Will SEC No-Action Relief generate more Crowdfunding Platforms in the future?

Crowdfunding, the process of attracting investment for a venture from a network of investors outside of one’s personal network – typically from new online portals designed to connect startups and investors – is poised to become the largest shift in capital flow in recent decades and is the subject of fierce debate in the U.S at the moment. Check out our recent video with Crowdfunding expert Simon Dixon, and see here for an update.

“Crowdfunding is an industry that is growing exponentially, in part because traditional sources of capital are becoming increasingly limited,” said Joe Rubin, Director and Co-Founder of FundingPost.com, one of the leaders in the large crowdfunding movement. “People are really using crowdfunding as an alternative method of financing.” The concept of crowdfunding isn’t new, Rubin noted. The Internet supercharged the ability to raise money from “the crowd” more than a decade ago, and the passage and pending implementation of new legislation is poised to have a dramatic impact on the venture world.

Published reports suggest the SEC could by this summer finalize rules for the implementation of the Jumpstart Our Business Startups (JOBS) Act. It is anticipated that the final rule making on the new law will remove the ban on general solicitation by companies seeking to sell their shares for capital, igniting significant growth in the numbers of companies seeking accredited investors via third-party online portals.

“This has been an age of angels stepping up to fill the voids left by bank loans and VCs that were decimated by the financial crisis,” said David Drake, a Partner with LDJ Capital in New York. “Angels stepped in to fill the gap and now crowdfunding, which we estimate will hit $6 billion globally in 2013, is the new kid on the block.”

In two recent no-action letters the SEC granted exemptive relief from broker dealer registration to crowdfunding sites accepting only pre-screened accredited investors on the basis that the platforms received carried interest rather than transaction based compensation. The two no-action letters were aimed at FoundersClub, Inc. and AngelList, LLC .  Although the SEC made it clear that the no-action letters are to be narrowly construed to the specific facts of each case, some commentators have extrapolated that the letters indicate that the SEC is likely to take a similar position in regard to platforms seeking to help entrepreneurs raise capital from non-accredited investors under the JOBS Act’s crowdfunding provisions. The letters don’t say anything one way or the other about unrestricted crowdsourcing of venture capital — something that crowdfunding advocates have been wishing to become reality.

Weighing in on the debate, securities attorney Simon Riveles of Riveles Law Group said JOBS Act crowdfunding portals are unlikely, however, to be able to rely on the letters issued to FoundersClub, Inc. and AngelList LLC in so far as JOBS Act crowdfunding platforms are unlikely to be compensated on the basis of carried interest and will accept non-accredited investors.

FundersClub CEO Alex Mittal is quoted at Techcrunch as saying this about the letter his company received:

“The letter is a win for accredited investors, startups, and the VC industry, and strong validation of the business model of FundersClub — to bring the transformational impact of the Internet to venture capital. It allows FundersClub to do something online that historically venture capital advisers have only done offline. Via the no-action letter, the SEC has officially recognized the legitimacy of online VC….”

While the structure and strategy employed by FoundersClub and AngelList differ in certain material respects, their central business models do not. Both companies have controlling entities that identify and vet promising early stage businesses. Once satisfied that a start-up is an attractive investment opportunity and is sound from a due diligence perspective the portals establish a wholly owned subsidiary to serve as the investment vehicle that purchases shares in the start-up. A set of pre-screened “accredited investors” may evaluate the start-up through the portals password protected web-platform and make an investment in the company through the investment vehicle established for that purpose. The platform’s sponsor provides administrative services and investment advice to the investment vehicle including exercising any management rights.

Speculating on whats next to come for everyone else, crowdfunding.org said

Given all the restrictions imposed by Title III of the JOBS Act for crowdfunding platforms that desire to be open for non-accredited investors, there may be very, very little in the FundersClub and AngelList models to imitate”.

Certainly in my opinion, the recent development does not open the door to lower net worth or lower income individuals investing online.  The reason is traditionally, securities law has restricted venture investing to “accredited investors,” meaning those who are high net worth or high income.  This law is designed to protect financially-unsophisticated members of the public.   These letters don’t change that.  Both AngelList and FundersClub deal with accredited investors only.

According to Mr, Riveles, the no-action letters in FoundersClub and AngelList do not represent a relaxation of the securities laws regarding private offerings and are not likely to have an impact on implementation of crowdfunding under the JOBS Act. Nevertheless, the letters remove an important potential impediment to migration of venture capital investing to the web and are likely to encourage additional players to enter the space – particularly in light the freedom to market generally promised by the lifting of the ban on general solicitation. Companies seeking to operate online crowdsourcing platforms should be very careful when designing the compensation and fees structures associated with their related investment vehicles.

Image credit: crowdfunding.org