Intrastate and Small Fund Exemptions to the 1940 Act: Now Is the Time

Intrastate and Small Fund Exemptions to the 1940 Act: Now Is the Time

Imagine a typical American community in these very untypical times. COVID-19 has taken a heavy toll. Many small businesses have closed — temporarily, it is hoped. Unprecedented numbers of workers have been laid off or furloughed as businesses conserve cash in the face of sharply declining revenues.

But in time, when the shelter-in-place orders are finally lifted and businesses are free to resume operations, everything quickly gets back to normal, right? No. It’s clearly not going to be that simple. Some businesses may be able to quickly ramp up to pre-COVID-19 levels, but others will need a boost.

But in this community we are imagining, something magical starts to happen. The community pools its resources and invests in its own recovery. A community investment fund is established, and anyone in the community can invest in it, from the wealthiest to anyone with a few hundred dollars. Many people invest the full amount of the stimulus check they receive from the government.

This fund then makes investments in local businesses to help them get back up and running and to help them grow. These are mostly equity investments, because that’s what entrepreneurs often need, and that’s the kind of investment that’s often hardest to get. And these equity investments can help entrepreneurs get more traditional loans, which amplifies the potential boost to their business. The fund also makes revenue-sharing investments, which help to ensure a financial return to the fund, while automatically adjusting for the entrepreneur’s cash flow.

This fund isn’t demanding extractive returns, and it isn’t searching for unicorns. But all of its investments offer upside potential, meaning that when the businesses succeed, the fund succeeds. And that upside is shared with its many local investors, because those investors are equity owners in the fund and share in its profits. That helps build wealth for all those local investors, regardless of their economic status. That means investors are incentivized to patronize the businesses in which the fund invests. It’s a win-win.

Except that it can’t happen, not under our existing laws.

Now to be sure, there are several types of community investment funds that can be formed under existing law. And by “community investment fund” we mean a fund that can take investment from anyone in its community, including both accredited and non-accredited investors. At Cutting Edge, we’ve been writing and speaking about these funds for years because they have the potential to dramatically scale up community capital, while the diversification inherent in community investment funds can reduce the risk to investors, which is particularly important with non-accredited (and often unsophisticated) investors. And I’m honored to be on the board of directors of the National Coalition for Community Capital, which has just published a handbook on community investment funds.

The long and short of it is this: There are laws that allow for the formation of charitable loan funds and real estate funds without being burdened by the heavy compliance obligations of the Investment Company Act of 1940. But a simple equity investment fund such as what I described earlier cannot be done economically at a community scale because it will be subject to all of the same compliance burdens that apply to multi-billion dollar mutual funds.

It doesn’t have to be that way. Last September, we wrote to the Securities Exchange Commission (the federal securities regulator) in response to their request for input on streamlining access to exempt offerings. In our letter we argued for two new exemptions from the 1940 Act that would allow for the creation of small community-based funds without having to comply with those heavy compliance obligations of the 1940 Act. You can download the letter here:

Letter to SEC

The first exemption would provide for intrastate funds — that is, funds in which all investors are residents of the same state where the fund is based. This type of fund would have no size limit and would be self-executing, meaning that it would not require the fund to seek permission from the SEC. Such a fund would not need SEC regulation or oversight, because it would be sufficiently regulated at the state level. State securities regulators are in a better position than the SEC to determine whether and to what extent intrastate funds would need to be regulated.

A second new exemption is needed in view of the fact that many communities consist of a metropolitan area that spans two or more states — like Kansas City, Portland, and Washington DC. For those communities, an intrastate fund would not work because it excludes a portion of their community. What those communities need is a small fund exemption, just like the intrastate exemption except that instead of limiting all investors to residents of one state, the fund would be limited by size to $50 million.

We believe these two new exemptions, taken together, would dramatically change the investing landscape in America. Not only would that fund in our hypothetical American city become a reality, but we believe funds like that would, in time, be launched in every community across America. And why not? If given the choice between investing in Wall Street or investing in one’s own community, we can expect that most investors would move at least a significant portion of their investments into their community. All together, we’re talking about moving potentially trillions of dollars out of the financial centers and back to the communities that earned that money and where it can be put to use locally.

We’re not aware that any action has been taken by the SEC in response to our September proposal. But September seems so long ago, after the enormous upheavals brought about by COVID-19. We think the time is now to push for this change in the law. Not only would this put much-needed money in the hands of small businesses everywhere across America, but it would do so without any effort or tax dollars from the federal government and with minimal regulatory oversight at the state level. And this is not a red-versus-blue or conservative-versus-liberal kind of issue. We can all unite together in our support of local communities.

But we’ll have to push for it, because the Investment Company Act is relatively obscure and seldom discussed by policy-makers. Fortunately, the changes we are seeking are not complicated and shouldn’t require more than a single page of text.

There are two ways these changes in the law can come about. The first is through an act of Congress. That sounds daunting, but there has never been a better time than now, when Congress is searching for ways to solve the financial woes of small businesses across the country. We encourage anyone who cares about community capital to reach out to their Senator or Representative about this.

The second approach is to push the SEC, which has the power to create new exemptions on its own, without an act of Congress. We think the SEC may also be amenable to this type change, since the potential benefits are huge, while the burden on the SEC and on taxpayers is negligible, if anything. The challenge is to get this on the radar of the right people at the SEC. Ultimately, we believe the best course of action is to push both Congress and the SEC, and hope that this two-pronged approach will lead to conversations between lawmakers and SEC staff about how to get this done efficiently and effectively.

If we all use whatever connections we have, with regulators or lawmakers, we can make this happen. Now is the time.

Welcome Elizabeth Carter! Our New Cutting Edge Attorney

Welcome Elizabeth Carter! Our New Cutting Edge Attorney

We are so excited to have Elizabeth Carter join our team!

Elizabeth is a social enterprise and community development attorney licensed in NY, NJ, and IL (pending). As Principal Attorney of the New Jersey-based law firm The Law Office of Elizabeth L. Carter, Elizabeth represented low and moderate income individuals, nonprofits, small businesses, and government agencies in the areas of real estate, redevelopment, property tax, and various business transactions.  In order to provide greater access to legal services to those of low and moderate income, Elizabeth’s practice included flexible payment options for low and moderate income individuals and small start-ups, such as barter and flat-fee arrangements.  Prior to her private practice, Elizabeth served as Special Counsel within the City of Newark’s Department of Economic and Housing Development where she assisted in a number of economic development initiatives, including serving as project manager and lead counsel of a $8.1 mill affordable housing cooperative project and authoring the City’s amended tax abatement ordinance which provides tax incentives for inclusionary development by women,  racial minorities,  and cooperatives. Lastly, Elizabeth founded the Urban Cooperative Enterprise Legal Center, Inc., a nonprofit legal center with a mission to create and support cooperative enterprises within marginalized communities, where she presided over the Board of Directors, served as General Counsel of the organization, and lead the nonprofit’s organizational and programmatic development [for three years] as its Executive Director. Currently, Elizabeth primarily engages in the business legal support of small businesses, cooperatives, nonprofits, and entrepreneurs, especially those that are Black-owned, controlled, and managed.  

Insights From Innovators: WEPOWER

Insights From Innovators: WEPOWER

At the end of 2019, Cutting Edge was contacted by St Louis non-profit, WEPOWER to help support their accelerator program for Black and Latinx entrepreneurs in St. Louis. Cutting Edge attorney, Sarah Kaplan, took on the project specifically to create a securities law strategy for their funding activities–raising funds into the accelerator that will then be invested into the start-ups that participate in the accelerator. Below is our interview with the WEPOWER team.

In 2-3 sentences could you explain what WEPOWER does and what are the guiding principles?

We’re a start-up nonprofit that partners with Black and Latinx communities to activate their power to advance equity & justice for all — particularly by transforming health, education, economic, and justice systems. That breaks down into three main areas of work — (1) engaging community by knocking on people’s doors, calling them, asking about their needs and dreams, (2) activating changemakers to work on policy and systems change (through programs like Power Building Academies, and our Tomorrow Builder’s Program), and (3) elevating entrepreneurs through our business accelerator, Elevate/Elevar, which is focused on building wealth and creating living wage and family sustaining wage jobs in disinvested areas of St. Louis. One of the most important principles in this work is activating the inherent potential that exists in Black and Latinx communities. We also focus across all of our work on dreaming boldly and unapologetically, challenging convention, listening and learning with humility, and focusing on results that matter to the Black and Latinx communities we work with.

Tell us a little about Elevate/Elevar. What is it, and how did its mission originate? 

WEPOWER activates community power. Recognizing that our local communities are closely tied to our local economies, the Elevate/Elevar Accelerator is the part of our work focused on economic power building and job creation. 

Elevate/Elevar is a one-of-a-kind, six-month accelerator that elevates early-stage, for-profit companies founded by Black and Latinx entrepreneurs. WEPOWER is partnering with Village Capital on the Elevate/Elevar Accelerator, as part of an international network that supports ready-to-scale companies.

Elevate/Elevar engages entrepreneurs who:

  • Identify as Black and/or Latinx
  • Run an early-stage company with demonstrated traction
  • Work in industries that can create living wage jobs that do not require a bachelor’s degree, and so can create living wage jobs for community-members living in poverty
  • Commit to their company full time or agree to make the leap once the Accelerator begins
  • Agree to our Founder’s Commitment to Community

From the beginning, WEPOWER has known that policy change and building economic power are both crucial to close the gaps faced by Black and Latinx entrepreneurs, and are excited to be launching a program that directly addresses economic power. 

What are the main goals for participants in Elevate/ Elevar? 

The intention of the accelerator is to provide cohort members with the resources they need to take businesses to the next level, acquiring capital, tools, and skills. Our quantifiable five-year goals for success are:

  • 70% rate of survival among the cohort, a significant improvement compared to other fledgling businesses.
  • 50% of companies supported through Elevate/Elevar Accelerator hire residents in North St. Louis City and pay living wage salaries along with holistic benefits, increasing the number of accessible family-sustaining wage jobs in North St. Louis.
  • 85% of workforce development programs have formal pipelines partners and strategies from which they recruit North St. Louis City residents. 
  • 85% of workforce development and startup support organizations leverage a shared technology and support team to foster connecting North St. Louis residents to employers.
  • Improved relationships between businesses & disinvested communities, built around the idea of shared power; a movement of changemakers and entrepreneurs co-creating prosperous communities.

A less quantifiable, but integral goal: to change the narrative around Black and Latinx entrepreneurs, communities, and dreams. We want to illustrate that disparate outcomes are due to unequal access to support, that Black and Latinx individuals have incredible potential, that our strength lies in our communities, that we truly can create a system where everyone supports and everyone succeeds.

Are entrepreneurs the only people who can get involved with the Accelerator? 

No, there are a number of other ways to get involved! We’re looking for people and organizations interested in sponsoring Elevate/Elevar or providing donated capital for an evergreen investment fund (the Elevate/Elevar Fund). We’re also actively recruiting mentors and guest experts — especially investors and lenders, founders who have hired/built teams, corporate executives, and other subject matter experts — to provide feedback, ideas, and connections to entrepreneurs as part of a mentoring team or on a one-time basis. Anyone interested in getting more involved as a sponsor or donating to the Elevate/Elevar Fund should reach out to yoni@wepowerstl.org. If you’d like to learn more about being a mentor, find more info and share your interest at http://bit.ly/wepowerelevatementor or email edgar@wepowerstl.org.
If you’re an entrepreneur who’d like to get involved, there’s room for you too! Entrepreneurs have already been selected for the first cohort, which will begin in March. Anyone interested in applying for the next cohort is welcome to email edgar@wepowerstl.org in order to be notified when the next round of applications open.

We know that Black and Latinx business founders have not had, and continue to lack, the same access to resources that white founders have. How does WEPOWER connect founders in your network to resources? 

Elevate/Elevar offers founders:

  • Access to seed capital
  • Training, using Village Capital’s research-based investment-readiness curriculum
  • Advising from guest experts, a team of five mentors for each entrepreneur, and two paid business coaches
  • Office hours with attorneys, accountants, HR, and marketing professionals
  • Co-working space and community

Tell us about how Elevate/Elevar connects with communities (or tell us about what community self-determination has to do with Elevate/Elevar?)

We believe that businesses are strongest with community support, just as communities are strongest with businesses that truly support the community. We’ve put a lot of thought into including community input at every stage to reinforce that cycle of support. Community members applied and nominated entrepreneurs for the cohort; community leaders partnered with us to interview applicants and select finalists; and over 800 St. Louisans voted on the finalists to select the actual cohort! During the accelerator, the cohort members will be mentored by a mixture of experts in their particular industries and community leaders, recognizing local knowledge as an important form of expertise. The accelerator will wrap up with a community pitch day, deliberately cultivating community engagement to the last; and even after exiting the accelerator, each of the businesses will partner with a community advisory board to continually foster community involvement. We’re also working with Cutting Edge Counsel and Janice Shade of Local Capital to explore what a community capital strategy could look like to fund our investments in the future.

If all goes well, what will Elevate/Elevar look like in 5 years?

In five years, we will have scaled to two cohorts a year, having supported 90 founders who will be on track to create 200 jobs in our community. With the entrepreneurs committing to hiring at or on a clear path to a living wage, this will be a meaningful addition not just of jobs but of family-supporting jobs to the local landscape. In the broader investment landscape, we hope to have shifted the narrative of what investable businesses look like, what potential looks like, and what our communities can achieve.

How can our readers get involved and support you?

We’re looking for people and organizations to join us by sponsoring Elevate/Elevar or providing donated capital for our evergreen investment fund (the Elevate/Elevar Fund). If you or your organization might be interested, please reach out to Yoni at yoni@wepowerstl.org. Readers can also choose to directly support Elevate/Elevar here: http://bit.ly/elevate-donate. We are driven by community involvement and passion — and money helps too!

We’re also actively recruiting mentors and guest experts (local and remote) to help advise our entrepreneurs — especially investors and lenders, entrepreneurs who have hired/built teams, corporate executives, and other subject matter experts — to provide feedback, ideas, and connections to entrepreneurs as part of a mentoring team or on a one-time basis. Anyone interested in getting more involved supporting entrepreneurs should email edgar@wepowerstl.org! We recognize that many different types of expertise will be valuable to our entrepreneurs, and are eager to present them with a broad range of voices to learn from. 

The guest experts will join our workshops to work with the entrepreneurs on market mapping, customer acquisition, team building, and overall investment readiness (a ~2 hour, one-time commitment). Each entrepreneur will also have a support team made up of five mentors who will meet as a team for 1.5hr/month (for 6 months) to collaborate and support them in achieving their goals. 

Insights From Innovators: TechSoup

Insights From Innovators: TechSoup

Cutting Edge has worked with TechSoup  for the past three years to provide legal strategy and expertise on their Reg A+ offering, which debuted in November 2018. TechSoup is the first nonprofit to participate in a Reg A and has seen great success in their first year. TechSoup has reached 70% of their overall capital raise goals.

Cutting Edge president, John Katovich, interviewed TechSoup VP of Development, Ken Tsunoda to discuss the successes and obstacles he has experienced in this process. In addition, Ken provides advice for other nonprofits interested in a direct public offering.

 

You can find TechSoup’s offering on svx.us.com

 

We have really enjoyed working with the TechSoup team and are excited to support them in their continued successes.

 

 

Insights From Innovators: The Staffing Cooperative

Insights From Innovators: The Staffing Cooperative

All sectors and industries need workers to function. However, too often staff can find themselves being exploited by upper management and undervalued for the work they provide. The Staffing Cooperative exists to build staffing companies where workers are in control. The Staffing Cooperative is a holding company for staffing companies. Those subsidiaries are investable Delaware corporations, but they’re all majority owned by the cooperative, which is worker-owned. This allows the workers to control the businesses and set priorities. The Staffing Cooperative believes that the equity a worker puts into the company should be valued across the whole and that workers should have the ability to determine who is in a management role. 

Cutting Edge attorney, Sarah Kaplan describes her client as, “giving people access to owning a business, access to owning their own jobs. They are turning the power structure of labor upside-down.” Working with an innovative client like The Staffing Cooperative allowed Kaplan to be creative and design a slideshow of bylaws instead of using a dense legal document. She was inspired by Janelle Orsi’s work at the Sustainable Economies Law Center (SELC). 

The Staffing Cooperative is pioneering a new structure in cooperatives. Since their inception about four years ago, they’ve created a parent holding company, The Staffing Cooperative, that oversees subsidiary companies. Currently, there are two subsidiaries. The first, CORE Staffing in Baltimore, was created in 2016. It is made up of worker-owners who have previously been incarcerated and now staff jobs in a variety of industries including construction, demolition, carpentry, food service operation, and more. Workers have the opportunity to work part-time or hourly full-time jobs. CORE allows workers to grow communally and socially as they reintegrate into society. 

Tribe is The Staffing Cooperative’s newest subsidiary of tech workers. These workers are located all over the country and are typically staffed into tech agencies as web designers, creatives, and developers. Tribe also developed the staffing platform that is used by The Staffing Cooperative, CORE, and will continue to be used by all future worker-owners. 

When asked about The Staffing Cooperative’s long-term plans, their team hopes to continue acquiring and creating new subsidiaries with workers in different industries. This would allow for a conglomerate of industry knowledge that can be used to benefit workers and the overall health of the cooperative. In addition, the goal isn’t just to acquire for growth, but to support workers long-term and provide ways for them to move between industries. Typical worker-cooperatives are not looking at scale in the same way. The Staffing Cooperative is creating a new way of thinking about cooperative potential. By being a holding company on a large scale, there’s potential for higher wages and rates, more benefits, and better insurance policies. 

We asked The Staffing Cooperative for three pieces of advice for others interested in worker-ownership models. They said: 

  • Don’t think of it as structure first, think of the worker first. 

 

  • Don’t let a company’s structure get in the way. 

 

  • Prioritize relationships. For them, it took sitting together as an entire team and hashing out what exactly membership would look like. 

 

Kaplan expressed how much she loves working with her client and that she’s “proud of them for taking the lead and creating a well-optimized structure that is designed to be accessible for investors, but the cooperative maintains control.” 

If you’re interested in getting involved or learning more about The Staffing Cooperative, you can contact them at coordinators@staffing.coop or on Twitter at @staffing_coop. They also accept donations! They’re hoping to continue growing the worker-owner training program and even have plans to launch a school through their fiscally sponsored non-profit program. To donate, email info@staffing.coop

Are you interested in learning more about structuring a cooperative? Do you want to talk to an attorney about how cooperatives can take in outside investment? Contact Sarah@cuttingedgecounsel.com

Is the IRS About to Make a Huge Mistake That Only Supports the Wealthy?

Is the IRS About to Make a Huge Mistake That Only Supports the Wealthy?

The IRS may be making a huge mistake that only supports the wealthy. (But you can help fix it.)

At Cutting Edge Counsel we stand for fairness and equity. A big part of what drives us is the need to level the playing field between the wealthy and the non-wealthy. We envision an America where everyone can invest, with the same benefits available to all investors regardless of economic status.

So we were very disappointed in a recent IRS release that will lead to the opposite result. We’re talking about some of the tax benefits of investing in a Qualified Opportunity Fund — a new type of fund that is intended to incentivize investment in low-income communities designated as Opportunity Zones, which we wrote about here.

The new tax rules are contained in Subchapter Z of the Tax Cuts and Jobs Act of 2017. Section 1400Z-2 of that new law provides for three tax benefits of investing in a Qualified Opportunity Fund (a QOF): Clause (a) provides for a deferral of tax on rolled-over capital gains until the end of 2026. Clause (b) provides for a 10% or 15% step up in basis for rolled-over capital gains held in a QOF for at least five or seven years by the end of 2026. Clause (c) provides that “any investment” held in a QOF for at least ten years will get a step up in basis to market value upon a sale of the investment. This last benefit is the most valuable of them all.

While the plain language of Section 1400Z-2 says that literally any investment in a QOF, which would include an investment of after-tax capital, can get this last benefit (tax-free capital gains after ten years), the IRS stated in an October 2018 release that this benefit is available only to rolled-over capital gains. The IRS offered no analysis or reasoning behind its statement, which suggests the IRS may have simply mis-read the statute.

This is more than just a technical detail. This is a fundamental reinterpretation of the law in a way that excludes the roughly 95 percent (i.e. non-accredited investors) who may not have capital gains to roll over. As passed by Congress, the law allows for the creation of a true community investment fund that invests in real estate projects in Opportunity Zones. Taking in investment from residents of the very low-income communities that the fund is designed to serve would help to ensure not only that the profits from those projects circulate within the community, but it would also give those residents a voice in the kind of development that happens in their communities. The benefit of tax-free capital gains after ten years in the fund can be a critical factor in attracting these investors.

But this reinterpretation by the IRS changes everything. Bear in mind that, typically, it’s only the wealthiest Americans who have capital gains that can be rolled over into a QOF. From the point of view of a QOF manager, if only the wealthiest investors can enjoy any of the tax benefits of an investment in the QOF, there is no incentive at all to open up the QOF to the less-wealthy residents of those Opportunity Zones.

Hence, under the IRS’ reinterpretation of the law, QOFs will likely be only open to wealthy (accredited) investors; and those wealthy investors will then effectively determine the kinds of development that happens in low-income communities, with no opportunity for the residents of those communities to have a voice or to participate in any way. The outcomes will be very predictable. Overwhelmingly, these wealth-driven funds will invest in so-called “market rate” housing – a euphemism for unaffordable luxury housing that is not intended to serve the residents of those communities but is intended to displace them.

It does not have to be this way; it should not be this way; and the law does not say this! Our firm has written this letter  IRS-Letter-Re-Opportunity-Fund-Tax-Benefit.pdf to the IRS pointing out the apparent error, and we have asked the IRS to clarify that the benefit of tax-free capital gains after ten years in a QOF is available for any investment in the QOF, including investments of any kind of after-tax capital, whether or not an investor is sheltering or eliminating their capital gains taxes. 

But meanwhile, we are making an ask of our community — individuals and organizations. It would be easy for the IRS to ignore one letter from a small law firm based in Oakland that only serves mission-aligned businesses. It would be much more difficult for them to ignore howls of protest from around the country. If you care about leveling the playing field (and if you’ve read this far, you likely do), we strongly encourage you to write to the IRS (addressed to CC:PA:LPD:PR (REG-115420-18), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044), or to your Congressperson, to bring this to their attention. While the official comment period for the proposed regulations has closed, we think this is too important to ignore.

And there is urgency to this, because the IRS may be finalizing their QOF regulations at this very moment. Once they have issued final regulations, it will be much harder to get them to back away from their blunder. So the time to act is now. Together, we can make a difference.