tandard SAFE agreement showing how discount and valuation cap terms can create unintended outcomes in early-stage startup financing

Some SAFEs Aren’t Safe

On By crowdfundattnyIn Crowdfunding Investors, Crowdfunding Portals, Investor, Legal Documents, SAFELeave a comment

Why “standard” SAFE terms can produce unintended – and unfair- results.

Simple Agreements for Future Equity are used widely in the startup world, including the Crowdfunding world. My impression, however, is that almost nobody reads them, not companies, investors, or funding portals. That’s too bad, because while SAFEs are simple in theory, they can be extremely complicated and lead to unintended results. Today, I’ll describe what can happen with one variation still being used by some funding portals.

Background

We use SAFEs in the earliest stages of a company’s life, when it’s impossible to know what the company is worth. A founder creates what he believes is an incredible app and goes to the market to raise $700,000 in development costs. Looking into a rosy-colored future, he thinks his company is worth about $50 million already. His investors, aided by their snarky lawyers, think it might be worth $5 million, if everything goes right.

To bridge the unbridgeable gap, we don’t agree on a value. Instead, we issue a SAFE. The SAFE says, essentially, “We’ll wait until later to put a value on the company, when it’s farther along.” Everyone agrees that when the company raises more money in the future, in a round where the parties can agree on a price, then the early investors will get what same price as the new investors get.

Well, not exactly the same price. Because they took more risk by coming in sooner, the early investors get a better price, typically in one of two ways:

  • A Discount:  The earlier investors get a discount vis-à-vis the priced round. If the new investors buy shares for $10.00 each, maybe the earlier investors convert at $8.50 per share, a 15% discount.
  • A Valuation Cap:  No matter how much the new investors think the company is worth, the earlier investors convert at a price that assumes the value of the company is no higher than a “valuation cap” established in the beginning. Here, the early investors might have insisted on a $5 million valuation cap. If the new investors value the company at $10 million, the early investors pay half the price as the new investors. But if the new investors value the company at only $4 million, the earlier investors get that price instead.

I said that early investors typically get either a discount or a valuation cap. But sometimes they get both. In that case, when the new money comes in the SAFE holders get the lower of the price they would get from the discount or the price they would get from the valuation cap.

That’s the best kind of SAFE for investors. Unfortunately, the standard SAFE with both a discount and valuation cap can reach the wrong result.

The Standard SAFE Form Doesn’t Work as it Should

Suppose NewCo, Inc. issued a SAFE with both a discount (15%) and a valuation cap ($5 million), for $500,000. Other than the SAFE, NewCo has 1,000,000 shares outstanding. Now the company is preparing for a priced round of Series A Preferred, in which NewCo will raise $1 million. That triggers a conversion of the SAFE.

NewCo and the new investors agree that NewCo is worth $4 million immediately before the investment. That means that immediately following the investment, the new investors should own 20% of the stock ($1 million investment divided by $5 million post-money valuation). All that’s left is some simple arithmetic to decide how many shares they should receive for their 20% interest.

They should get that number of shares such that, if NewCo were sold for $5 million the next day, they would get exactly their $1 million back.

To calculate that number, we need to calculate how much all the other shareholders would get, including the SAFE holders.

Given the structure of the SAFE, where the holders get the better of X or Y, you might think the standard SAFE would say that upon a sale of NewCo, the SAFE holders receive the higher of the amount they would receive from the discount and the amount they would receive from the valuation cap. But it doesn’t. Instead, it says they will receive the higher of the amount they paid for the SAFE or the amount they would receive from the valuation cap. The discount is nowhere to be found.

In this case, because the valuation cap is higher than the new valuation, the SAFE holders would receive their $500,000 back, nothing more. The other stockholders, who own 1,000,000 shares, will get $3.5 million, or $3.50 per share. And the new investors, to get their $1 million back, should get 285,714 shares of the new preferred for $3.50 each.

Upon a conversion, the SAFE holders receive the better of the number of shares they would receive under the valuation cap and the number of shares they would receive under the discount. Because the $5 million valuation cap is higher than the new valuation, the SAFE holders will get the number of shares under the discount. The share price for the new investors is $3.50, so the conversion price for the SAFE holders, with a 15% discount, is $2.98. Having invested $500,000, they receive 168,067 shares.

The fully diluted cap table now shows:

OwnerSharesPercentage
Original Stockholders1,000,00069%
New Investors 285,71420%
SAFE Holders168,06712%
TOTAL1,453,781100%

Here’s how a $5 million selling price would be divided based on those percentages:

OwnerPercentageConsideration
Original Stockholders69%3,439,308
New Investors 20%982,658
SAFE Holders12%578,034
TOTAL100%$5,000,000

As you see, the new investors get less than they’re supposed to, the original stockholders get less than they’re supposed to, and the SAFE holders get the difference. And that’s not because the SAFE is ambiguous. It’s because that’s how the SAFE was written.

Although Y Combinator no longer uses that SAFE, many still do, including funding portals like WeFunder. 

What Do We Do Now?

If you’re the new investors, you don’t do the deal unless someone makes you whole.

If you’re the SAFE holder, you hold your ground or, if you really want the investment, you negotiate with the existing stockholders.

If you’re the existing stockholders, you try to talk reason to the SAFE holders. That’s not how it’s supposed to work!

If you’re the unlucky founder and own only a chunk of the 1,000,000 shares already outstanding, you’re squeezed. To make the new investors whole on your own, you’ll have to give up 5,042 more shares to the new investors, on top of the shares you’ve already transferred to the SAFE holders because of the structural flaw in the SAFE.

What Do We Do in the Future?

If you’re the company or funding portal, you correct the standard SAFE.

If you’re the new investor and see such a SAFE, you don’t spend a lot of time until the existing stockholders and the SAFE holders figure something out.

If you’re investing in a startup and are offered such a SAFE, you say, Sure! 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

music industry operating agreement

Hall & Oats: Not Together Again (For Lack Of A Good Operating Agreement)

On By crowdfundattnyIn Operating Agreement2 Comments

Does either of my readers remember Hall & Oates? They were among the most successful pop acts of all time, with hits like ‘She’s Gone,’ ‘Sara Smile,’ ‘Turnaround,’ and ‘Back Together Again.’

But they’re not together anymore. In fact, they recently emerged from painful and expensive litigation. Their saga is one more example of what happens for lack of a good Operating Agreement.

They signed a partnership agreement when they were young, successful, and close friends. As they drifted apart musically their interests were no longer as completely aligned. Disagreements crept into their friendship, disagreements that their partnership agreement hadn’t anticipated. John Oates tried to sell his stake in their business; Daryl Hall sued to stop him. The words they used were typical of this situation, words like “betrayal” and “outlandish.”

The litigation was settled but the friendship is finished and the wounds won’t heal. Both declare they will never work together again.

Their partnership agreement failed to address the most important question that any Operating Agreement should address: how we get away from another if things don’t work out, treating one another fairly and inflicting as little emotional and economic damage as possible?  

I’ve seen this play many times, just with different actors. One client didn’t want to spend a few thousand dollars on an Operating Agreement because his partners were close friends. By the time the litigation was finished, he had paid me in the seven figures and both the business and the friendship were destroyed.

A good Operating Agreement should address, among other things:

  • Who puts up how much money, when, and what happens if they don’t.
  • Who makes decisions.
  • How the partners can get away from one another.
  • Ownership percentage.
  • Compensation.
  • How the partners share profits.
  • Time commitment.
  • Whether partners can compete.
  • What happens on death, disability, retirement, etc.

You’ll notice that none of those things is industry specific. Operating Agreements are about people, and people are the same.

Those can be tough issues to discuss at the beginning of a business relationship, like a bride and groom negotiating a pre-nuptial agreement. The good news is that all of them can be dealt with.

Two tech guys come to me asking for documents:  a new corporation, a stock option plan, an inventions agreement, an offer letter, corporate resolutions, a contribution agreement, all the things to start a unicorn. What they never ask for is a good Operating Agreement. Because, you know, they’re friends. 

In every business, the Operating Agreement is the most important document of all, like the foundation of a sturdy house. Put it in the (digital) drawer and know you’ve saved yourself lots of time and money, and possibly your friendship. 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Who should use a crowdfunding vehicle and why

Who Should Use A Crowdfunding Vehicle And Why

On By crowdfundattnyIn Crowdfunding Vehicles, Entrepreneurs, Exchange Act, Reg CF, SEC2 Comments

Most of the time, the SEC writes rules to clarify technical legal issues. When the SEC allowed crowdfunding vehicles, on the other hand, it was in response to a psychological issue, not a legal issue.

Entrepreneurs tempted to raise capital using Reg CF, thereby bypassing VCs and other professional investors, were told by those same VCs and professional investors that Reg CF would “screw up your cap table.” Even though that wasn’t true, many entrepreneurs believed it was true. The SEC gave us crowdfunding vehicles to solve the psychological problem:  with a crowdfunding vehicle, you can put all your Reg CF investors in one entity with one entry on your cap table. 

In that way, using a crowdfunding vehicle for your Reg CF offering is like using a C corporation rather than an LLC. You the entrepreneur might know it’s unnecessary, but if your prospective investors think it’s necessary, then it’s necessary. As I often say only partly tongue-in-cheek, that’s why they call it capitalism.

In fact, there is one reason for using a crowdfunding vehicle beyond the psychological. That’s because of a quirk in section 12(g) of the Securities Exchange Act of 1934.

Section 12(g) of Exchange Act

Section 12(g) of the Exchange Act provides that any company with at least $10 million of assets and a class of equity securities held by at least 2,000 total investors or 500 non-accredited investors of record must provide all the reporting of a fully public company. You don’t want that burden for your startup.

The good news is that Reg CF investors aren’t counted toward the 2,000/500 limits, provided:

  1. The issuer uses a registered transfer agent to keep track of its securities; and 
  2. The issuer has no more than $25 million of assets. 

Most startups will never have $25 million of assets. Most startups will never have 500 non-accredited investors or 2,000 total investors. Some startups will issue debt securities rather than equity securities. But some startups could find themselves subject to full public reporting under section 12(g). 

For those startups, a crowdfunding vehicle makes sense. That because, through a quirk in the rules, if you use a crowdfunding vehicle then the only investors who count toward the 2,000/500 limits are entities, like LLCs and corporations. Individual investors aren’t counted at all, and the assets of the company don’t matter.

Thus, if you’re a startup that might otherwise trigger section 12(g), a crowdfunding vehicle makes sense.

Requirements for Crowdfunding Vehicles

A crowdfunding vehicle must:

  • Have no other business.
  • Not borrow money.
  • Issue only one class of securities.
  • Maintain a one-to-one relationship between the number, denomination, type, and rights of the issuer’s securities it owns and the number, denomination, type, and rights of the securities it issues.
  • Seek instructions from investors with regard to:
    • Voting the issuer’s securities (if they are voting securities).
    • Participating in tender or exchange offers of the issuer.
  • Provide to each investor the right to direct the crowdfunding vehicle to assert the same legal rights the investor would have if he or she had invested directly in the issuer.

Those are requirements, not suggestions. In a later post I’ll explain what they mean. Here, I’ll just point out that some high-volume portals violate some of the requirements routinely, in my always-humble opinion. 

******

NOTE:  Crowdfunding vehicles work only with Reg CF. If you raise money from 127 accredited investors using Rule 506(c), you can’t put them in a separate entity. But don’t worry, it doesn’t have to screw up your cap table. 

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

How to Write A Biography For A Crowdfunding Disclosure Document

Improving Legal Documents In Crowdfunding: How to Write A Biography For A Disclosure Document

On By crowdfundattnyIn Form C, Legal Documents, Offering Statement, Regulation ALeave a comment

Investors want to know the people running the show. That’s why we always include a brief biography of the principals in a securities disclosure document, whether a Form C, a Private Placement Memorandum, or an Offering Statement. In Regulation A offerings, for example, companies must:

Give a brief account of the business experience during the past five years of each director, executive officer, person nominated or chosen to become a director or executive officer, and each significant employee, including his or her principal occupations and employment during that period and the name and principal business of any corporation or other organization in which such occupations and employment were carried on. When an executive. officer or significant employee has been employed by the issuer for less than five years, a brief explanation must be included as to the nature of the responsibilities undertaken by the individual in prior positions to provide adequate disclosure of this prior business experience. What is required is information relating to the level of the employee’s professional competence, which may include, depending upon the circumstances, such specific information as the size of the operation supervised.

Note the italicized language:  “What is required is information relating to the level of the employee’s professional competence. . . .” I point that out because to often we see business biographies like this:

John Smith is a visionary leader with an unwavering commitment to excellence, known for his dynamic approach to seizing opportunities and delivering unparalleled value. With a forward-thinking mindset and a passion for innovation, he leverages his far-reaching vision to create transformative strategies that align with stakeholder interests. His results-oriented leadership style empowers teams, drives growth, and positions the company for long-term success in a rapidly evolving market landscape. Outside of his professional achievements, Mr. Smith enjoys spending time with his [fourth] wife and three children, traveling to exotic destinations, and pursuing hobbies such as gourmet cooking, marathon running, and landscape photography.

Alas, that has nothing to do with Mr. Smith’s professional competence.

Mr. Smith’s biography should look more like this:

John Smith has more than 25 years of experience in the logistics and supply chain sector, with a track record of leading operational growth and efficiency in both privately held and publicly traded companies. From 2012 to 2021, he served as Chief Operating Officer of MidAtlantic Freight Systems, where he managed a network of five regional distribution centers, implemented a company-wide warehouse automation initiative that reduced order fulfillment times by 30%, and oversaw a workforce of more than 300 employees.

Before that, Mr. Smith was Director of Business Development at Eastern Transport Group, where he negotiated long-term contracts with Fortune 500 clients and led market expansion into three new states, increasing annual revenue by 45% over four years. Earlier in his career, he held senior operations roles at Interstate Logistics and Northstar Supply Chain Solutions, where he specialized in integrating newly acquired facilities and standardizing operational processes across multiple regions.

Mr. Smith holds a B.S. in Business Administration from Rutgers University and an MBA from Temple University’s Fox School of Business. He has extensive experience in vendor contract negotiations, ERP system implementation, transportation network optimization, and capital project management. Over the course of his career, he has built a reputation for data-driven decision-making, disciplined cost control, and the ability to align operational capabilities with long-term strategic goals.

That’s much more useful to investors. And it’s much more impressive, isn’t it?

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

Choosing The Right Security For Your Crowdfunding Offering

Choosing The Right Security For Your Crowdfunding Offering

On By crowdfundattnyIn Crowdfunding Offerings, SAFE2 Comments

A company trying to raise capital is faced with a lot of decisions. One of the first is the type of security the company will issue to investors. To newcomers, that decision can seem daunting. In this post I’ll try to make it less so.

I’ll describe the most common types of securities in broad terms. As you read, bear in mind that within each category are an endless number of possible permutations. For example, the preferred stock used by one company might be very different than the preferred stock used by a second company.

Each type of security has advantages and disadvantages and some types might be better for your business than others. You will choose the security that’s right for your offering after speaking with your professional advisors.

Common Stock

Common stock represents the most basic kind of equity ownership of a company. You probably own common stock in your own company.

All other things being equal, the owners of common stock have the right to share in any dividends paid by the company and the right to receive the proceeds if the company is sold or liquidated, after all the company’s creditors have been paid.

A company can have more than one class of common stock – for example, one class could be entitled to vote while another class is not entitled to vote.

Investors almost never want common stock. They want something with economic rights superior to the rights of the company’s founders, i.e., your rights.

Preferred Stock

Preferred stock gets its name because it is usually “preferred” as compared to common stock.  That usually means that holders of preferred stock have a right to receive dividends and the proceeds of a liquidation before holders of the common stock receive anything.

EXAMPLE:  Company X raises capital by selling $1M of preferred stock. Three years later Company X is sold and after paying creditors there is only $900K left. Typically, the holders of the preferred stock would get the whole $900K and the holders of the common stock (typically the founders) would get nothing.

The holders of preferred stock usually have the right to convert their preferred stock into common stock if the common stock becomes valuable.

Sometimes, but not always, the company needs the consent of the holders of the preferred stock to take major corporate actions like amending the Certificate of Incorporation or issuing more securities.

Sometimes, but not always, the holders of preferred stock have the right to vote along with the holders of common stock. 

Preferred stock can come with all kinds of other rights, including these:

  • Preemptive Rights:  The right to participate in any future offering of securities.
  • Anti-Dilution Rights:  The right to receive more shares for free if the company sells shares in the future with a lower price.
  • Participation Rights:  The right to receive more than you invested when the company liquidates, before holders of the common shares receive anything.
  • Dividend Rights:  The right to receive annual dividends.
  • Control Rights:  The right to appoint Directors or otherwise exercise control.
  • Liquidity Rights:  The right to force a sale of the company, or to force the company to buy back the preferred shares.

LLC or Limited Partnership Interests

The ownership interests of limited liability companies and limited partnerships go by all kinds of names, including units, interests, percentage interests, membership interests, and shares. Giving a name to the ownership interests is really up the lawyer who writes the governing agreement for the entity.

Whatever name you use, these are all equity interests, just like the stock of a corporation. And just as a corporation can have common stock and preferred stock, an LLC can have common units and preferred units or common membership interests and preferred membership interests. And the common and preferred ownership interests of an LLC or limited partnership can have exactly the same characteristics as the corporate counterparts, described above.

In fact, an LLC or limited partnership can issue all the other types of securities described here, too.

In fact, another choice facing a startup is whether to use a corporation or an LLC in the first place. I talk about that choice here and explain why Silicon Valley prefers corporations here.

SAFEs

“SAFE” stands for Simple Agreement for Future Equity.

Investors in Silicon Valley grew tired of arguing about the value of a startup where the amount of the investment was small (for them). So they invented the SAFE. A SAFE bypasses valuation, or rather postpones valuation until the company raises a lot more money in the future. The idea is that when the company raises a lot more money in the future the new investors and the company will negotiate the value of the company, and the SAFE investors will piggyback on that. This makes SAFEs faster and simpler than common stock or preferred stock.

EXAMPLE:  A company raises $100,000 by selling SAFEs. Two years later the company raises $2M by selling stock for $10 per share. The SAFEs would convert into 10,000 shares, i.e., the same price paid by the new investors.

Nothing stays that simple for long. Today SAFEs come in in many shapes and varieties. Among other possibilities:

  • Discount:  Sometimes the SAFE investors are entitled to a discount against the price paid by the new investors. If SAFE investors had a 15% discount in the example above, the SAFEs would convert at $8.50 per share, not $10.
  • Valuation Cap:  Sometimes the SAFE includes a maximum conversion price. If the SAFE in the example above included a valuation cap of $1.5M, then the SAFEs would convert at $7.50 per share, not $10.
  • Delayed Conversion:  Sometimes the company can stop the SAFE from converting, even if the company raises more capital.
  • Right to Dividends:  Sometimes the holders of the SAFEs have the right to participate in dividends even before they convert.
  • Payment on Sale:  If the company is sold before the SAFE converts, the holder typically is entitled to receive the greater of the amount she paid for the SAFE or the amount she would receive if the SAFE converted just before the sale. But sometimes she’s entitled to more, e.g., 150% of what she paid.

A Silicon Valley SAFE probably isn’t the best for Crowdfunding. Read about it here.

Convertible Note

When a company issues a Convertible Note, the holder has the right to be repaid, with interest, just like a regular loan, but also has the right to convert the note into equity when and if the company raises a lot more money in the future.

EXAMPLE:  A company raises $100,000 by selling Convertible Notes. The Convertible Notes are due in three years and bear interest at 8%. Two years later the company raises $2M by selling stock for $10 per share. The Convertible Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

If you’ve already read the section about SAFEs, you’ll see that the conversion of a Convertible Note into equity is exactly the same as the conversion of a SAFE into equity. That’s not a coincidence. A SAFE is really just a Convertible Note without the interest rate or the obligation to repay. 

Convertible Notes were once the favored instrument in Silicon Valley but were replaced when SAFEs came along. The idea is that interest is immaterial in the context of a startup investment and that the obligation to repay is illusory because the startup will either be very successful, in which case the Convertible Note will convert to equity, or it will go bust. Today Convertible Notes are rare in the startup ecosystem.

Not surprisingly, all the features of SAFEs described above are also available with Convertible Notes:  conversion discounts, valuation caps, and so forth.

Revenue Sharing Note

A Revenue Sharing Note gives the investor the right to receive a portion of the company’s revenue, regardless of profits.

EXAMPLE:  A company issues a Revenue Sharing Note giving investors the right to receive 5% of the company’s gross revenue for three years or until the investors have received 150% of their investment, whichever happens first. If investors haven’t received 150% of their investment at the end of the third year the company will pay the balance.

For investors, a Revenue Sharing Note offers liquidity, assuming the company is generating revenue. In return, they give up the “grand slam” returns they might get with an equity security.

For the company, a Revenue Sharing Note is less dilutive than equity because the investors will soon be gone – in no more than three years in the example above. Plus, because investors have any interest only in gross revenues and not profits, there should be no disputes over expenses, including the salaries of management. But the company is using valuable cash to pay investors.

Some Revenue Sharing Notes convert to equity, just like SAFEs.

EXAMPLE:  Suppose that, in the example above, investors purchased Revenue Sharing Notes for $100,000. At a time when they have received total distributions of $50,000, the company raises $2M by selling stock for $10 per share. The Revenue Sharing Notes would convert into 10,000 shares, i.e., the same price paid by the new investors.

Revenue Sharing Notes make a lot of sense for early-stage companies. I’m surprised they aren’t used more.

Simple Loan

The simplest security of all – simpler than a SAFE, simpler than a Revenue Sharing Note – is a plain vanilla promissory note, where the investor lends money to the company and the company promises to pay it back with interest.

A simple loan is good for the company in the sense that there is no dilution of ownership. On the other hand, the company is obligated to pay the money back on a date certain.

A simple loan is good for the investor in the sense that he or she has the right to repayment, unlike an equity investment. On the other hand, the company might not be able to repay the loan. And if the company is a startup the investor might wonder whether the interest rate on the loan is adequate for the risk of non-payment.

******

Don’t be fooled by labels. You can do anything you want. Just make sure you choose a security that’s right for you and your company.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

how to get rid of artificially low targets in reg cf

How To Get Rid Of Artificially Low Targets In Regulation Crowdfunding

On By crowdfundattnyIn Crowdfunding Portals, Reg CF, SEC, Securities Exchange CommissionLeave a comment

As I’ve explained several times to both readers, I believe artificially low minimums are a huge impediment to Reg CF. A company needs to raise $750,000, sets its target at $10,000, and raises $17,439.98. Poof, that money disappears. The company offsets some of its expenses and the funding portal claims a successful offering.

In my opinion, very few serious investors will participate in such an offering. And because it’s so common, I believe most serious investors just stay away from the industry.

I’ve never heard anyone defend artificially low minimums. What I have heard from both portal and issuers is they need artificially low minimums for financial reasons. The issuer comes to the portal with no money. Both the issuer and the portal plan to use the first dollars raised to market the offering. If we can raise $10,000 and invest in marketing, maybe we can raise $50,000 more. If we raise $50,000 more and invest in marketing, maybe we can raise the rest. 

As my friend Irwin Stein says, a well-planned, well-funded Reg CF offering should succeed. The challenge is that many issuers come to the table without a marketing plan or budget. The issuer and the funding portal bridge the gap by effectively asking early investors to take a lot more risk without telling them about it or compensating them for it. 

Long ago I learned it’s better to deal with reality. If the reality is that the issuer lacks a marketing plan or budget, then rather than hide the ball from early investors, let’s split the offering into two parts. Let’s have a first offering for $50,000 to pay for marketing, then a second offering for $750,000 (or whatever) with a real target, maybe $550,000. The company is saying, “Ideally we’d like $750,000 but we can still manage to execute a viable business plan with $550,000.” 

Investors in the first offering are taking far more risk than investors in the second and should be compensated accordingly. They might get two or three times the shares per $1.00 invested or might even get a different security altogether.

We might find that the company’s most ardent supporters – friends and family – will fund the first round. We would also find, I expect, that companies seeking to raise money for marketing will explain their marketing plans in detail and want to advertise high-quality marketing firms.

Far too often, well-intentioned people look to the SEC or Congress to improve Crowdfunding, only to see their hopes dashed. For example, many people look to the SEC or Congress to improve liquidity in Crowdfunding. Last Autumn I suggested a way that portals and issuers could ensure liquidity themselves. I have a client doing that right now. 

We can do the same with artificially low minimums. They’re bad for investors and bad for the industry. And we don’t need them.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com

shark tank for regulation crowdfunding

Shark Tank For Regulation Crowdfunding?

On By crowdfundattnyIn Reg CF, Regulation CF, Rule 2042 Comments

I’ve been asked by more than a handful of entrepreneurs about using Reg CF in a Shark Tank format. The founder appears in a TV studio with experienced investors, who pepper her with questions. If viewers like what they see, they scan a QR code at the bottom left, which takes them through the Reg CF investment process.

Non-accredited investors getting easy access to great startups, agnostic as to geography. Exactly what the JOBS Act wanted. 

I’ve had to tell each of those entrepreneurs No.

Each entrepreneur thought I was the bad guy, but the real bad guy is Rule 204, the Reg CF advertising rule. Rule 204 gives a company raising money two choices for advertising outside the funding portal. One, you can say anything you want as long as you don’t mention any of the six “terms of the offering.” Two, you can mention the terms of the offering but say almost nothing else, just the company’s name, address, phone number, and URL, and a brief description of the business (i.e., a “tombstone” ad).

The six deadly “terms of the offering” are:

  1. How much you’re trying to raise
  1. What kind of securities you’re selling (e.g., stock or SAFE)
  1. The price of the securities
  1. How you plan to use the money
  1. The closing date of your offering
  1. How much you’ve raised to date

Now imagine the founder answering questions in the studio. She can say anything she wants about the product, about herself, her team of advisors, the market, the social benefits of the company, all that stuff. Even with careful scripting, however, it’s unrealistic to think she can answer questions accurately and generate enthusiasm in the audience (which is the point) without mentioning any of those six items. Maybe a founder can do it here and there, but you wouldn’t bet your TV show on it.

The purpose of Rule 204 is to ensure that every Reg CF investor gets the same information as every other investor. The regulations want everything about the company and the offering to be in one place:  the funding portal. They don’t want someone who watches your TV show to know either more or less than someone who doesn’t.

Personally, I think Rule 204 is misguided. If there’s a risk that someone who watches your TV show will know either more or less than someone who doesn’t, you can (i) post a video of the TV show on the funding portal, and (ii) make sure TV viewers invest through the funding portal’s platform, where they can see everything. Eliminating Rule 204 would invigorate the Reg CF market without hurting investors.

Eliminate Rule 204 and stop issuers and portals from using artificially low minimums. That’s my platform for 2026.

In the meantime, I’m afraid a Shark Tank for Reg CF isn’t going to work.

Questions? Let me know.

Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com


Perks of crowdfunding in Delaware state

Another Reason To Use Delaware for Crowdfunding

On By crowdfundattnyIn Delaware, Delaware Crowdfunding, IDCsLeave a comment

Long ago, I posted about the advantages of using a Delaware entity. If you’re Crowdfunding in the oil and gas industry, there’s another.

The U.S. tax code provides for special treatment of expenses associated with drilling wells, things like labor costs and site preparation, known as “intangible drilling costs,” or “IDCs.” Under general tax principles, a taxpayer would be required to capitalize IDCs and amortize them over time, just as you would depreciate the costs of building an industrial complex. But §263(c) of the code allows taxpayers to deduct IDCs right away, rather than amortize them over time. That’s a significant economic advantage.

Section 469 of the code goes one step farther. In general, §469 prevents investors from deducting losses incurred in a “passive activity,” like investing in an industrial complex, against wages or other income from other sources. But §469(c)(3)(A) provides:

The term “passive activity” shall not include any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest.

Thus, §263(c) allows taxpayers to deduct IDCs immediately, and §469(c)(3)(A) allows even passive Crowdfunding investors to deduct their share provided they hold their interest through an entity that does not limit their liability.

This is where Delaware has the advantage.

In Delaware, as in every other state, the general rule is that the members of a limited liability company are not personally liable for obligations of the entity. Section 303(a) of the Delaware statute provides:

Except as otherwise provided by this chapter, the debts, obligations and liabilities of a limited liability company, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the limited liability company, and no member or manager of a limited liability company shall be obligated personally for any such debt, obligation or liability of the limited liability company solely by reason of being a member or acting as a manager of the limited liability company.

Unlike other states, however, Delaware adds another statute immediately afterward, §303(b):

Notwithstanding the provisions of subsection (a) of this section, under a limited liability company agreement or under another agreement, a member or manager may agree to be obligated personally for any or all of the debts, obligations and liabilities of the limited liability company.

By contrast, Texas (where many oil and gas firms operate) includes a statute providing for the limited liability of members (§114) but does not explicitly allow that rule to be changed by an Operating Agreement. 

In my opinion, Delaware §303(b) makes it much easier to conclude that, with the right provisions in the Operating Agreement, a Delaware LLC can be “an entity which does not limit the liability of the taxpayer.” Under the Texas statute, it is probably possible to provide for personal liability, but the absence of an explicit statutory exception makes the argument under §469(c)(3)(A) much more difficult.

Let me know if you’d like to see the appropriate Operating Agreement provisions.

Questions? Let me know.

Lawyers and AI

Lawyers And Artificial Intelligence: An Update

On By crowdfundattnyIn AI, Crowdfunding, PredictionsLeave a comment

I posted about lawyers and artificial intelligence in late 2023, predicting that AI tools would drive down the cost of legal services while making high-quality legal service available to more people. The great thing about predictions like that is that nobody can prove you were wrong until it’s too late. So far, however, it hasn’t happened.

I thought AI would enter the legal world through “intermediated” channels like Westlaw. With their enormous, curated databases of court cases, administrative rulings, and other source materials, as well as libraries of excellent legal forms drafted by top-notch lawyers, I expected companies like Westlaw to race quickly to the top, leaving “brute strength” tools like ChatGPT behind.

Since then, I’ve tried just about every AI tool on the market, including the most recent version of Westlaw’s AI tool, CoCounsel. Beginning each demonstration with high hopes, I am always left with great disappointment. 

Here are some things I’d expect from an AI tool for business lawyers:

  • Review Documents:  The tool should analyze an Asset Purchase Agreement or Operating Agreement and tell me (i) how it differs from “market” terms, and (ii) how it should be changed for the benefit of my client.
  • Summarize Documents:  The tool should summarize a legal document. One type of summary would tell me what’s in the document, at any level of detail I want. Another would prepare a summary I can use in an Offering Circular (e.g., “Summary of Management Agreement”).
  • Search Documents:  I’ve drafted approximately seven million Operating Agreements. If I’m looking for a clause I used two years ago, the tool should be able to find it.
  • Improve Documents:  The tool should review my document and point out ambiguities, inconsistencies, mistaken references, and logical gaps. 
  • Draft Sections of Documents:  If I’m drafting an IP License Agreement and need a section saying the Licensee is responsible for prosecuting infringement claims, the tool should produce one with a simple prompt.
  • Draft Whole Documents:  If I need a Rule 144 opinion, the tool should take me through the steps of preparing one, including the Certification from my client.
  • Legal Research:  The tool should vastly improve the process of legal research.
  • Reserve Flights:  Not necessary. 

In the earliest stages, I don’t expect an AI tool to produce great results. During a recent demonstration, the sales rep said, “You should view this as the work of a second-year lawyer.” Unfortunately, it was more like the work of a high school junior.

The good news is that brute strength tools like ChatGPT have improved dramatically. You still can’t rely on them – recently ChatGPT produced a quote from a court case speaking directly to my issue, but when I checked (always check), the quote was hallucinated – they are better than the intermediated tools, so far. 

When ChatGPT was released, many experts predicted that lawyers were the most vulnerable. Two and a half years later, that hasn’t happened, either. If you’re a lawyer, I guess that’s good news in a different way.

Questions? Let me know.

Crowdfunding

Crowdfunding Loan Participation Interests

On By crowdfundattnyIn Crowdfunding Laws, Loan Participation Interests, Rule 10b-5Leave a comment

Company A wants to borrow $1 billion and approaches Bank X. Bank X says sure, we’ll lend you $300 million ourselves and get the rest from other institutions. Bank X then approaches banks, insurance companies, and other lenders, raising the full $1 billion. Each lender holds a piece of the $1 billion loan, as if holding a separate promissory note. The pieces they hold are called “loan participation interests.”

The market for loan participation interests is gigantic and received a gigantic boost in 2023 when the Second Circuit Court of Appeals, in a case called Kirschner v. JP Morgan Chase Bank, N.A., decided that loan participation interests generally are not “securities” for purposes of the U.S. securities laws.

To illustrate why that matters, imagine that when Company A approached Bank X, Bank X formed a limited partnership, naming itself as general partner and offering limited partnership interests to the other banks, insurance companies, and other lenders. Those limited partnership interests (probably) are securities. And that means the other banks, insurance companies, and other lenders can sue Bank X for securities law violations, including violations of Rule 10b-5 (material misstatements or omissions).

The gigantic market for loan participation interests breathed a gigantic sigh of relief at the decision in Kirschner v. JP Morgan Chase Bank, N.A. Today, some entrepreneurs are taking the decision one step farther. Reading law firm blogs captioned “Loan Participation Interests Are Not Securities,” these entrepreneurs are offering loan participation interests to the public in Crowdfunding-like offerings, without bothering with securities laws. Unfortunately, this one step farther might be a step too far.

If we ignore the blog captions and look at the case itself, we see there is no bright-line rule. To determine whether the loan participation interests were securities, the court in Kirschner v. JP Morgan Chase Bank, N.A. relied on a case called Reves v. Ernst & Young, where the Supreme Court created a four-part test to determine whether a given loan participation interest (or promissory note generally) is a security. The decision balanced on the second test:  the “plan of distribution,” meaning how and to whom the interests were sold. The court stated, “This factor weighs against determining that a [loan participation interests] is a security if there are limitations in place that ‘work to prevent the [loan participation interests] from being sold to the general public.’”

In the case before it, the court found that the loan participation interests were offered only to “sophisticated institutional entities.” Hence, the court concluded that “This allocation process was not a ‘broad-based, unrestricted sale to the general investing public.’” No sale to the general investing public, no security.

In the Crowdfunding-like offerings I’ve seen, loan participation interests are offered to “sophisticated investors.” No doubt they hope to fall within the “sophisticated” language of the Kirschner v. JP Morgan Chase Bank, N.A. decision. But the decision doesn’t say just “sophisticated.” It says, “sophisticated institutional entities.” In the jargon of Regulation D offerings, a doctor with two real estate investments is often referred to as “sophisticated,” but under Rule 506(b)(2)(ii), that just means she “has such knowledge and experience in financial and business matters that she is capable of evaluating the merits and risks of the prospective investment.” The doctor is a far cry from a “sophisticated institutional entity.”

For that matter, selling loan participation interests on a website accessible to everyone seems very close to a “sale to the general public,” exactly what the court in Kirschner v. JP Morgan Chase Bank, N.A. was watching out for.

The blog caption “Loan Participation Interests Are Not Securities” would have been more accurate saying “Loan Participation Interests Are Not Securities If Sold to Sophisticated Institutions” or even “Loan Participation Interests Are Securities Unless Sold to Sophisticated Institutions” or even “Alert:  Loan Participation Interests Sold Through Crowdfunding Are Securities.”

Websites selling loan participation interests to the public – even to the “sophisticated” public – are taking great risks. By selling unregistered, non-exempt securities, they risk lawsuits from unhappy investors, both as a company and as individuals. They also risk enforcement actions by the SEC, actions that could leave the company and the individuals branded as “bad actors” for the next 10 years.

Questions? Let me know.