CHAPTER 11
Should You Set Up a Funding Portal?
Throughout this book we have looked at the role funding portals will play in the crowdfunding process and the responsibilities they have for ensuring that crowdfunded offerings of securities go smoothly and legally. In fact, both the JOBS Act and Regulation Crowdfunding put the burden squarely on funding portals to make sure the crowdfunding systems work—most of Regulation Crowdfunding’s nearly seven hundred pages are devoted to rules and regulations governing funding portals.
A few enterprising readers may be thinking to themselves, “Hey, the money in crowdfunding is with the funding portals! I should be thinking about starting up a funding portal!” This chapter will discuss funding portals, the advantages and disadvantages of getting involved in the funding portal business, and the right way to set up a funding portal operation.
It May Be Too Late for the Early Money
As this book goes into print, about a dozen companies are positioning themselves to open funding portals under the JOBS Act. By the time you read this book, at least some of those portals will have registered with the SEC and FINRA and will have opened their doors for business.
In addition, the JOBS Act and Regulation Crowdfunding not only allow but appear to encourage investment banking firms, brokerage houses, and other registered broker-dealers to get into the funding portal game, and it may be expected that at least some of these firms will consider opening crowdfunding divisions in coming months. Any such firms would, of course, be extremely powerful competitors in an early-stage market because of their extensive experience in the securities industry and because of the huge amounts of capital they already have available for building a successful portal business.
It may therefore already be too late to get into the funding portal game in a big way and become a key player.
Picking a Crowdfunding Niche
There may, however, be opportunities to develop funding portals that focus on specific industries or verticals, specific types of companies, and specific types of offerings. Regulation Crowdfunding expressly permits such specialization as long as it is based on objective criteria that are designed to result in a broad selection of offerings, are applied consistently, and are clearly displayed on the portal website. Examples of such specialized portals are:
Energy-related companies
Start-up fast-food franchises
LLC securities
Issuers located in a particular state or region
Offerings of less than $50,000
Focusing on a niche may well reduce the costs of setting up a funding portal and get you into the market more quickly than offering a broad range of crowdfunding services. In looking for the right niche, however, it is important to ask:
Is the niche big enough to generate substantial revenue in the first few years of operations?
Is the niche small enough to be unattractive to the large investment banks, brokerage firms, and early-stage portals that may come to dominate the industry?
Do issuers in the particular niche have enough money to pay decent commissions and the add-on fees the portal will need to stay afloat?
Are there enough investors interested in the niche to justify an exclusive portal?
Setting Up a Funding Portal
There are five basic steps in setting up a funding portal:
1.The founders must form a corporation for the funding portal (due to the high degree of liability imposed on funding portals, an LLC would not provide enough protection to the portal’s shareholders).
2.The portal is then required to register with the SEC as either a funding portal or a broker, using the SEC’s new Form Funding Portal (the text of which can be found at SEC Release No. 33-9974, www.sec.gov/rules/final/2015/33-9974.pdf, beginning on page 21).
3.The portal is then required to register with FINRA and pay a fee of $2,700 (the text of the FINRA application form is at www.finra.org/industry/rule-filings/sr-finra-2015-040).
4.The portal must obtain a $100,000 fidelity bond.
5.The portal must hire the staff necessary to provide all the services and perform all the obligations imposed on funding portals by Regulation Crowdfunding.
It will likely take at least a year, and possibly longer, to complete all these steps.
The cost of setting up a funding portal is likely to be prohibitive for many start-up companies. Operating a funding portal is also likely to be extremely labor intensive: reviewing offering documents from dozens or perhaps hundreds of issuers, furnishing them with advice on putting together their offerings, dealing with dozens or perhaps hundreds of investors, and keeping track of dozens of crowdfunded offerings at the same time, without making mistakes that could subject the portal to liability—performing these functions will require many, many warm bodies sitting at computer terminals.
Many funding portals are likely to try to minimize these costs by outsourcing their internal operations to a location in India or another country in the developing world—a highly ironic outcome, to say the least, for a statute designed to create jobs in the United States.
Before launching a portal, each of the its founding executives must understand that they cannot:
Have a financial interest in any issuer
Participate in offerings either as an issuer or investor
Engage in any activity that might constitute a conflict of interest with an issuer, investor, or any other third party (for example, by referring the portal’s business to another company in which the executive has a financial interest)
The Portal’s Obligations to Vet Issuers
The JOBS Act and Regulation Crowdfunding impose somewhat inconsistent obligations on funding portals in their dealings with issuers.
When reviewing an issuer’s offering documents, funding portals must have a “reasonable basis for believing” that the issuer (1) has met the disclosure and other requirements of Regulation Crowdfunding and (2) has the means to keep accurate records of investors once an offering is completed. Regulation Crowdfunding provides that funding portals may rely on representations to that effect by the issuer, absent any indication that the representation is not true.
On the other hand, Regulation Crowdfunding states that funding portals must be able to “adequately and effectively assess the risk of fraud from the issuer or its offering.” Funding portals are also required to investigate whether any of an issuer’s directors, officers, or other key executives have committed “bad acts” sufficient to disqualify the issuer’s offering under Regulation Crowdfunding. If it cannot do so (for example, because an issuer’s directors are foreign nationals whose country of origin does not allow for third parties to review criminal or regulatory enforcement background information), the funding portal must deny access to its platform.
If a funding portal becomes aware that any crowdfunded offering “presents the potential for fraud or otherwise raises concerns regarding investor protection,” it must deny the issuer access to the portal. If a funding portal becomes aware that there is the potential for fraud after an offering has commenced, or that one or more of the issuer’s principals is disqualified as a bad actor, it must cancel the offering and return any investors’ money.
Can an issuer sue a funding portal if the portal mistakenly rejects its offering or denies it access to the portal? That is an interesting question, the answer to which will hinge on how the issuer would calculate damages for not having access to that particular portal.
Given these heavy obligations, to what extent must a funding portal conduct due diligence on issuers before accepting their offerings? Regulation Crowdfunding isn’t clear, and each funding portal will need to determine how closely and aggressively to review offering documents.
While Regulation Crowdfunding allows a funding portal to rely on an “issuer representation” that all rules have been complied with, I don’t think many portals will feel comfortable that their obligation to prevent fraud can be satisfied by having the issuer click “I agree” to accept terms and conditions that it has never read—and I strongly doubt that legal counsel representing a portal will sanction such an informal approach.
On the other hand, the need to generate a high volume of issuer offerings during the early years of a portal’s operation may lead it to go easy on issuers in an effort to gain a competitive advantage.
The Portal’s Obligations to Investors
As discussed in Chapter 10, funding portals are required to develop educational materials for each offering it handles and to deliver them to each investor who opens an account and expresses a desire to participate in a particular offering. It must also develop a means of confirming that the investor understands the information in the educational materials and agrees to play by the rules. This send-out-materials-and-obtain-confirmation procedure must be repeated each time an investor indicates an interest in a particular offering.
Funding portals are not, however, required to investigate or do background checks on investors to make sure they legally can participate in crowdfunded offerings. While a funding portal can check its records to see if the total amount of an investor’s commitments exceeds her investment limit, there is no practical way for a portal to confirm if she has exceeded her limit by reason of investments with other portals. Accordingly, Regulation Crowdfunding provides that a funding portal may rely on an investor’s representations concerning the investment limits that apply to the investor and the amount of the investor’s investments in crowdfunded securities through other portals.
That said, funding portals will be best advised to make each investor focus hard and long on his other crowdfunded investments when completing the affirmation documents for each offering by asking as many focused, specific questions as possible and requiring the investor to respond to each one. That way, there will be little likelihood an investor can claim he wasn’t sure what the portal was getting at if he is later found not to have been qualified to invest in a crowdfunded offering.
Can a funding portal bar access to an investor who is found to have lied in his statements to the portal? Perhaps. If the investor is a heavy hitter who participates in lots of offerings and has an otherwise decent track record, I have a suspicion most funding portals will find a way to deal with the problem discreetly.
What is clear from Regulation Crowdfunding is that a funding portal may not reject an investor because it feels a particular investment isn’t suitable for the investor.
Funding portals must provide to investors all information about an offering by one of three methods: via email, via a link to the portal’s website, or via notice on the portal website as to where such information can be found. Investors must be allowed to save, store, or download the information.
When an investor commits to an offering, the founding portal must accept the investment on the issuer’s behalf but must direct funds to the qualified bank that has agreed to hold them in escrow for that offering. Funding portals are expressly prohibited from holding investor funds or issuer securities. The portal must also ensure that an investor fills out and signs any and all subscription documents the issuer has required for the offering, and issue a “notice of investment commitment” to both the issuer and the investor. If an investor cancels an investment commitment up to forty-eight hours before the offering closes, the portal must refund the investor’s money promptly.
When an offering closes, the portal must issue a confirmation statement to the investor detailing the amount of the investment, the number of securities purchased, and other information required by Regulation Crowdfunding.
The Portal’s Obligations to the SEC
Funding portals are not required to file documents periodically with the SEC the way issuers are. Funding portals are, however, required to maintain extensive books and records, subject to examination by the SEC at any time. These records include:
Records related to an investor who purchases or attempts to purchase securities through the portal
Records related to issuers who offer and sell or attempt to offer and sell securities through the funding portal and the people who “control” such issuers (for example, people who own a majority of the issuer’s shares, or an affiliated company that is owned by the same company that owns the issuer);
Records of all communications occurring on or through the portal
Records relating to promoters
Records required to demonstrate compliance with Regulation Crowdfunding
Notices provided by funding portals
Written agreements entered into by the funding portal
Daily, monthly, and quarterly summaries of transactions effected through the portal, including successful issuers, amounts distributed, and transaction volume (number of transactions, number of securities involved, total amounts raised by and distributed to issuers, and total dollar amounts raised across all issuers on the portal)
A log reflecting the progress of each issuer toward achieving its target offering amounts
The organizational documents of the funding portal
Funding portals are required to preserve all records for five years. During the first two years, records are required to be kept in an easily accessible place.
While the SEC does not require funding portals to register as broker-dealers, funding portals are not exempt from the compliance requirements that apply to registered brokers. These compliance requirements include the SEC’s anti-money-laundering regulations, customer-privacy protections, and the provisions relating to examination and inspection of books and records and facilities by the SEC and FINRA.
The Portal’s Obligations to Market and Grow Its Business
Funding portals are allowed to advertise their own existence, and (with some limitations) to pay third parties for referring issuers and investors to the portal. For example:
A portal can pay a third party for referring potential investors to the portal so long as the third party does not provide the portal with any personally identifiable information about any of the potential investors (information that can be used to distinguish or trace an individual’s identity), as long as the payment is not based on the number of investments made by those investors on the portal.
A portal can enter into agreements with registered broker-dealers by which they can pay each other for services.
Funding portals cannot, however, charge issuers for special placement for their offerings on the portal, or for recommendations or endorsements of specific offerings. Funding portals also cannot solicit offers or sales to buy securities offered on the portal.
The Portal’s Obligations in Managing Offerings
A funding portal is a platform only, a “program or application accessible via the Internet or other similar electronic medium” as defined in Regulation Crowdfunding, designed to facilitate interactions between issuers and investors but without itself getting involved in the offering process. In many ways, funding portals are intended to be set up the same way as eBay is: buyers and sellers interact with each other without any intervention from eBay (except, of course, for the collection of fees from buyers and sellers).
Funding portals are obligated to ensure public access to all offering documents posted to the portal and to all communications taking place on the portal, including search functions to enable issuers and investors to find each other.
Funding portals are obligated to set up communications channels by which issuers and investors communicate with each other, such as chat rooms, discussion threads, webinars, and telephone conference calls. Funding portals may not, however, participate in any discussions other than to establish guidelines, to moderate, and to remove postings that violate the rules or their own communications guidelines.
What happens if the portal website goes down and issuers and investors cannot communicate for a period of time? Regulation Crowdfunding does not provide specific liability for such a situation, and presumably funding portals will do everything possible to limit their liability for such outages in their published terms and conditions.
A more significant question, however, is what happens if an offering closes during a portal outage, such that investors are prevented from making last-minute investments during the outage period? To avoid liability to the issuer in such a situation, I suspect most funding portals will develop a policy of automatically extending the offering period for the same amount of time that the portal site was down or five business days, whichever is longer. Such a policy would not be prohibited by Regulation Crowdfunding as long as the portal follows the rules for extending an offering (giving investors notice of the extended period and five business days within which to reconfirm their investments). Of course, issuers won’t be too happy if investors fail to reconfirm their investments during the five-business-day period and the funding portal is required to give them back their money because of something that wasn’t the issuer’s fault.
During the offering period, funding portals are also obligated to:
Maintain accounts with banks or other financial institutions to hold investors’ money until an offering closes
Accept investment commitments on behalf of issuers and ensure that investors fill out and sign all subscription documents required for the offering
Release funds to the issuer when the offering closes (or the minimum offering amount has been reached)
Deliver confirmations of investment to the issuer and each investor when the offering closes
The Portal’s Liability for Mistakes
Issuers, including their directors and officers, are liable under the JOBS Act to investors for “untrue or materially misleading statements” in their offering documents. Funding portals, their directors and officers, and lower-level employees who are “involved in the offering” are also liable to investors for “untrue or materially misleading statements” in an issuer’s offering documents, unless they or the issuer can prove they did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.
The good news is that a funding portal’s liability is limited to the amount paid by each investor affected by the mistake, plus interest. The bad news is that investors can sue the funding portal even after they have sold their investments. Funding portals are, however, permitted to exercise discretion in limiting the offerings and issuers they allow on their platforms, which may give them some ability to limit their liability to investors under Regulation Crowdfunding.
Funding portals will also have liability to the SEC for, among other things, failing to maintain all required books and records relating to the offerings it handles, and for a funding portal’s own breach of the requirements of the JOBS Act and Regulation Crowdfunding (for example, by advertising a particular offering or highlighting one offering over another in violation of the rules). Funding portals that violate specific provisions of the JOBS Act and Regulation Crowdfunding will be subject to the same civil and criminal penalties as are imposed for violations of the Securities Exchange Act of 1934.
How a Funding Portal Makes Money
As this book is going into print prior to January 26, 2016 (the date funding portals are first allowed to register with the SEC), no funding portals have been approved by the SEC. It is therefore difficult to predict the revenue model most funding portals will adopt over time.
Funding portals are prohibited from taking a “carried interest” (a piece of the action) in the crowdfunded offerings they manage. But there is nothing in the JOBS Act or Regulation Crowdfunding preventing funding portals from charging issuers and investors a commission or other fee for their services at both ends of the transaction.
Accordingly, it may be anticipated that most early funding portals will charge issuers a flat fee or commission for handling their offerings, which may be tiered based on the amount of the offering, the timing of the offering, and/or the amount of offering documentation the funding portal will be expected to process for a particular issuer.
In addition, funding portals are almost certain to charge extra for such add-on services as helping issuers prepare their offering documents or managing their shareholder lists and capitalization tables after an offering is completed.
While funding portals are prohibited from endorsing or promoting specific offerings in their communications with the outside world, the rules are a bit fuzzy when it comes to allowing issuers to add bells and whistles to their online presence so as to stand out from other offerings on the portal. Regulation Crowdfunding allows funding portals to “highlight and display” offerings on the portal based on “objective criteria that would identify a large selection of issuers.” Some of the objective criteria noted by the SEC are the type of securities being offered, the geographic location of the issuer, and the number or amount of investment commitments made. Funding portals are prohibited, however, from receiving special or additional compensation for identifying or highlighting an issuer or offering on the portal.
To the extent permitted by the rules, funding portals will almost certainly charge add-on fees for such bells and whistles as an issuer may request and are consistent with Regulation Crowdfunding, similar to the way eBay charges its sellers for using different colors, visuals, or graphics when listing items for sale on the site.
Given the high start-up and operating costs of running a funding portal business, the many responsibilities funding portals have under the JOBS Act, and the high degree of liability to which they are subject, portal fees may be expected to be quite high, at least during the early years of the portal’s operations, in amounts comparable to what an investment bank or brokerage firm would charge for handling a similar offering.
Funding portals may also charge fees to investors, although at least initially most funding portals will probably keep these as low as possible in order to maximize investor interest and participation.
Using Crowdfunding to Raise Money for a Funding Portal
A start-up funding portal is an entrepreneurial company just like any other. As long as it meets the qualifications for crowdfunded issuers under the JOBS Act and Regulation Crowdfunding, there is nothing to legally prevent a funding portal from using crowdfunding techniques the same as any other issuer to raise start-up capital.
Of course, a funding portal using crowdfunding techniques will need to find another funding portal to manage its offering, and other funding portals will be unlikely to want to help you if they see your operation as a potential competitor. In soliciting crowdfunding assistance from a funding portal, you will need to convince its management that (1) you are operating in a specialized niche that poses no threat to them and (2) once you are up and running you will be in a position to refer business to it or otherwise assist it in developing its business plan.
As to how you will do that successfully, I haven’t a clue. Good luck!