Diversified Community Investment Fund: A Versatile Vehicle for Democratizing Capital

Diversified Community Investment Fund: A Versatile Vehicle for Democratizing Capital

Image by Anna Dyshel from Pixabay

Community investment funds are an idea whose time has come. And the menu of offering strategies available to build community investment funds has now gotten slightly longer, with the addition of a particularly versatile strategy.

At Cutting Edge, we’ve been focused on community investment funds for several years. In 2016 we wrote a pair of blogs discussing why they’re a great way to scale up the democratization of capital and suggesting four compliance strategies for building such a fund. We then contributed to a handbook on community investment funds published by the National Coalition for Community Capital that went deeper, surveying a couple dozen fund strategies, as well as offering practical guidance on setting one up.

Any fund that raises capital and then invests in other ventures must have a compliance strategy under the federal Investment Company Act of 1940 (the “ICA”). In this blog we wrote that while a number of good fund strategies are available, there is still a gap in the law, which does not yet allow for a simple community investment fund that can invest in local businesses while raising equity capital broadly from the community and sharing profits with those community investors. Efforts are under way to fill that gap by adding new exemptions to the ICA, but those efforts have yet to bear fruit.

Still, in various conversations we’ve had in the past year, there is an emerging strategy that is suggested in some of our past publications but not explicitly described. This is a kind of hybrid strategy that is coming to be called the “diversified community investment fund” or “DCIF.” The idea is that a for-profit fund will invest primarily in real estate, but also invest a portion of its portfolio in local businesses. 

That primary focus on real estate opens up at least three potential compliance strategies under the ICA, depending on the details of how it will raise and deploy capital. A detailed breakdown of those three strategies is beyond the scope of this blog, but under what is perhaps the most versatile of the three, the fund has at least 60% of its assets invested in real estate or other non-securities assets, while up to 40% of its assets can be invested in local businesses. Those investments in local businesses can take any form, including loans, equity investments (like stock), or a revenue share.

A DCIF using this strategy could raise capital using any of a number of securities offering strategies, including Regulation Crowdfunding, direct public offering (registered with state regulators), or Regulation A (qualified with the SEC). This means that it can raise capital publicly from investors of any economic class, including residents of the fund’s own community – even from folks who have never invested before.

The fund can offer either voting or nonvoting interests to those investors, or it could offer different types of securities tailored to different types of investors. It can share profits with its investors, and there are ways it could even offer limited liquidity (so investors could potentially get their money back if needed). With so much flexibility, we’re currently working with several clients who are looking to deploy some variation of the DCIF in their respective communities.

There are, of course, a lot of legal nuances to building a DCIF, and it should not be attempted without legal counsel that understands the regulatory landscape for such funds. This blog, of course, is informational only and should not be taken as legal or investment advice. For more information about Cutting Edge and the services we offer, or to schedule a consultation, please visit our website or email us at info@cuttingedgecapital.com.

New Rules for Finders? Not So Fast…

New Rules for Finders? Not So Fast…

The SEC made a splash in October 2020 when it proposed a new set of rules that would allow finders to receive transaction-based compensation for introducing investors to issuers even though they are not licensed as a securities broker-dealer. 

This proposal represented a dramatic departure from the traditional rules, and it was driven, at least in part, by concerns about equity: If the success of entrepreneurs depends more on who they know than on what they can do, then the traditional rules serve to entrench class distinctions. Those who come from money and therefore have connections to wealth become successful entrepreneurs because they can raise the needed funds. Those who lack those connections may fail for lack of capital, despite their ability and innovations.

The role of a finder is most relevant in private offerings. In such an offering, no advertising or “general solicitation” is permitted. As a practical matter, that means the entrepreneur can only pitch the investment opportunity to investors that the entrepreneur personally knows, or those introduced to the entrepreneur by someone the entrepreneur personally knows. An entrepreneur who does not personally know any investors able to write big checks will have to rely on these introductions – which then raises the question of whether the entrepreneur can incentivize these introductions by paying some sort of compensation to finders.

And it went… nowhere

But those who hoped the SEC’s new rules would usher in a new paradigm for capital-raising have reason to be disappointed: The proposed rules have not been finalized; and with recent changes in leadership at the SEC, it now appears unlikely that the SEC will ever adopt the proposed rules.

To underscore this, in an annual report published in December 2021 by the SEC’s Office of the Advocate for Small Business Capital Formation, there is a reference to the proposed finder rules along with a statement that “the Commission has not taken further action on the proposal, and providing regulatory clarity for finders is not in the Commission’s current regulatory agenda.”

However, the concept is not entirely dead yet. Senator Kevin Cramer of North Dakota has introduced a bill in the Senate (S. 3922) that would exempt finders from registration as a broker-dealer. That bill has been picked up for inclusion in a Republican-backed “JOBS Act 4.0” package of legislation. At this point it’s too early to tell whether Senator Cramer’s bill will survive the legislative process.

So where does that leave us? For now, we’re right where we’ve been all along.

The current law

Unfortunately, the current law for finders is a bit murky. The rule for securities broker-dealers basically says that someone may not help facilitate securities transactions for compensation without having a broker-dealer license. But keep in mind two things:

1. The idea of “facilitating” an investment is very broad and may cover any activity intended to induce or bring about a transaction between an issuer (the organization raising capital) and an investor. A finder who attends meetings with an investor or who delivers documents will likely fall within its scope. A finder who does nothing more than make an introduction may not; but SEC no-action letters have gone both ways in that situation – sometimes finding that broker-dealer laws apply, and other times finding that they do not.

2. Similarly, the idea of “compensation” is also broad. It can include not just transaction-based cash compensation but just about any other kind of quid pro quo benefits a finder may receive from an issuer. And the closer the nexus is between a finder’s compensation and the success of the investment transaction, the more likely the finder would need to be licensed.

But there are alternatives

So what is an entrepreneur to do?

First, there may still be ways of paying finders without violating the broker-dealer rules. For example, a finder could be paid a flat fee for providing a list of potential investors, without any further involvement in the investment process.

But perhaps better yet, there are several capital-raising strategies that do allow for general solicitation and advertising, which largely eliminates the need for a finder. These include:

We at CEC will keep an eye on developments in the Senate or at the SEC for finders and will provide an update to our community if things change. But entrepreneurs need not let the SEC’s inaction here stop them from raising capital. 

Naturally, this discussion should be regarded as informational only and not as legal advice. If you’d like to talk with us about capital raising strategies, don’t hesitate to reach out to us.

Testing the Waters for Securities Offerings

Testing the Waters for Securities Offerings

Securities Offerings

Suppose your organization needs growth capital and you’ve talked about doing a securities offering of some sort.  But you’re reluctant to commit the time and resources that it takes to gear up for a  securities offering without having some confidence that it will be successful. What you’d really like to do is to put some feelers out there, at a minimal compliance cost, to see if potential investors would be interested. Then you could make a better-informed decision.

This is what we call “testing the waters.” In addition to helping your organization decide whether to launch a securities offering, a testing-the-waters campaign could potentially also help you choose from among several capital raising strategies. 

For example, if you find there is strong interest among accredited investors but less interest among non-accredited investors, you may opt for a Rule 506 offering targeted to accredited investors. If you find the opposite, you might choose a Regulation Crowdfund offering or a direct public offering. You might also gauge interest among out-of-state investors, which can help you decide whether to do an intrastate offering or a multi-state offering.

Legal Strategies for Testing the Waters

It has always been possible for organizations to speak privately with potential investors to test the waters. But the last few years have given us some new ways of doing this publicly. For example, the expanded Regulation A, which went into effect in 2015, has its own testing-the-waters provisions in Rule 255, for organizations contemplating a Reg A Tier 2 offering.

Then last November, an SEC final release gave us two new testing-the-waters pathways: Rule 206 for organizations contemplating a Regulation Crowdfund offering; and Rule 241 for organizations that haven’t yet decided on an offering strategy. 

This trio of testing-the-waters rules has some similarities. All of them generally require the following:

  • No money may be solicited or accepted when testing the waters.
  • Testing-the-waters materials must state that:
    • No money is being solicited or will be accepted;
    • Offers to buy securities will not be accepted; and
    • Indications of interest are non-binding.
  • The issuer must keep a copy of testing-the-waters materials, and any such materials that are made publicly available (or otherwise used in general solicitation) must be included with a subsequent filing under Reg A or Reg CF.

There are some important differences, which we’ll break down in the table below, to make it easy to compare them. But first, we’ll add one more: Rule 506(c) under Regulation D is not designed as a testing-the-waters strategy, but rather as a strategy for raising capital from accredited investors (with verification). But it can be advertised, and that opens the door for its use as a public testing-the-waters strategy.

Comparison of Testing-the-Waters Strategies

With four testing-the-waters options now, it can get a little confusing.  So here’s how we break them down:

TTW StrategyRule 255Rule 206Rule 241Rule 506(c)
Subsequent offering strategyReg A Tier 2 onlyReg CF onlyAnyPotentially any
State preemptionYesYesNoYes
Requires standard TTW disclosuresYesYesYesNo
Can take investment moneyNoNoNoYes, but only from investors verified as accredited
Other key elementsMay do TTW before or after filing Form 1-AMay not do TTW after filing Form CMay not use Rule 241 after deciding on a strategyRequires 30-day waiting period after TTW to avoid integration with any subsequent offering

We’ll draw attention to one critical differentiator among these rules: preemption of state laws. Most testing-the-waters rules preempt state laws, which means that an organization can safely test the waters under those strategies, even publicly on the organization’s website, without worrying about violating state laws. 

But Rule 241, the testing-the-waters rule for organizations that have not decided on an offering strategy, does not preempt state law. Many (and perhaps most) states’ securities laws do not permit testing-the-waters publicly, or allow it under only limited circumstances. So an organization should be very cautious in planning a Rule 241 testing-the-waters campaign so as to ensure it does not inadvertently violate state laws. As a practical matter, Rule 241 may not be very usable for this reason. Instead, organizations who want to test the waters but have not yet settled on either Reg A or Reg CF as their intended offering strategy may be better off using Rule 506(c).

With all of these strategies, there are some important nuances, and no organization should test the waters without first getting legal advice. Naturally, this discussion should be regarded as informational only and not as legal advice. If you’d like to talk with us about testing the waters or other securities strategies, don’t hesitate to reach out to us.

Community Investment Funds: A Change is Gonna Come

Community Investment Funds: A Change is Gonna Come

Community Investment Funds

In the aftermath of the protests and marches of the past year or so, community wealth building has emerged as an often-discussed strategy of economic justice. Community wealth building is really another term for community capital, and it’s been at the core of our work at Cutting Edge Counsel since our firm’s founding. It’s also the focus of the National Coalition for Community Capital (NC3), where I’m on the board.

In particular, there is a growing interest in community investment funds as a tool for community wealth building – something we’ve been writing and talking about in recent years. In this blog, we wrote about why these vehicles represent the ultimate impact investment – in short, because instead of seeking to remedy the harmful impacts of the prevailing system, they represents a systemic change in who invests and where profits go.

In the conventional system, only the wealthy can participate in the most profitable investments, which means the wealthy can grow their wealth at a rapid clip. The rest of us are generally stuck with investment options that, on a risk-adjusted basis, pay less than inflation. So instead of growing wealth, these options tend to erode wealth, which means the non-wealthy are effectively penalized for investing while the wealthy are generously rewarded. Naturally, this system contributes to a widening wealth gap.

But community capital (and community investment funds in particular) represents an entirely different approach to moving capital that decentralizes it, democratizes it, and recognizes that wherever your investors are, that’s where your profits go. If you want to get profits into the hands of non-wealthy people in your own community, you need to source capital from those same people.

However, community investment funds must be structured to comply with the Investment Company Act of 1940 – a rather restrictive federal securities law that hasn’t been updated significantly in a very long time. Previously, we wrote about four ways of building a community investment fund under current law. These included a charitable loan fund, a real estate fund, a supplemental fund (aka diversified business fund), and a business development company. Then, in this blog, we added another to that mix, a pooled income fund – which is generally considered a planned giving device, but can also serve as a type of community investment fund.

Then last year, the National Coalition for Community Capital published this handbook on community investment funds, which I co-authored along with Michael Shuman, Amy Cortese, and fellow NC3 board member Janice Shade. The handbook covers a lot of territory that would be useful for anyone who is thinking about launching a fund in their own community. In the chapter on legal strategies, we dug into a number of ways it can be done – again, right now, under existing law – including those mentioned above and a few more.

And yet, despite all the legal strategies that are currently available, there is still a big gap, which we discussed in this blog. What’s still missing is a way to build a simple community-scale equity fund – meaning a for-profit fund that can take investment from the community (including, of course, non-accredited investors) and deploy it in debt, equity, or revenue share investments into local companies, with the profits distributed among community investors – and all this in a cost-effective vehicle with a minimal compliance burden under the securities laws.

NC3 has recently taken the lead on an initiative to expand the investment fund options under the 1940 Act – advocating both a legislative change by Congress and rulemaking by the SEC. We have already had discussions with key people in the SEC about this. While securities regulators will, of course, apply a healthy dose of skepticism to any new ways of doing things (that’s their job!), the SEC specifically reminded us that they have created new exemptions for new types of investment vehicles in the past and could do so again. The door was left open for us, and NC3 is continuing to push on this front.

In the meantime, if you want to launch a community investment fund as a wealth-building tool in your own community, there are great options available now. There’s no need to wait, though we hope the menu of options will expand soon. Don’t hesitate to reach out to us at Cutting Edge if you’d like to talk about what might work for you.

Finally, I want to give credit to the late Sam Cooke, who penned the song referenced in the title above. And if you haven’t seen the movie One Night in Miami, I recommend it. You’ll see the connection. The struggle for equal opportunities for all Americans clearly didn’t end in the 1960s. I see our work to expand community wealth building options as within the arc of change that Mr. Cooke foresaw all those years ago. It’s been a long time coming. But a change is gonna come.

SEC Lowers More Barriers to Community Capital

SEC Lowers More Barriers to Community Capital

This month has been full of big news. Yes, there was the election, of course. But there was other important news for those interested in community capital. On Monday November 2, 2020 – the day before the election – the Securities and Exchange Commission issued final rules as part of a broad initiative to harmonize the regulatory framework for exempt offerings, i.e. securities offerings that don’t need to be registered with the SEC.

There are a host of exemptions from SEC registration, each for an offering of a particular type, and several of which are discussed in more detail on our Cutting Edge Capital website. The rules for these various offerings evolved in somewhat disjointed ways and had come to look like an uncoordinated patchwork quilt, with significant barriers making those exemptions more difficult to use than they needed to be.

But the SEC’s new rules lower those barriers and will not only make it easier for companies to use some of these exemption strategies, but may also open up avenues for raising capital that might not have been previously available.

The issuing release from the SEC is a rather daunting 388 pages long. The SEC has prepared this fact sheet summarizing the changes. Here are some of the highlights that we think will be most relevant to our clients:


Though the term sounds technical, integration has been an important concept in securities law for generations. It arises from the fact that each exemption strategy works within a fairly narrow set of circumstances. But what if you want to use two different strategies to reach two different groups of investors? The idea of integration is that two different offerings using two different strategies might be integrated, such that they are treated as one single offering that doesn’t meet the requirements of either intended strategy.

Here’s just one example of the way the integration doctrine worked: A company wants to raise capital under the Rule 506(b) private offering exemption from accredited investors that they personally know in several states, and then conduct an intrastate direct public offering to investors in just one state. If these two offerings are considered to be integrated – as they likely would – the combined offering would’t meet the requirements of either strategy. It wouldn’t meet the requirements of the private offering because the DPO is offered to the public; and it wouldn’t meet the requirements of the intrastate DPO because some of the investments are from other states, and because some of the investors came in before the company got the required regulatory approval for the DPO.

Over the years, courts have developed a five-prong test for when there will be integration, and they seem to always find integration where there are any similarities between the offerings. But going forward, we won’t need to dig into those factors, because here’s the good news: The new rules almost completely eliminate the integration doctrine.

Under the new rules, the focus will simply be on whether the requirements of each strategy have been satisfied. If so, there will be no integration. So, in our example above, if the company is meeting all the requirements for the Rule 506(b) private offering (for example, with no general solicitation), it won’t matter that immediately after that offering is completed the company then launches a direct public offering, with a press release, advertising, and other types of general solicitation.

But lest there be ambiguity about whether there is or isn’t integration in particular situations, the SEC has crafted two important “safe harbors” that can give confidence that two offerings won’t be integrated.

First, a private offering will not be integrated with a subsequent public offering of any kind, as long as they do not overlap in time.

Second, any two offerings that are separated by at least 30 days won’t be integrated, as long as:

  • Investors in a private offering that follows a public offering were not reached through general solicitation; or
  • The company had a substantive relationship with investors prior to commencement of a subsequent private offering.

Our Take: We often work with our clients on strategies involving multiple offerings, such as a private offering followed by a public offering; these new rules will open up more possible combinations of those offerings. It may also allow for two offerings concurrent with each other. For example, under the new rules, it appears that a small charitable loan fund could conduct a public offering under the federal charitable exemption in those states that also have a charitable exemption, while simultaneously conducting a Rule 506(c) offering (allowing general solicitation of a private offering) in those states that don’t have a charitable exemption. This would allow the fund to raise capital from every state in the country at a minimum compliance cost.

Regulation Crowdfunding

Several changes were made to the rules for Regulation Crowdfunding (also known as Reg CF) offerings:

  • The maximum size of offerings has been increased from $1.07 million to $5 million.
  • There is no longer a limit on how much an accredited investor can invest in a Reg CF offering.
  • For non-accredited investors, the per-investor cap is now calculated on the greater of either their annual income or their net worth. (Previously it was based on the lesser of the two.)
  • The SEC has extended for an additional 18 months a special temporary rule that allows for offerings of up to $250,000 without CPA-reviewed financial statements. (Previously, that cap was $100,000.)
  • A special purpose vehicle may now be used as a conduit for investors in a Reg CF offering to simplify the company’s cap table.

Our Take: Taken together, these changes will make it easier for many companies to raise capital under Reg CF, and we expect to see more of these offerings. Whether the increased cap of $5 million will make a difference remains to be seen. Already, most Reg CF offerings do not raise the full $1.07 million they are allowed to raise, so increasing the cap may not help much. However, if these changes lead to greater acceptance of Reg CF within the investing community at large, including institutional investors that have largely stayed on the sidelines so far, we may well see more success with bigger offerings.

Other Offering Limits

The new rules increase the amount that may be raised in two other types of offerings, in addition to Reg CF:

  • Reg A Tier 2: The cap is now $75 million, up from $50 million. (The cap for Tier 1 offerings, which are far less useful because they still require state registration, remains at $20 million.)
  • Rule 504: Often used for multi-state direct public offerings, the cap has been increased from $5 million to $10 million. (And interestingly, it had been increased from $1 million to $5 million just four years ago.)


Some of the new rules will make it easier for companies to communicate with potential investors, even when conducting or contemplating a private offering that does not allow for general solicitation.

Demo Days

The SEC will now allow companies looking to raise capital to make a presentation at “demo days” following these rules (which will comprise a new Rule 148):

  • The sponsor of the demo day must be a state or local government body, school, angel investor group, incubator, or accelerator. (But note that the list of potential sponsors does not include fund sponsors, venture capital associations, or professional organizations.)
  • The sponsor doesn’t make investment recommendations, get involved in investment negotiations, charge fees for making introductions, or charge attendees anything more than administrative fees.
  • There must be at least two companies presenting at the event.
  • Advertising for the event may not reference any specific offering by companies that will be presenting at the event.
  • At the event itself, the presenting companies can provide only certain basic information about their particular securities offerings.

Significantly, it is not necessary that attendees of an in-person demo day either be accredited or have any pre-existing relationship with either the sponsor or with any of the companies making a presentation; there is no limit on how many may attend in person. However, if the demo day event allows for online participation, it must be limited to online participants who are either:

  • members of the sponsoring organization;
  • individuals that the sponsor believes to be accredited investors; or
  • individuals who were invited to the event because of their experience, as described in any advertising for the event.

Our Take: While demo day and pitch events have become quite common in recent years, we have generally advised our clients to be careful, because many of those events flaunt the securities laws and put the presenting companies at risk. This new rule will give presenting companies confidence that they can make these presentations without worrying about violating securities laws. We expect these demo days to become much more common.

Testing the Waters

One of the challenges many companies face when deciding among different offering strategies is that they have no way of knowing which offering strategy is most likely to succeed, i.e. which target group of investors will most likely invest. And while the rules for Reg A Tier 2 offerings expressly allowed for “testing the waters,” or soliciting interest in an offering, before doing all the legal and other work that Reg A requires, other exemption strategies did not have that option.

The new rules will change all that and will allow a company that has not yet decided on a particular offering strategy to do a generic solicitation of interest – either publicly or privately – from potential investors to help it decide. Here are some guidelines under this new Rule 241:

  • The company must keep copies of the testing-the-waters materials; and if they end up doing a Reg A or Reg CF offering they must file those materials with the SEC.
  • No money can be solicited or accepted while testing the waters.
  • Specific disclosures must be included in the testing-the-waters materials (for example, a statement that indications of interest are non-binding).

This is a limited exemption that only applies to the testing-the-waters. A subsequent offering must still comply with all of the requirements for the chosen strategy. This means that if a company does a public testing-the-waters (i.e. with general solicitation or advertising) and then choses to do a private offering, the company will need to follow the new integration rules described above and ensure that the private offering does not involve general solicitation.

Our Take: This is a big step forward for companies that are weighing different offering strategies. However, the new rules on testing-the-waters expressly do not preempt state laws. This means that – for now at least – state laws may still prohibit testing-the-waters, even if allowed under federal laws. This will require careful analysis of the interplay of state and federal laws.

Rule 506(c) Accredited Investor Verification

Rule 506(c), which arose out of the JOBS Act of 2012, is a variation on the private offering exemption. It allows for general solicitation and advertising; but in exchange, it requires that every investor in the offering be an accredited investors, and it further requires that the company take steps to independently verify the accredited status of every investor.

But what happens if the same investor in a Rule 506(c) offering invests twice, or more often? Does the company need to go through the investor verification process every time the same investor invests? We now have an answer to that question. Under the new rules, once the company does its verification of an investor’s accredited status, it may rely on that verification for up to five years, as long as the company is not aware of any facts suggesting the investor is no longer accredited.

Our Take: Several of our clients have been in this situation, since it is not uncommon for an investor to make multiple investments in the same company, and this additional clarity will be helpful. It will both reduce compliance costs and increase confidence for companies using the Rule 506(c) strategy.

Final Thoughts

We welcome these changes in the federal securities rules, which will not only lower some of the barriers to using the existing exemptions, but also make some of those exemptions more useful and, hence, more likely to be used.

There are a number of other changes in the new Rules that are probably of less importance to our clients, such as financial disclosure requirements for Rule 506(b) offerings with non-accredited investors; and restrictions on the use of Reg A by companies delinquent in their reporting obligations. Note, too, that the new rules described here will be effective sixty days after they have been published in the Federal Register (which probably means some date in January 2021).

Naturally, this summary of the new rules is offered for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Counsel (including our capital-raising practice group known as Cutting Edge Capital), visit www.cuttingedgecapital.com or email us at info@cuttingedgecapital.com.