A Prerequisite: Pre-IPO Private Placements Tuesday, November 17, 2015, 8:30AM – 9:30AM EST Presenters: James R. Tanenbaum, Partner, Morrison & Foerster LLP Anna T. Pinedo, Partner, Morrison & Foerster LLP 1. Presentation 2. Morrison & Foerster LLP Client Alert: “Following the Wisdom of the Crowd?” 3. Morrison & Foerster LLP Client Alert: “SEC Proposes Rule Changes to Pave the Way for Intrastate and Regional Offerings” 4. Morrison & Foerster LLP User Guide: “Matchmaking Basics: How it Works, Current Regulations and Key Considerations” 5. Morrison & Foerster LLP User Guide: “Investor Criteria for U.S. Private Placements and Other Offerings” 6. Practice Description: Late Stage Investments

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Pre-IPO Private Placements

Overview

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The JOBS Act and private offerings • Although the aspect of the JOBS Act that has received the most attention relates to changes to the IPO process, in large measure, the JOBS Act related changes affecting the private market may be more significant. • Title V and Title VI changes to the Exchange Act Section 12(g) threshold • Changes to Rule 506 • Legal certainty for matchmaking platforms • Taken together, these measures have the effect of permitting companies to stay private longer and to rely on exempt offerings (while enabling companies to contact a broader range of potential investors) for their capitalraising.

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Reliance on private or exempt offerings • Even pre-JOBS Act, based on various studies, it was already the case that more capital was being raised in reliance on Regulation D and Rule 144A (in aggregate) than in SEC-registered offerings—according to the SEC’s Division of Economic Research and Analysis (DERA), in 2012, for example, the total raised in registered offerings was $1.2 trillion whereas the total raised through all private offerings was $1.7 trillion • Amounts for private offerings are likely to be understated given that many issuers fail to file Form Ds and amounts raised in 4(a)(2) offerings are not reported • The amounts raised in registered offerings include debt offerings, whereas the majority of Reg D offerings involve equity or “new capital” • These trends are likely to have become more pronounced since 2012

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Reliance on private or exempt offerings • Many companies that were able to deregister following the JOBS Act have done so • Since the JOBS Act, approximately 90 banks have deregistered • These banks will now have to rely on private or exempt offerings in order to raise capital going forward • Companies are choosing to defer their IPOs and rely on private financing for much longer than in the past • This is evident from various IPO reports • For example, based on statistics for the period from 1/1/12 through 9/30/15, the median market cap for IPO issuers was approximately $386 million, and the average was $1.4 billion • Fewer than 2.5% of IPO issuers have a market cap of $50 million or less

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Venture-backed companies delaying IPOs • U.S. IPOs by venture-backed companies fell to a two-year low in the first quarter of 2015 (National Venture Capital Association and Thomson Reuters) • Venture-backed tech companies have raised more capital in the private market ($20 billion) than the public market ($600 million) in the first five months of 2015 (CB Insights) • October 19 Wall Street Journal headline: Tech Startups Feel an IPO Chill

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Recent high profile pre-IPO private placements $1.5B

$500M

$367M

$1.0B $350M

$537M

$275M

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$526M

$2.8B

$300M

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Rationale • There may be a variety of different motivations for a late stage or preIPO private placement • Company may want to defer IPO and need to raise additional capital prior to the IPO • Company may want to take out early friends and family and angel investors and “clean up” balance sheet or provide partial liquidity for longstanding holders • Company may want to bring in strategic investors • Company may be advised that it should prepare itself for the IPO by gaining support and validation from key sector investors that are opinion leaders • Company and bankers may want to “de-risk” IPO by bringing in cross-over investors that will also invest in the IPO • Company may be advised that an up round will make higher IPO pricing easier for IPO investors to accept • May be quite sector dependent

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Biotech “case study” Percent of Life Science IPOs With Financing Event Within Six Months Before IPO

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Biotech “case study” Percent of Life Science IPOs with Existing Investor Participation

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Private Company Late Stage Investments

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Late stage investment characteristics • Impact on structuring and negotiating • Typically made into existing, relatively mature companies • Late stage • Proven product viability • Exhibits signs of increasing adoption and revenue growth • Focused on marketing and sales

• Very late stage • Cash flow is dependable • Past initial hyper-growth period and reasonable to expect sale or IPO within 12 – 24 months

• Larger and more diverse groups of existing shareholders • Founders, current/former management, employees, seed, family, high networth, early stage institutional venture and professional angels • Each group has different levels of involvement, varying rights and protections tied to equity and divergent objectives for investment • Founders/management may be significantly diluted by investment — need to create alternative incentives for them • Start-up, seed investors may desire quicker exit at lower valuation This is MoFo.

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Late stage investment characteristics (cont’d) • Reasons for seeking investment may vary • • • • • •

Expansion or acceleration of growth Existing shareholder liquidity Recapitalization Postponing exit to secure higher valuation Other extraordinary event for company Raising profile among IPO bankers

• By their nature, investments may require more extensive and complex due diligence • Current capitalization and issued/outstanding securities (accredited vs. nonaccredited former employees) • Existing shareholder rights • Liabilities — complex credit facilities • IP — may not have hit the “radar” of larger companies or trolls until $50mm in revenue; large enough to sue

• Control issues (above 20-30%) — subsidiary or affiliate status This is MoFo.

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Types of securities • Late stage equity • • • •

Typically equity deals based on the previous A-D series of preferred However, later stage deal can depart greatly from venture Can be greater upside depending on liquidation preference Key is calculation of preference, whether there is participation and whether/how many additional rounds to exit

• Alternative is to take debt that looks like equity and includes: • • • • • •

Interest payments to match PIK dividends Mandatory prepayment on trigger events to match redemption rights More financial control in terms of covenants Possible security interest in assets of issuer Convertibility features and warrant coverage Complications involve intercreditor/subordination issues with other lenders, particularly financial institutions • Less up-side, particularly in IPO, and therefore utilized more in pre-sale transaction • Consider tax issues (treated as equity) This is MoFo.

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Types of securities (cont’d) • Common stock versus preferred stock • “Growth equity” almost always preferred stock with preference on liquidation • Basis for preferred stock is previous series with departures in later stages for: • • • •

Conversion rights Liquidation and participation with common stock in remainder (usually capped) Dividend rights more often accrued and cumulative Board representation and approval is also critical (look for over-representation of early series with lower preference trigger for returns) • Control of triggers for drags and tags

• Common stock used for companies with simplified cap structures and if very close to exit (particularly IPO) • Depending on valuation and prior preferences, can give investor larger % and return • Can be used to “top up” ownership percentage after purchase of company issued securities (particularly through secondary)

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Pricing considerations • Calculating price per share • Complex process for investor • Commonly based on: • Pre-money valuation (common equity value of the company before investment)

• The pre-investment issued and outstanding shares of common stock plus all preferred stock on “as-converted” basis • May or may not be “fully diluted” (see next slide) • Also have to consider factoring in of SAR or “profit” interests to be paid out on certain events (including M&A)

• Price Per Share = Pre-money Valuation + Issued and Outstanding Shares of Common Stock on as-converted basis • Higher valuation for late stage will yield much lower percentage ownership for investment • Note usual requirement of additional value in M&A — right of first offer or notice

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Pricing considerations (cont’d) • Not fully diluted • Only includes issued and outstanding common stock • Excludes all shares underlying outstanding common stock equivalents (i.e., outstanding convertible debt and preferred stock, warrants and management equity incentives)

• Fully diluted including outstanding equity incentives • Includes issued and outstanding common stock measured on a fully diluted basis • Includes all shares underlying issued and outstanding common stock equivalents (i.e., stock options issued to management), as if these equivalents have been converted or exercised

• Fully diluted including entire equity incentive plan • Includes issued and outstanding common stock measured on a fully diluted basis; and, • Includes all shares of common stock underlying management equity incentive plans that are not yet subject to outstanding awards

• Fully diluted including increase to equity incentive plan • Same as above but also includes any increase to the management equity incentive pool that the investor proposes as part of the deal This is MoFo.

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Anti-dilution rights • Provisions require issuances of additional company securities under certain circumstances • Specific issues for late stage include: • Price for late stage investor that triggers rights — particularly if have to pay a much higher valuation • Full ratchet versus weighted average — can negotiate full ratchet if high valuation; however, this is very unusual; previous investors usually require weighted average using same formula as previous rounds

• “Pay to play” — much less common in later stage rounds (unless down-round) but may be required as condition to consent from early investors; if don’t participate, then lose anti-dilution protection: late stage investor more likely to receive antidilution rights in such cases • Exempt securities — issuances that trigger anti-dilution; much more heavily negotiated in late stage; issuer often desires to use equity in acquisitions and third party partnerships without triggering anti-dilution

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Participation rights and restrictions • Right of first refusal (“ROFR”) • Mirrors rights of previous investors to have the right to buy when designated stockholders sell • Issues around percentage trigger for stockholders who are subject to the right • Usual threshold is 1-5%; however, if retain same threshold, (a) aggregation of sales can have material impact and (b) may exclude senior management (if you don’t want them to sell out) because of dilution in round • Late stage investors typically not subject to ROFR

• Right of first offer • Typical right to have securities offered by the issuer first to investors prior to third parties • With later stage, because of lower % and higher valuation, can also include a right to buy-up to maintain ownership percentage in all securities issuances (including those that would previously be exempt) • Particularly important because of use of equity in M&A and partnerships and for employee/management consideration • Pricing is the key given typically high valuation for late stage (i.e., do the purchases outside of financings need to be at the investment valuation) • Also make sure to add “evergreen” true-up provision to provide flexibility in terms of timing and deal terms

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Stand-still provisions • Stand-still provisions more common in M&A transactions

• Sometimes asked of investors in late stage deals, particularly of strategics • Investor is obligated to refrain from actions that relate to acquisition of control of the issuer including making proposals to acquire the issuer, buying shares, or launching a proxy contest • Exceptions • Negotiated sale • Agreed-to-limits • Other investor action

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Transfer restrictions • Right of first refusal • Somewhat unusual for late stage investor to be subject to ROFR (and offer first to company and other investors) • Investor does not want to limit liquidity options • Will push for rights to purchase when others sell to maintain % ownership

• Tag-along • Almost always secure tag-along rights in M&A

• Drag-along • Almost always negotiate for rights to drag other investors • Late stage investor will not want to be subject to the drag except under certain conditions; negotiate for control to approve the transaction that triggers the drag rights • Alternative is protective provision - blanket right to approve sale (or more likely sale below dollar threshold to return liquidation preference) • Consider who else is required to trigger drag (what stockholders groups/classes are required – effectively a block on sale)

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Transfer and investment restrictions • Transfer to “competitors” • More heavily negotiated definition of competitors to whom investor may not transfer—current and future competitors

• Negotiated “update” rights to list of competitors

• Related – negotiation of the right for strategic investor to make investment in competitors of company • Particularly important to issuer if investment is coupled with strategic partnership • Key is definition of competitor – by type of product and/or by name – and update rights over time • Also negotiation regarding steps to be taken if investor buys into a competitor either directly or indirectly

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Right of first look for M&A • Right of first offer • Notice period • Negotiation period • Other potential rights

• Right of first refusal • Investor friendly • Chilling effect on competitive M&A • Terms of transaction

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Protective provisions — charter/contractual • High valuations at later stage yield minority investments and therefore protective provisions are usually stronger • Negotiate to include strong affirmative covenants • Financial and other information delivery rights • Registration rights and rights in M&A • Redemption rights

• Negotiate to include strong negative covenants • Specify the actions that the company may or may not take without specific vote of the class • Usually include all of the “ordinary course” provisions from venture – related to sales of company or assets, bankruptcy, expansion of option pool, IPO or sale • Expanded to include financial covenants, additional of debt, acquisition strategy, partnerships, management changes, etc.

• Contractual remedies for failure particularly with affirmative covenants – e.g., right to take over board if fail to redeem

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Liquidation preference • Liquidation preference of the investor’s preferred stock • Typically senior to all other outstanding classes or series of common stock and preferred stock • Sometimes pari passu to an existing series of preferred stock, particularly if the investment is priced as a flat or up round (using the same or higher pre-money valuation as the previous financing round) • Typically includes all accrued and accumulated dividends in the liquidation value of the preferred stock • Usually participating (sharing in any residual liquidation value of the common stock on an as-converted basis) • If participating, is generally not capped in a down round investment, but usually capped (by dollar amount or multiple of return on investment) in a flat or up round investment

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Dividend rights • Dividend terms for preferred stock: • Typically accrue a fixed dividend on the original liquidation value, with the dividend rate typically higher than in early stage deals (which typically have lower fixed dividend rates if they accrue a dividend at all) • Are more likely than those in an early stage deal to be payable periodically in cash and, if not, are usually cumulative, unlike those in early stage deals, which are usually non cumulative even when they do accrue a dividend. In addition, the cumulative dividend is often compounding (earning a dividend on the accrued dividends) on a quarterly or annual basis (whether or not declared by the board) • Often allow accumulated dividends to be convertible into common stock or, in some cases, are payable in cash on conversion (rather than forfeited on conversion as with many early stage deals that have cumulative dividends) • Participating, with the right to share pro rata on an as converted basis in any dividends paid on the common stock

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Redemption rights • Redemption rights – much more common in late stage deals • Not preferred exit method because investor relies on upside return of their underlying common equity value rather than minimal return of redemption and risk of non-payment of redemption price if company is struggling • Primary issues to consider: •

What securities will be redeemed and how many shares?

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Which particular stockholders will be redeemed or whether the redemption will be pro rata for all stockholders?

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Full redemption or partial redemption?

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Tax implications of the redemption

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Manner of redemption

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Redemption rights (cont’d) • Redemption rights — manner of redemption •

Cash redemptions  Question of whether company funds the redemption with existing cash on its balance sheets, with proceeds of the investment or from the proceeds of new debt

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Debt securities  The terms of interest on the debt, including the interest rate, the frequency of payment and whether interest is paid in cash or PIK  Principal payments, including the final maturity date and whether there are any scheduled prepayments or mandatory prepayments under certain conditions (such as on a change of control of the company, a sale of assets or excess cash flow)  Whether the debt is secured and, if so, which assets serve as collateral  The liquidation priority of the debt relative to any other debt of the company or relative to the growth equity investor's investment  The type of covenant protections and default remedies, if any, available to the existing stockholders

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Redemption rights (cont’d) •

Exchange structure •

Full or partial exchange used to readjust post-investment equity capitalization

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Exchange of common or common equivalents for new non-converting preferred

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Dilutes existing/non-participating investors

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Demand registration rights

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Piggyback registration rights

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S-3 registration rights

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Expenses

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Indemnification

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Additional Investment Considerations

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Representations & warranties • How much to rely on work of previous investors in diligence • Careful to distinguish between strategic and financial investors given risk profile and desired outcomes • Timing of last investment and composition of investors

• Usually include more detailed representations and warranties and disclosure schedules • • • • • •

Longer operating histories More “material” agreements, partnerships, joint ventures More complex balance sheets U.S. regulatory compliance – issues like privacy and environmental matters International compliance – issues like FCPA Intellectual property issues

• Indemnification • Unusual in early stage because issuer has few assets and founders would need to guarantee indemnification obligations • Much more common in late stage; protects against the down-side and provides increased incentives for full disclosure This is MoFo.

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Closing conditions • Typical conditions — differences from traditional VC deal • Early stage has fewer “outs” while closing conditions for late stage may more closely resemble M&A • Regulatory compliance (e.g., anti-trust waiting period) • Preemptive rights waivers (separate from consents) • Material adverse change/effect on issuer

• Bring-down of reps and which ones will provide “out” if there is a change • Depends on company and industry • Legal opinion issues

• Termination provisions/termination fees • More likely to include fees to cover expenses and to serve as deterrent to sale of issuer during interim closing period • Particularly important if combined with strategic deal

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Secondary purchases • Secondary purchases — often combine investment directly in issuer with purchase in secondary directly from existing stockholders • “Cross-purchase” structure • Less cash from investment available for company • Typically purchase of common stock from management and employees to provide liquidity • Can also purchase preferred from previous investors particularly those that need exit given LP demands  Note issues particularly with liquidation preferences and other terms not desirable to late stage investor  Can’t change charter rights of class but can change contractual rights  In contract rights, particularly important to ensure that you can bundle secondary shares with primary securities for co-sale, tag and registration rights

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Tender offers • Disclosure and process issues under the tender offer • Use of third party platform (e.g., Nasdaq Private Market) but administrative hassle • Not subject to tender offer rules but important that it be “fair” particularly if insiders are selling • Information prepared by the issuer and included in OTP but investor effecting the purchase and taking • Note issues with options (net exercise feature) • Issues with international stockholders/employees — tender offer rules in different countries • Mitigate risk through indemnification • Also need true-up in company issued securities recommended as opposed to allowing a “double dip” by participants • Risks mitigated further by purchasing directly from issuer and requiring issuer to effect tender

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Confidentiality issues • NDA subject to public company disclosure requirements • NDA for strategic partnership vs. investment • Carve-outs for: • Confidential information provided to Board representative • Related information learned from other parties (particularly other Portcos) • Residuals • Ability to use residuals to develop competing products • “Residuals” defined as in material in the “unaided” memories of employees who have access to the confidential information • “Unaided” if employee does not intentionally memorize or retain

• Info Rights/Access = back-door standstill • Insider trading considerations • Back-door standstill in M&A • Section 16 • 5-10% ownership (13G)

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Board seat • Private company issues • Board seat or observation rights? • May have confidentiality issues with board seat if equity investment is combined with strategic partnership • Need to carefully consider composition of board – particularly given approval of M&A – and incentives of early investors, particularly in event of liquidation event • Often necessary to push for removal of certain board members so early investors do not have too much control in M&A

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Material Non-Public Information and Valuation Issues

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Insider trading • Generally, most market participants associate concepts of “insider trading” with publicly traded securities • However, the prohibition on insider trading stems from Rule 10b-5, which, by its terms, is not limited to “public” companies • How should private companies think about insider trading and the information that they make public or that they are required (contractually) to share with certain parties? • • • •

Information requirements? “Regulation FD” parallels? What constitutes “current information”? What can we learn from information requirements applicable to other exempt offerings? • Should private companies implement trading windows?

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Valuation • How are the shares of privately held companies valued and who is responsible for valuations? • The IPO prices for many companies that have gone public have been lower than the prices at which these companies had last raised capital privately and lower than the prices at which secondary private transactions were completed • Private companies also have been able to raise money at higher premiums than their direct competitors who are public • What does this suggest, if anything? • Are investors no longer applying a “liquidity discount”? • Is the premium associated with the liquidation preference that typically accompanies preferred stock rounds only? • In IPOs, investment banks in pricing the IPOs and IPO investors demand an “IPO discount” (“IPO underpricing) • When VCs or “cross over investors” participate in successive private financing rounds, often they can negotiate for themselves downside protection, including protection should the company go public at a lower valuation—but what about participants in secondary private markets? This is MoFo.

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Valuation

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Valuation • Can the late stage investor/fund face any liability in connection with valuation issues? • Is the investor buying newly issued shares or shares from an existing holder? • Is the existing holder selling to the late stage investor sophisticated? Can s/he evaluate the company and its value as well as the late stage investor? • What information is available to the existing holder? Does the late stage investor have more information? Better information? • Will the late stage investor be shaping the IPO? Influencing the IPO price?

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Considerations for the Placement Agent

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Process considerations  Typically, the investors in late-stage private placements will be institutional investors that have their own internal teams to conduct diligence and to evaluate the investment and the investors will be represented by counsel  However, there are a number of considerations for the placement agent; placement agent will want to:  Ensure that it obtains from each institutional investor a letter to the effect that the institutional investor is an “institutional account” for FINRA purposes and is not relying on the placement agent for any suitability determinations or recommendations  Ensure that all investors are “institutional accredited investors” in order to avoid having any FINRA private placement filing obligations under FINRA Rule 5123  Exclude any individuals, such as “friends and family” of the company or “friends and family” of fund investors—otherwise, the placement agent will be deemed to have KYC obligations, be required to make suitability determinations, undertake AML and similar investigations for each such investor, etc.  Encourage the issuer to rely on Section 4(a)(2), and not on Rule 506

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Process considerations  Placement agent can consider:  Obtaining FINRA institutional account letters for its files  Obtaining a separate side letter  Relying on a representation from the investor in the securities purchase agreement

 Regardless, the placement agent as a broker-dealer and FINRA member will have a due diligence obligation  Placement agent should have all the reps and warranties in the securities purchase agreement made to it (or be a named third-party beneficiary)  Notice 10-22 reminds broker-dealers of their diligence obligations in connection with Regulation D offerings  Notice emphasizes obligation to conduct diligence on the issuer, management, the issuer’s business and prospects, the representations and warranties made by the issuer and the issuer’s intended use of the offering proceeds  How will placement agent otherwise satisfy its diligence obligation?

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Marketing materials and other information  Placement agent should consider carefully the materials used to market the private placement  Will there be a “teaser”? A company presentation?  Who has prepared what? Are any of the materials prepared by the placement agent? If so, how have those materials been diligenced? Are the materials fair and balanced?  Is the placement agent sharing with investors a model? Vetting the company’s model?  If the investors are receiving projections and financial models, will these be stale by the time of the IPO?

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IPO Dynamics

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Preparing for the IPO  Timing between the private placement and the IPO  Are expectations aligned between the late stage investors and the company?  What if the timeline for the IPO is extended?  Will the late stage investors need liquidity? Will other existing stockholders of the company or employees require liquidity?

 Valuation issues  As discussed, most late stage private placements include provisions providing for IPO price protection  How will this work in a volatile market? What if IPO price is almost certainly less than the private price?  How is the new valuation determined?

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Preparing for the IPO  Well recognized cross-over investors may be helpful in promoting the issuer’s interests when dealing with the IPO bankers  Will cross-over investors participate in the IPO?  Ideally, the pre-IPO round investors will be the “anchor orders” in the IPO  No ability in the U.S. to obtain and secure cornerstone investors  Only two options: either obtain an indication of interest from the cross-over investor that can be disclosed in the IPO prospectus, or do a concurrent private placement to the cross-over investor at the IPO price concurrent with the IPO  Maybe more uncertainty with the indication of interest option if the market remains volatile and IPOs price below stated ranges

 Did the cross-over investors receive confidential information during the preIPO process? Has that information been disclosed in the IPO prospectus? Are they cleansed of material nonpublic information?

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Client Alert

November 2, 2015

Following the Wisdom of the Crowd? A Look at the SEC’s Final Crowdfunding Rules

In this alert, we provide a detailed overview of the final rules, Regulation Crowdfunding, which will be applicable to crowdfunding offerings conducted in reliance on Section 4(a)(6) of the Securities Act of 1933 as amended (the “Securities Act”), which was added by Title III of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), as well as to those intermediaries participating in such offerings. We do not address the proposed FINRA framework applicable to funding portals, which will be covered in a separate alert. All rule references, unless otherwise noted, refer to rules under Regulation Crowdfunding. We will supplement this alert with a more detailed practical analysis comparing the various new offering exemptions available to issuers as a result of the JOBS Act. PART ONE: GENERAL REQUIREMENTS Limit on Capital Raised Consistent with the statutory limitations, Rule 100(a) provides that an issuer may sell up to $1 million in any 12-month period to investors in an offering made pursuant to the exemption. Of course, an issuer may consider conducting other exempt offerings in close proximity with its crowdfunded offering. In calculating the amounts sold for purposes of the threshold, amounts sold by a predecessor or by an entity under common control with the issuer will be aggregated with the amounts sold by the issuer. Individual Investment Limits In the final rules, the Securities and Exchange Commission (the “SEC”) has modified the investor limits from those included in its proposed rules. The final rules make clear that the individual investor limit is an aggregate limit, which applies to all investments made by the individual over a 12-month period in crowdfunded offerings and not to a specific offering.

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An investor will be limited to investing: (1) The greater of: $2,000 or 5% of the lesser of the investor’s annual income or net worth if either annual income or net worth is less than $100,000; or (2) 10% of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more. As we discuss below, the issuer can rely on the intermediary’s calculation of the investment limit; provided that the issuer does not have knowledge that the investor has exceeded, or would exceed, the investment limits as a result of participating in the issuer’s offering. Offering through an Intermediary An issuer would only be able to engage in an offering through a registered broker-dealer or through a funding portal, and an issuer can only use one intermediary for a particular offering or concurrent offerings made in reliance on the exemption. The offering must be conducted online only through the intermediary’s platform, so that the “crowd” has access to information and there is a forum for an exchange of information among potential offering participants. A “platform” is defined as “a program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6) of the Securities Act.” Eligible Issuers The ability to engage in crowdfunding is not available to all issuers. By statute, the following issuers cannot rely on crowdfunding transactions under Section 4(a)(6): • • • •

issuers not organized under the laws of a state or territory of the United States or the District of Columbia; issuers already subject to Securities Exchange Act of 1934, as amended (the “Exchange Act”) reporting requirements; investment companies as defined in the Investment Company Act of 1940 (the “Investment Company Act”) or companies that are excluded from the definition of “investment company” under Section 3(b) or 3(c) of the Investment Company Act; and any issuer that the Commission, by rule or regulation, determines appropriate.

The final rules also exclude: • •

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issuers disqualified from relying on Section 4(a)(6), or “bad actors;” and issuers that have sold securities in reliance on Section 4(a)(6) and have failed, to the extent required, to make required ongoing reports required by Regulation Crowdfunding during the two-year period immediately preceding the filing of the required new offering statement; and

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any issuer that is a development stage company that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies. PART TWO: ISSUER REQUIREMENTS

Disclosure Requirements The statute sets out a number of required disclosures in any Section 4(a)(6) offering. An issuer that elects to engage in a crowdfunding offering must comply with disclosure requirements, including: an initial disclosure about the offering on Form C, amendments to Form C to report material changes (Form C-A), periodic updates on the offering on Form C-U and ongoing annual filings until a filing obligation is terminated. The annual filing must be made on Form C-AR and a termination notice on Form C-TR. Form C The Form C would be filed with SEC and the intermediary would post the filing or provide a link to the filing for investors. The Form C must include disclosures relating to the issuer’s business, officers, directors and control persons, use of proceeds, capital structure and financial results, as discussed below in more detail. In many respects, the Form C requirements resemble those for Form 1-A used in connection with Regulation A offerings. The final Form C also includes an optional Q&A format that issuers may elect to use to provide certain disclosures. Basic issuer information would be required, including: the entity name, the form of entity, the jurisdiction of formation, formation date, address, website, number of employees, the issuer’s website on which an investor can find the issuer’s annual report and the date by which such report will be made available, whether the issuer or any predecessor previously failed to comply with the ongoing reporting requirements of Regulation Crowdfunding. In addition, the form must disclose certain basic information about the intermediary, including: the intermediary’s SEC file number and FINRA CRD number and fees being paid to the intermediary, expressed either as a dollar amount or as a percentage of the offering amount, and a description of the intermediary’s financial interests in the transaction and in the issuer. In addition, the form will require, among other things, a discussion of: • • • • •

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Use of Proceeds: a specific use or range of possible uses for the offering proceeds, as well as the factors impacting the selection by the issuer of each such use; The Targeted Offering Size: as discussed further below, the issuer must disclose the maximum offering size and the subscription process; Offering Price: a description of the price to the public of the securities and a description of how the offered securities were valued; Business: the form must include a business description, for which no particular format is prescribed; Directors and officers: each individual’s name, positions held with the issuer and duration in those positions and business experience during the last three years;

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•

• • • • • •

Beneficial Ownership and Capital Structure: for principal stockholders, the issuer would be required to identify each shareholder who owns 20% or more of the issuer’s outstanding voting equity securities (calculated as of the most recent practicable date), as well as provide a description of capital stock, including any special voting rights or investor rights; Indebtedness; Related party transactions: a description of transactions that involve amounts in excess of 5% of the amount raised by the issuer in crowdfunded offerings in the trailing 12-month period including in the proposed deal; Exempt offerings: a description of all exempt offerings undertaken during the preceding three years; Risk factors: a discussion of risks associated with an investment in the securities and with participation in a crowdfunded offering; Transfer restrictions; and Management’s Discussion and Analysis: a discussion that covers each period for which financial statements of the issuer are provided, as well as a discussion of material changes or trends known to management.

Financial Statement Requirements In a change from the proposed rules, the final rules provide some accommodations with respect to financial statement requirements depending upon the target offering size and for first-time issuers. Based on target offering size, the requirements are as follows: •

$100,000 or less: the amount of total income, taxable income and total tax or equivalent line items, as reported on the federal tax forms filed by the issuer for the most recently completed year (if any), certified by the principal executive officer of the issuer, and the financial statements of the issuer, also certified by the principal executive officer. If financial statements of the issuer are available that have either been reviewed or audited by a public accountant independent of the issuer, then, these financial statements must be provided instead of the materials described in the preceding sentence.

•

More than $100,000 and less than $500,000: financial statements of the issuer reviewed by a public accountant independent of the issuer. If financial statements of the issuer are available that have been audited by a public accountant independent of the issuer, the issuer must provide those instead of the reviewed statements.

•

More than $500,000: financial statements of the issuer audited by a public accountant independent of the issuer; provided, however, that for issuers that are first-time issuers, offerings that have a target offering amount of more than $500,000 but not more than $1 million, financial statements of the issuer reviewed by a public accountant independent of the issuer. If audited statements are available, those must be provided instead.

Financial statements must be prepared in accordance with U.S. GAAP. Audited financial statements must be conducted in accordance either with American Institute of Certified Public Accountants (“AICPA”) standards (referred to as U.S. GAAS) or Public Company Accounting Oversight Board 4

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(“PCAOB”) standards. These requirements are similar to those applicable for Tier 1 offerings made under Regulation A. A signed audit report must accompany audited financial statements. During the first 120 days of the issuer’s fiscal year, an issuer may conduct an offering in reliance on Section 4(a)(6) using financial statements for the fiscal year prior to the most recently completed fiscal year if the financial statements for the most recently completed fiscal year are not otherwise available. Amendments to Form C An issuer would be required to amend its Form C disclosures using Form C/A for any updates or material changes. The materiality determination is left up to the issuer based on the customary guidance that the SEC considers a material change to be a change that would affect an investor’s investment decision. The issuer must identify on Form C/A whether the amendment is filed to disclose a material change. Investor reconfirmations must be obtained following the occurrence of a material change. Progress Update An issuer also is required to file progress updates with the SEC on a Form C-U. Updates are required five days after any of the following milestones: commitments for 50% of the deal are received, commitments for the full deal are received, subscriptions in excess of the initial offering amount will be accepted, or the issuer closes the offering. Annual Report An issuer that completes a crowdfunded offering must file with the SEC and post on its website an annual report on Form C-AR along with financial statements of the issuer certified by its principal executive officer within 120 days of the end of the issuer’s fiscal year. The annual report is required to contain the same information required in the offering statement, described above. Termination of Reporting An issuer must file with the SEC a Form C-TR to terminate its reporting obligation within five days of the date on which it becomes eligible to do so. An issuer can terminate its ongoing reporting requirements upon the earliest to occur of the following: • • • • •

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the issuer is required to file reports under the Exchange Act; the issuer has filed at least one annual report and has fewer than 300 holders of record; the issuer has filed at least three annual reports and has total assets that do not exceed $10 million; the issuer or another party purchases or repurchases all of the securities issued pursuant to Section 4(a)(6), including any payment in full of debt securities or any complete redemption of redeemable securities; or the issuer liquidates or dissolves in accordance with state law.

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Offering Amount and Offering Mechanics In connection with a proposed offering, the rules contemplate that the issuer would include in its disclosures a discussion of the target or maximum amount to be raised, and a discussion of the subscription or offering process. The description of the subscription process must disclose that investors can cancel their investment up to 48 hours prior to the deadline identified in the offering materials, but if an investor does not cancel the investment, then the investor’s funds will be released to the issuer upon closing. The intermediary will notify investors when the target offering amount has been met, and if the target offering amount is not met, then no securities will be sold and all funds will be returned to investors. If the target offering amount is met prior to the deadline identified in the offering materials, the issuer must provide five days’ advance notice before closing the offering early. If an investor does not reconfirm the investment commitment after a material change is made to the offering and disclosed on Form C-A, the investment will be cancelled, and the issuer must return the funds to the investor. Types of Securities Offered The final rules do not limit the types of securities that may be offered in reliance on Section 4(a)(6). The release notes that an issuer may offer debt securities and discusses the exemption from the requirement to qualify an indenture under the Trust Indenture Act of 1939 (the “Trust Indenture Act”) for any offering exempted by Section 4 of the Securities Act from the provisions of Section 5 of the Securities Act; however, the final rules do not include a specific exemption from Trust Indenture Act requirements for crowdfunded offerings. Status of Securities Securities sold in a crowdfunded offering pursuant to the exemption would be subject to transfer restrictions. Pursuant to Rule 501, securities issued in a crowdfunded offering could not be transferred by a purchaser for one year from the date of purchase, except for transfers to: the issuer; an accredited investor; a family member of the purchaser or in estate type transfers; and third parties in an SECregistered offering. The statute exempts securities sold in Section 4(a)(6) offerings from the Exchange Act “holder of record” count for the purposes of determining if registration of a class of equity securities is required under Section 12(g). An issuer will be required to establish a means for tracking its shareholders. This may require an early-stage company to engage the services of a transfer agent or other similar service provider in order to monitor its security holders. Integration An offering made pursuant to the Section 4(a)(6) exemption will not be integrated with another exempt offering that precedes the crowdfunded offering or that takes place concurrently or subsequently. The issuer must ensure that it has satisfied all of the conditions for the exemption that it is claiming for each such offering. If the issuer is conducting a Rule 506(c) offering (using general solicitation), it must ensure that the Rule 506(c) offerees were not solicited by means of the communications used for the crowdfunded offering. 6

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Restrictions on Advertising and Promotion The final rules limit the ability of the issuer, as well as the ability of others acting on the issuer’s behalf, to advertise. Pursuant to Rule 204, an issuer is permitted to advertise a Section 4(a)(6)-exempt offering by releasing an offering notice that contains only the following information: • • • • • • • • •

a statement that the issuer is conducting an offering; the name of the intermediary and a link to the intermediary’s offering page; the amount of securities offered; the nature of the securities; the price of the securities; the closing date for the offering; and the name, address, phone number and website of the issuer; the email address of a representative of the issuer; and a brief factual description of the issuer’s business.

The adopting release notes that this notice is intended to be similar to tombstone ads permitted under Securities Act Rule 134. The issuer would be able to communicate with potential crowdfunding investors if the communications occur through the platform; however, it should be clear to potential investors which platform communications are being made by the issuer or on the issuer’s behalf. The final rules do not limit an issuer from being able to continue to engage in regular business communications so long as it does not disclose information about the offering, except as permitted in an offering notice. However, the final rules do not contain an express safe harbor for regularly released business information. Promoter Compensation Rule 205 prohibits an issuer from compensating, or committing to compensate, directly or indirectly, a person for advertising or promoting a Section 4(a)(6) offering through the intermediary’s platform, unless the issuer takes reasonable steps to ensure that the person clearly discloses the receipt (past and prospective) of compensation each time that such person makes a promotional communication. A founder or employee of the issuer that engages in promotional activities on the issuer’s behalf through the intermediary’s platform would be required to disclose in each posting that s/he is engaging in those activities on the issuer’s behalf. The release discusses a number of “reasonable steps” that an issuer can take in order to ensure that promoters disclose the receipt of communication, including, but not limited to, obtaining representations from the promoter and monitoring communications. PART THREE: INTERMEDIARIES Title III of the JOBS Act provides that a crowdfunded offering must be made through an intermediary that is either a registered broker-dealer or a funding portal. The intermediary is intended to function as a gatekeeper and, in this role, protect investors from fraud. The SEC’s final rules establish a regulatory framework for these intermediaries. As discussed below, in the case of funding portals, the regulatory framework is a scaled back version of the framework applicable to broker-dealers. 7

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We discuss the final rules in the sequence of an offering and then provide an overview of the registration, compliance and other requirements applicable to intermediaries. Conducting a Crowdfunded Offering Single Intermediary As discussed above, the final rules require that an offering be made only through one intermediary. Financial Interests in Issuer Rule 300 prohibits directors, officers or partners (or others having a similar status or performing a similar function) of an intermediary from having any financial interest in an issuer using its services and prohibits such persons from receiving a financial interest in an issuer as compensation for the service provided to or for the benefit of the issuer in connection with the offering. An intermediary cannot have a financial interest in an issuer that is using the intermediary’s platform, unless: • •

The intermediary receives the financial interest from the issuer as offering compensation; and The financial interest consists of securities of the same class and having the same terms as those sold in the offering.

A “financial interest” in an issuer means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities. Measures to Reduce Risk of Fraud Under Rule 301, an intermediary must have a reasonable basis for believing that the issuer is in compliance with relevant regulations and has established means to keep accurate records of holders of the securities it offers. An intermediary could reasonably rely on the issuer’s representations, absent knowledge or other information that would suggest that the representations are not true. An intermediary must deny access to an issuer if it has a reasonable belief that the issuer or its offering would present a potential for fraud. An intermediary would be required to deny access to its platform to an issuer if the intermediary has a reasonable belief that the issuer, or any of its directors, officers or 20% beneficial owners is subject to a disqualification under Rule 503. An intermediary must conduct a background and securities enforcement regulatory history check on each issuer whose securities are to be offered by the intermediary, as well as on each of its officers, directors (or any person occupying a similar status or performing a similar function) and 20% beneficial owners. Account Opening Under Rule 302, no intermediary or associated person may accept an investment commitment until the investor opens an account with the intermediary and the intermediary obtains consent to electronic delivery of materials. An intermediary is required to certain information to each investor, including educational materials, by electronic message with links to information posted on the intermediary’s website. 8

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Educational Materials Rule 302 requires that in connection with establishing an account, an intermediary deliver educational materials in plain English. Any revised materials must be made available to all investors before accepting any additional investment commitments or effecting any further crowdfunded transactions. The materials must discuss: • • • • • • • • •

the process for the offering; the types of securities sold through the platform and the associated risks; the restrictions on resale; the offering statement; the investment limitations; the limitations on an investor’s right to cancel an investment commitment and the circumstances under which an issuer may cancel the commitment; the need to consider the appropriateness for the investor of an investment in a crowdfunded offering; that following the completion of the offering there may or may not be a continuing relationship between the issuer and the intermediary; and that under certain circumstances the issuer may cease its ongoing reporting.

An intermediary also would be required to inform investors that disclosure is required regarding any past or prospective compensation paid to a promoter. An intermediary also must disclose the compensation it will receive in connection with crowdfunded offerings. Issuer Information Under Rule 303, an intermediary must make available to the SEC and potential investors not later than 21 days prior to the first day on which securities are sold to any investor any information provided by the issuer under Rules 201 and 203(a). The information must be made publicly available on the intermediary’s platform, in a manner that reasonably permits a person accessing the platform to save, download or store the information; this information be made publicly available on the intermediary’s platform for a minimum of 21 days before any securities are sold in the offering, during which time the intermediary may accept investment commitments; and this information, including any additional information provided by the issuer, remain publicly available on the intermediary’s platform until the offer and sale is completed or cancelled. An intermediary cannot require any person to establish an account with the intermediary in order to receive this information. Investor Qualifications Securities Act Section 4A(a)(8) imposes an obligation on intermediaries to make sure no investor exceeds the statutory investment limitations. The final rules implement this requirement by providing that, before permitting an investor to make an investment commitment on its platform, an intermediary must have a reasonable basis to believe that the investor satisfies the investment limitations discussed above. 9

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The final rules allow reasonable reliance on an investor’s representation to this effect. Investor’s Acknowledgment of Risks Securities Act Section 4A(a)(4) requires an intermediary to ensure that each investor reviews the educational materials, positively affirms that the investor understands that he or she is risking the loss of the entire investment and that the investor could bear such a loss, and answer questions demonstrating an understanding of the level of risk involved in startups. As discussed above, educational materials must be provided at account opening. Rule 303 requires that an intermediary, each time before accepting an investment commitment, obtain from the investor a representation that the investor has reviewed the intermediary’s educational materials, understands that the entire investment may be lost and can bear the risk of loss. The intermediary also must ensure each time before accepting an investment commitment that each investor answers questions demonstrating the investor’s understanding that there are restrictions on the investor’s ability to cancel an investment commitment and obtain a return of his or her investment, that it may be difficult for the investor to resell the securities and that the investor should not invest any funds in a crowdfunding offering unless s/he can afford to lose the entire amount of his or her investment. Communication Channels Rule 303 requires an intermediary to provide, on its platform, channels through which investors can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform, subject to certain conditions. This is intended to provide a centralized and transparent means for members of the public to share their views and to communicate with the issuer. The intermediary cannot participate in the communications. It can set rules regarding the postings or remove postings that use offensive language. Communications should be available for public viewing, but the intermediary would only be able to permit those persons who have opened accounts with it to post comments. With each post, a person must disclose whether such person is a promoter or affiliate of the issuer and whether it has been or will be compensated. The intermediary must keep records of these communications. Notice of Investment Commitment An intermediary, upon receipt of an investment commitment from an investor, must promptly give or send to the investor a notification disclosing: the dollar amount of the commitment, the price of the securities (if known), the name of the issuer and the date and time by which the investor may cancel the investment commitment. Notification would be required to be provided by email or other electronic media and to be documented in accordance with applicable recordkeeping rules.

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Maintenance and Transmission of Funds Securities Act Section 4A(a)(7) requires that an intermediary “ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount.” An intermediary that is a registered broker must comply with established requirements in Exchange Act Rule 15c2-4 for the maintenance and transmission of investor funds. Investor funds must be held in escrow until the specified contingency occurs (i.e., the targeted amount or the minimum amount is raised), and then the funds would be promptly transmitted to a bank, which has agreed in writing to hold such funds in escrow for the investors and to transmit or return such funds directly to the issuer or to investors, as the case may be. Proceeds are to be transmitted to the issuer only if the target offering amount is met or exceeded. Because a funding portal cannot receive or handle any funds, it would be required to direct investors to transmit money or other consideration directly to a qualified third party (a registered broker-dealer, a bank, or a credit union) that serves as an escrow agent. A funding portal must promptly direct transmission of funds from the qualified third party to the issuer when the aggregate amount of investment commitments from all investors is equal to or greater than the target amount of the offering and the cancellation period for each investor has expired, but no earlier than 21 days after the date on which the intermediary makes publicly available on its platform the information required to be provided about the issuer and the offering. A funding portal must direct the return of funds to an investor when an investment commitment has been cancelled or the offering is terminated or cancelled. Confirmation of Transaction At or before the completion of a transaction, the intermediary is required to give or send each investor a notification, like a confirmation, disclosing the transaction date; the type of security; the price and number of securities purchased; the number of securities sold by the issuer in the transaction; the price at which the securities were sold; certain specified terms of the security (for example, if it is a debt or callable security); and the source and amount of any remuneration received or to be received by the intermediary in connection with the transaction, whether from the issuer or other persons. This notification must be by email or other electronic media and subject to recordkeeping rules. Completion of Offerings, Cancellations and Reconfirmations Investors have an unconditional right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. Thereafter, an investor cannot cancel any investment commitments made within the final 48 hours (except in the event of a material change to the offering, as discussed below). If an issuer reaches the target offering amount prior to the deadline identified in its offering materials, it may close the offering once the target offering amount is reached, provided that the offering will have remained open for a minimum of 21 days; the intermediary provides notice about the new offering deadline at least five business days prior to the new offering deadline; investors are given the opportunity to reconsider their investment decision and to cancel their investment commitment until

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48 hours prior to the new offering deadline; and at the time of the new offering deadline, the issuer continues to meet or exceed the target offering amount. If there is a material change to the terms of the offering, or the information provided by the issuer regarding the offering, the intermediary must give or send to any potential investors who have made investment commitments notice of the material change, stating that the investor’s investment commitment will be cancelled unless the investor reconfirms his or her commitment within five business days of receipt of the notice. If the investor fails to reconfirm his or her investment within those five business days, the intermediary, within five business days thereafter, must provide or send the investor a notification disclosing that the investment commitment was cancelled, the reason for the cancellation and the refund amount that the investor should expect to receive, and direct the refund of investor funds. Finally, if an issuer does not complete an offering because the target is not reached or the issuer decides to terminate the offering the intermediary within five business days must give or send to each investor who made an investment commitment a notification disclosing the cancellation of the offering, the reason for the cancellation, the refund amount that the investor should expect to receive, direct the refund of investor funds and prevent investors from making investment commitments with respect to that offering on its platform. Intermediary Registration and Other Requirements Registration and SRO Membership An intermediary must be registered as a broker-dealer with the SEC under Section 15(b) of the Exchange Act or a funding portal registered with the SEC in accordance with the requirements of Rule 400 and also a member of a national securities association registered under Section 15A of the Exchange Act, which is FINRA. Additional Requirements on Funding Portals The SEC has established a streamlined registration process under which a funding portal would register with the SEC by filing a form, Form Funding Portal, with information consistent with, but less extensive than, the information required for broker-dealers on Form BD. A funding portal would register by completing a Form Funding Portal, which includes information concerning the funding portal’s principal place of business, its legal organization and its disciplinary history, if any; business activities, including the types of compensation the funding portal has received and disclosure of its disciplinary history, if any; FINRA membership with any other registered national securities association; and the funding portal’s website address(es) or other means of access. A funding portal’s registration would become effective the later of (1) 30 calendar days after the date that the registration is received by the SEC; or (2) the date the funding portal is approved for membership in FINRA. In order to promote transparency, all such Forms Funding Portal will be available publicly.

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A funding portal must file an amendment to the Form Funding Portal within 30 days of any of the information in the original form becoming inaccurate for any reason. The final rules require a funding portal to promptly file a withdrawal of registration on Form Funding Portal upon ceasing to operate as a funding portal. The withdrawal would be effective on the later of 30 days after receipt by the SEC after the funding portal is no longer operational within such longer period of time as to which the funding portal consents or within such period of time as to which the SEC, by order, may determine as necessary or appropriate in the public interest or for the protection of investors. A funding portal can operate multiple website addresses under a single funding portal registration provided that the funding portal discloses on the Form Funding Portal all the website and names under which it does business. Non-U.S. Funding Portals Entities domiciled or organized outside of the United States (“nonresident funding portals”) are able to act as funding portals; however, they are subject to additional requirements. There must be an information sharing arrangement in place between the SEC and the competent regulator in the jurisdiction under the laws of which the nonresident funding portal is organized or where it has its principal place of business. In addition, a nonresident funding portal would be required to have an agent for service of process in the United States, as well as an opinion of counsel addressing the ability of the applicant to provide the SEC and the national securities association of which it is a member with prompt access to its books and records and to submit to onsite inspection and examination by the SEC and the national securities association. The nonresident funding portal also would be required to consent that service of any civil action brought by, or notice of any proceeding before, the SEC or any national securities association of which it is a member, in connection with the funding portal’s investment-related business, may be given by registered or certified mail to the nonresident funding portal’s contact person at the main address or mailing address indicated on the form. Fidelity Bond The proposed rules would have required a fidelity bond, however the final rules do not require a fidelity bond. Exemptions from Broker-Dealer Registration and Safe Harbors But for the exemption from registration for funding portals that Congress directed in the JOBS Act, a funding portal would be required to register as a broker under the Exchange Act. The SEC’s final rules exempt an intermediary that is registered as a funding portal from the requirement to register as a broker-dealer under the Exchange Act, although a funding portal would remain subject to the full range of the SEC’s examination and enforcement authority. A funding portal cannot: •

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Solicit purchases, sales or offers to buy the securities displayed on its platform;

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Compensate employees, agents or other persons for such solicitations based on the sale of securities displayed or referenced on its platform; or

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Hold, manage, possess or otherwise handle investor funds or securities.

In addition, the final rules set out certain “permitted activities” of a funding portal. Providing Communication Channels: as noted above, a funding portal should provide a channel for potential investors to communicate about the merits of an offering. Highlighting Issuers and Offerings: a funding portal may highlight a particular offering made through its platform based on objective criteria, such as the type of security, geographic region, industry, etc. Criteria must be objective and cannot be based on investment advice or implicitly endorse an issuer or an offering. The funding portal cannot receive special or additional compensation for highlighting one or more issuers or offerings on its platform. Advising Issuers: a funding portal may advise an issuer on the structure or content of its proposed offering and prepare offering documentation. Paying for Referrals: a funding portal may pay for referrals, subject to various limitations. Compensation Arrangements with Registered Broker-Dealers: a funding portal may enter into arrangements with a broker-dealer pursuant to which they could compensate one another provided such arrangements are not prohibited by the national securities association of which the funding portal is a member. Advertising: a funding portal could advertise its services as well as offerings that are available through its platform, subject to compliance with various requirements. Limiting Offerings: a funding portal can limit the offerings on its platforms (for example, by limiting the offerings to issuers in certain industries, geographies, etc.) without being deemed to be providing investment advice. The criteria would be required to be reasonably designed to result in a broad selection of issuers offering securities through the funding portal’s platform and be applied consistently to all potential issuers and offerings. Criteria must be displayed on the funding portal’s site. Compliance Policies and Procedures A funding portal is required to implement written policies and procedures designed to achieve compliance with applicable regulations. A funding portal will be required to comply with the same privacy rules (Regulation S-P, Regulation SAM, and Regulation S-ID) applicable to broker-dealers.

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A funding portal is subject to the SEC’s examination and inspection authority. Also, a funding portal is subject to recordkeeping requirements in order to ensure that there is an audit trail for all crowdfunding transactions and communications. Disqualification (“Bad Actor”) Provisions Rule 503 sets out bad actor disqualification provisions. The Section 4(a)(6) exemption will not be available for a sale of securities if the issuer, a predecessor of the issuer, an affiliated issuer, any director, officer, general partner or managing member of the issuer, a beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, any promoter or solicitor, or any general partner, director, officer or managing member of any such solicitor is subject to a “statutory disqualification.” Conclusion

With the much anticipated crowdfunding rules now adopted, it will be interesting to observe the extent to which the rules will prove useful for issuers and intermediaries in raising small amounts of capital. While the SEC sought to add more flexibility in the final rule within the confines of the statutory directive from Title III of the JOBS Act, the exemption contemplates procedural and informational requirements that will require the significant dedication of resources by the smaller issuers that would likely find the exemption most useful, as well as their intermediaries. We will continue to monitor developments as market practices emerge for issuers and intermediaries.

For a jump start on the JOBS Act, please visit our MoFoJumpstarter blog: www.mofojumpstarter.com.

Authors David M. Lynn Washington, D.C. (202) 887-1563 [email protected]

Anna T. Pinedo New York (212) 468-8179 [email protected]

About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life sciences companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2015 Morrison & Foerster LLP. All rights reserved. For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Client Alert November 5, 2015

SEC Proposes Rule Changes to Pave the Way for Intrastate and Regional Offerings By David Lynn At the same time the Securities and Exchange Commission (the “SEC”) adopted rules implementing Regulation Crowdfunding pursuant to Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”), the agency proposed rule changes that could potentially facilitate intrastate and regional offerings that are subject to state blue sky regulation. In particular, the SEC proposed to modernize Rule 147 under the Securities Act of 1933, as amended (the “Securities Act”), and establish a new exemption to facilitate offerings relying upon recently adopted intrastate crowdfunding exemptions under state securities laws. The SEC also proposed amendments to Rule 504 of Regulation D under the Securities Act to increase the aggregate amount of securities that may be offered and sold in any twelve-month period from $1 million to $5 million and to disqualify certain bad actors from participating in Rule 504 offerings. The SEC indicated in the proposing release that these proposals are “part of the Commission’s efforts to assist smaller companies with capital formation consistent with other public policy goals, including investor protection.” PROPOSED AMENDMENTS TO RULE 147 Rule 147 is a safe harbor for intrastate offerings exempt from registration pursuant to Securities Act Section 3(a)(11), which exempts “any security which is a part of an issue offered and sold only to persons resident within a single state or territory, where the issuer of such security is a person residing and doing business within, or, if a corporation, incorporated by and doing business within such state or territory.” The proposed amendments would eliminate the restriction on offers, while continuing to require that sales be made only to residents of an issuer’s state or territory. The proposed amendments also would redefine “intrastate offering” and ease issuer eligibility requirements. The SEC proposes to limit the availability of the exemption to offerings that are either registered in the state in which all of the purchasers are resident, or conducted pursuant to an exemption from state law registration in such state that limits the amount of securities an issuer may sell pursuant to such exemption to no more than $5 million in a twelve-month period and imposes an investment limitation on investors. The SEC noted that over time it has been observed that the statutory limitation on offers in Section 3(a)(11) and the prescriptive threshold requirements that an issuer must satisfy in order to be considered “doing business” instate as specified in Rule 147 have combined to limit the availability of the exemption for companies that otherwise might have considered using the exemption in order to conduct intrastate offerings. In particular, these provisions make it difficult to conduct intrastate offerings utilizing the Internet. The SEC also noted that a number of states have adopted and/or enacted crowdfunding provisions, or currently have crowdfunding legislation pending. These state-based crowdfunding provisions generally require that an issuer, in addition to complying with various state-specific requirements to qualify for the exemption, also comply with Section 3(a)(11) and Rule 147. State securities regulators have indicated to the SEC that Section 3(a)(11) and Rule 147 make it difficult for companies to take advantage of these new crowdfunding provisions.

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Client Alert The proposed amendments to Rule 147 would permit an issuer to engage in any form of general solicitation or general advertising, including the use of publicly accessible Internet websites, to offer and sell its securities, so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located, and the offering is registered in the state in which all of the purchasers are resident, or is conducted pursuant to an exemption from state law registration in such state that limits the amount of securities an issuer may sell pursuant to such exemption to no more than $5 million in a twelve-month period and imposes an investment limitation on investors. The proposed amendments would also define an issuer’s principal place of business (as opposed to its “principal office” as defined in current Rule 147) as the location in which the officers, partners, or managers of the issuer primarily direct, control, and coordinate the activities of the issuer and further require the issuer to satisfy at least one of four threshold requirements discussed below regarding the in-state nature of the issuer’s business. As defined, an issuer would only be able to have a “principal place of business” within a single state or territory and would therefore only be able to conduct an offering pursuant to amended Rule 147 within that state or territory. Further, as proposed, the provisions of Rule 147 regarding legends and mandatory disclosures to purchasers and prospective purchasers would be retained. Rule 147, as it is proposed to be amended, would no longer fall within the statutory parameters of Section 3(a)(11); therefore, the SEC proposed to amend Rule 147 to create an exemption pursuant to the SEC’s general exemptive authority under Section 28 of the Securities Act. As proposed to be amended, Rule 147 would function as a separate exemption rather than as a safe harbor under Section 3(a)(11), and Section 3(a)(11) would still be available as a potential statutory exemption in and of itself. Based on its belief that the rules should continue to require that the securities sold in an intrastate offering in one state should come to rest within such state before sales are permitted to out-of-state residents, the SEC proposes to limit the ability of an issuer that has changed its principal place of business to conduct an intrastate offering in a different state until such time as the securities sold in reliance on the proposed exemption in the prior state have come to rest in that state. For this purpose, the SEC proposes that issuers that have changed their principal place of business after making sales in an intrastate offering pursuant to proposed Rule 147 would not be able to conduct an intrastate offering pursuant to proposed Rule 147 in another state for a period of nine months from the date of the last sale in the prior state, which is consistent with the duration of the resale limitation period specified in proposed Rule 147(e), discussed below. For the purpose of determining the “in-state” nature of the issuer utilizing Rule 147, the rule as proposed would require that, in addition to the requirement that an issuer have its principal place of business in-state, the issuer must meet at least one of the following requirements (instead of all requirements, as currently specified in Rule 147): (i) the issuer derived at least 80% of its consolidated gross revenues from the operation of a business or of real property located in or from the rendering of services within such state or territory; (ii) the issuer had at the end of its most recent semi-annual fiscal period prior to the first offer of securities pursuant to the exemption, at least 80% of its consolidated assets located within such state or territory; (iii) the issuer intends to use and uses at least 80% of the net proceeds to the issuer from sales made pursuant to the exemption in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state or territory; or (iv) a majority of the issuer’s employees are based in such state or territory (this fourth prong is proposed to be added to the list).

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Client Alert While current Rule 147(d) requires that offers and sales of securities pursuant to the rule be made only to persons resident within the state or territory of which the issuer is a resident, so that the exemption would be lost for the entire offering if securities are offered or sold to one investor that was not in fact a resident of the state, the proposed amendments would add a reasonable belief standard to the issuer’s determination as to the residence of the purchaser at the time of the sale of the securities. An issuer would satisfy this by either the existence of the fact that the purchaser is a resident of the applicable state or territory, or by establishing that the issuer had a reasonable belief that the purchaser of the securities in the offering was a resident of such state or territory. The SEC also proposes to eliminate the current requirement in Rule 147 that issuers obtain a written representation from each purchaser as to his or her residence. The proposed amendments also would define the residence of a purchaser that is a legal entity (i.e., a corporation, partnership, trust, or other form of business organization) as the location where, at the time of the sale, the entity has its principal place of business. The proposed amendments would define a purchaser’s “principal place of business,” consistent with the proposed definition for issuer eligibility purposes, as the location in which the officers, partners, or managers of the entity primarily direct, control and coordinate the activities of the issuer. Under current Rule 147(e), “during the period in which securities that are part of an issue are being offered and sold by the issuer, and for a period of nine months from the date of the last sale by the issuer of such securities, all resales of any part of the issue, by any person, shall be made only to persons resident within such state or territory.” This limitation on resales is designed to help ensure that the securities issued in an intrastate offering have come to rest in the state of the offering before any potential redistribution out-of-state. The SEC proposes to amend the limitation on resales in Rule 147(e) to provide that “for a period of nine months from the date of the sale by the issuer of a security sold pursuant to this rule, any resale of such security by a purchaser shall be made only to persons resident within such state or territory, as determined pursuant to paragraph (d) of this rule.” The SEC believes that a nine-month limitation on resales by resident purchasers to non-residents would ensure that the securities purchased by such residents were purchased without a view to further distribution to nonresidents. In addition, Rule 147 would be revised so that compliance with Rule 147(e) would not be a condition for the issuer relying on the exemption. The SEC also proposes to align the integration safe harbor in Rule 147 with the recently adopted integration safe harbor in Rule 251(c) of Regulation A. As proposed, offers and sales made pursuant to Rule 147 would not be integrated with: •

Prior offers or sales of securities; or

•

Subsequent offers or sales of securities that are:

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o

Registered under the Securities Act, except as provided in Rule 147(h);

o

Exempt from registration under Regulation A;

o

Exempt from registration under Rule 701;

o

Made pursuant to an employee benefit plan;

o

Exempt from registration under Regulation S;

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Exempt from registration under Section 4(a)(6) of the Securities Act; or

o

Made more than six months after the completion of an offering conducted pursuant to Rule 147.

As with Rule 251(c) of Regulation A, the proposed integration safe harbor would expressly provide that any offer or sale made in reliance on the rule would not be integrated with any other offer or sale made either before the commencement of, or more than six months after, the completion of the Rule 147 offering. There would be no presumption that offerings outside the integration safe harbor should be integrated. The proposing release also indicates that an offering made in reliance on Rule 147 would not be integrated with another exempt offering made concurrently by the issuer, provided that each offering complies with the requirements of the exemption that is being relied upon for the particular offering. Further, consistent with the approach that the SEC took to integration in Rule 251(c), the proposed rules provide that, subject to certain exceptions specified in the rule, offers or sales made in reliance on Rule 147 should not be integrated with subsequent offers or sales that are registered under the Securities Act, or qualified by the SEC pursuant to Regulation A. PROPOSED REGULATION D AMENDMENTS Rule 504 of Regulation D currently provides issuers with an exemption from registration for offers and sales of up to $1 million of securities in a twelve-month period, provided that the issuer is not: •

subject to reporting pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”);

•

an investment company; or

•

a blank check company.

Additionally, Rule 504 imposes conditions for the availability of the exemption, including limitations on the use of general solicitation or general advertising in the offering and the restricted status of securities issued pursuant to the exemption, with limited exceptions in this regard for offers and sales made: •

exclusively in one or more states that provide for the registration of the securities, and require the public filing and delivery to investors of a substantive disclosure document before sale that are made in accordance with state law requirements;

•

in one or more states that have no provision for the registration of the securities or the public filing or delivery of a disclosure document before the sale, if the securities have been registered in at least one state that provides for such registration, public filing, and delivery before sale, offers and sales are made in that state in accordance with such provisions, and the disclosure document is delivered before sale to all purchasers (including those in the states that have no such procedure); or

•

exclusively according to state law exemptions from registration that permit general solicitation and general advertising so long as sales are made only to “accredited investors” as defined in Rule 501(a) of Regulation D.

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Client Alert Offerings conducted pursuant to Rule 504 must be registered in each state in which they are offered or sold, unless an exemption to state registration is available under state securities laws. Most states require registration of Rule 504 offerings; however, Maine recently adopted a form of state-based crowdfunding that permits the use of general solicitation, but still exempts the issuances of securities from state registration where, in addition to satisfying various state-specific requirements to qualify for the exemption, an issuer also complies with Rule 504 of Regulation D. The SEC proposes to amend Rule 504 of Regulation D to increase the aggregate amount of securities that may be offered and sold in any twelve-month period from $1 million to $5 million and to disqualify certain bad actors from participation in Rule 504 offerings by referencing the disqualification provisions of Rule 506 of Regulation D. The SEC also seeks public comment on whether additional changes to Rule 504 should be adopted. The SEC noted that if the proposed amendments to Rule 504 were adopted, Rule 505 of Regulation D would become less useful, and, therefore, the SEC requests comment on whether Rule 505 should be retained in its current form or in a modified form, or repealed in its entirety. The SEC believes that the proposed amendments to Rule 504 could provide state securities regulators with greater flexibility to develop regional coordinated review programs that would rely on Rule 504 at the federal level, given that the proposed changes would increase the maximum amount of capital that could be raised while providing states with assurance that certain bad actors would be excluded from such offerings. The SEC believes that the proposed increase in the offering limitation would increase the flexibility of state securities regulators to set their own state offering limitations and to consider whether any additional requirements should be implemented at the state level. In addition, the SEC believes that the proposed changes “would facilitate state efforts to increase the efficiencies associated with the registration of securities offerings in multiple jurisdictions through regional coordinated review programs.” CONCLUSION The proposed amendments to Rule 147 and Rule 504 represent the SEC’s first efforts since the enactment of the JOBS Act to address, through rulemaking, some of the other areas of concern for small company capital-raising that were not specified in the JOBS Act. Rather than utilizing preemption of state laws, as was done in Regulation A and Regulation Crowdfunding, the SEC’s proposed amendments recognize the role of state regulation and seek to utilize that regulation as a basis for exempting smaller offerings at the federal level. The proposals further recognize the work of the states in adopting their own crowdfunding exemptions and in coordinating blue sky review efforts.

Contact: David M. Lynn (202) 887-1563 [email protected]

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Anna T. Pinedo (212) 468-8179 [email protected]

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Client Alert About Morrison & Foerster: We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.

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Matchmaking Basics: How it Works, Current Regulations and Key Considerations Background “Matchmaking sites,” also referred to as “matchmaking platforms,” have come to play a more significant role in capital formation in recent years. A matchmaking site generally relies on the Internet in order to “match” or introduce potential investors to companies that may be interested in raising capital. However, in order to avoid the requirement to register with the Securities and Exchange Commission (SEC) as a broker-dealer, a matchmaking site generally will limit the scope of its activities. Under Section 3(a)(4) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), a “broker” is defined as any person that is “engaged in the business of effecting transactions in securities for the account of others.” The SEC has noted that a person “effects transactions in securities if he or she participates in such transactions ‘at key points in the chain of distribution’” and that a person is “engaged in the business” if he or she receives transaction-related compensation and holds himself or herself out “as a broker, as executing trades, or as assisting others in completing securities transactions.” 1 The determination as to whether an entity is acting as a “broker” is complex. The SEC closely considers many criteria and the specific facts and circumstances. Generally, though, the SEC has attributed great significance to whether the entity receives transaction-based compensation. Prior to the enactment of the Jumpstart Our Business Startups Act (the “JOBS Act”), the SEC staff issued several no-action letters to matchmaking sites that sought relief from the requirement to register as broker-dealers. 2 The no-action letter relief generally was conditioned on the requirement that the matchmaking site: • • • • •

•

not provide any advice, endorsement, analysis or recommendation about the merits of securities; not receive compensation that is contingent on the outcome or completion of any securities transaction (“transaction-based compensation”); not participate in any negotiations related to securities transactions; not have any role in effecting securities trades; not receive, transfer or hold any investor funds or securities; and not hold itself out as a broker-dealer.

Section 201 of the JOBS Act Section 201(b) of the JOBS Act provides further legal certainty regarding the activities a matchmaking site may engage in without triggering registration as a broker-dealer. Under Section 201(b) of the JOBS Act, in the absence of other activities that would require registration, a matchmaking site is exempt from the requirement to register as a broker-dealer if in connection with offerings made pursuant to Rule 506 (“Rule 506”) of Regulation D under the Securities Act (“Regulation D”): • • •

it does not receive compensation based on the purchase or sale of securities; it does not handle customer funds or securities; and it is not a “bad actor.” 3

In addition, a matchmaking site may maintain a platform or mechanism that permits the offer, sale or purchase of securities, or permits general solicitations, general advertisements or similar or related activities by issuers of such securities, whether online, in person or through any other means. 4 A matchmaking site also may provide “ancillary services” in connection with Rule 506 offerings. Such services include: •

due diligence services, in connection with the offer, sale or purchase of such security (so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors); and

1

See SEC Denial of No-Action Request to Oil-N-Gas, Inc. (June 8, 2000); SEC Denial of No-Action Request to Progressive Technology Inc. (Oct. 11, 2000); and SEC Denial of No-Action Request to 1st Global, Inc. (May 7, 2001). 2 See Angel Capital Electronic Network, SEC No-Action Letter (Oct. 25 1996); E-Media, LLC, SEC No-Action Letter (Dec. 14, 2000); Swiss American Securities, Inc. and Streetline, Inc., SEC No-Action Letter (May 28, 2002); The Investment Archive, LLC, SEC No-Action Letter (May 14, 2010); Roadshow Broadcast, LLC, SEC No-Action Letter (May 6, 2011); and S3 Matching Technologies LP, SEC No-Action Letter (July 19, 2012). 3 JOBS Act § 201(c)(2). 4 Id.

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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). 5

Although many articles in the popular press refer to the use of the Internet to offer securities in Rule 506 offerings to accredited investors as “crowdfunding” or “accredited investor crowdfunding,” it is important to note that the transactions taking place through such sites do not rely on the exemption under Section 4(a)(6) of the Securities Act for crowdfunded offerings and that the exemption from brokerdealer registration would not necessarily be available for crowdfunded offerings. Crowdfunded offerings must be conducted by either a registered broker-dealer or a registered funding portal. To date, most matchmaking sites conduct their activities by relying on Rule 506(b) of Regulation D (rather than Rule 506(c)) and the SEC no-action letter Lamp Technologies, Inc. 6 Under Rule 506(b), an issuer cannot use general solicitation or advertising to market its securities, but may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchasers (so long as such nonaccredited investors are sophisticated in financial and business matters). 7 In Lamp Technologies, Inc., the SEC staff found that the qualification of accredited investors and the posting of a notice concerning a private fund on a website administered by Lamp Technologies, Inc. (“Lamp”) that is password-protected and accessible only to subscribers who are predetermined to be accredited investors would not involve a general solicitation or advertising. 8 In order to obtain access to private fund information available on the website, potential subscribers would be required to (1) complete a questionnaire designed to allow Lamp to form a reasonable basis for determining that the subscriber was an accredited investor and (2) pay a subscription fee. Subscribers who pre-qualified as accredited investors and paid the subscription fee would receive a password permitting them access to the website and Lamp would require subscribers to agree not to invest in any posted fund for 30 days following their qualification. The SEC staff noted that (1) both the invitation to complete the questionnaire used to determine whether an investor is accredited and the questionnaire itself would be generic in nature and would not reference any specific funds posted or to be posted on the password-protected website, (2) the passwordprotected website would be available to a particular investor only after Lamp made the determination that the particular potential investor was accredited, and (3) a potential investor could purchase securities only after the 30-day waiting period. 9 Note that contacting only accredited investors or making opportunities available only once an investor is identified as accredited would not necessarily constitute general solicitation or advertising and force a matchmaking site to consider relying on Rule 506(c) of Regulation D. Rule 506(c), in contrast to Rule 506(b), permits general solicitation if all of the investors are accredited investors and the issuer takes reasonable steps to verify that the investors are accredited investors.

SEC Frequently Asked Questions In order to provide additional guidance relating to matchmaking sites, the SEC staff issued a set of Frequently Asked Questions (“FAQs”) on February 5, 2013. 10 The key FAQs are summarized below: •

• •

Question 2 asked whether the exemption from registration in Section 4(b) is operational in light of the fact that brokerdealers are required to register under the Exchange Act. The SEC staff responded that the exemption is fully operational because Congress exempted persons described in Section 4(b) from broker-dealer registration requirements under Section 15(a)(1) of the Exchange Act. Question 3 asked if the Section 4(b) exemption is available to an online platform that offers and sells securities not sold pursuant to Rule 506. The SEC staff responded that the exemption only applies when securities are offered and sold pursuant to Rule 506. Question 4 asked whether an Internet website or social media would qualify as a permissible “platform or mechanism” for general solicitation purposes. The SEC staff responded that Congress specifically intended Section 4(b)(1)(A) to cover social media and Internet websites.

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Id. See Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1997). 7 Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but the investors in the offering must all be accredited investors and the company must take reasonable steps to verify that its investors are accredited investors. 8 Cf. IPOnet, SEC No-Action Letter (July 26, 1996) (stating that the posting of a notice of a private offering on a website would not be deemed a general solicitation or advertising when pre-qualification and password-protection procedures designed to limit access to the website were in place). 9 The SEC staff, however, did not take a position as to whether the information obtained by Lamp was sufficient to form a reasonable basis for believing an investor to be accredited. 10 See Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act, available at http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm. 6

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•

• • •

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Question 5 asked what forms of compensation would cause an entity to be unable to rely on the Section 4(b) exemption. In its response, the SEC staff indicated that impermissible compensation is not limited to transaction-based compensation. However, co-investment in the securities offered on an online platform is permissible compensation for the purposes of Section 4(b). Question 6 asked if an entity such as a venture capital fund can operate an Internet website that lists offerings of securities by potential portfolio companies. In its response, the SEC staff indicated that subject to the restriction on transaction-based compensation under Section 201 of the JOBS Act, an entity such as a venture capital fund or its adviser may operate an Internet website that lists offerings of securities, and such websites may also provide standardized documents for use by issuers and investors. Question 7 asked whether an associated person of an issuer of Rule 506 securities could rely on the Section 4(b) exemption to maintain a “platform or mechanism” for the issuer’s securities. The SEC staff responded that such reliance is permitted, assuming the associated person otherwise qualifies for the exemption. Question 8 asked whether an entity whose staff is paid a salary to promote, offer, and sell shares of privately offered funds are exempt from registration under Section 4(b). In its response, the SEC staff indicated that the exemption is not available to any person who is paid a salary to promote, offer, or sell shares of a privately offered fund. Question 9 asked if an entity who is exempt from registration as a broker-dealer is nonetheless a broker-dealer. The SEC staff indicated that even those who are exempt from registration are still considered broker-dealers. Question 10 asked whether Section 4(b) provides an exemption from state registration requirements, to which the SEC staff responded that the exemption only applies to federal registration requirements.

SEC No-Action Letter Relief In March 2013, the SEC provided the first no-action relief from registration as a broker-dealer subsequent to the JOBS Act taking effect in a letter to FundersClub (“FundersClub”) and FundersClub Management (“FC Management”). 11 In the letter, the SEC staff indicated that the Division would not recommend enforcement action under Section 15(a)(1) of the Exchange Act if FundersClub and FC Management operated a platform through which its members could participate in Rule 506 offerings. FundersClub identifies start-up companies in which its affiliated fund will invest and then posts information about the start-up companies on its website so that the information is only available to FundersClub members, who are all accredited investors. The FundersClub members may submit nonbinding indications of interest in an investment fund, which relies on Rule 506 to conduct an offering. When a target level of capital is reached, the indication of interest process is closed, and FundersClub reconfirms investors’ interest and accredited investor status and negotiates the final terms of the investment fund’s investment in the start-up company. Members may withdraw their indications of interest at any time. In this process, FundersClub and FC Management do not receive any compensation; however, some administrative fees are charged. FundersClub and FC Management stated in the letter that they intended to be compensated for their role in organizing and managing the investment funds (at a rate of 20% or less of the profits of the investment fund but never exceeding 30%). The SEC staff notes in the no-action letter that FundersClub’s and FC Management’s activities, as described in the letter, appear to comply with Section 201 of the JOBS Act, in part because they and each person associated with them receive no compensation (or the promise of future compensation) in connection with the purchase or sale of securities. In another no-action letter, the Division of Trading and Markets granted relief to AngelList from the requirement to register as a brokerdealer. 12 In the letter, the SEC staff explained that it would not recommend enforcement action if AngelList were to establish an Internet-based platform to facilitate angel investing by accredited investors. The SEC staff noted in the letter that the AngelList Internetbased platform must be “exclusively available” to accredited investors. In order to remain exempt from broker-dealer registration, the SEC staff indicated that AngelList must not receive any transaction-based compensation. The response went on to explain that AngelList cannot solicit investors outside of the website itself, and the specific terms of any compensation paid to AngelList-affiliated investment advisers must be described in any offering document. The distinction between the FundersClub and AngelList online matchmaking platforms lies in the latter’s proposed use of a “lead angel,” who would identify the start-up and structure terms of the investment. In its request letter, AngelList stated that the lead angel would not receive a management fee. Instead, compensation would be restricted to a back-end carried interest that would be shared between an AngelList-affiliated investment adviser and the lead angel. However, the SEC may have opened the door for other unique fee arrangements by not treating back-end carried interest as transaction-based compensation. Moreover, the SEC conditioned its no-action relief on the fact that AngelList’s services did not extend beyond traditional advisory and consulting services.

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See FundersClub Inc. and FundersClub Management LLC, SEC No-Action Letter (Mar. 26, 2013). See AngelList LLC, SEC No-Action Letter (Mar. 28, 2013).

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Although helpful in certain respects, these letters are narrowly focused and do not address whether other registrations (such as registration as an investment adviser under the Investment Advisers Act of 1940) are required for the activities described in the letters. So long as the crowdfunding website adheres to the aforementioned requirements and does not receive transaction-based compensation, it will be exempt from registration as a broker-dealer. However, the FundersClub and AngelList no-action letters do not definitively explain the registration requirements for matchmaking sites that have different functions and compensation structures, including the use of Section 201(c) of the JOBS Act which exempts crowdfunded offerings from registration. On October 23, 2013, the SEC issued proposed rules to implement the crowdfunding exemption. 13 However, until final rules are adopted, the crowdfunding exemption is not available.

Key Considerations For Issuers Given the popularity of matchmaking sites, an issuer may consider using such a service in connection with a proposed Rule 506 offering. However, there are a few considerations that should be taken into account when choosing a matchmaking site over a traditional brokerdealer or financial adviser. First, there may be a benefit to using a traditional broker-dealer or financial adviser because a broker-dealer or financial adviser has a suitability obligation with respect to investors. In order to meet its suitability obligation, a traditional brokerdealer or financial adviser may be more focused on ascertaining whether an investor is experienced in investing in private offerings and may identify investors who have fewer liquidity needs. Second, if an issuer chooses to use a matchmaking site, the issuer should be prepared to have a more dispersed ownership (assuming accredited investors invest individually and not through a fund) and consider how this might affect the issuer’s capital structure and the issuer’s activities in the future. For example, if special rights are assigned to various classes of securities (e.g., voting rights, rights of first refusal, etc.), a more dispersed ownership will make it more difficult to effect or obtain waivers of such rights. A more dispersed ownership may also make it more difficult for the issuer going forward (after the financing) to contact holders in order to verify for Exchange Act Section 12(g) purposes (if the issuer is still a private company) that the holders are still accredited investors. 14 Third, there might also be a benefit to having a financial adviser help “position” the issuer with respect to marketing for the financing, which may include taking the issuer on a “road show” to meet with potential investors. These types of marketing efforts are not possible with matchmaking sites. Fourth, consideration should be given to how the issuer’s existing holders may view the financing, including the potential investor base. Again, existing holders may have certain rights that may be implicated in a contemplated financing. In addition, while some may view matchmaking sites as helping to democratize venture capital, some issuers may find using traditional broker-dealers or financial advisers preferable in the sense that they offer issuers an experienced investor base that can add value to the enterprise. For example, traditional broker-dealers or financial advisers may introduce issuers to entrepreneurs, engineers, recruiters, marketers, testers and the most experienced investors, who can provide value to issuers. If an issuer decides to use a matchmaking site, then the issuer and its counsel should familiarize themselves with the business model and the operations of the matchmaking site. The issuer needs to know (1) whether the matchmaking site is relying on the exemption under Section 201 of the JOBS Act, or whether the matchmaking site is a registered broker-dealer or intends to be exempt from registration, and (2) the functions or services that the matchmaking site will provide in connection with the financing. If the matchmaking site is not a registered broker-dealer or is not relying on the exemption under Section 201 of the JOBS Act, then its compensation structure will determine whether the matchmaking site is exempt from registration. Furthermore, the issuer needs to know whether the activities of the matchmaking site are organized in a manner that would constitute a “general solicitation.” If the matchmaking site is using general solicitation, then the issuer must rely on Rule 506(c) for its exemption and then will need to take “reasonable efforts” to verify that the investors are accredited. “Reasonable efforts” to verify investor status should include consideration of the nature of the investor, the nature and amount of information about the investor and the nature of the offering. Rule 506(c)(2)(ii) sets forth non-exclusive and non-mandatory accredited investor verification methods that, if satisfied, serve as safe harbors for issuers who will be deemed to have satisfied the “reasonable steps” verification requirement. The safe harbor verification methods include obtaining written confirmation from a third party of their

13 For more information regarding the SEC’s proposed crowdfunding rules, see our client alert, “Standing out from the Crowd: A Closer Look at the SEC’s and FINRA’s Proposed Crowdfunding Rules” (Nov. 15, 2013), available at http://www.mofo.com/~/media/Files/PDFs/jumpstart/131115-SEC-FINRA-Crowdfunding.pdf. 14 Under Exchange Act Section 12(g), an issuer must register a class of equity securities if, at the end of its fiscal year, an issuer has at least $10 million in assets and a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited investors.

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verification of accredited investor status within the past three months. The SEC has also provided additional guidance on the investor verification process in the form of Compliance and Disclosure Interpretations. 15 Notwithstanding the above, until the SEC adopts final rules on the crowdfunding exemption and implements Section 201 of the JOBS Act, it seems likely that issuers and matchmaking sites will rely predominantly on the exemption from broker-dealer registration.

For Matchmaking Sites As emphasized in a recent speech by David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets, in connection with any collective investment scheme for angel investing or venture capital or private equity investing for startups and emerging companies, fund sponsors and matchmaking sites should carefully consider their activities and determine whether specific exemptions from brokerdealer registration are available. 16 Acting as an unregistered broker-dealer should not be viewed as only a technical violation because engaging in these activities without registration can have serious consequences. For example, in addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right of rescission that an investor may have. 17 Fund sponsors and matchmaking sites should also consider whether their activities require registration as investment advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Although using social media to engage in selling activities would not by itself trigger registration as an investment adviser, the SEC has provided guidance on the applicability of Rule 206(4)-1(a)(1) under the Advisers Act to social media use by investment advisers, which applies to all investment advisers, whether or not they are registered under the Advisers Act. 18 In this regard, the FundersClub and AngelList no-action letters are helpful. However, there are limitations to their use as precedents for other matchmaking sites. As noted above, the FundersClub and AngelList no-action letters rely on the Rule 506 exemption and do not address the applicability of Section 201(c) of the JOBS Act to investment crowdfunding. As a result, FundersClub and AngelList stipulated that they would not receive commissions on sales, finder’s fees, success fees or management fees, but only carried interest. Although committing to receive only carried interest is essentially co-investment, it remains to be seen whether limiting compensation to solely carried interest will be economically viable for matchmaking sites in the long-run. Matchmaking sites are still relatively new and are evolving; thus, it remains to be seen whether matchmaking sites will continue to structure themselves according to the FundersClub and AngelList models or will adopt different structures once the SEC’s final rules on crowdfunding are available. Matchmaking sites must also decide whether they will use (1) the Rule 506(c) exemption (which permits general solicitation or advertising) or (2) the Rule 506(b) exemption with protections in place to restrict non-accredited investors from gaining access. If a matchmaking site chooses to use the Rule 506(c) exemption, then it must decide whether the investor verification will be performed by itself or a third-party vendor. There may also be compliance costs associated with investor verification, and privacy and other protections will be needed to safeguard sensitive investor information, which could be significant. Further, if the investor verification will be performed by a third-party vendor, the matchmaking site will need to consider the kind and level of due diligence performed by such vendor and whether it will be adequate.

Contacts Ze’ev Eiger New York (212) 468-8222 [email protected]

Alex Stone New York (212) 336-4088 [email protected]

15

See, e.g., “What’s New in the Division of Corporation Finance, July 2014,” available at http://www.sec.gov/divisions/corpfin/cfnew/cfnew0714.shtml. See speech of David W. Blass, Chief Counsel, Division of Trading and Markets, titled “A Few Observations in the Private Fund Space” (Apr. 5, 2013), available at http://www.sec.gov/News/Speech/Detail/Speech/1365171515178#.VLkzYWl0xWI. 17 In the same speech, Mr. Blass mentioned that the SEC was working collaboratively with FINRA on a more customized approach for regulation of market participants who perform only limited broker-dealer functions. In this context, Mr. Blass mentioned the SEC staff’s work with FINRA to consider the appropriate level of regulation for funding portals given the limited scope of their activities. Mr. Blass also noted that the SEC staff was considering whether there were opportunities to extend the approach to other types of brokers-dealers whose activities are limited. 18 See IM Guidance Update, No. 2014-04 (Mar. 2014), available at http://www.sec.gov/investment/im-guidance-2014-04.pdf. For more information regarding SEC guidance on social media use by investment advisers, see our blog post, “New Regulatory Guidance on Use of Social Media by Investment Advisers” (Apr. 7, 2014), available at http://www.sociallyawareblog.com/2014/04/07/new-regulatory-guidance-on-use-of-social-media-by-investment-advisers/. For more information regarding investment adviser issues that the SEC will focus on, see speech of Andrew J. Bowden, Director, Office of Compliance Inspections and Examinations, titled “People Handling Other Peoples’ Money” (Mar. 6, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370541260300#.VLlArGl0xWJ. 16

© 2015 Morrison & Foerster LLP

Investor Criteria for U.S. Private Placements and Other Offerings Summary Tables and Comparisons Regulation D: Accredited Investors • • • • • •

• •

Banks and savings and loan associations. Registered brokers or dealers. Insurance companies. Registered investment companies, business development companies, small business investment companies. Employee benefit plans established by a state or its subdivision with assets exceeding $5 million. ERISA plans where the investment decision is made by a plan fiduciary, or if the plan has assets exceeding $5 million. (Or if a self-directed plan, investment decisions are made by accredited investors.) Private business development company under the Investment Advisers Act. Corporations and other entities with assets in excess of $5 million.

•

• •

•

•

Director, executive officer or general partner of the issuer of the securities being offered (or any director, executive officer, or general partner of a general partner of that issuer). Natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1 million. Natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years (and has a reasonable expectation of reaching the same income level in the current year). Any trust, with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person”. Any entity in which all of the equity owners are accredited investors.

Source: Rule 501 of Regulation D.

Institutional Accredited Investor: Regulation D This category is not a defined term in Regulation D. Instead, an offering document or agreement may limit sales of the applicable securities solely to the Regulation D accredited investor categories that are institutional in nature (i.e., to those described in Rule 501(a)(1), (a)(2), (a)(3) or (a)(7)). This limitation is imposed in Regulation D offerings when the offering participants do not want individuals to purchase securities in the offering.

Rule 144A: Qualified Institutional Buyers •

Any of the following, which owns and invests at least $100 million in securities of unaffiliated entities: o

Insurance companies.

o

ERISA employee benefit plans.

o

Registered investment companies (subject to special aggregation rules relating to fund families) or any business development company.

o

Certain trust funds where the trustee is a bank or trust company, and where the participants are certain institutions.

o

Business development companies.

o

Licensed small business investment company.

o

Corporations and other entities.

o

Employee plan established by a state or a subdivision.

o

Registered investment advisers.

•

Registered broker-dealers, acting for their own accounts or the accounts of other QIBs, that owns and invests at least $10 million in securities of unaffiliated issuers.

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Any entity, all the equity owners of which are QIBs, acting for its own account or the accounts of other QIBs.

•

Any bank, savings and loan or non-U.S. bank or savings and loan that owns at least $100 million in securities of unaffiliated issuers that are not affiliated with it and that has an audited net worth of at least $25 million.

Source: Rule 144A(a).

Major U.S. Institutional Investor: Securities Exchange Act • • •

A U.S. institutional investor that has, or has under management, total assets in excess of $100 million (for purposes of determining the total assets of an investment company under this rule, the investment company may include the assets of the family of investment companies of which it is a part). A registered investment adviser that has total assets under management in excess of $100 million. Must be: o A registered investment company; or o A bank, savings and loan association, insurance company, business development company, small business investment company, or certain employee benefit plans; a private business development company (as defined in Rule 501(a)(2)); a 501(c)(3) entity; or a trust.

Source: Rule 15a-6 under the Securities Exchange Act.

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Investor Criteria for U.S. Private Placements and Other Offerings Summary Tables and Comparisons Qualified Purchaser: Investment Company Act •

Any natural person who owns at least $5 million in investments.

•

Any company that owns at least $5 million in investments and that is owned by or for 2 or more natural persons that are related (or foundations or trusts established for their benefit).

•

Certain trusts established for the investors in the two prior bullets.

•

Any person, acting for its own account or the account of other qualified purchasers, who owns and investment at least $25 million in investments.

Source: Section 2(a)(51) of the Investment Company Act.

Knowledgeable Employee: Investment Advisers Act •

An executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the investment company or an affiliated management person.

•

An employee of the investment company or an affiliated management person who participates in the investment activities of the investment company or its affiliates, provided that the individuals has performed these duties for at least one year.

Source: Rule 3c-5 under the Investment Advisers Act.

Qualified Client: Investment Advisers Act •

A natural person or a company that has at least $1 million under the management of the investment adviser.

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A person or a company that investment reasonably believes either:

•

o

Has a net worth (together with a spouse) of more than $2.1 million (as of August 15, 2016); or

o

Is a “qualified purchaser” under the Investment Company Act.

A natural person who is: o

Part of the investment adviser’s management; or

o

An employee of the investment adviser who participates in the investment activities of such investment adviser, and has had such duties for at least one year.

Source: Rule 205-3 under the Investment Advisers Act.

Eligible Contract Participant: Commodity Exchange Act •

Entities with more than $10 million in assets (or an entity guaranteed by such an entity).

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Individuals with at least $10 million invested (or $5 million if the individual is hedging).

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An entity with a net worth of at least $1 million that are hedging commercial risk.

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Financial institutions.

•

Insurance companies.

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Registered investment companies and similar non-U.S. entities.

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Commodity pools with at least $5 million in assets under management.

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ERISA plans with assets of at least $5 million (or that have investment decisions made by a registered commodity pool adviser, commodity trading adviser or a financial institution or insurance company).

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U.S. federal, state and non-U.S. government entities.

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U.S. registered broker-dealers and similar non-U.S. entities.

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Futures commission merchants and similar non-U.S. entities.

Source: Section 1a(18) of the Commodity Exchange Act.

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Practice Group Description

Late Stage Investments Our lawyers regularly advise issuers, placement agents and investors in connection with private placements of equity, debt and hybrid securities. Private placements may be the first step for a venture capital or entrepreneurial client, or an alternative for a well-established issuer needing to raise capital when the public equity markets are unavailable. As privately held companies choose to remain private longer and defer their initial public offerings or other liquidity opportunities, these companies are focused on raising capital in private placements principally to institutional investors, cross-over funds and strategic investors. Often, these late-stage private placements are a prelude to an initial public offering. Late-stage private placements raise a number of special considerations for issuers, investors and financial intermediaries. A late-stage private placement may follow after many successive prior rounds of financing and requires addressing the rights of various categories of existing stockholders. In addition to providing a capital-raising opportunity, a late-stage private placement also may serve as a means of providing liquidity to longstanding stockholders, such as angel investors and friends and family. This can take place through a secondary private placement or through a tender for shares held by existing stockholders. Properly structuring a late-stage private placement is important to the issuer’s IPO planning. Given our understanding of the private placement market and our expertise with IPOs, we are well-placed to address these concerns. Over the years, we have worked with our financial institution clients to devise new distribution methodologies for securities, such as the PIPE transaction. Created by Morrison & Foerster lawyers in 1985, the PIPE (private investment in public equity) transaction has become a key financing alternative for public companies choosing to raise capital in tough markets or to address specific objectives. PlacementTracker and other data providers rank the firm as one of the most active in representing issuers and agents in connection with private placements and PIPE transactions.

Recent Representative Late Stage Investment Matters We regularly represent our issuer clients in connection with their capital-raising needs, including their private financings and pre-IPO private placements. Similarly, we regularly work with our placement agent clients in connection with late stage institutional private placements.

Late Stage Investments | 1

Practice Group Description We highlight below a few matters on which we were engaged to advise the issuer or the investor on the financing. Revolution Foods •

Represented Revolution Foods, a provider of school meals and ready to eat meal kits, in its $31.5 million Series H venture funding from Revolution Growth. The Series H funding gave the company a reported pre-money valuation of approximately $172 million. We are currently advising the company on a Series I financing.

Fortress Investment Group •

Represented Fortress Investment Group in its later stage investments in:

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Uber Technologies, a mobile application that connects riders and transportation — provider of ride-sharing services. The company is reported to have an estimated pre-money valuation of $51 billion as of August 2015 (Wall Street Journal/Dow Jones Venture Source).

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Lyft, an on-demand ride sharing service matching drivers with passengers who request rides through the company’s iPhone or Android application. Fortress was a new investor in a late stage funding, which at the time, raised Lyft’s valuation to approximately $2.5 billion. (March 2015)

BrightPath Capital Partners •

Sungevity. Represented BrightPath Capital Partners L.P., as lead investor in a $63.8 million later stage Series C venture investment in Sungevity, an international provider of residential solar installations. The company is reported to have a pre-money valuation of approximately $235.8 million.

Buchanan Investments •

Tri Alpha Energy. Representing Buchanan Investments, a San Franciscobased venture investment firm in its proposed late stage investments in Tri Alpha Energy, a developer of plasma-fusion technologies used to generate energy.

Intel Corporation •

Cloudera. Represented Intel in its $740 million later stage investment in Silicon Valley's Cloudera, a leading enterprise data management software provider. Intel Corporation and Cloudera announced their broad strategic technology and business collaboration, as well as the equity investment from Intel, in March 2015. This was Intel's single largest "big data" center technology investment in its history.

Late Stage Investments | 2

Practice Group Description Softbank Group •

SoFi. Represented the SoftBank Group in a $1 billion Series E funding of SoFi, one of the nation's leading marketplace lenders. The funding led by SoftBank marked the largest single financing round in the fintech space to date.

SoftBank Corp. •

Legendary Entertainment. Represented SoftBank in its $250 million investment in Legendary and the formation of a joint venture to exploit Legendary’s intellectual property rights.

Corvus Pharmaceuticals •

We represented investors led by Rock Springs Capital Management in their investment in Corvus Pharmaceuticals, Inc. Corvus is a private clinicalstage biopharmaceutical company focused on the development of novel agents targeting the immune system to treat patients with cancer. Rock Springs and other healthcare focused funds invested $75 million in a Series B financing.

Late Stage Investments | 3