A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

VALUATION • The Growth of Equity

CROWDFINANCE OPTIONS FOR PRIVATE COMPANIES­—AND SECONDARY MARKETS FOR —WILL KEEP EXPANDING By David M. Freedman, Editorial Adviser to The Value Examiner and Matthew R. Nutting, Esq. •

ost Americans either the New York Stock Exchange and THE “NEW” don’t know what crowd- Euronext NV). Niederauer predicted NEW INTERMEDIARY funding is or still think that , if properly Crowdfunding is a method of crowdfunding is nar- done, “will become the future of how collecting many small contributions, by rowly confined to and other most small businesses are going to means of an online funding platform, 3 rewards-basedM fundraising websites. In be financed. ” Mary Jo White, the to finance or capitalize a popular polite company, the terms “securities SEC chair since April 2013, said that enterprise. Thanks to the phenomenal crowdfunding” or “equity crowdfund- crowdfunding is “the start of what success of rewards-based crowdfunding ing” typically evoke bewilderment, promises to be a period of transformative platforms like Kickstarter and 4 derision, or fear of fraud, oh my. change in capital formation. " since 2008, and donation-based sites Meanwhile, start-ups and growing If equity crowdfunding goes well for like GoFundMe since 2010, it was companies have raised billions of dollars issuers and investors, a surging supply only natural that intermediaries in through equity-based offering platforms (of early-stage equity offerings) and the angel capital world would exploit 1 on the Internet. Some exuberant demand (for investment opportunities and adapt the crowdfunding platform pioneers in this new investment class have in those offerings by investors who want infrastructure, harnessing the power of predicted that crowdfunding will spark to diversify into alternative asset classes) social networking and e-commerce to a revolution in private capital markets, could result in not only phenomenal accomplish the following objectives: if not the redefinition of Wall Street.2 growth of private capital markets but A moderate optimist, and one with also “transformative” innovations. •• Unite start-ups and growing whom we agree, is Duncan Niederauer, Innovation might include not only Web companies with angel investors CEO of NYSE Euronext (a merger of technology that better connects issuers •• Announce equity offerings, and to investors and facilitates disclosures disclose risks and deal terms and transactions, but also simplified deal •• Enable potential investors to 1 Equity-based offering platforms, featuring terms, automated valuation “calculators” Regulation D offerings, were at first reluctant to call collaborate with one another on deal their operations “crowdfunding” because (before (see sidebar on page 10), and new selection and due diligence June 2015) they were not open to the “crowd” of business entities (like a Subchapter CF •• Facilitate investment transactions. nonaccredited investors. The SEC generally uses corporation) structured specifically for • the term equity crowdfunding portals in reference • Accomplish all of that in a matter to Title III of the JOBS Act of 2012, which allows equity crowdfunding transactions. of weeks or days, sometimes nonaccredited investors to participate, but which even hours, at little cost has not yet been implemented. Gradually, however, Reg. D platforms have come to be referred to in the media, and in the crowdfunding industry as well, as 3 “The New Thundering Herd,” The Economist, The Jumpstart Our Business Startups equity crowdfunding platforms. June 16, 2012, p. 71 2 A December 17, 2013, conference in New York 4 Mary Jo White, SEC chairwoman, speech to Act of 2012 accelerated the growth of City, cosponsored by Thomson Reuters, was called the 41st Annual Securities Regulation Institute, equity crowdfunding. Title II of the JOBS “Crowdfinance 2013: Redefining Wall Street.” Coronado, California, January 27, 2014

6 July/August 2015 the value examiner A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

Act lifted the ban on general solicitation where issuers with headquarters in a it lifts the ban on general solicitation. for securities offerings under Regulation particular state may sell securities to But only accredited investors may D, Rule 506(c), which allows equity all investors (nonaccredited as well as participate, on- or off-platform. This crowdfunding platforms to advertise accredited) who live in that state. At this is where consumer product and retail those offerings, and thereby publicize moment, at least seventeen states have companies tend to congregate. equity crowdfunding itself, much such exemptions in place, and at least one more widely than before. On-platform more is awaiting the governor’s signature. Title II went into effect in 2013 with the Reg. D offerings are still open only to Some of these exemptions are variations full implementation of SEC regulations. accredited investors, about seven percent of Title III of the JOBS Act, in terms of Now you might see 506(b) offerings, of the population. the dollar limits on raises and investment 506(c) offerings, and Reg. A+ offerings all Title III of the JOBS Act will someday limits for nonaccredited investors. listed on the same equity crowdfunding let nonaccredited investors, the other Securities crowdfunding also includes platforms. But the tendency among ninety-three percent, participate in peer-to-peer lending (P2P), more successful platforms these days is to private securities offerings, but this recently known as marketplace lending specialize in one kind of exemption exemption (also called Regulation CF) because true peers (individuals) are or another. So, for example, you will has not yet become effective. The SEC being overwhelmed by institutional see some tech-oriented crowdfunding may issue final rules under Title III this lenders. Debt-based crowdfunding is a platforms with predominantly 506(b) year, although it is possible that Congress hot sector of the securities markets in the “quiet deals.” Consumer product will revise Title III before the SEC blesses United States and some other countries, companies naturally tend to gravitate it. The U.K. and Australia are way ahead including China. to platforms that focus on 506(c) deals. of the United States in letting average or You will also find platforms that focus on “unsophisticated” investors participate REGULATION D PLATFORMS particular industries, such as real estate— in equity crowdfunding, but Issuers have raised tens of billions of which is the hottest sector of securities demand for crowdfunded securities is dollars through Reg. D offering platforms crowdfunding after P2P. still fairly weak in those countries.5 since they launched in 2011 in the United According to Crowdnetic’s Q1 2015 Title IV of the JOBS Act, which States. These early-equity offerings used Report,7 in the first quarter of 2015 alone, became effective in June 2015, does the Rule 506 exemption under Reg. D. the seventeen most prominent securities allow nonaccredited investors to invest That was before the JOBS Act, which offering platforms (not including P2P) in “Regulation A+ offerings,” some of most argue will boost overall volume in the United States recorded capital which will be made via crowdfunding of capital formation, now that the non- commitments totaling about $650 platforms. The Title IV exemption is solicitation rules have been relaxed. million—a thirty-five percent increase structured primarily for growth- and What Title II of the JOBS Act did from the previous quarter. These figures later-stage companies that want to file was prompt the SEC to split Rule 506 represent the performance of offerings “mini-IPOs,” not ideal for seed-stage into parts: under Rule 506(c); they do not include start-ups since compliance costs alone Rule 506(b) offerings, some of which may overwhelm the amount of capital •• Rule 506(b) is the “traditional” are listed on crowdfunding platforms being sought. part, also known as the “quiet deal,” as well. It is likely that the numbers of Another form of equity crowdfunding because it retains the ban on general 506(b) offerings, and the amount of is the intrastate securities exemption,6 solicitation. For off-platform offerings capital raised thereby, are higher than it permits up to thirty-five non- that of 506(c) offerings. Rule 506(c) allows 5 Richard Swart, “Challenges in SME Access to accredited investors to participate general solicitation, while Rule 506(b) Capital,” Roosevelt Institute, July 6, 2015 (https:// in each deal. This is where many does not. nextamericaneconomy.squarespace.com/thought- high-tech start-ups have tended briefs/2015/7/7/challenges-to-sme-access-to- capital) to congregate. 6 Under Section 3(a)(11) of the Securities Act of •• Rule 506(c) is the “new” part, because 7 http://www.crowdnetic.com/reports/apr-2015- 1933 report (accessed July 8, 2015) the value examiner July/August 2015 7 A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

Significantly for the valuation Regulation A+” at http://www.sec.gov/ Professionals in the securities industry profession, the types of securities offerings news/pressrelease/2015-49.html. are calling Reg. A+ offerings “mini-IPOs,” that received capital commitments were: Some Regulation A+ offerings will be as issuers are required to go through a equity (sixty-two percent), convertible listed through online offering platforms. scaled-down registration process and debt (twenty-two percent), straight debt Such platforms may be dedicated to file a prospectus-like document called (nine percent), and other (seven percent). Reg. A+ offerings, or they may feature an “offering circular” with the SEC. The The of crowdfunding a mix of Regulation D and Regulation benefits of Reg. A+ for seed-stage and offerings “remains relatively consistent A+ offerings. Neither Reg. D nor Reg. start-up companies seem limited mainly with previous quarters,” says Crowdnetic. A+ offerings are required to go through because offerings up to twenty-million- intermediaries, though. dollars still require blue sky review and REGULATION A+ MINI-IPOS Before the JOBS Act, Regulation A compliance, which can be costly and Under Title IV, the moribund issuers could sell unrestricted securities time-consuming. Time will tell whether Regulation A exemption was expanded to nonaccredited as well as accredited seed-stage and start-up companies try from a five-million-dollar raise limit to investors. The expanded Reg. A+ still to take advantage of Reg. A+ rather than a fifty-million-dollar limit, and for raises lets nonaccredited investors participate, (or in addition to) Reg. D, intrastate, or above twenty-million-dollars (Tier 2 but it limits their annual investment in someday Title III equity crowdfunding. offerings) it preempts blue sky review offerings higher than the twenty-million- “We are still at the first pitch in the (i.e., no need for approval by every state dollar threshold to ten percent of their first inning of the equity crowdfunding in which the offering is made). Blue sky income or net worth, whichever is greater. ball game,” says Madelyn Young, content review is still required for offerings less All investors can invest an unlimited development manager at , a than twenty million dollars in Tier 1. For amount in Tier 1 offerings up to twenty Reg. D platform based in Miami, Florida. more details, see the SEC’s “Fact Sheet: million dollars. Over the next few years we will see how

KINDS OF EQUITY OFFERINGS ON INTERNET-BASED PLATFORMS Raise Limit per Intermediary Online Launch Investor Status Investment Limit Year Required? Reg. A+ Tier 1 2015 $20 million All investors No limit Depends on No Reg. A+ Tier 2 2015 $50 million All investors income/worth Reg. D Rule 506(b) 2011 No limit Accredited only No limit No Reg. D Rule 506(c) 2013 Intrastate Equity 2013 (Georgia Typically $1m to Depends on All investors Varies with state Crowdfunding was first) $2m income/worth Title III Equity Depends on Yes: online Maybe 2016 $1 million All investors Crowdfunding income/worth portals*

* Title III offerings may appear on non-broker-dealer funding portals that are registered with the SEC or on broker-dealer platforms.

8 July/August 2015 the value examiner A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

the various JOBS Act financing schemes of delivering their results.”8 Mollick believes crowdfunded shares. Secondary markets really work, what kinds of companies use that the low rate of fraud (at least this will emerge, however, not only for which exemptions, and how investors particular type of fraud) is a result of “the private securities in general, but some perceive value in each new opportunity. influence of the community,” by which he for crowdfunded shares specifically, means the ability of backers and prospective as securities crowdfunding grows FRAUD AND CROWD WISDOM backers to interact with one another on- and evolves. Of course fraud is everywhere, and and off-platform, and with the campaigner/ Congress and the SEC are exploring it will infect crowdfunding. So far, issuer on-platform via open Q&A forums. the idea of allowing venture exchanges though, equity crowdfunding has been Such discussions are similar to those to facilitate trading of securities issued remarkably fraud-resistant, not only in that “take place on other social media sites, by small companies. The proposed Main the United States but also in the U.K. blogs, and forums, [as well as] Wikipedia Street Growth Act, for example, would and Australia. and open-source software development,” permit venture exchanges to connect Equity crowdfunding issuers and writes Mollick, whose main areas of study buyers and sellers of small-company funding platforms are subject to the at Wharton are innovation and early-stage securities, but not to process transactions antifraud provisions of federal securities . “These communities between those parties. The act defines law. (Intrastate platforms are subject play several important roles in improving small companies as those—both public to state and federal antifraud laws.) offerings, preventing fraud, and making and private—with assets under two Platforms that are broker-dealers have crowdfunding successful. In the case of billion dollars. an even higher standard for screening Kickstarter, communities have successfully CFX Markets will be the first out fraudulent offerings. Beyond the legal detected fraudulent projects.” secondary market for crowdfunded shares framework, however, all crowdfunding The kind of fraud Mollick addresses in his specifically. CFX “provides an open and platforms have something in common 2013 study is what we call “take the money secure network to facilitate secondary that is transformational in terms of and run.” To be sure, there are other kinds market transfers of private securities fraud prevention: a very powerful of fraud in the context of crowdfunding that in alternative asset classes” strictly for social networking component that he does not address, including intentional accredited investors. (See details at includes various kinds of discussion or negligent misstatement or omission. But http://www.joincfx.com.) It is owned forums. Crowds—of donors, backers, Mollick clearly believes in the wisdom of by PeerRealty, a real estate securities or investors—discuss, evaluate, and crowds, in the context of both rewards- crowdfunding platform based in Chicago, collaborate (on due diligence, for based and equity-based crowdfunding. Illinois, but it will list crowdfunded shares example) throughout funding platforms. originating on other platforms as well, Ethan Mollick, assistant professor of SECONDARY MARKETS FOR including PropertyStake (real estate), management at the Wharton School, CROWDFUNDED SECURITIES CrowdFranchise (franchises), and more University of Pennsylvania, concluded Crowdfunded equity investments in the future. in a 2013 study of 48,500 Kickstarter are generally illiquid because there is (rewards-based, not equity-based) no organized secondary market for ACCREDITED campaigns that “less than one percent INVESTORS PREDOMINATE of the funds in crowdfunding projects Because Reg. A+ is brand-new and in technology and product design go to 8 Ethan R. Mollick, PhD, “The Dynamics of intrastate securities crowdfunding is slow projects that seem to have little intention Crowdfunding: An Exploratory Study,” Journal to emerge, the equity crowdfunding world of Business Venturing, 2013. Available at http:// papers.ssrn.com/sol3/papers.cfm?abstract_ is still occupied mainly by accredited id=2088298&http://papers.ssrn.com/sol3/papers. investors under Reg. D. This might be cfm?abstract_id=2088298

the value examiner July/August 2015 9 A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

comforting to some regulators and EQUITYNET’S STARTUP VALUATION CALCULATOR investor protection groups, and maybe One of the pioneers in equity- on the platform since 2005. to some accredited investors who don’t based offering platforms in the United The free, “public” version of the want the world to change. States, EquityNet calls itself a “capital calculator, available at https://www. The world will change. Title III is not marketplace,”—with 17,000 private .com/crowdfunding-tools/ dead, though it seems to be hibernating. businesses seeking more than two startup-valuation-calculator.aspx, is More states will enact or promulgate billion dollars in equity and debt radically scaled down, with only eight intrastate exemptions that welcome investment capital. The company’s parameters, yielding a “quick ballpark nonaccredited investors, with investment platform offers two versions—one valuation figure.” limits based on their net worth or free and the other fee-based—of its Hollas says the fee-based version income. Some of the exclusive bastions automated Valuation Calculator. is being used by companies ranging of private securities will be blown wide According to Judd Hollas, founder from seed-stage start-ups to those open, and small, inexperienced angel and CEO of EquityNet, the fee-based with $100 million in revenue. investors will flood in, some wisely and valuation tool uses “hundreds of It is not necessarily intended to some recklessly, funding all manner of parameters” for the company being eliminate the need for professional start-ups. The private capital markets valued, and estimates a valuation valuation analysis. EquityNet, based will shudder. This is good. VE based on the discounted cash flow in Fayetteville, Arkansas, holds a method and correlations with data patent for an “electronic system for David M. Freedman, a financial and provided by the 17,000 “peer group” analyzing the risk of an enterprise” legal journalist since 1978, has served on companies in EquityNet’s database. (US 8,793,171 B2 dated July 29, 2014) the editorial staff of The Value Examiner These peers are privately held that is integrated into the valuation since 2005. companies that have registered to calculator. have their securities offerings listed Matthew R. Nutting is a corporate lawyer with Coleman & Horowitt in Fresno, California. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015). Website: www.ec4i.com

10 July/August 2015 the value examiner