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Thoughts On Equity Crowdfunding Portals

I recently completed a read of “Equity Crowdfunding for Investors, A Guide to Risk, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms”, authored by David M. Freedman and Matthew R. Nutting. The book provides timely contextual descriptions, investment process education and recommendations, and resources for investors in advance of the May 2016 operational launch of equity crowdfunding (“CF”) portals. Equity CF portals will provide small companies with a capital formation conduit for raising up to $1 million annually from non-accredited investors. Non-accredited investors are subject to investment limitations in any particular (single) transaction. Equity CF portals were enabled via Title III of the Jobs (Jumpstart Our Business Startups) Act passed by Congress in 2012.

Subsequent to Congressional passage of the Jobs Act of 2012, the U.S. Securities and Exchange Commission (“SEC”) passed rules governing the conduct and registration requirements for intermediaries operating equity CF portals. The rules were finalized in January of 2016.

The SEC, pursuant to a separate element of the Jobs Act, Title II, also now differentiates two types of offerings under Rule 506 of Regulation D of the Securities Act of 1993. As noted in the book, “Regulation D is a set of rules adopted by the SEC in 1982 to clarify the conditions of certain exemptions from registration under the Securities Act of 1933. Reg D actually contains three different exemptions for private offerings: Rules 504, 505 and 506. Of the three, Rule 506 is by far the most popular; it accounts for 99% of the capital raised in Reg D offerings and 94% of the number of successful capital raises. Those include offerings on Reg D platforms.”[1. See page 25 of Equity Crowdfunding for Investors, A Guide to Risk, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms.] The SEC (since 2013) permits general solicitations of accredited investors only, so verified as accredited investors via reasonable efforts made by the offering platform (intermediary), for offerings under Rule 506(c) of Regulation D. Separately, Regulation D offerings, offered to accredited investors (and up to 35 non-accredited investors), as such status is distinguished via self-certification (vis-a-vis platform verified under Rule 506(c)), are made pursuant to provisions of Rule 506(b). I note that Mary Jo White, SEC Chairwoman, recently stated that, from 2013 through 2015, “you had about a $2.8 trillion sized market for 506(b) and about a $71 billion market for 506(c).”[2. February 10, 2016 article from ThinkAdvisor entitled “SEC Has Open Investigations of Private Offerings to Accredited Investors.”]  The SEC additionally, implemented changes to Regulation A (limited public offerings of securities) pursuant to mandates of the Jobs Act.

Online Regulation D and equity CF portals will significantly increase private company access to capital. It will be fascinating to see how these new vehicles and issuers perform from investors’ perspectives – particularly since the bulk of companies raising capital with equity CF portals may be seed and very early stage development companies. Investor caveats are highlighted throughout the Freedman and Nutting book – a book that I would generally characterize as describing an exciting and enthusiastic future for the portals. Nonetheless, in no sooner than the forward commentary of the book, provided by Charles Sidman of ECS Capital Partners, Mr. Sidman states that “even faithfully following all of this well-founded guidance (from the book), however, the deck remains stacked again the financial success of most small-scale equity crowdfunding investors for several reasons. As discussed at length in this book, early-stage investing is inescapably a risk-filled endeavor in which most ventures and commitments do not succeed. This is true even for all investors including angels and venture capitalists.”[3. See page XI of book.] Successful early stage companies and their rewarded sponsors, therefore, defy laws of probability.

The authors provide material data and statements throughout the book from experienced angel investors, venture capitalists and academics with respect entrepreneurial success rates and early stage return on investment realities. Investors should take note of the commentary. I am pleased to note that important educational features and investor certification requirements are demanded of equity CF portals by the SEC / Financial Industry Regulatory Authority (“FINRA”) – the latter the self regulatory organization to which registered broker dealers conducting Regulation A & D offerings and equity CF platform operators must belong. Investors should make a conscious and sustained effort to educate themselves in this area of investing, independent of the crowd, prior to committing capital to early stage investing.

I completed the Chartered Financial Analyst program in 1989 and previously raised senior debt, mezzanine and equity capital for businesses in private capital market transactions through registered broker dealers. As I read through the Freedman and Nutting book, I tended to reflect primarily upon how this equity CF phenomenon will play out for investors (relative to issuers). My training and experiential-related points set forth in the remaining paragraphs of this article, therefore, mainly suggest considerations for prospective equity CF investors. In my view, issuers desire and benefit from informed investors; hence I consider these observations equally value-added for such issuers.

Financial success stories receive tremendous exposure in the press. Understand, however, that investing is a risk-return proposition. Successful investors spend sufficient time evaluating BOTH of these elements of the process. Take a view to evaluating and considering your prospective and required returns on investment in a risk-adjusted framework. In addition, take a portfolio view with respect to evaluating risk-return contributions of given investments.

Know that OVERALL asset class allocation, investment time horizon, liquidity needs and diversification are among the central considerations with respect to determining your portfolio risk and returns. Think through and document your risk appetite. Maintain a risk posture consistent with a prudent risk appetite.

If you are an equity CF investor, placing, for example, $5,000 per year at risk on early stage investments, within a reasonable alternative investment allocation framework, decide (meaning analyze) if the activity over a particular time horizon (life cycle of investing for example) is worthwhile from an absolute return ($) on investment perspective. To what extent will anticipated results, in other words, make a difference to the projected terminal value of your portfolio?

It may prove challenging to contribute significant time to thoroughly evaluate the merits of each individual, relatively small investment prior to committing capital. You may enhance your chances for long term success, however, by purposefully developing a strong evaluative model or system. Professional investors (venture capitalists) develop and employ such models by nature of experience.

Recognize that issuers typically select value-added investors, particularly from the perspective of development stage and industry expertise, if afforded the opportunity, within the angel and venture capital communities. This enhances a company’s probability for success. While an individual equity CF investor may maintain marginal influence on an issuer’s decision making, I nonetheless support Freedman’s and Nutting’s view that equity CF investors should focus upon what they know. Issuers and investors will seemingly benefit from the knowledge and support of an informed ownership group in the collective.

Professional investors likewise utilize a systematic reporting and monitoring system to identify a company’s progress toward meeting strategic and operating objectives and financial milestones. This facilitates communication and collective decision making with the management team and ownership group. Keep track of what is going on to the extent possible.

Ownership fragmentation can indeed present challenges for issuers with respect to raising subsequent rounds of equity. This point receives good discussion and emphasis in the book. It seems, therefore, that platforms which pool equity CF capital into special purpose vehicles (“SPV”), would present some advantages and attraction for issuers. Investors should carefully read documentation, such as SPV LLC operating agreements, in these situations as member interest ownership transfer restrictions, and LLC member rights restrictions, with respect to affecting SPV management changes, liquidation and distributions, can potentially negative impact the values of LLC member interests.

I hope both Title II and Title III of the Jobs Act of 2012 achieve their important economic development objectives and simultaneously promote the overall economic interests of individual investors. I will certainly be watching eagerly and look forward to commenting on this in the future, accordingly.