Tuesday, September 30, 2014

Tough Time Making a Living in the Crowd: What Services Are Crowdfunding Platform Operators Allowed to Provide and What Fees Can They Charge? (Article 7 in a series of 14 articles about Deal-Makers)

By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or purchase my books http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
or read my newspaper articles at

This article is one of 14 articles in a series about Deal-Makers called:


In article (1) in this series of articles, we discussed the public policy reasons securities law reforms should create more competition among deal makers by letting smaller deal makers compete with Wall Street – especially in deals by smaller companies which are not economically attractive for big investment banks.

In articles (2) and (3) of this series of articles, we discussed how the SEC broadly interprets the broker registration requirements of Section 15 (a) (1) of the Securities Exchange Act of 1934 to require virtually everyone who accepts a fee for introducing people who need capital to investors.

In articles (4), (5) and (6) of this series of articles, we discussed Section 201 (c) of the JOBS ACT, which created new exemptions from registration requirements for brokers and dealers and the SEC's attempts to limit the applicability of this new exemption.

Now, let's talk about the SEC's proposed Crowdfuding rules from the perspective of the people who operate crowdfunding portals.

Technology + Deal Making = Crowdfunding

The SEC's proposed crowdfunding rules merge technology with deal making in a more structured way than is required for Rule 506 (c) offerings, which also permits you to use technology portals to raise capital.  Crowdfunding has more restrictive rules for what dealmakers can do than Rule 506 (c) has.  In return, crowdfunding allows you to conduct a general solicitation on the crowdfunding portal and sell securities to people who are not accredited investors.  Every aspect of the transaction is conducted on the crowdfunding portal.

Under the SEC's proposed crowdfunding rules, people who operate crowdfunding portals will do short-form registrations with the SEC and FINRA that does not subject them to all the rules broker-dealers and investment advisers are required to follow.  These limited registrations do not permit you to:

  • Charge a success fee based on a percentage of the money raised through the funding portal.
  • Accept equity compensation for services.
  • Raise money for businesses in which the funding portal operator owns an interest.
  • Provide "investment advice" or "recommendations" to investors.
  • Actively soliciting purchases, sales or offers to buy securities offered or displayed on the funding portal beyond listing the offering and executing the transaction through the portal.
  • Hold money or securities (a third party depository must handle all transaction payments).
Proposed Rule 402 states:

"(a) General. Under Section 3(a)(80) of the Exchange Act (15 U.S.C. 78c(a)(80)), a funding portal acting as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6) of the Securities Act (15 U.S.C. 77d(a)(6)) may not: offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered or displayed on its portal or portal; compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its portal or portal; hold, manage, possess, or otherwise handle investor funds or securities; or engage in such other activities as the Commission, by rule, determines appropriate."

Given the SEC's broad interpretation of what constitutes making recommendations and providing investment advice and soliciting, Rule 402 (b) offers a safe harbor for certain permitted activities. 

Permitted activities under proposed Rule 402 (b) include applying objective criteria for:

  • Accepting or rejecting issuers.
  • Highlighting offerings.
  • Providing investors with search tools.
Generally the criteria a funding portal operator uses must be disclosed to investors, be designed to result in a broad selection of issuers and be consistently applied, but operators cannot deny access based on the advisability of investing in the issuer, except to avoid fraud.

Portal operators must provide communications channels for investors and issuers, but operators cannot make comments about any issuer or offering.

The thrust of these crowdfunding rules is that the issuers are doing the selling.  Operators of crowdfunding portals are merely providing the technology portal that facilitates sales activities by the issuer.  And issuers cannot actively promote their offering outside the funding portal.

Of course, funding portal operators are allowed to promote their portal to attract both investors and issuers to the portal.  Promoting the funding portal to attract investors indirectly helps issuers to sell through the portal.  But portal operators must be careful about compensating for promotion.  Proposed Rule 305 states:

(a) Prohibition on Payments for Personally Identifiable Information. An intermediary may not compensate any person for providing the intermediary with the personally identifiable information of any investor or potential investor in securities offered and sold in reliance on Section 4(a)(6) of the Securities Act (15 U.S.C. 77d(a)(6)).

(b) Certain permitted payments. Subject to paragraph (a) of this section, an intermediary may compensate a person for directing issuers or potential investors to the intermediary’s portal, provided that unless the compensation is made to a registered broker or dealer, the compensation is not based, directly or indirectly, on the purchase or sale of a security offered in reliance on Section 4(a)(6) of the Securities Act (15 U.S.C. 77d(a)(6)) on or through the intermediary’s portal.

(c) For purposes of this rule, personally identifiable information means information that can be used to distinguish or trace an individual’s identity, either alone or when combined with other personal or identifying information that is linked or linkable to a specific individual.

Although the issuer is doing the selling, crowdfunding portal operators have a duty to investigate issuers and prevent fraud.

Note that the technology portals that Section 201 (c) of the JOBS Act permits for Rule 506 offerings are not subject to any of these specific rules.  General fraud rules apply and unregistered Rule 506 (c) portal operators are prohibited from receiving "compensation in connection with the purchase or sale of securities" or for separate compensation providing services that include "investment advice" or "recommendations."

Therefore, the primary difference between Rule 506 portal operators and registered crowdfunding portal operators are that Rule 506 portal operators have greater freedom in what they do and how they do it, but are at greater risk because the SEC may determine they crossed a line regarding compensation or services that requires registration.

Permitted Crowdfunding Portal Fees

 Although in other contexts the SEC has indicated that accepting any type of compensation you can cause you to be a broker who is required to register, crowdfunding rules only explicitly prohibit fees that are contingent on selling securities or that are calculated based on the volume of securities sold in the offering

If "crowdfunding portal operators" can't provide "investment advice" or make "recommendations" to buy securities, how will crowdfunding portals work? 

What can operators do to make money? 

Crowdfunding portal operators are permitted to:

·         Charge fees for permitting people to sell securities through their portal. 
·         Charge fees for "ancillary services."

The ancillary services the SEC permits crowdfunding operators to provide are broader than the definition of ancillary services permitted by Section 201 (c) of the JOBS Act, which we discussed at length in Part (3) of this series of articles – due diligence and providing standard forms.  On crowdfunding portals, ancillary services can include:

·         Advice about offering content.
·         Advice about deal structure.
·         Helping the issuer prepare its offering documents. 

The proposed crowdfunding rules do not specify the amount or timing or nature of fees other than to prohibit success fees.  Therefore, the market will probably set the fees for these services.

Crowdfunding portal operators also cannot use their portal to raise money for businesses in which they or their affiliates own any interest, unlike Section 201 (c) of the JOBS Act that covers Rule 506 offerings, which permits co-investment by unregistered deal makers.  This restriction on ownership and co-investment eliminates the ability to use equity interests to create an indirect success fee from the appreciation in value the deal creates.

Success Fee Prohibition Means High Volume is Required for Crowdfunding Portals

The prohibitions on crowdfunding portal operators charging success fees and raising capital for affiliated companies mean that crowdfunding portals will probably have to attract many issuers to be profitable.  Small companies that raise money are usually reluctant to pay large fixed fees.  They often can't afford to pay much unless they raise money.  This fact of life in the small issuer marketplace sets practical limits on how much crowdfunding portal operators are likely to be able charge for each offering their portal hosts.  The $1 million annual limit on how much issuers can raise also imposes practical limits on how much each issuer will be willing to pay.

It's something like buying a lottery ticket for a $1 Millon prize.  How much would you pay to try to raise $1 Million with no guaranty of success and an absolute obligation to pay even if you raise no money?

These practical limitations on how much money crowdfunding operators can make from any single issuer mean that crowdfunding portals will probably have to attract a high volume of issuers to be profitable.

Rules Limit the Value Crowdfunding Portal Operators Can Add to Offerings

The high volume of deals required to make crowdfunding portals profitable means that crowdfunding portals will probably eventually become as crowded as the old classified advertisements in newspapers. 

Overcrowding is likely to make it difficult for investors to find the diamonds in the rough. 

There will likely be a lot of rough to sort through.

Other provisions of the SEC's proposed rules prohibit crowdfunding portals operators from doing other things to help investors, such as:

·         Making recommendations to investors.
·         Categorizing companies selling securities by risk or size. 
·         Telling investors they screen deals for quality. 

The SEC views all these activities as providing "investment advice," or "recommendations," which the portal operator will not be licensed to provide.  Deal makers who do not operate crowdfunding portals should keep in mind the SEC's views about what may constitute "investment advice" or a "recommendation" to investors when they determine whether their activity may require them to register as a broker-dealer.

Objective Criteria

Crowdfunding portal operators are only allowed to classify issuers offering securities based on what the SEC calls "objective criteria," which would not be interpreted by investors as offering investment advice.  Objective criteria include:

·         Industry,
·         Geographic location, and
·         Types of securities offered.

Portal operators can also use objective criteria to highlight the offering size and the progress the deal is making with securing investor commitments.  For example, portal operators will be permitted to highlight offerings that achieve 30% of their investment goals (or 70% or 90% or any percentage).  Knowing whether an offering is attracting other investors is an important sales tool.  I note that crowdfunding portals that sell products and services often use the 30% number as a screen to avoid overcrowding by eliminating offerings that fail to achieve 30% of their goal within a fixed time period.

Portal operators cannot charge either issuers or investors for highlighting an offering using these objective criteria.

Companies that sell through crowdfunding portals can't sell their deals outside the crowdfunding portal.  Issuers are limited to issuing bland communications that only identify the issuer and the crowdfunding portal the issuer is using.

The SEC's proposed rules clearly try to level the playing field among issuers, but in doing so they make it more difficult for investors to find the deals they like.  Most the companies will look very similar in the crowdfunding portal's index of offerings until you dig deeper into the issuer's offering materials.  Looking at a full screen of listings can cause the listings to blur together. 

This often happens if you look at online real estate listings.  But real estate listings are allowed to provide search tools that let users narrow their searches by using criteria that real estate buyers consider most important to their discussions, such as price, location, number of bedrooms etc. 

Search tools for crowdfunding portal cannot be based on useful criteria like:

·         Does the company have revenue?
·         Is the company profitable?
·         Has the management team done a successful start-up before?
·         How much money has the company raised before?
·         Does the company have patent protection?

Crowdfunding portals that can provide only limited generic search tools will be less valuable to investors.  To answer the questions they care about, investors will have to spend the time sorting through lengthy descriptions in numerous offerings.

Is this limitation on search tools really in the interests of investors?

Or is the SEC simply trying to discourage investors from using crowdfunding portals?

These are legitimate questions, because of the SEC's long delay in implementing crowdfunding rules.  Four years of waiting for the SEC to approve rules is primarily the result of the SEC's basic hi-hostility to the concept of crowdfunding.

Opportunity for Deal Makers

By limiting the amount of value that crowdfunding portal operators can add to offerings with strict rules about how crowdfunding portals can operate, the SEC's regulatory rules create a market opportunity for other deal makers to compete with crowdfunding portals by offering useful services to both investors and companies raising capital. 

This is another reason why many deal makers will choose to conduct offerings under Rule 506 (c), which permits deal makers to utilize the best combination of:

  • In person sales efforts.
  • Traditional advertising.
  • Internet and Social Media communications.
Deal makers will, however, have to be careful to avoid making "recommendations" or providing "investment advice," if they are not registered as broker-dealers, keeping in mind the SEC's broad views (expressed in its Crowdfunding Release) about what types of statements and technology features may constitute a "recommendation" or "investment advice."

If you would like to learn more, you can reach me at JFV@WardandSmith.com.
Or you can check out my eLearning course at www.YouTube.com/eLearnSuccess
or read my newspaper articles at



ND: 4841-0336-9243, v. 1

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