Using the Web to Match Private Companies and Potential Investors: SEC No Action Letters Open a Door, but Questions Remain

In a no action letter dated March 26, 2013 (the "FC Letter"), the staff of the U.S. Securities and Exchange Commission (the "SEC") indicated that they would not recommend action against the operators of the FundersClub website ("FundersClub") for failing to register as a broker/dealer under the U.S. Securities Exchange Act of 1934 (the "Exchange Act). Two days later, a similar letter (the "AL Letter") was issued to the operators of the AngelList website ("AngelList").^{<spanclass="pubbodytext">[1]</spanclass="pubbodytext">}

The Letters may remove one of the most significant obstacles to the development of a broad-scale, online business in which accredited investors are able to select and invest in private companies. However, the Letters are based upon a number of representations made by FundersClub and AngelList that may be difficult to defend or apply in practice. They also leave unaddressed a number of related legal issues. Thus, the Letters may represent only the beginning of a process in which entrepreneurs, investment managers, private companies, the Staff, the SEC and others explore and develop the rules and practices under which such a business may be operated.

This Client Alert briefly describes certain key issues and conclusions associated with the Letters and highlights some of the issues and risks that remain.

Background

Historically, the process by which private companies raise capital and by which investors find private companies in which to invest has been characterized by club-like activities involving insiders within a relatively close-knit community. There are many reasons for this, but the most significant include:

• Private placement rules. Under U.S. securities laws, private (e.g., pre-IPO) companies generally are not permitted to publicly offer their securities for sale (e.g., via a "general solicitation"). This typically has forced private company management/entrepreneurs to raise capital on a one-to-one or one-to-small-group basis. (These rules are expected to be relaxed in the near future, as described below.)
• Broker/dealer rules. Under U.S. securities laws, qualified intermediaries such as registered broker/dealers ("RBDs") may seek to place private company securities with a broader market of prospective investors. However, the burdens associated with being an RBD are high. Key individuals associated with an RBD must satisfy testing requirements, and RBDs are subject to complex compliance rules. Often, an RBD will refuse to place securities for a private company because the small size of the offering cannot support an adequate level of compensation to the RBD for its efforts. Some private companies have sought to bridge this gap by employing "finders" who perform limited RBD-style services while not actually registering as RBDs. However, the scope of activities that may legally be performed by "finders" is extremely narrow, and the SEC has targeted finders whose placement activities exceed legal limits, as well as the companies that engage/pay them.^[2]
• Accredited investor requirements. Under U.S. securities laws, private companies that raise capital from investors generally face much more significant burdens, risks and limits when accepting investments from persons that are not "accredited investors."  In general, an individual will be an accredited investor if the individual earns at least $200,000 per year (or $300,000 per year if combined with a spouse) or has at least $1 million of net assets (excluding the net value of a primary residence). An entity generally must satisfy higher standards to qualify as an accredited investor (typically, an entity must have at least $5 million in assets). The need to find accredited investors can be a substantial burden for a private company whose offering activities are limited under the private placement rules.^[3]

In the face of these rules and requirements, many private companies seek to raise capital from professionally managed venture capital funds. In general, venture capital fund managers ("VCs") achieve economies of scale by aggregating into "fund" vehicles numerous separate investors (often called "Limited Partners" or "LPs" because of the limited partnership structure most commonly used for venture capital funds). Importantly, VCs generally are able to structure their operations so that RBD qualification is unnecessary, although they generally must comply with different rules applicable to "investment advisers" (see below).

Of course, VCs often provide private companies with much more than capital. VCs often will provide substantial assistance as board members, temporary officers, mentors and advisers. They often have substantial networks through which they can assist with personnel recruiting, customer introductions, technology assessment, identification of potential joint venture partners or acquirors, etc. In general, VCs seek to be "value-added" investors and, because they typically receive a portion of the investment profits generated by the funds they manage ("carried interest"), they are incentivized to help their investee (i.e., "portfolio") companies achieve success.

From the perspective of Limited Partners, VCs often add value in ways that go beyond helping portfolio companies achieve success. In particular, Limited Partners expect VCs to identify and obtain access to attractive investment opportunities, exercise discipline when structuring investments to minimize risks of investment losses while maximizing the potential for gain, hold portfolio company management accountable and vote for their replacement when necessary, exercise judgment in selling or distributing portfolio investments at appropriate times and (more generally) diligently manage each venture fund and its operations.

Over the last few decades, the greatest portion of capital invested by Limited Partners has been placed in "blind pool" venture funds, which are expected to invest in a variety of different portfolio companies. However, a meaningful subset of venture capital funds are "rifle shot" funds that are organized solely to invest in a single portfolio company (or even to participate in a single investment round of a single portfolio company).

When organizing venture capital funds, VCs face substantially the same limitations and burdens as private companies under the U.S. securities laws discussed above (i.e., the private placement rules, the broker/dealer rules and the accredited investor requirements). Additionally, VCs generally are subject to regulation under the U.S. Investment Advisers Act of 1940 (the "Advisers Act") and must restrict the number of the Limited Partners from whom they raise capital under the U.S. Investment Company Act of 1940 (the "Company Act").

• Under the Advisers Act, fund managers with more than $25 million under management may be subject to extensive federal regulation as registered investment advisers ("RIAs"). However, there is a special exemption for VCs who manage exclusively "venture capital funds" ("VCFs"). In general, VCFs must invest substantially all of their capital into equity and equity-related securities directly acquired from qualified, private portfolio companies, cannot incur indebtedness to leverage their investments, cannot offer broad redemption rights to their Limited Partners and must clearly indicate to Limited Partners that they pursue a venture capital strategy. A VC that qualifies for this exemption generally is known as an exempt reporting adviser ("ERA"). ERAs are subject to quite modest regulatory burdens under the Advisers Act, but (in particular) must comply with key anti-fraud rules and their operations may be subject to comprehensive examination at the option of the SEC.^[4]
• Under the Company Act, a VCF may be subject to extensive federal regulation as a registered investment company if it has more than 100 beneficial owners (unless all of the beneficial owners are "qualified purchasers" or another exception applies).^[5] However, even if a VCF were owned exclusively by qualified purchasers, if it has total assets exceeding $10 million and 2,000 or more holders of record, it will be required to register as a public reporting company under the Exchange Act (subjecting the VCF to current and periodic reporting requirements similar to those of a publicly traded company).

The FundersClub Model

As set forth on its website and in the submission it provided to the Staff in connection with receiving the FC Letter, FundersClub seeks to enhance the efficiency by which private companies seeking capital, and accredited persons seeking to invest capital, may come together. In particular:

• FundersClub operates a website that presents opportunities to invest (through FundersClub VCFs) in specifically identified private companies that are listed on the site ("Identified Companies"). Private companies may become Identified Companies in a variety of ways, including by making a request through the site. FundersClub "vets" companies before presenting them on the site, and presents only a subset of the companies that request, or are otherwise referred for, presentation.
• Persons who wish to view the listed opportunities may become "Members" of FundersClub through the website. However, a person cannot view the listed opportunities without first having certified that such person is an accredited investor, and cannot invest until after an initial 30-day waiting period. These procedures may change under forthcoming SEC rules (see below).
• A Member may use the website to express a non-binding indication of interest to invest in a particular Identified Company. Once the aggregate indications reach a target amount (determined by FundersClub and the Identified Company), FundersClub closes the opportunity to invest through FundersClub. At this point, the interested Members' indications (and accredited investor status) are reconfirmed and final terms are negotiated with the Identified Company. FundersClub then aggregates the interested Members into a VCF, which makes the investment.^[6]
• FundersClub (directly or through an affiliate) then manages the VCF, on a post-investment basis, in the same manner as a typical VC. Going forward (in reliance upon the FC Letter), FundersClub intends to be compensated for its efforts via a carried interest in each VCF.

Key Issue Addressed by the FC Letter

The FC Letter provides guidance on one specific question. Based upon its activities, must FundersClub register with the SEC as a broker/dealer and comply with the substantial obligations imposed upon an RBD under the Exchange Act?

Based upon a series of detailed representations made by FundersClub, the Staff concluded that FundersClub need not register or be regulated as an RBD. As a result, it is more likely that FundersClub will be able to conduct its business as contemplated and, in particular, to participate in private company financings that would be uneconomically small if FundersClub were subject to RBD obligations.

The representations made by FundersClub are important for two reasons. First, if those representations prove to be incorrect, FundersClub cannot rely upon the FC Letter and may even be subject to various forms of liability for failing to satisfy the obligations of an RBD.^[7] Second, although the FC letter applies by its terms only to FundersClub, Staff no-action letters and similar interpretations are viewed as providing general guidance to those who must comply with U.S. federal securities laws. We anticipate that the FC Letter will prompt other persons to consider entering the same business as FundersClub. If such persons wish to use the FC Letter as a guide, they must consider conforming their operations to FundersClub's representations.

Among the key representations made by FundersClub, and relied upon by the Staff in issuing the FC Letter, are the following:

• FundersClub provides investment advice exclusively to VCFs. In particular, FundersClub does not provide investment advice to Members who view investment opportunities through the website.
• FundersClub provides traditional, post-investment, VC-style services to the VCFs that it organizes.
• The carried interest that FundersClub receives in respect of each VCF is solely in consideration for "traditional advisory and consulting services" and does not constitute "transaction-based compensation." In this context, "transaction-based" compensation includes the traditional compensation that a broker receives for bringing buyer and seller together (technically, "effecting transactions in securities"). In essence, FundersClub has represented that: (i) the services it provides in organizing and managing each VCF are sufficient to justify the entirety of the carried interest it receives, so that no portion of the carried interest need be treated as compensation for effecting transactions in securities; and (ii) as a matter of substance, each carried interest it receives truly is in exchange for organizing and managing the applicable VCF in the traditional manner of an investment adviser, and is not (in whole or in part) for effecting transactions in securities in the traditional manner of a broker.^[8]
• Beyond carried interest, FundersClub receives no compensation from portfolio companies, VCFs or FundersClub Members.^[9]

The AngelList Model

As set forth in its submission to the Staff, the AngelList model is very similar to the FundersClub Model, with the following principal differences:

• AngelList affirmatively seeks to leverage the insights, experience and efforts of third-party "Lead Angels."  In particular, a fund organized by AngelList will invest only alongside, or otherwise in collaboration with, a Lead Angel. In some cases, the Lead Angel will receive a portion of the carried interest.
• Each Lead Angel generally must be a well-known, experienced venture capital investor with demonstrated experience investing in and working with start-up companies.
• AngelList will be an RIA (under U.S. federal or state law), and therefore will not necessarily limit the funds it organizes to VCFs.
• An Identified Company may review and approve each prospective Limited Partner before such prospective Limited Partner is permitted to invest in the applicable fund.^[10]

Key Issue Addressed by the AL Letter

The question presented to the Staff by AngelList, and the Staff's conclusion as set forth in the AL Letter, are substantially identical to the question presented, and conclusion received, by FundersClub. However, the representations made by AngelList differ in a few significant respects, including the following. It should be noted that some of these representations appear to be implicit in the FC Letter and its related submission, but are more clearly stated in the AL Letter and its related submission.

• For each investment, AngelList will disclose any compensation to be paid to a Lead Angel and any conflict of interest that may arise between AngelList and the Lead Angel (when the Lead Angel is entitled to a portion of the carried interest) due to the Lead Angel's direct financial involvement in the investment.
• Each Lead Angel's services (if any) will be "traditional advisory and consulting in nature" and it will not receive transaction-based compensation.
• AngelList will not solicit investors to participate in a fund, other than through its website. Other than making information regarding potential investment opportunities available through its website, AngelList will not engage in any selling efforts with respect to interests in its funds.
• The carried interest compensation structure provides an incentive for AngelList and Lead Angels to identify profitable investment opportunities and seek to increase their value, not to sell securities.
• AngelList's role with respect to any securities transactions is purely to facilitate, rather than solicit, an investment in a fund.
• Neither AngelList nor any Lead Angel will hold itself out to the public as a broker in any way.

Key Issues Not Addressed by the Letters

General Solicitation. As described above, the FundersClub and AngelList websites make information regarding private company investment opportunities available to Members based upon such Members' self-certification that they are "accredited investors." The rules regarding communications with the public regarding such investment opportunities currently are in flux. Responding to a directive contained in the Jumpstart Our Business Startups Act (the "JOBS Act"), the SEC has released proposed rule amendments that would substantially relax limitations on general solicitation and therefore enhance the ability of industry participants to communicate with the public via websites and otherwise.^[11] After a substantial delay, recent reports indicate that progress on finalizing these rule amendments has recommenced and that final rules may be issued in the near future.

Verifying Accredited Investor Status. The same final rules under the JOBS Act are expected to specify detailed procedures under which the accredited status of prospective Limited Partners must be verified. While those procedures may be demanding, it is anticipated that private sector companies will develop and market suitable verification services.

Conclusion

The Letters may be a key milestone in the development of a broad-based marketplace in which Web-based efficiencies are applied to matching (i) private companies seeking capital with (ii) accredited investors willing to provide it. Nevertheless, important open issues remain. In particular, the representations made by FundersClub and AngelList in obtaining the Letters may prove difficult to defend or apply in practice. Moreover, key questions (e.g., regarding general solicitation and the procedures by which investors may be verified as "accredited") await further guidance from the SEC. Finally, other parties such as state regulators and various self-regulatory organizations have not yet weighed-in and may have a material impact.

[1]  The FC Letter and the AL Letter (together, the "Letters"), issued by the staff of the SEC's Division of Trading and Markets (the "Staff"), are available here and here.

[2] See Goodwin Procter Client Alert, "Aiding and Abetting Liability of Fund Manager for Use of Unregistered Broker – Recent SEC Enforcement Action."

[3]  Except for a few examples noted below, this Client Alert is focused upon issues arising under U.S. federal securities laws. However, many of the federal rules discussed in this Client Alert have state law analogs that may apply in addition to, or in lieu of, the federal rules. 

[4]  For a detailed introduction to these rules, see Goodwin Client Alert, "SEC Adopts New Advisers Act Rules and Implements Registration Exemption." See also our video Client Alert, "The 2011 Venture Capital Fund Exemption Under the U.S. Investment Advisers Act: A Primer for Private Fund Managers."

Qualification as an ERA does not preempt regulation of a VC under state equivalents of the Advisers Act. Nevertheless, other exemptions may be available. For example, many VCs may be exempt from RIA-equivalent burdens under California law by virtue of managing exclusively funds that are not required to register as investment companies under the Company Act. Because most VCFs are not required to so register, many VCs with activities in California are therefore exempt from RIA-equivalent burdens that would otherwise apply under California law.

[5]  In general, a natural person will be a qualified purchaser if he/she owns at least $5 million in investment assets. An entity may need more substantial investment assets (typically $25 million).

[6]  This description is focused upon FundersClub's rifle shot funds. However, FundersClub has indicated that it also organizes blind pool funds.

[7]  The Letters are not binding upon state securities regulators, many of whom are charged with enforcing state laws analogous to the broker/dealer provisions of the Exchange Act. While this Client Alert does not focus upon issues of state law, we note that a number of state securities regulators have expressed concern that the recent direction taken by Congress and the SEC in favor of expanding access to private company investments (e.g., via crowdfunding) may result in increased fraud and other misbehavior against unsophisticated investors. See, e.g., the July 3, 2012 letter to the SEC from the North American Securities Administrators Association, available here. Beyond state regulators, parties to a transaction may have their own rights if RBD-style requirements are breached. See, e.g., California Corporations Code Sec. 25501.5, which may entitle a person who purchases securities from, or sells securities to, an unlicensed broker/dealer to damages or a right of rescission.

[8]  Under Section 3(a)(4) of the Exchange Act, a person is a broker if the person is "engaged in the business of effecting transactions in securities for the account of others."  There is no bright-line test in this regard, but key indicia of broker status include: (i) receiving transaction-related compensation; (ii) holding oneself out as a broker; and (iii) handling customer funds and securities. In general, a person should not be considered a broker for purposes of the Exchange Act merely because the person provides those services customarily associated with organizing and managing a VCF (although providing those services generally will subject the person to regulation as an investment adviser). Because the Letters rely upon detailed representations made by FundersClub and AngelList (particularly regarding the absence of transaction-related compensation), the Letters may provide little, if any, new insight into distinguishing the services of a broker from those of a fund organizer/manager/investment adviser.

[9]  In the traditional VCF structure, the VCs generally are entitled to receive (in addition to carried interest) a "management fee" based upon the amount of capital committed to the VCF by Limited Partners. FundersClub represented that it will not receive such a fee. Based upon its representations, it appears that FundersClub also will not receive any listing or similar fees from potential portfolio companies that are listed on the website. As described in the FC Letter, Members who participate in a VCF are obligated to bear an administrative fee to cover third-party expenses of the VCF (e.g., tax preparation costs), but no portion of such administrative fee will be paid as compensation to FundersClub.

In the FC Letter, the Staff highlighted additional representations that it considered particularly important, including (for example) that (i) FundersClub personnel will not personally receive transaction-based compensation, (ii) full disclosure of all carried interest, fees and charges will be made to FundersClub Members before they invest, (iii) assets associated with investments by FundersClub Members will be maintained in accordance with certain custody-related requirements and (iv) neither FundersClub nor certain of its related persons are subject to statutory disqualification under the Exchange Act. A complete list of the representations highlighted by the Staff is set forth in the FC Letter.

[10]  AngelList also notes in its submission to the Staff that it expects to engage in more than one transaction per year and therefore will not be entitled to avail itself of the safe harbor exemption from RBD registration provided to employees and other associated persons of an issuer by Rule 3a4-1 under the Exchange Act. This issue is not directly addressed in the FC Letter, although it appears that FundersClub also is expected to engage in more than one applicable transaction per year.

[11]  For additional information, please see our Financial Services Alert, "SEC Proposes Rule Changes to Implement JOBS Act Mandate to Remove General Solicitation Prohibition for Rule 506 and Rule 144A Offerings."