Title III Crowdfunding Now Everyone Can Invest

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Well last Friday it finally happened. The SEC passed Title III of the JOBS Act which effectively allows non-accredited investors to invest in private placement investment deals. In plain English this means when you visit any of the crowdfunding platforms they will allow you to view and invest in their offers without confirming that you are an accredited investor. Well at least in theory this will be the case.

On the surface this seems like the day we have all be waiting for in the crowdfunding industry but in reality it may have limited impact. While everyone has been jumping for joy about the new legislation and don’t get me wrong there is a lot to jump for here, there are still some issues. The problems are basically due to the capital limits placed on the deals which can be offered to non-accredited investors. In the current version of Title III the maximum that can be raised in these offerings will be $1 Million dollars. This may seem like a lot, but for most high quality real estate deals the capital limit basically prevents any of these deals from opening up to the small retail investor.

In my opinion the greatest potential crowdfunding offers retail investors is precisely in these type of investments which are relatively lower risk investments compared to start-up investing. The limit will have a small impact on the start-up investing platforms such as seedrs.com and seedinvest.com as most of these offerings are for less than $1 Million dollars. This is the exact issue that Nav Athwal, CEO of Realtyshares.com addresses here.

There are other issues regarding the additional regulatory hurdles which will be placed in front of the companies wishing to take advantage of this new legislation as Tanya Prive points out as well. You can read more about her concerns here.

In contrast to the issues raised by Athwal who runs a real estate crowdfunding platform, Chance Barnett CEO of crowdfunder.com a platform for startups, was singing the praises for the new legislation in his article here.

The contrast of these two views I think is really dependent on what Athwal pointed out. The implications of Title III are vastly different for real estate platforms as opposed to start-up platforms. The start-up platforms have a lot to gain as most of their offerings will fit under the $1 Million dollar cap and due to inherent riskiness of investments into start-ups investors will in any case want to commit less of their money to these investments. The opposite is true for the real estate platforms, which need more capital for each deal and are inherently much more stable investments which attract larger investments from each investor, the investment caps on these type of deals will seriously hinder the participation of retail investors.

One of my major concerns as well is that when the legislation actually goes into effect the start-up platforms will be the first to adopt offerings under title III. The hype and exuberance on the part of many retail investors to get in on these deals will lead to money flowing in without sufficient due diligence and without the proper hedges against risk. Since these are the most risky investments in the crowdfunding space it is really a horrible place for us to have to start with retail investors. A few deals that go bad and with start-ups the majority go bad will put a black cloud over the industry in terms of retail investors and this is all before the real estate platforms will be able to figure out the proper way to take advantage of the new legislation.

I hope for the industry and for investors both platforms and investors will proceed with caution using the proper due diligence and diversification to invest.

Skeletons in the Closet: Due Diligence Findings

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Here is a great article from Seedinvest.com outlining their strict due diligence procedures for vetting start-ups before they launch on their platform.  Warning: some of this is  downright scary! It just proves our point that an investor needs to make sure the platform they invest through has strict screening procedures and due diligence. Keep reading and you will see why Seedinvest is a crowdtrader.net favorite when it comes to equity investing in crowdfunded start-ups.

This is what Harrison Hines from seedinvest.com had to say about their screening process.

Investors frequently ask me about our due diligence process and what we look for in a startup. We have recently started to make a portion of our due diligence findings available to investors. While the Due Diligence Summary Reports do provide some insights into our process, they still do not paint the full picture. A significant portion of our due diligence work must still be left out of the published reports due to compliance and confidentiality reasons.

In the six months that I have been at SeedInvest, I have led due diligence on over thirty companies. These companies had all made it past our initial Screening Committee. This essentially means that the companies had already passed a “sniff test” – a light due diligence that the Venture Team does before a deal is presented to the Screening Committee to ensure that there are no blatant red flags. You might expect that a company which entered formal due diligence would not have many more skeletons to uncover. However, this is rarely the case.

Over half of the companies that I have analyzed have had at least one significant red flag (revenue, customers, partnerships, product, team, use of proceeds, corporate structure, financing history, valuation, etc.) which needed to be corrected or explained before proceeding with the transaction. Often times, a company will decide to revise the terms of their financing round based on what we uncover before they launch on our platform. There are some instances, however, where the issues I uncover are just too serious, and therefore the deal has to be killed.

Many of the mistakes that I see do not stem from bad intentions; they are just naive errors that the founders could have avoided by structuring the company more carefully and taking advice from lawyers, accountants and mentors early on.

Seven of the thirty five deals that I have performed due diligence on have been killed outright. Below are a few high-level examples of deals that did not make it through the due diligence review process:

 

Startup #1:

Initial Understanding: Company had four team members.

Due Diligence Findings: Company was one guy working from home. All other team members had other day-jobs, no equity in the business, were not being compensated, and had no firm plans to join the company.

Initial Understanding: Company had 1,000 customers.

Due Diligence Findings: Company had collected 1,000 e-mails, not customers. They only had 75 users participating in a private beta.

 

Startup #2:

Initial Understanding: Company was planning to use one third of their round to pay back an old line of credit. They then wanted to open up a new line of credit to be guaranteed by the company to fund their manufacturing.

Due Diligence Findings: Company had not applied for their own line of credit yet. I requested that the company apply with the bank to see if they would be accepted – the company was denied.

Initial Understanding: Company’s wholesale margins were 30-35%.

Due Diligence Findings: Actual wholesale margins for 2014, after markdowns, were 10%.

 

Startup #3:

Initial Understanding: Company was raising at a $9.5M pre-money valuation and claimed this was fair to investors.

Due Diligence Findings: Company had raised $7.4M in total, dating back to 2012, and had a down-round financing in 2014. 2014 total revenue was under $10K.

Initial Understanding: Money company spent to date was on product development.

Due Diligence Findings: Significant portion was spent on travel, entertainment, rent, salaries, meals, and other expenses for founders.

 

Startup #4:
Initial Understanding: Company was raising $6M at a $10M pre-money valuation.

Due Diligence Findings: Company was raising $6M at a $5M pre-money valuation. Company had previously raised $5.2M dating back to 2008, and had a down-round financing in 2013.

Initial Understanding: Company had a typical CEO and management team structure.

Due Diligence Findings: Management team represented less than 1% of the equity of the company. CEO was not a founder, and was not even an employee of the company.

 

At SeedInvest, we like to say that the companies we present to our investors are “highly vetted.” The process we put our companies through to be considered “highly vetted” is no small task, for the companies or us. While this may lead to fewer companies being listed on SeedInvest, it results in a curated list of investment opportunities that we can stand behind and prevents our investors from being exposed to unnecessarily suspect investments.

 

Source: Seedinvest.com

 

 

Regulation A+ Crowdfunding

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capitol-552645_1280 Recent legislation was just passed by the SEC referred to as Regulation A+ as Title IV of the JOBS act. This new legislation will help solve a major issue faced by most crowdfunding platforms. Until now, for platforms to open up an investment to non-accredited investors the investment would need to have passed approval by each state separately subject to their Blue Sky Laws. The process was too lengthy and costly for most of the platforms to pursue which is why these investments remained closed to non-accredited investors. With Reg. A+ the SEC basically pre-empts the rights of the individual state to review the investments and allows the sponsor to open the investment to the public in the form of a mini-ipo. This pre-emption will apply to TEIR II offerings which are for funding up to $50 Million but the investors will be subject to investment limits and the offerings will be subject to greater scrutiny. The TEIR I offerings will be increased to allow fundraising up to $20 Million and a new review system will be tested referred to as coordinated review, which will be a combined effort of the states to reduce the time and effort to gain approval for an offering.

Here are the highlights of the new legislation as outlined from Kiran Lingam, General Counsel at equity crowdfunding platform SeedInvest.

  • High Maximum Raise:  Issuers can raise up to $50,000,000 in a 12 month period for Tier II and $20,000,000 for Tier 1.
  • Anyone can invest:  Not limited to just “accredited investors” – your friends and family can invest.  Tier 2 investors will, however, be subject to investment limits described below.
  • Investment Limits: For Tier II, individual non- accredited investors can invest a maximum of the greater of 10% of their net worth or 10% of their net income in a Reg A+ offering (per offering).  There is no limit for accredited investors in Tier II. There are no investment limits under Tier 1.
  • Self-Certification of Income / Net Worth:  Unlike Rule 506(c) under Title II of the JOBS Act, investors will be able to self-certify their income or net worth for purposes of the investment limits so there will be no burdensome documentation required to prove income or net worth.
  • You can advertise your offering:  There is no general solicitation restriction so you can freely advertise and talk about your offering, including at demo days, on television, and via social media.
  • Offering Circular Approval Required:  The issuer will have to file a disclosure document and audited financials with the SEC.  The SEC must approve the document prior to any sales.   The proposed indicate that the Offering Circular will receive the same level of scrutiny as a Form S-1 in an IPO.    This is the biggest potential drawback of using Reg A+.   
  • Audited Financials Required:  For Tier 2, together with the Offering Circular, the issuer will be required to provide two years of audited financial statements.  Tier 1 offerings require only reviewed financials (not audited).
  • Testing the Waters:  An issuer can “test the waters” and see if there is interest in the offering prior to spending the time and money to create the Offering Circular.  This would be “Preview” mode on SeedInvest where investors can express interest, but can’t yet invest.  This is important so that companies don’t have to gamble on their fundraise and can see if there is interest prior to investing in legal and accounting fees.
  • Ongoing Disclosure Requirements:  For Tier 2, the issuer will be required to make an annual disclosure filing, a semi-annual report, and current reports, each of which are scaled back versions of Form 10-K, Form 10-Q and Form 8-K, respectively.  These reports will also require ongoing audited financials.  These disclosures can be terminated after the first year if the shareholder count drops below 300.  There are no ongoing disclosure requirements for Tier 1.
  • State Pre-Emption:  As discussed above, the old Regulation A (now Tier I) was never used because it required registering the securities in every state that you make an offer or sales.  New Reg A+ Tier 2 preempts state law – again – this is huge.  Tier 1 Reg A+ again does not have state pre-emption but will be a testing ground for NASAA Coordinated Review.
  • Shareholder Limits:  In a welcome departure from the proposed rules, it appears that the Section 12(g) shareholder limits (2,000 person and 500 non-accredited investor) will not apply to Reg A under certain circumstances.  This fixes a major problem from the proposed rules which would have limited the potential for very small investments (i.e. $100).
  • Unrestricted Securities:  The securities issued in Reg A+ will be unrestricted and freely transferable, though many issuers may choose to impose contractual transfer restrictions.
  • No Funds:  Investment companies (i.e. private equity funds, venture funds, hedge funds) may not use Reg A to raise capital.
  • Integration:  There are several safe harbors so it seems that you can use Reg A+ in combination with other offerings.  There are safe harbors for the following:

No integration with any previously closed offerings

No integration with a subsequent crowdfunding offering

No integration where issuer complies with terms of both offerings independently – can conduct simultaneous Reg D – 506(c) offering.

Bottom line, this is what we have all been waiting for or at least sort of. It remains to be seen how quickly these filing procedures will take and whether they will be quick enough for many of the platforms to make use of. Although timing may be less of a factor when a start-up is looking for funding because their product or offering is usually unique to them, this is not the case when the offering is for real estate. Since the real estate deals are basically subject to competition between sponsors who ever can close the deal and get the financing quicker is usually the winner. The projects don’t stay on the market long enough for a drawn out funding process.

It will be interesting to see how the platforms adapt to the new legislation and whether they begin to offer investments under Reg A+. I am confident there will be a solution and we can look forward to freely investing : )

For a comprehensive update on the new legislation read the full post by Kiran here.