Once again, I asked my trusty AI image generator to create a graphic to illustrate this article’s title. Once again, AI cannot spell. In addition to “structures” with signs saying Reg A and Reg CF, we get “CFF” “Res A” and “ROO A”
Part Five of a Six Part Series Comparing Regulation A and Regulation Crowdfunding. See Part One Here, Part Two Here, Part Three Here and Part Four Here.
In this series, I’ve been exploring the legal and regulatory issues surrounding Reg A and Reg CF, the two types of equity crowdfunding offerings. Both are incredible laws for small businesses, and selecting between which of the two laws to use for equity crowdfunding purposes can be confusing. This week’s article focuses on some specific things that are important to know before you structure a Reg A or Reg CF offering.
Liquid After 1 year vs. Immediate Liquidity
One main issue to consider related to Reg A vs. Reg CF is liquidity. When someone invests in a Reg A offering, the securities they purchase are liquid – they can be sold immediately to anybody whether the purchaser is an accredited investor or a non-accredited investor. As a general rule, most private company investments do not have this level of liquidity that public companies enjoy. This is a definitive advantage for Reg A. This may, in reality, be more of a theoretical advantage because many Reg A offerings do not sell out and therefore there is no immediate market for buying the same stock at a higher price than the issuer was selling. But for some Reg A offerings that are tradable on a secondary market this is a huge advantage, or for companies that grow and make great strides in valuation after the Reg A offering. For example, I will discuss below the growing phenomenon that is the Series LLC offering, something that cannot be done effectively with Reg CF because of the lack of immediate liquidity.
Reg CF securities are not immediately liquid like Reg A securities or securities sold by public companies. Regulation CF securities may not be sold or traded for one year after they are purchased except if they are sold to a family member, an accredited investor, or back to the issuer.
Public Companies
While most people think of Reg A and Reg CF as vehicles to raise capital for private companies, Reg A may also be used by public companies to raise capital. Not so with Reg CF. There has not been a significant amount of Reg A use by reporting companies. This is primarily because the cost benefit of Reg A over a traditional IPO is in the lower up front cost and the far lower cost of ongoing SEC reporting that Reg A enjoys over a traditional SEC reporting company are far less of an advantage for a company already required to report like a public company. But there are some limited reasons a public company might want to use Reg A. Reg A can be a stepping stone to becoming a public company and holding a traditional IPO and getting used to some public company disclosures and reporting.
Series LLC
The Series LLC model is something being used in many verticals to lower the cost of multiple Reg A offerings and to provide a secondary market for certain Reg A securities. Put simply, a Series LLC is a limited liability company, generally formed in Delaware, that allows one issuer to sell several different “series” of securities under one umbrella, without having to go through the costs and time of doing a Reg A offering for each series of securities. In theory, each series is pretty much treated like its own company and the assets and liabilities of each Series are not shared by the other series, or the parent company.
This model is used frequently with fractional ownership of collectibles like art or vintage automobiles. It also may work well for certain real estate offerings and several other areas. Here is a made-up example to illustrate how a Series LLC Reg A offering might look:
Let’s say a restauranteur wants to open 5 new locations at a cost of $5M each, and wants to be able to tap into the local accredited and non-accredited investor markets to do so in 5 different cities. While the restauranteur could do 5 Reg A or 5 Reg CF offerings, that would require 5 separate SEC filings and everything including the expenses, that go with each offering. Or, the restauranter could file a Series LLC Reg A offering with the SEC, and each of the 5 restaurants could be a separate “series” and each series could raise capital only for one of the restaurants – but it is all done in one SEC filing. The restaurateur could raise up to $75M every twelve months under each “Series LLC” Reg A filing – and only incur the costs of the initial Reg A filing one time. Then, once each series raises capital, there can be secondary trading of those securities in various different ways without becoming a public company and listing on an exchange.
One important note – while Series LLC Reg A seems like a great idea for companies who have multiple assets to finance, they are still a relatively new phenomenon and have not been battle tested through the courts. There are differences of opinion about taxation issues, whether bankruptcy cuts across the various series into each other, and many other undecided legal issues. Some states do not recognize the Series LLC format. If you think you are a good candidate for a Series LLC< check with experiences counsel before you jump in.
Series LLC offerings are not an option for Reg CF.
Crowdfunding SPVs
Now we get to one of the most wonderful, but also potentially most frustrating aspects of all equity crowdfunding... the number of investors. The benefit of equity crowdfunding, as a whole, if to be able to tap into a large number of people who invest a small amount of money each that adds up to a large investment when totaled. But that large number of investors also creates a few compliance issues with both Reg A and Reg CF.
There is a pesky little thing called the Securities Exchange Act of 1934 and a part of that set of statutes that securities lawyers call “12(g)” that rears its ugly head when you have a lot of investors. In a nutshell, 12(g) says that an issuer must register with the SEC as a public company (and incur all the ongoing expense of full SEC reporting) if the company (a) has gross assets of more than $10M and (b) has a class of securities held of record by more than 2,000 persons or more than 500 non-accredited investors.
Obviously, these rules that were written 90 years ago make no sense in today’s world of equity crowdfunding. Nearly every successful Reg A or Reg CF offering will end up with more than 500 non-accredited investors. Fortunately, both Reg A and Reg CF have workarounds for the 12(g) investor limits.
Reg CF solved this problem by allowing a “Crowdfunding Vehicle” to be created that, in essence, puts all of the Reg CF investors into a special purpose vehicle (“SPV”) that only appears as one entry on the issuer’s cap table. Not only does this solve the 12(g) problem but it also alleviates concerns that follow up rounds by VCs or institutional investors may be affected by those groups not wanting to deal with thousands of people on a cap table. One note: entities such as a company or LLC may not invest through a Crowdfunding Vehicle.
Crowdfunding vehicles and SPVs are not allowed in Reg A offerings. But Reg A does have a workaround for the 12(g) investor limitation problem. A Reg A issuer may have more than 2000 total investors and/or more than 500 non-accredited investors if (a) the company is current on all required SEC filings, does not have a public float of $75M, or if not publicly traded had revenues of less than $50M in the most recent year and engaged an SEC registered transfer agent.
Can Only U.S. Companies Use Reg A or Reg CF?
Here is another difference between the two equity crowdfunding laws.
Reg A can only be used by “an entity organized under the laws of the United States or Canada, or any State, Province, Territory or possession thereof, or the District of Columbia, with its principal place of business in the United States or Canada.” Reg CF may only be used by an issuer that “organized under, and subject to, the laws of a State or territory of the United States or the District of Columbia.”
What does this mean? Simply put, for Reg A your company must have been (a) formed under U.S. or Canada law and (b) have its principal place of business in the U.S. or Canada. Reg CF only allows a company formed in the U.S. to utilize the law but does not have the “principal place of business” requirement that Reg A has. This basically means that with some legal restructuring, a foreign company may use Reg CF even if their principal place of business is in another country outside the U.S. as long as the entity formed to raise Reg CF capital is formed in the U.S. But that company’s offices and operations may be anywhere in the world.
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Coming next week: Part 6 of the 6 part series: Kendall’s Tips and Tricks For A Successful Reg A or Reg CF Offering. Also, this article is not and should not be considered legal advice. Yes, I am a securities lawyer but no, you did not hire me to provide you with legal advice. In all cases, consult with your own lawyer as every legal situation is unique and do not rely on my educational and informative article as legal advice.