In two recent "no-action" letters, the U.S. Securities and Exchange Commission (SEC) has established fairly clear rules regarding which Internet funding network sponsors may operate their funding networks without being required to register as broker-dealers. On March 26 and 28, 2013, the SEC's Division of Trading and Markets addressed this narrow, fact-specific issue in response to requests from FundersClub Inc. and AngelList LLC seeking assurances that their online investment matchmaking activities would not result in enforcement action by the SEC. The no-action letters did not take up the broader issue of whether the solicitation of investors by the Internet network sponsors would constitute “general solicitation” or “advertising” prohibited for private offerings under the Securities Act of 1933, as amended, and Regulation D promulgated thereunder.1 Nevertheless, as the SEC moves closer to issuing its anticipated JOBS Act crowdfunding rulemaking release for public comment,2 the letters provide interim guidance and, one suspects, a trial balloon for the SEC's Division of Corporation Finance to test how the rules might work in practice.
FundersClub Inc., SEC No-Action Letter (March 26, 2013)
FundersClub operates a website that provides opportunities to invest in certain private companies listed on the website. In order for a private company to be listed on the website, it must first pass an internal due diligence investigation by FundersClub. In order for a prospective investor to view the list of investment opportunities, the investor must qualify as a “member” of FundersClub. Among other requirements, an individual must be an accredited investor and wait during a 30-day cooling off period before investing.3
Once a member is qualified and permitted to see the list of companies identified by FundersClub, the member may submit non-binding indications of interest for companies in which the member would like to invest. Once that company reaches a level of interest pre-determined by the company and FundersClub, FundersClub closes the company investment opportunity to further indications of interest, reconfirms the already submitted indications and accredited investor status with the interested members, and negotiates final terms with the company. The members' investments are then aggregated into an investment vehicle and an investment in the company is made, with the investment vehicle being managed by FundersClub or its affiliates in a structure similar to a venture capital fund.
In laying out its business model for the SEC’s determination, FundersClub made the following key representations:
- FundersClub would not receive transaction-based compensation (nor would any of its officers, directors or employees), although it would receive a carried interest (or profits interest) associated with managing the investment vehicles;
- Various safeguards against general solicitation would be in place, such as a 30-day waiting period and no advertising of specific portfolio companies;
- The investment vehicles would be “venture capital funds,” as defined under the Investment Advisers Act of 1940, as amended, so FundersClub and its managers would not need to register as investment advisers;
- FundersClub would provide investment advice to its investment vehicles only, and not to investors or members on the website; and
- FundersClub would provide additional services and advice to the portfolio companies in which it invests, similar to a typical venture capital firm (such as financial and business expertise, networking and mentoring).
Based on FundersClub's specific representations, the SEC concluded that FundersClub would not be required to register with the SEC as a broker-dealer.
AngelList LLC, SEC No-Action Letter (March 28, 2013)
In AngelList, the SEC affirmed its position in FundersClub. AngelList’s business model, however, added certain complexities.
Whereas FundersClub reviews potential companies to be listed on its website and provides all the advisory services to its venture capital investment vehicles, AngelList relies on well-known, established third party "Angel Investors" or "Lead Angels" on whom AngelList would rely to perform due diligence. AngelList’s model is to coinvest in a company only with the participation or collaboration of a Lead Angel. A deal may be an “Angel- Advised Deal,” in which the Lead Angel provides many of the non-investment services typically associated with a venture capital firm’s investment (including financial expertise, mentoring and business contacts and networking), or an “Angel-Followed Deal,” in which the Lead Angel is essentially a passive investor and does not perform any of these services. Additionally, in an Angel-Advised Deal, the Lead Angel takes a leading role in negotiations with the company. Lead Angels may also receive a portion of the carried interest.
Once a Lead Angel and a company complete due diligence and are approved by AngelList Advisors (an affiliated registered investment adviser), AngelList Advisors forms a separate investment vehicle into which individual accredited investors’ contributions are aggregated. Once this investment vehicle is formed, AngelList Advisors lists the company on its website and investors may submit non-binding requests for information about the company. In order to submit such a request, the investor must submit a detailed questionnaire which, among other things, asks the investor to confirm its accredited investor status. Similar to FundersClub, the investor also must wait 30 days after submitting the questionnaire to close on the investment. Upon submission of a request for information, the investor will receive a private placement memorandum or other offering documents providing information about the company and a supplemental memorandum providing additional information about the investment vehicle, AngelList Advisors and the Lead Angel, and outlining risks associated with this type of investment and any conflicts of interest. The investor can then close the investment by executing a binding investment agreement. Unlike FundersClub, a portfolio company identified by AngelList may review and approve or reject the investors who wish to invest in it through the AngelList fund.
In describing its business model for the SEC’s determination, AngelList made the following key representations: AngelList Advisors would be a registered investment adviser; 4
- AngelList Advisors would exclusively act as an advisor to the investment vehicles, not to individual investors;
- AngelList Advisors would not receive any transaction-based compensation (nor would any of its officers, directors or employees), but it would receive a carried interest;
- Neither AngelList Advisors nor any Lead Angel would hold itself out as a broker;
- All of the investors would be accredited investors, and AngelList’s website list of investment opportunities would be available only to accredited investors;
- AngelList Advisors would not solicit investors, other than through its own website;5
- AngelList Advisors would disclose all compensation (which includes a portion of the carried interest) being paid by it and to the Lead Angel, and any conflicts of interest between AngelList Advisers and the Lead Angel; and
- Neither AngelList Advisors nor any Lead Angel would handle any customer funds or customer securities.
Based on AngelList's letter, the SEC concluded that it would not require AngelList to be registered with the SEC as a broker-dealer.
The SEC’s analysis seems to indicate that with compensation in the form of a carried interest (much like the typical venture capital fund model) and if an Internet network sponsor provides advice and assistance to the investment vehicles (rather than to the individual investors), the more likely the SEC will deem the Internet network sponsor not to be effecting securities transactions in violation of the prohibition on unregistered brokerage activities.6 Through these no-action letters, the SEC has given its imprimatur to a viable pathway to combining traditional venture capital investment with 21st century funding over the Internet.