On March 26, 2013, the United States Securities and Exchange Commission (SEC) issued a no-action letter to FundersClub Inc. and FundersClub Management LLC. There has been speculation in the crowdfunding, VC and angel investor communities that this no-action letter may permit an important new funding model.
By way of background, "no-action" letters can be requested by the public from SEC staff to clarify whether a particular product, service, or action would constitute a violation of U.S. federal securities law. If the staff grants the request for no action, that means that staff would not recommend that the SEC take enforcement action against the requester based on the facts and representations described in the request. The no-action relief is limited to the requester and the specific facts and circumstances in the request.
FundersClub Inc. operates a public website that serves as a platform by which accredited investors who are members of FundersClub can access private investment opportunities in start-up companies vetted and curated by FundersClub. In general, here is how FundersClub works: FundersClub’s public website allows users to view unrestricted general information about FundersClub, its business model and the investment process. To learn more about investing in start-ups through FundersClub, a website user needs to sign in and confirm its status as an accredited investor and become a member of FundersClub. A member can then browse opportunities to invest in funds established and managed by FundersClub Management (“FC Management”), a wholly owned subsidiary of FundersClub Inc., specifically for investment in the start-ups that FundersClub has identified. A member cannot seek to invest in a fund managed by FC Management without taking certain steps, as detailed in the no-action letter and on the website, including the completion of certain legal documents and provision of payment information.
The investment fund established by FC Management is itself the actual investor in a start-up. After identifying and performing due diligence on the start-up, FC Management enters into a non-binding term sheet with the start-up that specifies a target amount of capital that the FC Management-managed investment fund may invest in the company. FundersClub then posts this information on the private section of its member website, along with the standard legal documents for a member’s investment in the investment fund. After members have indicated interest sufficient to meet the investment target, FC Management negotiates with the start-up the final terms of its fund’s investment in the start-up, including the post-investment management rights that FC Management will have in the start-up, such as voting rights and rights to access books and records. A member’s requested investment in an FC Management-managed fund is not completed until FundersClub reconfirms the member’s (i) interest in the investment, (ii) status as an accredited investor, (iii) legal documents submitted in connection with the investment.
When FC Management reaches a definitive agreement with a start-up on the terms of investment by the investment fund, FC Management then signs the limited liability company agreements with the FundersClub members seeking to invest in the fund and closes the fund. Investors in the fund provide their capital directly to a custodian, which provides periodic statements for the investment fund to fund investors. The investment fund’s investment in the start-up is then funded directly by the custodian. As a result of this process, FundersClub does not handle any customer funds or securities. The money invested by fund investors and funded to the custody account may include an administration fee, which had been disclosed to fund investors in the legal documents for the fund. None of the administration fees can be paid to FundersClub or any of its affiliates or principals.
Prior to the submitting the no-action letter, neither FundersClub nor any of its directors, officers or employees received any compensation, including management and transaction-based compensation, in connection with any of the activities resulting in a fund’s investment in a start-up. In the no-action request, however, FundersClub noted its intention to potentially earn and receive a carried interest for the management of its investment funds. The amount of the carried interest would be disclosed in fund documents to potential investors in the fund and would be generally be equal to 20% or less of the net profits earned by the fund at the time of the fund’s liquidation (but could be as high as 30%). FC Management would not earn any annual management fee. In explaining FundersClub’s proposal to potentially earn and receive carried interest, the no-action request stressed that both FundersClub Inc. and FC Management satisfied the definition of a “venture capital fund adviser” as defined in Section 203(l) of the Investment Advisers Act and that the investment funds managed by FC Management satisfied the definition of “venture capital fund” in Rule 203(l)-1. FundersClub further stressed that the carried interest it could earn and receive was a “traditional venture capital fund adviser type of compensation” and cited a line of SEC no-action letters in which the SEC concluded that an investment adviser receiving typical investment adviser-style compensation would not be required to register as a broker or dealer.
Perhaps FundersClub could have left the argument there. However, it also undertook to comply with all of the requirements in Section 4(b)(2) under the Securities Act, which was added (together with the other paragraphs of Section 4(b)) by Section 201(c) of the JOBS Act in July 2011.
Section 4(b) states, in full, that:
(1) With respect to securities offered and sold in compliance with Rule 506 of Regulation D under [the Securities Act], no person who meets the conditions set forth in paragraph (2) shall be subject to registration as a broker or dealer pursuant to section 15(a)(1) of this title, solely because—
(A) that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitation, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through other means;
(B) that person or any person associated with that person co-invests in such securities; or
(C) that person or any person associated with that person provides ancillary services with respect to such securities.
(2) The exemption provided in paragraph (1) shall apply to any person described in such paragraph if—
(A) such person and each person associated with that person receives no compensation in connection the purchase or sale of such security;
(B) such person and each person associated with that person does not have possession of customer funds or securities in connection with the purchase or sale of such security; and
(C) such person is not subject to a statutory disqualification as defined in section 3(a)(39) of this title and does not have any person associated with that person to such a statutory disqualification.
(3) For the purposes of this subsection, the term ‘ancillary services’ means—
(A) the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and
(B) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.
The SEC has described Section 4(b) as providing an automatic exemption from the broker-dealer registration requirements for “so-called Regulation D portals.” The SEC has also stated that the exemption applies only when securities are offered and sold under Rule 506 of Regulation D, and that the “platform or mechanism” by which such transactions are conducted can be through an Internet website or other mode of social media. The wrinkle for FundersClub may have been due to the SEC’s statement that it would broadly interpret the term “compensation” in Section 4(b)(2)(A) to include any “direct or indirect economic benefit.”
The SEC provided the no-action relief requested by FundersClub, based on its representations that both FundersClub Inc. and FC Management are advisers solely to venture capital funds as defined in Rule 203(l)-1 under Advisers Act and that, in essence, FundersClub (including its officers, directors and employees) would not receive any compensation or fees whatsoever, including transaction-based compensation or fees, for its services other than the carried interest for its “traditional advisory and consulting” services, and that FundersClub would comply with all of the provisions of Section 4(b)(2) under the Securities Act.
Reaction to the no-action letter has been generally quite positive, with some articles suggesting that the no-action letter removes “significant obstacles” to online private offerings made under Rule 506 of the Securities Act. We disagree that the no-action letter goes that far. In fact, we wonder, however, does the no-action letter really provide any significant new insight into the relevant provisions under the Dodd Frank Act, the JOBS Act and related SEC rules? Or even the line of no-action letters cited by FundersClub as permitting it to receive carried interest in the manner described without requiring FundersClub to register as a broker or dealer? In short, our view is that the no-action letter is most helpful in clearly laying out a business model that may prove attractive to everyone in the space -- from angel investors to early-stage companies. The letter also reaffirms the view that accredited investors can be “solicited” via a public website for participation in private offerings, in compliance with the Securities Act, provided that the accredited investors are carefully identified as such and a sufficient period of time lapses between the identification of the accredited investor and its participation in a private offering. But the letter does not provide any relief from the rules that fence in FundersClub’s potential ability to change its business model or significantly grow: the SEC itself has stated that, due to the prohibition on compensation in Section 4(b)(2), it believed “as a practical matter” the exemption would not be available to a person “outside the venture capital area.” Furthermore, the relief under Section 203(l) and related rules under the Advisers Act and under Section 4(b) under the Securities Act is limited, and to avoid registration either under the Advisers Act or as a broker-dealer, FundersClub must continue to comply with all of the representations in its letter and the laws they invoke.
We also believe that participants in the online private offering space, not only FundersClub but also companies like AngelList (which received its own SEC no-action relief just a few days after FundersClub) and SecondMarket, will be impacted more significantly by anticipated SEC rules that further implement the JOBS Act by permitting general solicitation with respect to offers made under Rule 506 and that address the process for accrediting investors.
Remember as well that the no-action letter only covers U.S. securities laws - if the online platform, investors and/or start-ups are outside of the U.S., securities laws of other jurisdictions will also apply.