Community Capital Makes Strange Bedfellows

Community Capital Makes Strange Bedfellows

These past few months have shown us an America more politically polarized than ever. Any proposed solution is viewed through a conservative vs. liberal lens, and each side vows to oppose any proposal by the other. So it may be worth asking where community capital fits on that spectrum.
As our readers know, the term “community capital” refers to community-focused investment opportunities that are open to anyone in the community, including both wealthy and non-wealthy investors; in other words, everyone can participate in community capital. But is that a liberal idea or a conservative one?
Our answer: Both. And neither.
You could say that community capital is conservative because that is the way capital was raised for centuries until economic power became concentrated on Wall Street in recent decades. But you could also say it is liberal because it defies the dominant Big Money-driven paradigm.
It is conservative because it is fundamentally pro-business. It is liberal because it reflects the belief that business can be a force for good.
It is conservative because it restores economic power to local communities. It is liberal because it restores economic power to local communities. Oh wait, what was that?
Maybe the traditional liberal vs. conservative distinction just doesn’t make sense when we’re talking about democratizing the economy and empowering everyone to invest, grow local businesses, and build wealth in their communities. Don’t we all want those things regardless of our political views?
It’s true that our firm is based in left-leaning Oakland, California.

But our work transcends the political divide. Our mission is to build an economy that works for all. The economy we envision offers opportunities for everyone, regardless of economic class, to participate in the economy, profit from investments, and thereby to build wealth, while financing the growth of local businesses and other values-aligned ventures. When this happens, everyone benefits.
In fact, we see our work as a way for liberals and conservatives to work together toward a common goal. Perhaps the distinctions between those two groups aren’t as important as our common interests. We all want a fair and equitable economy, with opportunities for everyone to achieve their full potential. And we all hope this results in a safe, prosperous, and cohesive community where we live and beyond. Maybe it’s time to forge a movement to democratize the economy and seek these common goals, a movement that includes both liberals and conservatives.
Strange bedfellows? Maybe not so strange.
At Cutting Edge Capital, we’re fortunate in that there is no real opposition to what we do. Our biggest challenge is simply the need for education: Entrepreneurs don’t realize it’s possible to raise capital from their own community. Regular people don’t realize it’s possible to invest in local businesses or in alignment with their values. They only know what Wall Street offers, and they have learned to live with those disappointing options. Because that’s just the way it is. Except that it doesn’t have to be.
We would love your help in getting the word out about what’s possible. How? Invest in local businesses, nonprofits, and community investment funds. Tell your friends about direct public offerings. Help start a community investment fund in your community if there isn’t one already. Little by little, we can together change the culture, and make community capital as ubiquitous as a corner convenience store. Are you in?

What is Community Capital?

What is Community Capital?

Community capital is investment sourced from a broad spectrum of a community, including both wealthy and non-wealthy investors. While typically defined by geography (like a city or county), it can also be based on a common interest (like education or biodynamics).

Why is Community Capital Better for My Venture?

Better terms: Your community invests in you to help you succeed, not just to maximize their profit.

Deeper connection with your community: Your investors can be great ambassadors, and sometimes customers.

Why is Community Capital Better for My Community?

Keep wealth circulating in your community: Through a cycle of investment, growth, returns, and reinvestment, you can help your community build wealth sustainably.

Democratize the economy: You can level the playing field for wealthy and non-wealthy investors alike, and help narrow the wealth gap.

How Can I Raise Community Capital?

Directly, using a direct public offering. This approach offers maximum control over the terms. And engaging your community directly has non-financial benefits.

Indirectly, from a community investment fund, which raises community capital and invests in community ventures. For entrepreneurs, this approach can be easier and quicker. For investors, it offers diversification and efficiency.

What Types of Community Investment Funds Are There?

Charitable loan funds: Some (though not all) nonprofit lenders raise community capital via direct public offerings. Examples include NCCLF and RSF Social Finance.

Diversified business funds: This type of fund supplements another primary business and makes equity or other types of investments, while sharing profits with investors.

Real estate funds: While not a source of funding for ventures, a fund that deploys community capital into real estate can be a key revitalization tool.

Community Investment Funds: Four Models

Community Investment Funds: Four Models

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:

  • New businesses are attracted to newly renovated properties;
  • Property values rise as blight is eliminated;
  • Safety improves, as more workers and customers generate more foot traffic;
  • City tax revenues rise as all those people spend more money locally;
  • Local investors share in the profits of the business and reinvest in the community.

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:

  • Affordable or workforce housing
  • Agricultural land (perhaps in conjunction with a community land trust that acquires a conservation easement)

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:

  • Majority-owned subsidiaries: If the fund acquires a majority ownership position in a target company, that won’t count toward the 40%. Note that while such an investment would ordinarily be treated as a “security,” it is specifically excluded from the definition of “investment security” for purposes of the 1940 Act. One challenge here is that the entrepreneur behind a potential target company may (understandably) not want to give up a majority position in their company. That concern can be addressed through two sub-strategies. First, the equity structure of the target company can be designed to ensure the entrepreneur has majority voting power even with a minority ownership position. The second is that the investment can be coupled with a redemption right giving the entrepreneur the right to re-acquire a majority position at some time in the future.
  • Real estate: As long as it is directly held by the fund, real estate is not a security at all, as noted earlier. A syndication interest, or an interest in a real estate partnership would likely be an investment security. But real estate that the fund owns for its own use or to lease to others would not be.
  • Secured loans: For purposes of the federal securities laws, not every loan is a security. Where a loan is privately negotiated between lender and borrower, is not offered broadly to potential lenders, and is secured by assets, it will probably not be deemed a security at all, so it will not count toward the 40% threshold.
  • Non-securities assets: The fund may also invest in equipment and other assets that are not securities.

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:

  • Company history: A company with a history as an operating company in some primary business other than investing is less likely to be deemed an investment company.
  • How it represents itself to the public: If investors are likely to invest because of the investment portfolio, investing is more likely to be deemed its primary business.
  • Activities of its officers and directors: Whatever the officers and directors spend most of their time doing is likely to be deemed the primary business.
  • Nature of its assets: The more of a company’s assets that are associated with a line of business, the more that will be considered their primary business. However, courts have recognized that some businesses are asset-light, and that fact should not by itself transform an operating company into an investment company.
  • Sources of its income: Both net and gross income should be considered. An activity that produces a majority of both will likely be considered the 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:

  • An intrastate fund: The 1940 Act includes an exemption for a fund of up to $10 million where all investors reside in the same state where the fund is based. While this sounds promising, it has two key limitations: First, it must be a “closed-end fund”—meaning that the fund has a specified life (say, 7 years); investors come in at one time and are cashed out at the end of the fund, with little opportunity to come in and out of the fund during its life. Second, this is not a self-executing exemption; rather, the fund would need to request an exemptive order from the SEC, and the SEC would have the power to impose any requirements they believe are needed to protect investors. This exemption has rarely, if ever, been used.
  • Microloan fund: An exemption is available for a fund that makes “small loans”—a term that appears to be interpreted by the SEC to mean personal and consumer loans, not business loans. One possible example: A solar fund could use this strategy to make loans to homeowners to finance rooftop solar installations.
  • Manufacturer/seller loan fund: Another exemption covers a fund in the business of lending to manufacturers and sellers of merchandise or services.

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 info@cuttingedgecapital.com.

Community Investment Funds: The Ultimate Impact Investment

Community Investment Funds: The Ultimate Impact Investment

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:

  • It allows ventures to raise capital from their own community, rather than putting their fate in the hands of the wealthy institutions and investors who currently control the economy.
  • It allows everyone everywhere to invest in their local community, in local ventures, in something that’s meaningful to them.
  • When the community invests in local ventures, those ventures grow, hire local workers, generate profits locally, and pay those profits to community investors who can then reinvest. It’s a cycle that allows the community – any community – to build wealth.
  • With broadly shared ownership and participation, the community can now channel resources to where they are most needed. The community is empowered to solve its problems, leveraging the abilities and experience of all its constituents.

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.

  • A CIF can be more scalable because it can potentially raise an unlimited amount of money and finance an unlimited number of local ventures. Note that we don’t use “scale” in the Wall Street sense of bigger transactions. In a CIF, the transactions should always be at a human scale, but we need a lot more of them to truly change the economy and to create a culture of community investment.
  • A CIF can be more efficient because each investor only needs to do due diligence once on the fund, and then the fund handles due diligence on outgoing investments.
  • A CIF is more diversified when compared to having each investor invest in one or a small number of local ventures.
  • A CIF may be in a better position than individual ventures to offer its investors liquidity (i.e., a way to sell the investment). A CIF can be set up to redeem investors who need to exit the investment.

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:

  • Making a small short-term loan to cover the costs of a DPO.
  • Lending to the business on the strength of the equity raised in the DPO.
  • Providing a sounding board to the venture on pricing and other terms of their DPO.
  • Investing in the DPO early to seed it and inspire others to follow.
  • Investing late in the DPO process to backstop it and ensure its success.
  • Providing liquidity to DPO investors by purchasing their investment if they need an exit.

 

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 info@cuttingedgecapital.com.

Exit Opportunities for DPO Investors

Exit Opportunities for DPO Investors

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 six months after the date the investment was made 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.

Looking ahead…

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.