THE NEW “CROWDFUNDING” EXEMPTION WHAT IT IS AND WHAT IT IS NOT

THE NEW “CROWDFUNDING” EXEMPTION

WHAT IT IS AND WHAT IT IS NOT

Eugenie D. Rivers

Rivers Business Law, Inc.

In the common vernacular, “Crowdfunding” has come to mean a large group of people making individually small investments in a company, usually via the Internet on such sites as Kickstarter.  There, people of all levels of financial sophistication pay a relatively low amount in advance for a company’s goods, or a discount on products, to be delivered at a later date after development.  However, companies cannot currently offer to sell their equity (i.e. stock or LLC interests) or debt (i.e. multiple promissory notes) under this model.  Both equity and debt are “securities” and are therefore subject to the substantial restrictions of both federal and state securities laws.  

Current Securities Law.  The basic rule under our securities laws is that companies must register any securities offering, and become a public company, unless the offering qualifies for one of the numerous exemptions from registration.  However, before the JOBS Act, once a Company had more than 500 shareholders, it had to register as a public company anyway, even if a Company didn’t do any offerings, or conducted all of its offerings under exemptions from registration. 

Currently, the exemptions most widely used to fund start-up companies are those found Regulation D under the federal Securities Act of 1993  (Reg D), and in each states’ small offering exemptions.  Reg D does not permit “general solicitation” in connection with exempt offerings, which includes any type of general advertising.  In addition, federal Reg D does not permit more than 35 “non-accredited” investors to participate in any offering. Internet offerings can only be shown after a potential investor has confirmed their “accredited investor” status through tightly controlled internet portals and a waiting period has passed.

Crowdfunding Exemption.  Until the JOBS Act, there has been no exemption from registration available for a Crowdfunding-style securities offering.  However, the process of grass roots investments allowed under the JOBS Act’s Crowdfunding exemption is very different than the current Kickstarter model.  The limitations in the Crowdfunding exemption (see below) make it primarily useful only in raising start-up capital to fund operations until a company is able to successfully raise money from strategic partners, angel investors or venture capital funds under Reg D or other available exemptions. 

Offering Limitations.  Under the JOBS Act’s Crowdfunding exemption, eligible companies may sell their securities in order to raise capital only if they comply with the following rules:

• Advertisements of a Crowdfunding offering must be limited to directing potential investors to a specified broker or funding portal.  Advertisements may not include the specific terms of the offering.
• The company may not raise more than $1 million, under the Crowdfunding exemption, in any 12-month period.  (However, offerings under other available exemptions may be permitted during that period.)
• Crowdfunding investors may not purchase more than the following amounts, in any 12-month period:
•  (1) the greater of $2,000 or 5% of the investor’s annual income or net worth (for investors with either an annual income or net worth of less than $100,000), or
• (2) 10% of the investor’s annual income or net worth with a cap of $100,000 (for investors with either an annual income or net worth of $100,000 or more).

• Investors may not transfer the purchased securities for at least one year, except for transfers (1) to the company, (2) to an accredited investor, (3) as part of an SEC-registered offering or (4) to a family member of the investor or in connection with the investor’s death or divorce under rules to be prepared by the SEC. 
• The securities acquired in a Crowdfunding offering will also be subject to any other limitations that the SEC deems necessary.

Company Filing Requirements. Under the JOBS Act, the company must file its anticipated business plan, financial condition, financial statements and ownership and capital structure with the SEC, as well as provide that same information to all potential investors, brokers and funding portals, before selling securities in a Crowdfunding offering.  In addition, the Company must file reports, at least annually, of the Company’s results of operations and financial statements with the SEC and investors, brokers and funding portals.  However, the SEC has not yet issued rules regarding the implementation of these conditions, as required under the JOBS Act.

Broker and Funding Portal Requirements.  Crowdfunding offerings can only be conducted through brokers or funding portals that are registered as a broker or funding portal with the SEC, and any state regulators, unless the broker or funding portal is exempt from those filing requirements.  However, Crowdfunding brokers and funding portals are not allowed to (1) offer investment advice or recommendations, (2) solicit purchasers, sales, or offers to buy the securities displayed on its website or portal, (3) compensate anyone for solicitation or based on the sale of securities displayed on its website or portal, (4) holding, managing or handling investor funds or securities, or (4) engaging in any other activities specified by the SEC.

Prohibited Investors.  The following investors cannot participate in an offering under the Crowdfunding exemption:  (1) non-US companies, (2) public reporting companies, (3) investment companies and companies excluded from the definition of investment company by Sections 3(b) or 3(c) of the Investment Company Act of 1940, and (4) any other company that the SEC determines appropriate.

Liability for Material Misstatements.  The Crowdfunding exemption imposes (a) liability for material misstatements and omissions on the company, and (b) personal liability on any director, partner, principal executive officer, principal financial officer, controller or principal accounting officer of the company, or any other person that offers or sells the company’s securities under the Crowdfunding exemption.  Under current securities laws, that liability may be up to three times the amount of damages incurred by the complaining investor(s).

State Securities Regulation.   Under the JOBS Act, Crowdfunding offerings would be exempt from registration with state securities commissions, except for (a) the state of the company’s principal place of business and (b) any state in which purchasers of 50% or more of the aggregate amount of the Crowdfunding offering are residents.  Those states are permitted to require a notice filing and an associated fee in connection with the Crowdfunding offering.  In addition, all state securities commissions would retain the authority to investigate and take enforcement action against any company or intermediary for fraud, deceit or other unlawful conduct in connection with one of their residents.

Number of Shareholders.  The JOBS Act provides that Crowdfunding investors receive shares will not be counted as “shareholders of record” when determining if a company has to register as a public company.[1]   This exclusion will allow companies to conduct a Crowdfunding offering without having to worry about triggering public company reporting requirements as a result.   However, there remain downsides to a Company having the large shareholder base that would presumably be caused by a Crowdfunding offering: (a) future later-stage investors may shun crowdfunded companies due to the presumably high number of small shareholders, and (b) a large, diverse base of shareholders with voting rights could make shareholder approval very difficult for subsequent corporate actions such as additional fundraising rounds, mergers and acquisitions.

Summary

The Crowdfunding exemption contained in the JOBS Act is the first major change in our securities regime in a very long time.  Using the Crowdfunding model in the securities context is an exciting prospect for start-up and small company capitalization.  However, some commentators have expressed concern that eligible companies may be deterred by the cost of complying with the numerous investor protections and regulatory requirements contained the Crowdfunding exemption, plus those that are sure to be added by SEC rules.  At the least, I am sure that many companies that have been eagerly awaiting a Crowdfunding exemption are disappointed by its lack of resemblance to the easy Kickstarter model. 

As a securities lawyer working with many start-up companies, I totally understand that frustration and the desire to have a simple click-through process for internet offerings.  Unfortunately, by necessity, the Crowdfunding exemption will need to be very carefully implemented by the SEC and state securities regulators.  Without the investor protections required under the JOBS Act, the unscrupulous among us will undoubtedly use the Crowdfunding exemption to recreate the rampant fleecing of unsophisticated people that caused the adoption of our securities laws and regulations in the first place.

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[1]  The JOBS Act also increased the number of shareholders that a Company may have before having to register as a public Company from 500 to 2,000 shareholders (not counting Crowdfunding investors), so long as there are no more than 500 non-accredited investors. 

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"Sweat Equity" RECEIVING LLC INTEREST IN LIEU OF SERVICES

RECEIVING LLC INTEREST IN LIEU OF SERVICES

Individuals often desire to invest in an LLC by performing services instead of paying cash.  In other cases, the Company may want to award a key employee with an ownership interest in the LLC.  Both of these scenarios are common in the corporation context.  However, in the LLC context, whether the Service Provider’s investment is characterized as an “initial capital account” or as a “future profits interest” will have significant tax consequences for the Service Provider.  The following is a very brief and simplified discussion of this complex area of tax law, intended to assist you in discussing the issue more fully with your tax advisor.

Basically, an “LLC Interest” is composed of three parts which can be computed separately: voting rights and two categories of economic interests: “capital accounts” and “future profits interests”.  In a corporation, the economic interests cannot be separated.  However, in an LLC they can be different, based on how the LLC Agreement is written and the how the Service Providers investment is characterized.

1.         An LLC investor’s “capital account” represents an undivided percentage ownership in the LLC’s underlying assets, equal to the amount it invested, plus profits, and minus losses, allocated to the investor.  The relative percentages of an LLC’s capital account are generally the basis for distributing the LLC’s assets on liquidation, but may also be used to determine voting, and other rights, depending on how the LLC Agreement is written.

2.         An LLC investor’s “future profits interest” is the percentage of the LLC’s future income and losses allocated to the investor, although the amount actually distributed to the investor will be governed by the LLC Agreement. 

Initial Capital Account

Cons.  If the value of the services invested is characterized as an initial Capital Account balance, the IRS looks at it as if Company has paid the Service Provider cash for the services, and then the Service Provider has turned around and invested that same amount back into the LLC.  The Service Provider will receive a Schedule K-1 from the LLC that reports a guaranteed payment equal to the value of the services.  This amount is taxable income to the Services Provider in the year the services were provided, even though the LLC did not distribute any cash to the Services Provider, i.e. it is “phantom income”.  Most Service Providers are not intending this result.

Pros.  Since the Service Provider receives a Capital Account balance equal to the amount of the services rendered, the Service Provider will also receive an allocation of the LLC’s profits or losses equal to its Capital Account percentage.  Any allocated losses may offset some part of the Services Provider’s taxable phantom income from the services investment, since the amount of those losses will reduce the Service Provider’s capital account balance.

Future Profits Interest

Pros.  If the Services Provider received a Future Profits Interest in exchange for the services, its initial Capital Account will be zero and it will not have taxable phantom income for the year the services were provided.  Each year that the LLC has profits, the Services Provider will be allocated its stated percentage of those profits, which will increase its Capital Account above zero.  The Service Provider will have taxable income equal to the amount of the profits allocated to it.    

Cons.  The Service Provider who receives only a Future Profits Interest generally will not be allocated any of the LLC’s losses so long as its Capital Account is zero.  Those losses are instead allocated among the investors who contributed cash in proportion to their Capital Accounts percentages.  As a result, the Services Provider will not realize any benefit from its investment until the LLC becomes profitable and begins to issue distributions.  In some cases, the value of the Services may be booked as an account payable, but in other cases this not feasible for various reasons.

Example.  Here is the analysis for a Service Provider who received a 2.08% Class A Interest in an LLC instead cash for its $18,000 fee. The Class A Interests were capital account investments and were entitled to a 10% preferred return before pro rata distributions to the Class A and Class B investors.  The Class B Interests were future profits interests only issued to non-cash investors.  

1.  If the $18,000 fee is accounted for as the purchase price of a 2.08% Class A Interest, then Service Provider will start with a capital account equal to $18,000 as if it had paid cash for the Class A Interest.  Each year, Service Provider's capital account will be increased by its percentage of the LLC's profits and accrual of the preferred return, and decreased by The LLC's losses and payments against the accrued preferred return.  For 2006 tax year, Service Provider will receive its percentage of the losses allocated to the members.  When the LLC liquidates, Service Provider will receive a maximum of its entire $18,000 capital account back, plus its pro rata share of the cash available after all of the capital accounts have been paid back, including whatever amount has accumulated in its capital account from profits allocations. 

2.  The IRS considers the value of Service Provider's capital account, ie. $18,000, as taxable income. Service Provider will then have to include this "phantom" income in its tax return and pay tax on it even though it did not receive any cash distributions from the LLC this year.  In order to address this cash flow issue, the LLC could make a cash "tax distribution" equal to an agreed-upon tax rate multiplied by the $18,000, so that he has the cash to pay that tax.  The amount of the distribution is also taxable, so the LLC could round up the tax distribution to approximate the actual tax burden.

In this case, if the LLC can't or doesn't elect to pay Service Provider a cash tax distribution, then the choices are for (a) Service Provider to accept the tax burden and retain its Class A Interest, or (b) for Service Provider's fee to be booked as an account payable, and for Service Provider to receive a Class B interest that starts with a zero capital account, i.e. a 2.08% "profits interests" as additional compensation. 

With a "profits" only interest, Service Provider will only be taxed on (1) payments it actually receives on the $18,000 account payable, and (2) 2.08% any profits which the LLC earns and allocates to its members in future years.  Service Provider will not receive the preferred return.  In addition, Service Provider will have to wait to use any losses allocated to the LLC's members until its capital account has been increased above zero by profit allocations in future years.

IRS Circular 230 Disclaimer:  To ensure compliance with requirements imposed by the IRS, we inform you that to the extent this communication contains advice relating to a Federal tax issue, it is not intended or written to be used, and it may not be used, for (i) the purpose of avoiding any penalties that may be imposed on you or any other person or entity under the Internal Revenue Code or (ii) promoting or marketing to another party any transaction or matter addressed in this communication.

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