Will Crowdfunding and General Solicitation Change How Companies Raise Capital? [e298]

Full Podcast Transcript

NASIR: Hi, and welcome to our podcast.My name is Nasir Pasha.

MATT: And I’m Matt Staub.We’re two attorneys here with Pasha Law, practicing in California, Texas, New York, and Illinois.

NASIR: And this is where we cover business in the news and add our legal twist to that news.Legally Sound Smart Business – we’ve been doing this podcast for now, I don’t know, I feel like it’s been like five, ten thousand years, something like that.

MATT: Well, I don’t know if those numbers are accurate, but there’s a recent story how the podcast industry is oversaturated which I would probably agree with because now everyone and their pets have a podcast.When we started doing it, I mean, we weren’t—

NASIR: It was novel at the time, but now it’s like everyone has a podcast.You know, we still get a lot of listeners, so why not?

MATT: Yeah, sure.That’s the thing. The market’s over-saturated, but there’s not a lot of podcasts – not in our category, I guess you could say. You know, not everyone is as charismatic as you and I are.

NASIR: Ah, yeah.Unlike other attorneys, we actually have lives and want to do something else other than write contracts and review contracts all day. Maybe that’s what it is. But we enjoy our work, so that’s why, I think.

MATT: Yeah, no complaints.

NASIR: Well, anyway, today is a tough topic because it’s a little kind of technical, so I don’t want to make it too dry. But, at the same time, it’s pretty relevant to so many of our clients in the sense that this is a pretty prominent issue, and that is raising capital for your company – whether you’re an early startup or really well into your road – what are your options out there and talking about what’s going on with crowdfunding and kind of give it a quick update in that regard as well.

MATT: Sure.Like you said, it can get pretty complex, pretty technical, so what we’re going to do – and I’ll start off with a recent story.

NASIR: Should we just start out by reading the statute? Regulation 506(b) says…

MATT: Now, I’m pretty sure, I’m going to say wit pretty strong confidence, there’s no podcast that does that, but I guess I could be wrong.

NASIR: We could be the first.

MATT: There’s a story – by the time this comes out, there might be an update, they’re just kind of waiting – there hasn’t been anything recent in at least about a month or so since we’re recording right now, but the story I’m talking about – and maybe the listeners saw it – I’ll try to summarize it here.It was a fairly young woman that was driving at night in Philadelphia. Car ran out of gas. She didn’t have any way to get gas, and no Triple A or anything like that. A homeless man happened to be around. He had only $20.00 to his name. He offered to give it to her. She was able to buy gas and get home. Really nice gesture.What ensues from there is what gets interesting.This woman Kate McClure and her boyfriend Mark D’Amico started a GoFundMe page to try to raise – at the time – $10,000 for this good Samaritan that gave his last dollars to this woman that was stranded on the highway. They started the page. The goal was $10,000. It got all the way up to over $400,000. They stopped it at that point just because it was just getting out of control.For those of you that are not familiar with how GoFundMe works, anyone can donate money and it goes into this pool. Correct me if I’m wrong, as long as you hit your goal, you get the funds, right?

NASIR: Right – minus their fees, of course.

MATT: They definitely hit their mark – 40 times over.So, the money goes to this couple. Basically, they promise that they’re going to give it to this guy. They promise him it’s going to be put in a trust, they’ll buy him a home. You can imagine it didn’t go that way because we’re talking about it now.Basically, the couple gave him some money. How much? It’s uncertain. They essentially what appears to be spent almost all of it. The man eventually files a lawsuit against them alleging fraud, conversion, and things of that nature. “Essentially, you stole money that was rightfully mine.” That’s what he’s saying.

NASIR: Yeah, and these crowdfunding sites, I mean, I swear, this story multiplied over and over again in a sense that someone raises a bunch of money, and either the money doesn’t get to them or the person that was asking for the money was committing fraud – like, they weren’t actually sick or what-have-you. It’s a prominent problemFrom a legal perspective, it’s pretty basic. Look, if you lie about what we’re raising money for, that’s fraud and misrepresentation. If you collect money on someone else’s behalf and don’t give them that money, then that’s also pretty clear as well.I know they have some kind of, well, maybe not a legal defense. They may have some kind of rational defense that this guy was going to use it on alcohol or drugs. “We did buy him things. We were not giving him cash. We were buying him a home,” for example – a mobile home or something to that effect.

MATT: Honestly, their defense is pretty weak. You’re pretty much correct on what they’re saying.Of the 400, they claim they gave him half of that – $200,000 in cash – personal property and then other services, whatever that means. But they’re saying that he spent it all or got rid of it all because he has some drug problem which would be a pretty extreme amount of money to blow through.There’s also all these photos and evidence of them going places, spending this money.Just real quick, to wrap up the actual facts here, a lawsuit was filed. You know, civil suit is filed, in the process. Eventually, it comes out that they say that all the money is gone.

NASIR: Shocking.

MATT: The civil case was halted because they’re waiting. Basically, the civil case is pending. For the criminal case, it’s now being looked into.In the last update I saw, their attorney – I know it is now ex-attorney – says, “I’ll likely be indicted.” I assume for misappropriation amongst other things. Their stuff was seized from their house. It’s not looking good for them, and that’s as far as we’re at right now.

NASIR: But, hey, at least they got that money for gas.

MATT: It’s true. She was able to go home that night, so that’s a plus.

NASIR: I don’t want to get too much into this, but they’re probably thinking, “No good deed goes unpunished,” but it doesn’t mean no good deed followed by bad deeds doesn’t work either.

MATT: Yeah, exactly.

NASIR: But, of course, these are alleged, so who knows what happened.

MATT: Exactly.

NASIR: So, yeah, this is, of course, what I think is commonly considered as not equity crowdfunding but actually donation-based crowdfunding. And so, for businesses, of course, there are Kickstarter-type models where you can raise money in exchange for nominal consideration in the sense that you’ll give them the product or what-have-you and jumpstart your product, but they’re not buying into your business and it’s not quite donation-based crowdfunding either. It’s close to it, right?I mean, I’ve seen on Kickstarter or other sites like it, you know, you have a film project, you’re not really getting your money’s worth back, so it’s not necessarily a market consideration perspective, so there is a donation feel to it.We’re talking more about capital raising on the equity side which is a whole other world because, typically, the SEC doesn’t get involved when it comes to this donation-based crowdfunding.

MATT: Right.Real quick comparison, typically, GoFundMe is raising donations for a charitable cause. The Kickstarter is more so pumping money into a company to basically get them up and running and get them to the point where they need to be. But, like you said, no equity is received for these funds, so that’s why the SEC doesn’t get involved – because there’s no equities being exchanged.But then, we get to the actual ways that you can do – what would we want to call it? – like, legal crowdfunding where you actually do have people providing money in exchange for equity in these various companies.

NASIR: Yeah, and I think, because people use the crowdfunding term a little loosely, we get called every once in a while. “Hey, I want to raise money through crowdfunding, et cetera.” But, depending upon what you mean by that, it can get kind of complicated.Really, the only way, I think, to break it down is to kind of go through the different types of raising capital raises. Let’s just start with the most traditional route.I think most people should – at least, if they’re not familiar with it – have heard of this type which is basically the typical what people would consider a Reg D filing. It’s not quite that because Reg D can also be referencing their 506(b) or 506(c). But the typical traditional Regulation D filing or offering is under 506(b) – as in boy. That’s where you are limited to 35 non-accredited investors or unaccredited investors and unlimited accredited investors, but that seems to be the typical route. You have to do your PPM – private placement memorandum. You have to do the certain disclosures – very simple filings. This is an exemption, so you don’t have to register with the SEC or anything like that. It’s pretty straightforward, and most law firms that have SEC experience have probably done a ton of these.

MATT: Yeah, and I think you’re right.When people hear about raising capital outside the company, this is probably what they’re referring to most of the time, just because it’s the most traditional route. You do have that nice ability to have up to 35 non-accredited investors, so that’s pretty big. That’s the opportunity to find people that might not have substantial assets or income and bring them into the fold. I was going to say it’s a fairly straightforward process but as much as it can be straightforward in a sense of raising funds, I guess.

NASIR: But the drawback of 506(b) is, of course, you can’t publicize or market your offering publicly. And so, of course, that really defats the purpose of crowdfunding because, if you want to get a huge crowd, you have to market it accordingly. And so, that’s why, when it comes to crowdfunding, everyone’s looking at other offerings besides the traditional 506(b) offering.

MATT: Right.We’ll move on to kind of compare and contrast with 506(c).To me, there’s obviously more than a couple of differences, but to me there’s a couple of pretty big differences. The one you just talked about was the solicitation piece. This isn’t marketed directly to the actual investors. I mean, this could be marketed over the internet or some advertisement or TV or social media even potentially. There are no limitations. It’s a pure solicitation raise.Now, the trade-off is it can only be to accredited investors which, you know, not many people are accredited investors. I don’t know if you have any idea of actual numbers.

NASIR: Percentage-wise, yeah.Just to kind of give you guys an idea, it’s basically, you know, just think of how many people do you know that have a net worth of more than a million dollars or how many people do you know that have a salary of more than what is it now? I want to say $200,000. I think $200,000. And then, if you’re married, yeah, it’s $200,000. How many people do you know that have an individual income of $200,000 or more? If they’re married, it has to be $300,000 or more. That’s a small segment of the population. I don’t know about percentages. I would assume, you know, a minority, obviously.

MATT: Oh, yeah. I mean, it depends on the pool of people we’re looking at. Worldwide, it’s a little bit different but, yeah, I mean, it’s not a huge number of people.The other big thing – at least in my opinion – under 506(b), for the accredited investors, they’re able to self-certify, usually. Under 506(c), since all of them do have to be accredited, there needs to be some certification process. Some reasonable steps need to be taken. I mean, it’s a more scrutinized certification process. You can’t kind of just take their word for it in that sense.

NASIR: Yeah.But, at the same time, it’s pretty straightforward, still. You go through the investor questionnaire and things like that. By the way, I just looked it up, it’s definitely less than five percent of the population. Some estimates I’ve seen three percent, four percent. It just kind of depends upon what stats you’re looking at. That’s a very small population.

MATT: Look to your left and then look to your right and then do that fifty more times. Three of those people will be accredited investors.

NASIR: Or just randomly collect a hundred people in a room and three of those are going to be accredited. I like that better. It’s easier.

MATT: That could work, yeah, sure.

NASIR: Don’t kidnap them.But, yeah, 506(c), I personally like 506(c), and I think we’ll find out why because even though you’re limiting to accredited investors, again, it depends how much you’re raising, too. But, because you’re limiting to accredited investors, the regulatory requirements and the hurdles that you have to go through is actually relatively so much easier than pretty much all the other exemptions.And so, just kind of tag that for a second. if anyone’s thinking of doing some crowdfunding, yeah, you may want to expand it to non-accredited investors, but understand that, as soon as you include those non-accredited investors, then you have other limitations. Let’s talk about how that works.

MATT: We can move on to what’s tagged as Regulation CF. This is more of the crowdfunding aspect.It’s similar to 506(c) in the sense that it’s a more general solicitation. This is marketed over the internet, but it’s all primarily done through a funding portal.

NASIR: And these portals have popped up. Since this regulation has been acted, they’ve popped up everywhere, and there’s a bunch of them. Those portals themselves have to go through a process. I’m not particularly familiar with how that works.But, a lot of times, basically, they have to be broker dealers because they’re basically acting as an intermediary, and there are some other limitations because, when you are actually providing the disclosures, they require audited financial statements, for example, and other disclosures that are mandated by statute regulation whereas, going back to the 506(b), there is a memorandum that’s typically used, and you do have to have certain disclosures.But then, on the 506(c) which is for the crowdfunding, you pretty much are pretty open as to what you can provide. Typically, it’s just a matter of what the market wants. I mean, you do want some sort of business plan. Investors want to see some kind of perform anyway. In order to be taken seriously, you need to disclose something, but it’s definitely not comparing that to the crowdfunding or Regulation CF. it’s definitely not as cumbersome.

MATT: Yeah. And so, maybe think about, “Well, it sounds great. What’s the catch here?” I think the big thing is the cap on how much can be raised. Just the one-million-dollar limits. Obviously, a million dollars isn’t nothing. But, when we’re talking raising funds, that’s not going to get you too far in the grand scheme of things, for any company with big aspirations.

NASIR: Yeah.But what’s also interesting though is that, unlike some of the others – Regulation A which we’re going to talk about in a minute – you actually can do contemporaneously a 506 offering with the Regulation CF. Just to kind of put that together, you could do a 506(b) offering – you know, people that you know directly and identify as a credit investors or people that are interested in your investment – along with this crowdfunding portal, and that can actually allow you to, I believe it allows you to increase those limits.In other words, the one-million limit would just be limited to just the crowdfunding source.

MATT: Yeah, it’s like the Jack in the Box of fundraising. It’s like, “Well, I wanted to get burger and fries. I also wanted to get a taco.” It’s like, “Well, you know what? You can do both of those at the same time because we have both of those options here.”

NASIR: By the way, you do know that you have to disclose if you’re sponsored by Jack in the Box.

MATT: Oh, yeah, I’m definitely not. Actually, I don’t think I’ve ever even been there, now that I think about it. It’s just the commercials are on nonstop.

NASIR: That’s true. They have the best commercials.

MATT: They definitely are good.

NASIR: And so, on the crowdfunding, they also have limits on how much a particular individual can invest as well. Again, just to kind of give some understanding, basically, the SEC is like, “If we’re going to allow crowdfunding, we want to have some protection still,” especially if you’re approaching non-accredited investors.”And so, basically, the limits are they individualize annual limits of five percent of their net worth or income below $100,000 and ten percent above $100,000 and then a floor of $2,000 and ceiling of $100,000.

MATT: That’s pretty restrictive. I think the idea behind this is a lot of people in the pool together, and it is smaller amounts of money that’s grouped together to get up to that potentially one-million-dollar ceiling. Again, keep in mind what we said before, but just kid of that soft cap of one million dollars.

NASIR: Regulation A, I feel like a lot of people, when crowdfunding and the crowdfunding rules were proposed and adopted, et cetera, Regulation A was a popular topic of consideration.Regulation A is actually split into two tiers – Tier One and Tier Two. Also, public offering, you don’t have to go through a portal, so to speak. It’s a little bit different in that respect, but it has much more filings requirements. That’s the trade-off there.

MATT: Yeah, and then the caps are higher as well – Tier One being 20 million annual limit, and Tier Two being 50 million annual limit. I believe there’s limits on individual investment as well for that second tier – ten percent of income or net worth per offering.It definitely grows in size. Like you said, there’s restrictions.

NASIR: There’s some little things, too – like the SEC must review, comment, and declare it “qualified before the sale.” There are some kind of extra steps. Again, just disclosure, we haven’t done a Reg A offering. It just hasn’t really made sense for any of the clients that we’ve gone through. Maybe there are some out there, but it just seems like maybe it’s right for a type of company and product that is only going to succeed in investment if you go to a pool of investors.But, I’ll tell you, typically, if you have a pretty decent business idea or existing business with history, raising funds from accredited investors or non-accredited investors – whether it’s a public offering or not, and public offering in the sense that you’re offering it publicly or not – you know, you can usually raise those significant funds or adequate funds fine without going through this process.

MATT: Yeah, and that’s the big thing. I think that’s the primary reason that you just don’t see these as much.One interesting point though, Reg A, I believe, it’s the actual securities are freely tradeable which is as opposed to the more restricted securities and the 506’s and even the Regulation CF.

NASIR: Yeah. Typically, they’re restricted stock meaning you can’t resell it within one year and things of that nature, and that could be appealing, especially if you’re in a startup kind of world where the value of the stock or the units or the equity interest can fluctuate dramatically, especially increase dramatically, and allowing those investors to kind of cash in early if there’s a second or third round with a higher purchase price.

MATT: Exactly. It could happen but, yeah, it still seems like, if that was the case, you would just have to be really strapped for cash in order to not want to ride that out. Or I guess if you thought it was just going to start to crash all of a sudden. I mean, usually, once it starts growing, in that sense, you want to at least hang on for a little bit, but I don’t know.

NASIR: You know, these are the basics, and I think, when most attorneys go through this, these are the differences, but keep in mind that there are some so-called advanced or deeper tier information that distinguishes between these different types of fillings.I’ll go through them quickly just as an example. For example, if you have an investment company or what is considered to be a blank check company, these crowdfunding options are not going to be available to you. For example, an investment company where you’re collecting money to invest into multiple securities, for example, or properties. Or a blank check company where you don’t necessarily have a business plan, so to speak. That wouldn’t be allowed under these options.

MATT: Yeah.So, I think we’re now ready to enter the shark tank, and we can offer up, I think we’ll do $150,000 for ten percent of this podcast.

NASIR: Hmm. That sounds appealing.

MATT: The first thing I’ll ask is do you have any sales? We’ll say, “Well, it’s a podcast, so not really.”

NASIR: We have a bunch of sales.

MATT: We just sell hard copies of the podcast.

NASIR: Very good.I think that covers it from top to bottom. I don’t know every detail. We didn’t cover every detail, but most of it.

MATT: Yeah. If people are interested, we gave the audience a little bit of everything – the ways to raise money and, also, if you want a good story, this one’s pretty interesting. I’m interested to see how that one plays out with the couple that ran that GoFundMe page.

NASIR: It sounds like they’re going to jail and most likely that homeless guy is no longer going to be or still going to be homeless because he’s probably not going to get his money. I hope his attorney took it on contingency. That’s all.

MATT: Yeah, the attorney was pro bono. And then, from what I read, the attorney for the couple is no longer their attorney.

NASIR: He withdrew, right?

MATT: Yeah, I assume he withdrew because he said they’re most likely going to be indicted. Not great coming from your former attorney, but I don’t know the actual result or how in danger they are. I guess we’ll see. I guess we’ll see what they do with the money, then we’ll find out.

NASIR: Well, thanks for joining us.

MATT: Keep it sound and keep it smart!