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February 28, 2024

Navigating the New Regulated Investment Crowdfunding Frontier: Rule 3a-9 and Regulation Crowdfunding SPVs

Part 1 of a 5 Part Series

In the dynamic landscape of entrepreneurship and startup investing, crowdfunding has emerged as a powerful tool for raising capital and democratizing investment opportunities in privately owned businesses. As the popularity of investment crowdfunding grew after the adoption of Regulation Crowdfunding in 2015 (“Reg CF”), however, so did the challenges for founders and entrepreneurs who soon found themselves with the added complexity of navigating a capitalization table of hundreds, if not thousands, of investors.

How Regulation Crowdfunding Gave Rise to the Crowded Cap Table Problem

Until recently, raising capital through investment crowdfunding created a somewhat unforeseen challenge for startups. While the opportunity to raise capital from the general retail public was of course a welcome one, the resulting administrative complexities of maintaining an extensive capitalization table of smaller and generally less financially sophisticated investors quickly presented a significant obstacle for successfully crowdfunded companies. The challenge, as many commentators noted during the SEC’s comment period leading up to the final rule release of the amendments to Reg CF adopted in 2021, arose from potentially having to obtain approval from hundreds or thousands of investors for future corporate actions or additional financings. This complication not only became an immediate logistical obstacle, but also a substantial financial burden, as the costs of capitalization table management and administering shareholder votes for all corporate decisions or actions in which crowdfunding investors were entitled to vote was no small figure. These challenges created such a roadblock for entrepreneurs and startups seeking the crowd’s blessing that it threatened to outweigh the benefits of investment crowdfunding itself.

Crowdfunding SPVs Treated as Investment Companies under the Original Regulation Crowdfunding Rules

In addition, and parallel to this growing tradeoff between the administrative burden of managing a crowded capitalization table and the benefit of having raised capital from the crowd, was the limit on a company’s ability to take advantage of what is commonly referred to as a “special purpose vehicle” (“SPV”) in a crowdfunding campaign. An SPV is a distinct legal entity with its own assets and liabilities that is typically formed for a specific purpose to isolate financial risk within a broader corporate structure. For example, a private equity fund may form and become the sole owner of several SPVs, and each SPV would own one of the equity investments the fund seeks to make. Later, if any one investment were exposed to risk of liability, the rest of the fund’s investments would be insulated from such risk, as each investment would be owned by a different SPV. In the crowdfunding context, a company could theoretically flip that structure upside down by forming an SPV to raise capital on its behalf in a crowdfunding campaign and then sell its securities to the SPV, which would be bought by the SPV with the capital it raised in the crowdfunding campaign. The result would be that the SPV would be owned by the crowd investors and the SPV would be the owner of the securities sought to be sold by the company raising capital.

Since Reg CF’s adoption, however, a company raising capital in a crowdfunding campaign could not utilize an SPV to raise capital on its behalf because Section 4A(f)(3) of the Securities Act of 1933, as amended, expressly prohibited an investment company from utilizing the Reg CF exemption. The SPV, as sought to be used in the crowdfunding context, fell under this prohibition because it fell squarely under the definition of an “investment company” as defined under the Investment Company Act of 1940, as amended (the “ICA”), which defines an “investment company” as a company “engaged primarily…in the business of investing, reinvesting, or trading in securities.”

Compounding Exchange Act Risks under Section 12(g)

Furthermore, successful utilization of the Reg CF exemption often gave rise to a parallel regulatory risk: Exchange Act Section 12(g). Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) outlines holder of record and asset thresholds that dictate when a company must register its securities with the Securities & Exchange Commission (the “SEC”). Under Section 12(g), a company must register its securities with the SEC if, within 120 days after its first fiscal year end, it “has total assets exceeding $10,000,000 and a class of equity security (other than an exempted security) held of record by either (i) 2,000 persons, or (ii) 500 persons who are not accredited investors (as such term is defined by the Commission).” While Reg CF issuers are afforded a conditional exemption to Section 12(g) under SEC Rule 12(g)-6, which will be discussed in greater detail in a later blogpost in this series, Reg. CF issuers who did not meet the criteria of the 12(g)-6 conditional exemption found themselves facing compliance risks on top of their unwieldly capitalization tables.

All this to say, these legal constraints forced prospective issuers to grapple with the burden of managing a potentially crowded capitalization table and the Exchange Act compliance risks that could arise in the event the company were to have a successful crowdfunding campaign and successful business operations in which it surpassed the 500 non-accredited investor threshold and the $10 million in assets threshold, respectively.[1]

Regardless, obtaining investment capital by other means for many founders was, and continues to be, an unyielding effort due to the preferences and priorities of venture capitalists, angel investor networks, geographical considerations, and overall market conditions. Alas, the decision not to raise capital pursuant to Reg CF, for many, meant more bootstrapping, slower scaling, and a continued disadvantage against those competitors able to secure investment capital.

In response to these issues, the Securities and Exchange Commission introduced Rule 3a-9 to the ICA in 2021. As will be explained in a later blogpost in this series, Rule 3a-9 provides a streamlined solution to the crowded capitalization table issue and the Exchange Act 12(g) issue by exempting the SPV from the definition of an “investment company” and thereby lifting the prohibition on a company’s use of the SPV to raise capital under Reg CF.

By: Jason Siev, Ryan Blum, and Robin Sosnow

[1] A traditional startup raising capital under Reg CF is typically in its early-stages and is raising capital for growth and R&D, and consequently may not have concerns for having assets greater than $10 million. On the other hand, for companies like real estate syndications, in which investors pool funds to acquire and/or develop real property, it is far more common to have assets that surpass the $10 million threshold stipulated by Section 12(g) of the Exchange Act, depending on the size of the syndication and the value of the property acquired. Therefore, the conditional exemption would likely not be available for the latter type of issuer.

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