The SEC recently issued two No-Action letters providing relief from registering as a broker-dealer under Section 15(b) of the Securities Exchange Act of 1934 to two investment advisers that operate websites to solicit prospective investors. Both letters stand for the proposition that Internet-based funding can be done without registering as a broker-dealer. However, the Investment Advisers Act of 1940 is implicated.
FundersClub Inc. (available March 26, 2013) operates as an investment adviser, but relies on the exemption from registration for venture capital funds. FundersClub manages a series of investment funds that invest in one or more startup companies. FundersClub posts information about the startups on their website portal, which is only accessible to club members, who must be accredited investors under Rule 501 of Regulation D. Members may choose to submit indications of interest in a startup, and when a fund reaches sufficient level of interest the posted information taken down, members reconfirm their interest and the terms of the investment are negotiated with the startup. Members deposit their contribution into a custodial account at a bank or trust company. FundersClub provides strategic assistance to the startup, votes the investment fund’s and decides when to dissolve the investment fund. Once FundersClub dissolves the investment fund, it then takes a portion of the profits in the form of carried interest. Other than a small fee charged to cover administrative expenses, such as legal, tax and filing, the carried interest is the only form of compensation that FundersClub receives.
In determining that the SEC Staff would not take enforcement action against FundersClub for not registering as a broker-dealer, the Staff focused on several representations of FundersClub, including:
- FundersClub will only operate venture capital funds, as defined under the Investment Advisers Act of 1940;
- FundersClub will only receive carried interest, no larger than 30%, for the traditional services of advisory and consulting services, as opposed to transaction based compensation;
- No officers, directors or employees of FundersClub will receive transaction based compensation;
- All compensation paid to FundersClub and all administrative fees are disclosed to investors;
- Administrative fees are solely used to offset expenses incurred and any amounts remaining in the custodial account when the fund is dissolved are distributed to investors;
- FundersClub has no access to withdraw funds from the custodian account for its own use; and
- All employees, board members, shareholders and associated persons of FundersClub are not disqualified from membership in self-regulatory organizations under Section 3(a)(39) of the Exchange Act.
AngelList Advisors LLC (available March 28, 2013) operates in a similar manner to FundersClub, but AngelList intends to register as an investment adviser and it will only be reimbursed for administrative costs upon exiting an investment. AngelList sets up a platform where investors submit non-binding requests for information about one or more of its portfolio companies and then the prospective investor is provided disclosure documents. Once AngelList receives sufficient investment interest, it will close the interest period, create an investment vehicle and collect a subscription agreement from each investor. Once the agreements are collected, capital contributions are forwarded from the investors directly to a bank where the investment vehicle maintains its custodial account. AngelList will provide investment advice and administrative services to the investment vehicle, decide the terms of and when to disburse funds from the investment vehicles and vote on behalf of the investment vehicle.
In determining that the SEC Staff would not take enforcement action against AngelList for not registering as a broker-dealer, the Staff focused on several representations of AngelList, including:
- AngelList will register as an investment adviser and provide only traditional advisory and consulting services;
- The AngelList online platform will only be available to accredited investors and all investments will be comply with Rule 506 of Regulation D;
- AngelList will only receive carried interest at the termination of the investment and not transaction based compensation;
- No officers, directors or employees of AngelList will receive transaction based compensation;
- All compensation to be paid and any financial conflicts of interests will be disclosed in the offering documents;
- AngelList will not handle customer funds or securities and, aside from the website itself, will not solicit investors; and
- All employees, board members, shareholders and associated persons with AngelList are not disqualified from membership in self-regulatory organizations under Section 3(a)(39) of the Exchange Act.
As No-Action letters are not in themselves statements of law or policy, an investment advisor wishing to setup an internet portal similar to FundersClub or AngelList and rely on the No-Action guidance given, should be cautioned to strictly adhere to the representations made in these two letters. A deviation from the particular set of facts in these two situations could lead to enforcement action for failure to register as a broker-dealer. In addition, while there are reporting and record-keeping requirements to operate as a venture capital fund under the Investment Advisers Act, they are less burdensome than the regulatory requirements of being a fully registered broker-dealer.