaviors? Can companies fudge, omit, or cleverly interpret the ratings questions so that the answers fit the right frame they want to display?
While the efforts to bolster transparency about private companies is a great step in the right direction, reliance on only the reporting approach to make investment decision poses meaningful risks. Borrowing the famous quote from Albert Einstein, I would refer to this as the investment equivalent of Spooky Action at a Distance. A potential investment candidate may have received high marks from an outside rating group, and only later might we find them to be acting in ways we deem distasteful. Maybe we didn’t realize they were hoarding revenues offshore to avoid paying U.S. taxes, or providing their services to any kind of planet damaging company while espousing high-minded values, or grabbing federal funds while really only focusing on driving profits to its shareholders.
How do we know from a label whether a company truly practices all of the values they received high ratings on? Similarly, how do we know from a report whether they might be making certain private compromises to what they publicly report in order to bolster their bottom line?
If we don’t know the people behind the company, we may be left with only our faith in the reports, provided mainly or only from information supplied by the company itself, with little if any recourse for misrepresentations or omissions (except possibly a future rescission of their seal of approval, or being publicly shamed for their hypocrisy). Unfortunately, there are likely as many forms of greenwashing today as there are new efforts to heighten transparency, so relying only on modern internet-based tools or chat groups should be done at every investor’s peril.
Some who work directly in the area of socially responsible investment advising have seemingly given up on trying to identify the right term or the right actions, now hoping they can simply determine whether a company is behaving “responsibly.” And perhaps it really may be more meaningful to apply a “smell test” than to blindly rely on a label or a report. To paraphrase SCOTUS Justice Potter’s famous line from the Jacobellis pornography case…trying to define terms like Sustainability, Impact, or Socially Responsible using shorthand descriptions can quickly become unintelligible. But, like Justice Potter, perhaps we can apply that same personal test… I know it when I see it!
And that then begs the question…how do you see it? One very well tested method is to invest in who you know, and that means being able to find and get to know the companies, and the team, before you invest. Community capital markets provide just that opportunity. Community capital markets enable companies and investors, connected geographically or in fellowship, to engage with each other on a personal level. These kinds of capital markets can take the spooky out of the action, by bringing a personal touch to our awareness, and engaging with each other in financial transactions that support each other.
There’s an old saying that you should “invest in what you know,” but what’s far more valuable is when you can “invest in who you know” as well. The new crowdfunding laws are not designed to nurture this; they are meant to prohibit investment conversations with the company insiders when the opposite has historically been the case.
Wealthy individual investors and funds (angels and VCs), will often do both, and it makes a lot of sense, when you have the time and the wherewithal to afford due diligence, apply your previous experiences, and meet with the founders or senior management to determine whether an investment is a good one. A secondary benefit to this approach is that you often get to insert your previous knowledge (i.e. what you know) into the equation, because you have invested enough to have a voice.
Aside from reading the company’s reports, the other main component to making an investment decision is the ability to get to know who you are investing in. This is arguably the more important component, especially for those with limited amounts to apply toward investing. But does this mean that all of the new opportunities to make investing available to everyone via crowdfunding helps us in this regard?
The last few years have been exciting ones for those following new crowdfunding laws at both the state and the national level. I am not speaking to donation-based crowdfunding here (such as Kickstarter, Indiegogo and the rest) but rather investment crowdfunding (that involves actual return on investment).
When the JOBS Act was passed and as we watched and waited to see what rules our federal government would create, the states took earlier actions to implement their own forms of state-based securities crowdfunding. However, many of the new rules are going in the exact opposite direction of how investing has historically been done, and those rules have created more barriers, not fewer, in terms of getting to know who you might invest in. For examples, the JOBS Act rules (and those of many states) that require a company to only post their offering onto a third-party “intermediary” platform, and that limit what a company can say directly to its potential investors, creates such a barrier.
Investing has almost always been more interaction than any reaction to data before a transaction is completed, where the personal aspects of the interaction weigh heavily in favor of any successful transaction. How many times have we used, heard or relied on the old adage that you need to look someone in the eye before you can do a deal with them? In this modern age of SEO, and the multitudes of interweb communications, there are still many dealmakers that need to meet, and should be able to meet, the other person first before any deal gets done. The same has held true for our investing in other businesses since the dawn of investments began, and still holds true today.
Consider most companies that raise funds privately, through a broker-dealer, or even those that go public via a IPO. In each and every case, the company or its representatives sell those offerings, and the investors only buy (invest) if they can get to know the team. With private offerings, the company goes directly out to the accredited investors that already know them, or to whom they have been introduced. Broker-dealers help companies with their offerings by introducing them to investors they know, and those investors then get to know the company. And broker-dealers are supposed to ensure that the deal is suitable for every investor they bring in. Even IPOs have a personal connection component. The main underwriter will take the company team out on a roadshow, and introduce the team to its potential syndicate of other dealers to bring them in to an IPO. Those potential dealers put a lot of weight into meeting that team, and likely would not consider investing without a chance to get to know them personally.
But not all securities crowdfunding takes the unfortunate approach that you need to separate the company from the investor and utilize technology platforms in the place of that person interaction. In addition to the Direct Public Offerings (DPO) that have been around for decades, there is also, for example, the new Oregon Community Public Offering (CPO). DPOs are federally exempt offerings that must be filed with any state in which the offering is conducted, either using a federal exemption that currently limits the raise to $1m (but allows you to file in multiple states), or what is known as the Intrastate Exemption that typically has no dollar limit but requires the company and all investors to be in just one state. The Oregon CPO, which was championed by Amy Pearl and Hatch Innovation, was designed to be a community capital raising tool, and companies are actually encouraged, not discouraged from raising those funds directly from their communities via meet-ups that actually allows people to look the CEOs in the eye.
Whether it’s a DPO, CPO, or another kind of offering that provides for and encourages direct and interpersonal connections, an investor is provided with a very valuable opportunity to meet the people behind the veil and to use their own personal assessments in addition to what a company states in its materials or ratings it’s received. And those personal connections then make a significant impact on those inside the company who are taking investments from people they now know. The decisions companies make are likely highly informed by how connected the investors are to them. And while we have not experienced DPO investors who have abused that personal connection, what we have seen is a deeper, richer and more connected community as a result – a community of investors and companies who actually know each other
With all of the recent changes in the securities laws ushered in by the 2012 JOBS Act, it may be helpful now to take a step back and look at how these changes fit into the broader landscape of capital-raising for small and medium sized businesses.
We’ll start with a definition of “crowdfunding.” This is a versatile term that means raising small amounts from many people, rather than large amounts from a few. In practice it includes both, because in any crowdfunding campaign you also want a few people putting in large amounts alongside the many putting in small amounts.
But there are several types of crowdfunding. Here are the major ones:
Donations: On donation-based portals like DonorsChoose.org, contributors get nothing in return for their donation, other than (maybe) a tax deduction. It works well for nonprofits, but not so well for others.
Rewards and pre-sale: Portals like Indiegogo and Kickstarter have surged in popularity. They can offer a variety of incentives, like a signed copy of your favorite band’s latest record or discounts off merchandise. But contributors still can’t get their money back or any financial return on investment.
Peer-to-peer lending: Also surging in popularity, portals like Prosper and Lending Club do offer a true investment in the sense that investors can get their money back and a return on their investment. From a borrower’s point of view, however, it looks (and typically is) more like a bank loan in the sense that the portal dictates the terms.
Investment crowdfunding: This is a true securities offering by an “issuer” (the for profit or nonprofit company raising the money) that is open for investment by the “crowd” (meaning both accredited and non-accredited investors). Since securities laws at both the state and federal level regulate these investments, it is important that a company gets sound legal advice to help it map out the best securities compliance strategy for its needs.
The category of “investment crowdfunding” can itself be broken down into several distinct legal strategies:
Title III exempt crowdfunding: This is the one that has generated the most buzz since the SEC issued enabling regulations on October 31, 2015. It’s a federal exemption that pre-empts state law and allows a company to raise up to $1 million from investors in all states. It has some pretty tight limitations that many think will limit its usefulness. One potential disadvantage is that it requires the use of a third-party intermediary portal, regulated by FINRA, which will significantly add to the costs. The new regulations will go into effect in May of 2016.
State-specific exempt crowdfunding: While waiting for the SEC’s Title III regulations, more than half of the states enacted their own crowdfunding laws. Most of them were modeled after Title III, though some of them are less restrictive. For example, a few do not require use of a third-party portal. Now that Title III is about to go into effect, most of them will probably not get much use, except for those that will remain advantageous because they are less restrictive.
Nonprofit direct public offering: The SEC and most states allow a charitable organization to offer an investment without securities registration, though a notice filing may be required. For nonprofits in those states, this is the easiest way to do a direct public offering. A few states, notably California, do not have such an exemption and require registration even for nonprofits.
Intrastate direct public offering: This may be the most popular strategy for direct public offerings because it allows a company to raise an unlimited amount of money, as long as all investors are in the same state (along with a few other requirements). It requires state-level registration of the offering, which is not nearly as burdensome or expensive as a federal registration; and it can be cost-effective for raises as small as $250,000.
Rule 504 direct public offering: This strategy allows a company to take investment from multiple states, as long as you register (or otherwise find an appropriate exemption) in each of those states. The disadvantage of this strategy is that there is a $1 million aggregate cap. The SEC recently proposed to increase the cap to $5 million, but there is no way to predict (or if) that will happen. Still, it can be an attractive strategy because it allows for a public offering in one state, while still being able to take private investment from other states.
Regulation A+ direct public offering: This strategy was also spawned by the 2012 JOBS Act and allows a company to raise up to $50 million from investors in multiple states. The main disadvantage is that it is a much more burdensome process that in some ways is akin to a full-blown SEC registration. It actually includes two different variants: Tier 1 allows a company to raise up to $20 million without audited financials, but it does require registration in each state where investors reside. Tier 1, which allows raises up to the full $50 million, requires audited financials but pre-empts state law.
So is a direct public offering (DPO) the same as crowdfunding? Not exactly. As indicated above, investment crowdfunding includes both direct public offerings and exempt crowdfunding. There are two reasons why Title III exempt crowdfunding, in particular, is not a direct public offering: First, it is not direct because the rules require use of a third-party crowdfunding portal. Second, while it has some of the characteristics of a public offering (i.e., it’s open to non-accredited investors), there are limitations on your ability to market the offering (specifically, all communications must go through the portal), so it may not be a true public offering.
Another distinction between a DPO and exempt crowdfunding is that most DPOs are vetted by either state regulators (in the case of intrastate or Rule 504 DPOs) or by the SEC (in the case of Regulation A+). In both Title III and state-specific exempt crowdfunding there is no regulatory review. This regulatory exemption can cut both ways: While it can help you launch your offering faster and at a lower cost, you may find that investors have less confidence than they might have in a registered offer that the state regulators reviewed.
At Cutting Edge Capital we like crowdfunding of any variety, because it democratizes the capital-raising process. The old conventional wisdom is that once you’ve tapped out your friends and family, your options are to get a loan from a bank or an investment from an angel, a venture capital firm or other institutional investor. Regardless of the option, your fate is in the hands of wealthy individuals or organizations who will make their decision largely on the basis of how much money you can make for them… and how fast they can get their money and their large returns back out.
But with investment crowdfunding you can raise capital from your own community, however you may define it – your neighbors, customers, affinity groups, or even your professional network. And their investment decisions may be based on much more than just profit or a quick exit. This opens the door for true impact investment for everyone.
We note that a lot of investment portals out there that purport to be crowdfunding portals are really only open to accredited investors, in reliance on the SEC Rule 506(c) exemption that allows for general solicitation and advertising. Yet even though an offering that is only open to the wealthiest 3% of Americans doesn’t qualify as true crowdfunding, these portals can still provide a great service for entrepreneurs, and we’ve worked with a number of them.
At Cutting Edge Capital, while we’re best known for our work with direct public offerings, we help our clients with many capital-raising strategies, including private placements, Rule 506 offerings (with or without general solicitation), and exempt crowdfunding. If you’d like to discuss which strategy is best for your enterprise, please contact us.