So Your Client Wants to Raise Funds on the Internet…

August 17, 2015

By: Gil B. Selinger

Law Week Colorado

Since the passage of the JOBS Act and subsequent regulatory rulemaking, the sale of private securities using general solicitation and general advertising has been permitted. This allows issuers to solicit new investors from a variety of media, but it also allows them to team up with online web portals, usually controlled by a FINRA registered Broker-Dealer, such as AngelList, Circle Up, SeedInvest, FundersClub or WeFunder. This access to capital is groundbreaking because investors can now find private placements in which to invest, where the Investor’s personal financial circumstances, goals and interests are met, especially when the investor has funds to invest, but previously didn’t know where or how to invest that capital. In recent months we have seen more and more clients being drawn to these web portals for the benefits they provide of connecting companies in need of capital with investors looking to invest their funds, who do not have the connections to have a wide variety of opportunities on their own. This article addresses the key negotiating points for any issuer, as they enter into an agreement with the web portal, to sell securities.

Review of Offering Materials and Accreditation

One of the greatest assets of Broker-Dealer web portals is the ability to draft and develop sales and disclosure documents with the help and advice of the portal. Once an issuer signs up with a portal, the portal creates a checklist of documents and other materials that the issuer needs to provide before their offering of securities can go live. Some of these items are simple corporate documents, showing the capitalization and organization of the issuer. Some of the items are much more in depth about the sales documents and investor presentation being created by the issuer. The checklist includes all of the key elements for a reasonable prudent investor to make their investment decision about the issuer, including elements mandated by the rulemaking under the JOBS Act, such as specific financials.

The JOBS Act requires that any issuer who undertakes the sale of its securities using general solicitation or general advertising, may only sell its securities to “Accredited Investors.” Rule 506(c) of Regulation D of the Securities Act of 1933, which now governs generally solicited private offerings, requires that the issuer verify that the investors are actually Accredited Investors. Broker-Dealer portals require an investor to submit certain key information before they can have access to the deal flow on the website, including those specific documents that the SEC has said are sufficient to verify accreditation. Where in the past offerings under Rule 506 merely used a check-the-box method for an investor representing and warranting that they are accredited, now there must be paper documentary back-up, and not just self-verification. The advantage here lies in the leg work that the portal does for the issuer. The portal vets the documents that are submitted by the investor, such as brokerage statements, tax returns, bank statements, and other evidence to verify their net worth. Placing the onus for this verification on the shoulders of the portal allows the issuer to focus on preparing their sales and disclosure documents, and not having to spend undue time reviewing materials on each potential investor, who may or may not ultimately decide to invest with the issuer. The potential investor is only able to access the issuer’s materials once the portal has verified that they are Accredited Investors.

Excluded Investors

The form contracts used by Broker-Dealer web portals to be engaged by an issuer are very expansive in the nature of potential investors covered by the engagement. This is a trap for the unwary issuer or their counsel. These agreements typically provide that any investment dollars taken in by the issuer, be it from the portal itself, or from other sources, will be subject to the fees dictated by the agreement. Generally, before engaging such a portal, an issuer has one or two decent leads on investors, whom they may have already spoken to at length, and possibly provided disclosure documents. At the point of negotiating the terms of the engagement, it is paramount for the securities attorney to discuss with their issuer/client about who they may have already spoken to, and negotiating a carve-out with the Broker-Dealer web-portal. The specific language about the carve-out is also very important. The portal will want the carve-out to be as narrow as possible, but many issuers want to use expansive lists of everyone they have ever talked to. The key take away for negotiating the carve out is to include the most promising and likely of investors, especially ones where the issuer has spent significant time developing the relationship, and also not forgetting to include other potential ancillary investors who may be introduced to the issuer through the existing investor development process, but who have had no direct contact with the portal.

Fees and Tails

Broker-Dealer portals will charge an issuer a fee for their services related to the private offering, developing the offering materials and providing the verification of accreditation services described above. When discussing whether or not to proceed with utilizing a Broker-Dealer portal, many clients ask us what fees they should expect to pay to the portal, and whether or not those fees are negotiable. After advising different clients on a range of offerings of different sizes, industries and types of securities, we have consistently seen fees in the range of anywhere from 6% to 12% of the total offering proceeds. This is usually called a “success fee.” The fees also fluctuate based on whether or not there are any carve-outs. Portals typically charge a higher fee when they know a certain investor or group of investors is being excluded from the calculation of the fee. Additionally, we are regularly seeing a breakup fee of approximately 2%. The breakup fee is a cautionary clause that is triggered if an issuer decides not to launch after the portal has spent significant time and energy doing due diligence and working with the issuer to prepare offering materials. Despite our best efforts, we have been consistently unsuccessful with removing this fee. Thus any issuer should be aware of the possible cost of engaging a portal, but the offering never goes live. It is important to note that this fee does not apply to a live, but unsuccessful offering on the portal.

The last type of fee that regularly appears in engagements with portals is a “tail fee.” This fee only comes into play after an issuer has terminated their offering on the portal, whether the offering was successful or unsuccessful. The tail fee applies when the issuer closes on an investment with a new investor, within a certain period of time after the offer was terminated on the portal; typically 6 months. This fee sometimes will cover any closing after the offer terminated on the portal, whereas others will only cover investors introduced to the issuer through the portal. The latter portion of the fee is completely unavoidable. Negotiating the length of the tail, and whether or not an outside investor, who is not part of the carve-out is covered by the tail, are both negotiable terms and lawyers should make all efforts to limit the issuer’s exposure to a fee to the portal in the time period after the offering terminates.

This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

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