You Cannot 'Crowdfund' a Fund (in case you were wondering)
Crowdfunding may provide an interesting way for some companies to raise capital. It’s definitely getting a lot of the hype since passage of the Jumpstart Our Business Startups (JOBS) Act earlier this month. I’ve read articles talking about how crowdfunding is going to disrupt funding for small businesses (in a good way). Personally, I don’t see it...certainly not in the short-term. Perhaps the SEC’s pending rulemaking will make this an amazing option, but right now I’m not sure that otherwise financeable companies will find this option better than the other existing methods. The currently projected costs are simply too great. The process is expensive both initially in setting up the intermediary/crowdfunding process itself (vs. dollars raised) and also on an ongoing basis in terms of shareholder maintenance. Add to that the likelihood that crowdfunded companies, at least early on, probably will be targeted by plaintiff class-action lawyers, possibly based on nothing more than the fact that the concept is new and untested. SEC rulemaking is scheduled for 270 days from passage but may take even longer. Until then, anyone trying to setup a crowdfund will be doing so at their own peril, without an understanding of the rules that may apply to them retroactively. In short, for private companies, crowdfunding remains an enigma and all we reasonably can do for the rest of this year is debate its merits.
For fund managers, however, the implications of crowdfunding are already clear – you can’t use it.
Almost all private funds are deemed to be “investment companies” under the Investment Company Act, and “investment companies” are required to register under the Investment Company Act of 1940 (the “Investment Company Act”) (similar to what mutual funds must do) unless they fall within an exemption from the registration provisions.
Fund managers of private equity funds typically rely on one of two exemptions from being treated as an “investment company”:
- Section 3(c)(1) provides an exemption for funds with fewer than 100 beneficial owners.
- Section 3(c)(7) provides an exemption of funds with solely qualified publishers – the functional equivalent of super accredited investors (e.g., accredited investor individuals generally need to have $1M in investment assets, while qualified purchaser individuals must have $5M in investment assets).
The new crowdfunding rules specifically prohibit investment companies, including those that are exempt from investment company registration under Section 3(c) or 3(b), from crowdfunding:
(f) Applicability.—Section 4(6) shall not apply to transactions involving the offer or sale of securities by any issuer that…(3) is an investment company, as defined in section 3 of the Investment Company Act of 1940, or is excluded from the definition of investment company by section 3(b) or section 3(c) of that Act; or (4) the Commission, by rule or regulation, determines appropriate.
In short, you can’t crowdfund a fund.