A Deeper Dive Into the New SEC Rules That Could Change the Face of Regulation Crowdfunding Forever
Introduction
Many within the crowdfunding space are excited to hear that the SEC adopted new rules regarding changes to Regulation Crowdfunding (Reg CF), Rule 504 (Direct Public Offering - DPO), and Regulation A+ (Reg A+ Tier 2). These changes will prove to be beneficial for the entire industry. Now, small business issuers can raise up to $5MM for Reg CF offers; $10MM for DPO offers; and $75MM for Reg A+ Tier 2 offers. In response to this collective excitement, others have already published articles highlighting many of these game-changing improvements. I even wrote an article on these very same changes entitled "Show Me The Money!" which can be read at www.elcesq.com/writings.
Still, there has not been any significant attention paid to the new rules that now allow Reg CF issuers to utilize “special purpose vehicles” (SPVs). Special purpose vehicles are really important for facilitating capital formation for small businesses and providing education and informed decision-making for investors. These two factors are necessary for upholding the integrity of the crowdfunding industry. As such, I am surprised to learn that no one has discuss special purpose vehicles to any great detail yet! Well, this short article will do a really great job of that, including how these vehicles can increase racial and economic diversity within investment crowdfunding.
Special Purpose Vehicles (SPVs): The Co-Offeror
Special purpose vehicles (SPVs) are investment companies formed by or on behalf of an issuer with a single purpose to only invest in the issuer so that managing investors comes easy. Currently, the SEC prohibits investment companies from utilizing Reg CF reasoning that the purpose of the statute is to “facilitate capital formation by early stage companies...” and according to this view, investment companies are not included.
Recently, however, the SEC has had a change of heart. The Commission now excludes "crowdfunding vehicles," i.e. SPVs, from the definition of "investment companies" under the Investment Company Act of 1940 so now SPVs can be co-offerors of securities along with the small business issuer. SPVs, acting solely as conduits between investors and issuers, will help issuers manage their investors by reducing their count on capitalization tables from hundreds (and in some cases, thousands) to only one entity - the SPV. Likewise, SPVs will make investing in the issuer more attractive by making it easier for an interested purchaser to assess the value of the issuer's shares or membership interests. SPVs will also make communication between issuers and investors more efficient by providing a streamlined approach. Now, instead of communicating with hundreds to thousands of different investors at any given time, the SPV will allow the issuer to simply communicate with all investors through one entity.
Furthermore, issuers may be more comfortable with providing voting rights to its investors if they were organized under a SPV. Currently, many Reg CF issuers are reluctant to offer any voting rights to crowdfunding investors since it is difficult for the issuer to get things done efficiently when it needs the approval of hundreds to thousands of investors. On the contrary, the SPV would aggregate the hundreds of investors into one single entity, thus making decision-making and governance within the issuer easier to manage. This new feature will prove to be very rewarding for the issuer since offering voting rights is likely to attract a more diverse set of investors.
In addition, SPVs will provide a more efficient way for issuers to offer investment education and other business information to investors. This is especially important since modern crowdfunding is still a new concept for many people, especially within Black and Brown communities. Currently, there is simply not enough education that makes crowdfunding attractive to different types groups who would otherwise become participants within the industry. As a result, the industry remains heavily dominated by White, wealthier, and more sophisticated participants. I expect the use of SPVs to increase greater representation of people of color within crowdfunding because it will make education and the distribution of pertinent business information more accessible to investors.
With all of its benefits, there are still others who see SPVs as a risk to investors. One of the biggest risks is that SPVs may create majority-minority interests among the investors whereby minority investors receive less protections than majority investors. This includes majority investors making decisions on behalf of the SPV that could potentially dilute or otherwise harm the interests of minority investors. However, there are ways to structure the SPV so that these risks are avoided.
The SPV can be created as any other business entity and administered by either the issuer, crowdfunding portal, or some other third-party, so long as the SPV is created with a single purpose of serving as a conduit for purchasers to collectively invest in the issuer. Under this approach, the SPV and issuer are co-issuers under Reg CF. This means both entities would jointly file a Form C in order to provide prospective investors with business information and offering disclosures of both the SPV and issuer. Remember, the sole purpose of the SPV is to serve as a conduit by which investors collectively invest in the issuer.
Thus, the disclosures provided by the SPV should mirror that of the issuer and include how many shares or membership interests it will purchase from the issuer as well as how many of these shares or interests will be divided among the individual purchasers within the SPV. Other disclosures by the SPV should include its voting and governance structure so that individual purchasers know exactly how much control they will have within the SPV. It is important to reiterate, however, that the economic, voting, and governance rights of individual purchasers within the SPV should match that of which is offered by the issuer.
The SPV will also be required to provide any and all information that it receives from the issuer to each individual investor. Similarly, the SPV will have to afford each investor the right to assert their individual investment rights under both state and federal law as if they had invested in the issuer directly. This includes the right to examine corporate records. Finally, the SPV will be required to have only one class of securities, thus preventing some investors having preferred rights over others.
Other benefits of utilizing SPVs include being able to attract thousands of investors without having to register its securities under the Exchange Act Section 12(g) rule. This rule states that an issuer will have to register its offering with the SEC, despite its previous exempt status, if (1) it has more than $10 million of total assets, and (2) it has more than 2,000 investors, or more than 500 non-accredited investors. This is very important for Reg CF issuers because many of them will have hundreds of non-accredited investors. This rule change is especially helpful since the allure of Reg CF is that it provides investment opportunities to thousands of non-accredited investors who would otherwise not be able to participate without this new rule.
Of course, creating and administering SPVs will add additional financial costs to the issuer. This is true even where the SPV is created and administered by a crowdfunding portal or some other third-party. Still, the benefit of a SPV can outweigh these costs, especially where it can help save on other costs pertaining to the management of thousands of investors. In addition, if crowdfunding portals start to include SPVs as part of their business model, it may encourage competitive fee structures among the portals which would benefit issuers and allow them to save costs in the long-run. The foregoing should help prevent the inherent risks of SPVs and make investment crowdfunding more worthwhile.
CONCLUSION
More and more non-accredited investors are participating in Reg CF offers, and now that Reg CF is becoming more popular, especially among underrepresented groups, the creation of SPVs are more important than ever. It is my hope that more attention is paid to SPVs so that others can learn how to create investment structures that better suit a diverse set of investors and issuers. If you care to learn more about special purpose vehicles, or need assistance with creating one, please do not hesitate to contact the crowdfunding securities law firm Elizabeth L. Carter, Esq., LLC at info@elcesq.com.