Friday, April 19, 2013

Accredited Crowdfunding Portals Receive No-Action Relief from the SEC

In my previous blog, I described the FAQs released by the Staff of the Securities and Exchange Commission (the “SEC”) earlier this year addressing the new exemption from broker-dealer registration found in Title II of the JOBS Act (codified as Section 4(b) of the Securities Act). On March 26, 2013, the SEC granted no-action relief to FundersClub, Inc., an operator of a web portal that intends to comply with this new exemption. On March 28, 2013, the SEC granted a similar no-action relief to AngelList. These no-action letters are an excellent illustration of how the new exemption will work in practice.

Let’s first take a look at the FundersClub letter. The proposed structure looks like this. FundersClub, Inc. is a Delaware corporation and is the sole owner of FundersClub Management LLC, which is the manager of investment funds formed to invest in start-up companies (usually one fund per start-up). The parent entity operates a website portal that provides information about pre-selected start-up companies. Only accredited investors can become members of the club. Once FundersClub Management LLC decides to invest in a start-up, it enters into a non-binding agreement with that company, identifying the target amount of investment. Then, FundersClub posts information provided by the start-up company on its website,, which is only available to members.  Members submit non-binding indications of interest. Once sufficient interest is reached, FundersClub forms an investment fund (a Delaware LLC) where members invest. All money is kept in a custodial account with a bank or a trust company and later invested into the start-up. FundersClub Management LLC exercises management rights and provides the start-up with strategic and networking assistance. It can vote the investment fund’s shares and can even sell them because the individual members are not record or beneficial shareholders of the start-up company. There may be an initial administrative fee charged by the fund to its members to cover the organizational expenses. The manager intends to be compensated by receiving a carried interest of 20-30% upon the fund’s liquidation. In particular, the waterfall would look as follows: upon liquidation, the proceeds of the fund would (i) first, be used to pay any expenses of the fund and the administrative fee, if not yet paid; (ii) second, to repay the capital contributions of each member; (iii) third, to pay a percentage of profits to the members on a pro-rata basis; and the remainder would be paid to FundersClub Management LLC as carried interest.

The Staff granted the FundersClub entities no-action relief for not registering as broker-dealers pursuant to the exemption found in Section 4(b) of the Securities Act. In arriving at the decision, the Staff noted that (i) the FundersClub entities are advisers solely to venture capital funds; (ii) their compensation (carried interest) is advisory in nature, and is not transaction-based; (iii) the amount of compensation is fully disclosed to the investors at the time of investment; (iv) the administrative fee is used to reimburse third-party expenses and is not paid to the FundersClub entities or their affiliates or principles; and (v) all investment money is kept in a separate custodial account and cannot be accessed by the FundersClub entities for their own use.

Now, let’s take a look at the no-action letter issued to AngelList. Currently, AngelList LLC operates a website that permits start-up companies to network with angel investors. AngelList provides companies and investors with standard form documents for investments and refers them to Second Market, a registered broker-dealer, to complete the investments. AngelList proposes to form AngelList Advisors LLC as its wholly-owned subsidiary. AngelList Advisors will be a registered investment adviser either with the SEC or in one or more states. AngelList Advisors will establish a separate website (or a portion of the existing website) which will assist investors and start-up companies. All portfolio companies that can participate on the website will have to go through a due diligence process and meet certain criteria. Lead Angel investors (accredited investors leading the deal) will also be subject to due diligence and approval by AngelList Advisors. Upon approval of both the portfolio company and the Lead Angel, AngelList Advisors will form a separate investment vehicle (either an LLC or an LP) for the purpose of investing in that one portfolio company. AngelList Advisors will provide initial capital needed in setting up the fund. Once the fund is formed, AngelList Advisors will make the potential investment opportunity be known to the investors who participate on the platform (only accredited investors are allowed to participate). Interested investors will submit a non-binding request for information, along with a questionnaire certifying that the investor is an accredited person. Investors have to agree to wait at least thirty days from that time to complete the investment. There are two investment models described by AngelList Advisors in the no-action letter. The first model is very similar to the one to be used by FundersClub. The second model is referred to as “Angel Advised”, whereby the Lead Angel takes on an active role in negotiating the investment, provides material managerial assistance to the portfolio company, invests at least 20% of the target amount, and in compensation, shares the carried interest with the AngelList Advisors.

As you can see, both no-action letters provide practical guidance to other accredited investor portals on how to avail themselves of the exemption from broker-dealer registration that has become available as part of the JOBS Act. Although the analysis is very fact-specific, there are main overarching factors that are instrumental in structuring the portals: (i) no transaction-based compensation but carried interest is permissible; (ii) no handling of investor money; (iii) all investors must be accredited, and (iv) the offerings must be conducted pursuant to Rule 506.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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