Crowdfunding: Business and legal issues for Launching an Equity Crowdfunding Platform (Part 1)

The passage of the JOBS Act in 2012 gave rise to a new industry of service providers: equity crowdfunding portals- online platforms that connect interested investors with emerging growth companies, and more recently, micro-venture capital funds. This article discusses some of the key business and legal factors to consider for launching an equity crowdfunding (“ECF”) portal.

General Overview

For business owners, raising money has traditionally been a complicated and costly endeavor, and the pool of potential investors was often limited to pre-existing relationships of the founders and its agents. For investors, access to investment opportunities has similarly been limited to offerings revealed via solicitations from pre-existing relationships and intermediaries like investment bankers.

Equity crowdfunding portals address these issues by making capital financing more cost-effective and accessible for both sides of the deal. ECF portals reduce transactional costs and other barriers commonly associated with capital offerings and provide entrepreneurs and investors greater access to capital and deal flow, respectively.

Currently in the U.S., ECF is only available to accredited investors, so a more precise way to think about the business is “accredited crowdfunding.” In fact, such platforms often refer to themselves as “angel investing platforms” or “online venture capital firms.” The following are some important issues to consider for those interested in launching an ECF platform.

Identify the Niche in the Marketplace 

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ECF platforms must identify their niche in the marketplace. Investors are looking for access to legitimate and attractive investment opportunities presented through a convenient, secure and sophisticated transaction process. Companies desire a platform that will help facilitate their offerings and achieve their fundraising goals.

However, with the staggering growth in ECF portals, the ECF competitive market will likely evolve into more and more specialized platforms with a track record of success in the target market and reputation for superior administrative support and user experience. Today, certain portals are industry specific, e.g., focusing on tech companies, real estate deals, entertainment and media, while others may be more industry agnostic but distinguish themselves by their particular business model or in other aspects.

 

Identify the Business Model 

In addition to determining the market niche, the portal operator will want to identify the business model and associated issues to address. Most ECF platforms are distinct in how they curate investors and investment offerings as well as how they facilitate transactions, receive compensation, and comply with federal and state security laws. Some have rigorous vetting processes for offerings promoted on the platform and may even require the offering party to complete a certain amount of funding (for instance, 20% of the target fundraising goal) before the offering is presented to the platform’s investors.

The manner in which a platform intends to generate revenue- e.g., transaction based, referral based, flat fee, subscription, or a hybrid of these- must comply with applicable laws. Generally, transactions are not processed on the platform directly unless the platform is also a broker dealer or is affiliated with a registered broker dealer. As a result, on some platforms, the actual transactions occurs between the investor and the company without involvement of the platform, whereas in other situations, investors may be co-investing with the platform via a separate fund that is managed by the platform through an affiliated entity.

Broker / Dealer

Generally, any person engaged in the business of effecting transactions in securities for the account of others must be registered with the SEC as a broker/dealer. This presumably applies to ECF portals as they are intermediaries and facilitators between investors and the businesses seeking capital, but Title II of the JOBS Act created a registration exemption for funding portals.  A funding portal is “any person acting as intermediary in a transaction involving the offer or sale of securities for the account of others” pursuant to the crowdfunding exemption of the JOBS Act.

Depending on the long-term goals of the platform, and the capital it has to invest into the business, there are certain issues to consider when deciding whether or not go through the time and cost intensive process of becoming a registered broker/dealer. One drawback to being registered as a funding portal and not a broker/dealer is that funding portals are prohibited from providing any investment advice or recommendations, as well as from soliciting purchases, sales, or offers to buy the securities available on its portal, whereas a broker/dealer is permitted to engage in these activities. However, the process of becoming a registered broker/dealer is costly and time consuming, and so portals may opt to hire a third party registered broker/dealer to handle its securities transactions.

Another difference between registered broker/dealers and funding portals is that broker/dealers are permitted to take transaction-based compensation, while funding portals are prohibited from doing so. As a result, funding portals are limited to charging users a flat fee in order to display the opportunity on its site. On the other hand, broker/dealers have the potential to receive more revenue based on the number of trades done on its platform and/or the successful completion of a round of funding.

Identify the Regulatory Requirements

Equity crowdfunding platforms facilitate the transaction of securities and therefore must comply with both federal and state securities laws in addition to other laws. The passage of Title II of the JOBS Act removed the prohibition on general solicitation of investment offerings, which is the primary basis for how ECF platforms are now able to promote investment opportunities to the public online. However, ECF platforms must still adhere to traditional securities regulations depending on the scope of the platforms involvement in the transaction and monetization model.

The industry is still in the infancy stage and the legal framework is still evolving; however, there are specific laws governing the rights and limitations of ECF portals. See prior posts in the series covering general ECF laws pertaining to portal operators and investors. Some platforms operate pursuant to “no-action” letters issued by the Securities and Exchange Commission, through their own broker dealer, via a rented broker-dealer, via FINRA authorization, and some under no authorization.  It is advisable for any prospective ECF portal to present its intended service model to the SEC and FINRA for comments, guidance and/or approval.