Community capital is about empowerment of communities. It is a set of strategies that allows ventures to raise capital from their ideal investors within their own community, allows anyone of virtually any economic class to invest in their community, and allows communities to build wealth though a cycle of investment, growth, profit, and reinvestment. As I wrote in a separate post, Community capital can be raised directly through direct public offerings (DPOs) and Title III exempt crowdfunding, or indirectly through community investment funds (CIFs). Of these, CIFs have several significant advantages: scalability, efficiency, diversification, and opportunity for liquidity.
With this much going for them, one may wonder why CIFs are not far more common than they are. One would think that every community should have a least one CIF. Yet most do not – at least not yet. Setting aside cultural factors that I noted in my previous post, the other key reason for their scarcity is the regulatory environment. A CIF must navigate through two layers of securities law. The first, and more commonly understood, are the laws that regulate the offering of an investment to the community. This is regulated at the federal level by the Securities Act of 1933 and by each state’s securities laws. In essence, a CIF must do its own DPO to raise investment. While this must be done carefully, it is not so burdensome as to prevent CIFs from flourishing.
But there is a second layer of securities law that is unique to investment funds and presents another challenge. The Investment Company Act of 1940 (the 1940 Act) imposes burdensome regulations on an entity that raises money from investors and then invests that money in other companies. This is the law that regulates mutual funds, and the compliance costs are well into the six and seven figure range for funds of that type. Among other requirements, such a fund must conduct a full registration under the 1933 Act.
However, the 1940 Act also includes a number of exemptions. And that is where the opportunities lie for a small CIF that cannot afford 1940 Act compliance. With all that in mind, the following are four models for a CIF that can raise capital from its community without running afoul of the 1940 Act:
Charitable Loan Fund
The simplest (and by far the most common) type of CIF is the charitable loan fund. This is because the two key federal securities laws noted above (the 1933 Securities Act and the 1940 Investment Company Act) both have a blanket exemption for charitable organizations. To be clear, this does not work for other types of nonprofits, such as cooperatives and mutual benefit corporations. The entity must be truly charitable—basically a 501(c)(3) organization. Most states also have an exemption from securities offering registration for charitable organizations, though a few do not, including California.
With those exemptions, it can be relatively straightforward to set up a charitable loan fund – with good legal guidance, of course. It is still a securities offering, which requires comprehensive disclosure of all material facts, risk factors, state level review (in some states), and so on.
There are two key limitations of this model. First, the assets of a charitable organization may only be used for charitable purposes. And charitable is not the same as socially beneficial. While an analysis of what makes a loan charitable is beyond our scope here, let it suffice to say that a charitable organization needs to be careful, so as to avoid jeopardizing its charitable status.
A second limitation of a charitable loan fund is that it can only raise debt investment, not equity, because no one can own a charitable organization. Moreover, a charitable organization is forbidden from sharing profits with investors. And while a charitable fund could in theory raise debt investment and deploy it in equity investments in other local business, that kind of leveraged equity investment is considered too risky and therefore an unwise strategy. So, charitable funds generally only make outgoing loans with little or no opportunity for capital appreciation. Then, after subtracting a spread to cover its operating costs, the fund typically pays its investors a fairly low interest rate, again with no opportunity for capital appreciation.
And yet, the charitable loan fund is a very effective model for community investment and there are many success stories. Here are a few charitable loan funds that appear on CuttingEdgeX.com, along with their funding focus:
Real Estate Fund
The purchase by a fund of real estate is most likely not a securities transaction at all; and even if it is, the 1940 Act provides an exemption for funds that invest in real estate. Therefore, a real estate CIF need not be concerned about 1940 Act compliance. On the other hand, there is no exemption from the other federal or state securities laws for a real estate fund, so a true real estate CIF typically must raise capital via a state-registered DPO.
A real estate CIF can be a powerful tool for urban or rural revitalization. The concept is simple: The community invests in a fund that acquires, renovates and leases out properties that have become blighted. A portion of the profits may be reinvested in further revitalization, but any remaining profits are distributed to investors. As a result:
We believe this model has enormous potential, and we hope it will be replicated in every city in need of urban revitalization. But there are other potential uses for a community real estate fund, such as:
Equity Investment Funds
There is no general exemption from the 1940 Act for funds that make equity investments in other companies. To be sure, many modestly-sized funds do invest in other businesses: hedge funds, private equity funds, and the like. What those all have in common is that none of them is open to non-wealthy investors. In other words, they are not community investment funds.
But there are ways to build a true community investment fund that can invest in equity positions in other companies (along with other types of investments) and share profits with its investors. The idea behind this model is that the entity is exempt from the 1940 Act because it is not primarily in the business of investing in securities. We will discuss two variants of this model.
The first of these variants begins with Section 3(a)(1) of the 1940 Act, which excludes from the 1940 Act’s coverage any fund that is not primarily in the business of investing in securities, and where investment securities comprise less than 40% of the fund’s total assets. As we’ll discuss further below, this type of fund will necessarily be fairly diversified; hence we have called it the “diversified business fund.”
The first requirement for the diversified business fund is that the fund is primarily in some other business besides investing. In other words, the fund’s investing activities must be supplemental to another primary purpose. There is a lot of flexibility in the kind of primary business that would support this type of fund, but three business types that would work particularly well are a start-up incubator, a business accelerator, and a co-working facility – or some combination of those. The fund could also be in the primary business of providing education or other services.
The second requirement of the diversified business fund is that no more than 40% of the entity’s total assets consists of investment securities. Fortunately, there are several types of investments a diversified business fund can make that are not counted as investment securities for purposes of the 1940 Act. These include:
So, as long as at least 60% of the entity’s total assets comprise these types of assets that are not counted as “investment securities,” the diversified business CIF will meet the second requirement. The remaining 40% or less can be any other type of investment, including minority positions in portfolio companies, as well as publicly-traded stocks, bonds and other investment securities. From an investor’s point of view, one key advantage of the diversification inherent in this model is that it may very well reduce the fund’s risk and make it a more attractive investment.
A second variant on the equity investment fund model is similar to the diversified business fund but doesn’t require the 60-40 split in its portfolio. Under Section 3(b)(1) of the 1940 Act, a company is exempt as long as it is clearly in a primary business other than investing in securities. For that reason we call this the “supplemental investment fund.” For this purpose, the following factors are considered important in determining whether it really is in another primary business:
We note that while business accelerators and other similar organizations in the US have often provided funding to their clients, to our knowledge none of them has yet done so using community capital. Therefore, the model as described here has not yet been utilized as of this writing, though CEC is working with several organizations who are pursuing this model.
Registered 1940 Act Fund / Business Development Company
We now come to the fourth model: A CIF could embrace, rather than avoid, the 1940 Act. While this strategy will clearly be out of reach for a small fund for cost reasons, it may be that a true community investment fund targeting a larger metropolitan area could achieve the scale necessary for full compliance with the 1940 Act to become cost-effective.
We won’t dwell on this model, except to point out that Calvert Foundation, through an affiliate, has offered a menu of Calvert mutual funds for several years. While they don’t have a specific geographic focus, they do have a strong social mission, and their success suggests strong potential for this model to serve large communities.
An interesting variation on the fully registered 1940 Act fund is the business development company (BDC), a type of investment fund that provides managerial assistance to its portfolio companies. While this model is technically an exemption from the 1940 Act, the BDC is exempt from only some of its more burdensome requirements. It must still register its offering with the SEC under the 1933 Act. And yet, a BDC with a state or regional focus could make financial sense. We will be observing a few BDCs (such as Hill Capital in Minnesota) with an eye toward the potential use of this model as a true community investment fund.
Other Possible Strategies
There are a number of other exemptions from the burdensome requirements of the 1940 Investment Company Act, each with its own limitations. At Cutting Edge Capital we will continue to explore alternative strategies that may work for community investing. Here are some possibilities:
Finally, we should mention one more strategy that may not be a true CIF, exactly, but might be used to achieve a similar result: the investment club. This is where a group of investors pool their resources into a single entity (typically a limited liability company) to make investments. As long as every member of the club is actively engaged in the management of the club (i.e. votes on investment decisions, etc.), the club will not be deemed to issue securities to its investor/members, and therefore it will not be subject to the 1940 Act. Because of the requirement that every member of the club be actively engaged in management, it usually works best for smaller groups of investors; but it can be open to anyone, wealthy or not.
All of the Above
Of the models described above, there is no “best” model. At Cutting Edge Capital we envision a more localized economy in which every community is served by a constellation of community investment funds of various types, each of which responds to a need in the community. For example, a real estate fund could build workforce housing, if housing is in short supply; a charitable loan fund could lend to agricultural and food-related businesses; and a diversified business fund could invest in homegrown tech start-ups.
Together with DPOs by local ventures, these CIFs would contribute to a vibrant community capital market in which everyone can participate on a level playing field, and help build a more equitable and prosperous community.
Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to schedule a consultation, please visit www.cuttingedgecapital.com or email us at firstname.lastname@example.org.
There’s a refrain we’ve been hearing recently at gatherings of community organizers: “Nothing about us without us is for us.”
While these words echo a centuries-old Latin slogan (“nihil de nobis, sine nobis“), they reflect a profound truth as relevant today as it has ever been. Their meaning is something like this: “Don’t try to solve our community’s problems for us. We understand our problems and their solutions better than anyone. We simply lack the resources and tools to solve our problems. You can help us by providing those resources and tools.”
The distinction is subtle, yet critically important. It’s about community empowerment.
In the world of impact investing, wealthy (yet conscientious) investors and institutions seek to invest in ways that help to improve the plight of others, typically while still making a good return on their investment.
And while this type of impact investment is certainly a good thing, the “impact” too often addresses the effects of underlying systemic problems without addressing the underlying problems in any meaningful way. By continuing to concentrate wealth (and reinforce the class distinctions between the haves and the have-nots), this type of impact investing could even exacerbate the very problems they seek to remedy.
The Community Capital Solution
What if there was a type of impact investing that had the power to solve some of the underlying systemic problems and bring about positive improvements in the economic structure of our economy? As my partner John Katovich explained in a Huffington Post blog, investing in institutions of community capital does precisely this. Community capital refers to community-focused investment opportunities that are open to the public, including both wealthy and non-wealthy investors; in other words, everyone can participate in community capital.
Why is this so important? It’s because most investment opportunities are available only to the wealthy, and investment opportunities beget more opportunities, and so on. The non-wealthy have very few options, and those few options typically pay a much lower rate of return than that earned by wealthy investors. But community capital is much more than just a way for a venture to expand its pool of potential investors. It is part of a revolutionary change in the structure of the local economy, because:
Community capital might be thought of as a separate asset class and an essential component of any investment portfolio, because it serves as a counter-balance to the global gyrations of the Wall Street-dominated economy while contributing to a healthier local economy.
Note that while we mainly use the term “community” in the sense of a geographically defined area, it could also be a dispersed community based around a common affinity or goal, such as renewable energy, biodynamic agriculture, or arts education.
What are the mechanisms for raising community capital? In general, a venture (nonprofit or for-profit) can raise capital from their community either directly or indirectly. The direct approach is sometimes referred to as investment crowdfunding, a term that includes both direct public offerings (DPOs) and Title III exempt crowdfunding. The indirect approach to community capital is where a community investment fund (CIF) aggregates investment from the community and then invests in local ventures. (See our separate post on several models of legally compliant community investment funds, including the charitable loan fund, the real estate fund, and the diversified business fund.)
While Cutting Edge Capital is best known for our work with DPOs, we also work with a number of CIFs, and we believe that a healthy local economy will feature a thriving mix of both. A CIF can be a particularly important component of a healthy local economy for four key reasons: Scale, efficiency, diversification, and liquidity.
Community investment funds and individual DPOs (or other types of investment crowdfunding) are not mutually exclusive, and there will always be a need for DPOs, particularly for ventures who prefer a direct connection with investors. Indeed, CIFs could play an important role for organizations conducting a DPO by:
A Problem of Culture
Even though the mechanisms to raise community capital are available, they are not commonly used. Cutting Edge Capital has specialized in DPOs for years, and we have helped build several successful community investment funds. And yet, these are the proverbial drop in the bucket compared to what is needed to significantly move the needle toward a more equitable and democratic economy.
What is standing in our way? In short, the problem is that in the US we lack a culture of community capital. Most investors (both wealthy and non-wealthy) are unfamiliar with DPOs and other legal strategies of community capital. Unfortunately, so are most investment professionals and lawyers. (After all, they don’t teach these strategies in graduate school.) This unfamiliarity breeds skepticism, which is probably the biggest barrier to widespread adoption of the strategies of community capital. And making matters worse, the non-wealthy (those who don’t meet the SEC’s definition of “accredited investor”) have been trained for decades to see themselves as unqualified to invest.
This is where visionaries, philanthropists and impact investors can make a big difference. To change the culture so that community capital is as ubiquitous as a corner convenience store, we need visionaries and thought leaders to help educate their communities about the game-changing potential of community capital. We need philanthropists to donate to nonprofit organizations who are seeking to promote community capital in their local areas. We need investors who will invest in the structures of community capital (for example, as founders of community investment funds), as well as investing alongside community investors to give credibility, strength and momentum to this revolution. And, of course, we need innovative leaders to make it happen.
Together, we can build an economy in which every community is served by a constellation of community investment funds of various types, along with DPOs by local ventures, which together contribute to a vibrant community capital marketplace in which all can participate on a level playing field, and together build a more equitable, prosperous, and empowered community. In other words, this is the ultimate impact investment.
Note that this discussion is for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer or to set up a consultation, please visit www.cuttingedgecapital.com or email us at email@example.com.
On October 26, 2016, the US Securities and Exchange Commission (SEC) issued new rules designed to make capital-raising for small businesses easier.
The two exemptions the SEC has updated, the intrastate offering exemption and Rule 504, are the two most commonly used strategies for companies doing direct public offerings to raise capital from their own community. At Cutting Edge Capital, we are very pleased to see the SEC implement changes that make it easier, rather than harder, to access community capital.
The important highlights are:
Here are the details.
Rule 504 Offerings
The SEC made two important changes to Rule 504, effective January 20, 2017. First, the aggregate cap is increased from $1 million to $5 million in a 12-month period. This change will make Rule 504 much more useful for companies whose investors are in more than one state but who need to raise more than $1 million in a year. Previously, such a company would have been forced to make a compromise: Either limit the investors to one state, or limit the offering to $1 million, or utilize the more burdensome Regulation A. We anticipate that more of our DPO clients will now opt for a Rule 504 offering.
The second change to Rule 504 imposes the same “bad actor” limitations on Rule 504 as are currently in place for private placements under Rule 506. This means that a company may not use Rule 504 if any of its key people (for example, an officer, director, manager, promoter, or 20% owner, besides the issuer itself) is the subject of a disqualifying event relating to securities transactions, such as criminal convictions, SEC orders, court injunctions and the like.
To protect an issuer who may be unaware of a key person’s past disqualifying event, there is a reasonable care exemption, which provides that as long as the issuer has made an appropriate inquiry (such as by requiring each of its key people to complete a questionnaire), it will not be disqualified from using Rule 504 if it turns out that one of its key people lied. As an additional protection for issuers, a disqualifying event that occurred prior to the new rules will not actually prevent the issuer from using Rule 504; but the disqualifying event must be disclosed to potential investors.
Previously, most Intrastate Offerings were conducted in reliance on Rule 147, which provided a “safe harbor” that ensured an offering would meet the requirements for the intrastate exemption in section 3(a)(11) of the Securities Act of 1933.
Effective April 20, 2017, the SEC is revising Rule 147 to relax some of its requirements. At the same time, the SEC is implementing a new Rule 147A, which is largely identical to Rule 147 but further relaxes the requirements in two important respects that take it out of section 3(a)(11).
Here is what the revised Rule 147 and the new Rule 147A have in common:
Issuer’s Relationship with the State of the Offering: Under the new rules, an issuer must have its principal place of business in the state of the offering (which could include a US territory) and meet any one of the following additional requirements demonstrating the in-state nature of their business:
Under the old rules, an issuer had to meet all of the first three requirements, which made it difficult for many businesses to qualify, particularly if they offered goods or services online. The new rules will now make it much easier for businesses to qualify to do an intrastate offering.
State of Residence of Investors: Under the new rules, every investor in an Intrastate Offering must actually be a resident of the state in which the offering is conducted or, if an investor is not actually a resident, the issuer must have had a reasonable belief that the investor is a resident of the state. Under the old rules, an investor’s reasonable belief did not matter; if one investor was not actually a resident of the state of the offering (even if they claimed they were), the issuer might have inadvertently violated securities laws.
The new rules also require that every investor in the offering provide a representation that they are a resident of the state of the offering (this is usually included in the subscription agreement). However, a written representation is not enough to establish the issuer’s reasonable belief of residency status for investors. In other words, if an investor represents that they are a resident of the state but they are not, without additional evidence of their state of residence, the issuer could still be in violation of the securities laws.
What does it take to establish reasonable belief as to residence status? The SEC provides the following examples for individual investors, though this is not an exclusive list, and the reasonableness of an issuer’s belief will depend on the specific circumstances in each case:
For an investor that is a legal entity, such as a corporation, LLC, or partnership, it’s the principal place of business that counts. This means the location at which the officers, partners, or managers of the entity primarily direct, control and coordinate its activities.
Significantly, a trust that is not a separate legal entity under the law of its creation is deemed to be a resident of each state in which a trustee is resident, which could be more than one state. This implies that an out-of-state resident who wants to invest in an intrastate offering could establish a revocable trust (which will normally not be deemed a separate legal entity) with an in-state trustee to make the investment. It also implies that a trust with multiple trustees, each of whom is resident in a different state, could invest in intrastate offerings in any of the states in which one of its trustees is a resident.
Restrictions on Transfer: Under the new rules, securities acquired in an Intrastate Offering may not be sold to an out-of-state investor until six months after the securities were purchased, regardless of when the offering ends. This is a significant change because the previous holding period was nine months, and the previous holding period did not begin until the issuer completed its offering, which could have been up to a year after a particular investor purchased their securities.
The SEC also clarified that bona fide gifts are not subject to this holding requirement (and are not subject to registration requirements at all under the 1933 Act); but sales by the recipient of donated securities are covered, which means those securities still cannot be sold to a nonresident of the state of the issuer during the holding period, even if the donee/seller is a resident of a different state).
Integration Safe Harbor: The new rules provide an important new integration safe harbor: Offers or sales under the intrastate exemption will not be integrated with any of the following:
This is a significant loosening of the integration rules. Previously, for example, a Rule 506 private placement could be integrated with a subsequent Intrastate Offering, and the effect could have been that the combined (integrated) offering would not meet the requirements for either strategy. Under the new rules, that is no longer a risk. This means any kind of offering can occur up until the date immediately before an Intrastate Offering commences, whether it’s a private placement or otherwise. And, offerings under the strategies listed above can occur immediately after an Intrastate Offering.
However, the SEC points out that the integration safe harbor doesn’t mean, for example, that the advertising of an offering that permits general solicitation will not affect a different offering that does not permit general solicitation, or that imposes restrictions on general solicitation. An issuer must still strictly follow the requirements for each offering strategy.
New Rule 147A: The new Rule 147A, which is also effective April 20, 2017, is largely identical to the revised Rule 147 but with two key differences. First, the issuer does not need to be formed under the laws of the state of the offering. This will be a significant benefit to organizations that are incorporated in one state (for example, Delaware) but are based in and otherwise meet all the requirements for an offering in another state.
Second, and perhaps more importantly, offers can be made anywhere, as long as actual sales are only made to residents of the state of the offering. This is intended to solve the problem presented when issuers put their securities offering on their website: If not done very carefully, the fact that non-residents of the state of the offering can access the website and see the offering could mean the issuer has inadvertently offered the securities to a non-resident, which is not permitted under Rule 147. But under Rule 147A, this concern is eliminated. Issuers will have more freedom to advertise the offering, as long as actual investors are limited to residents of the state of the offering.
One may wonder why Rule 147 has been retained at all, if Rule 147A serves the same purpose but with more liberal rules. The answer is that many of the state crowdfunding laws that have been implemented in the past few years explicitly require the use of Rule 147. The SEC retained Rule 147 (albeit in its updated form) to avoid placing a cloud of uncertainty over offerings made under those state laws. But for companies considering an intrastate DPO, Rule 147A will almost always be the better strategy.
We believe community capital is a necessary element of a more equitable and inclusive economy. Unfortunately, it is still not widely understood; many people, including lawyers and investment professionals, still do not realize it is possible to raise community capital. We expect these new SEC rules will now bring attention to this win-win strategy that allows entrepreneurs to raise capital from their ideal investors, allows accredited and non-accredited investors to invest in and profit from businesses in their community, and allows communities to build wealth organically through a continuous cycle of investment, growth, profit, and reinvestment.
This article is offered for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Capital and the services we offer to our clients, including Direct Public Offerings, visit www.cuttingedgecapital.com or email us at firstname.lastname@example.org