The SEC recently issued an important no-action letter for online portals, and for other issuers of securities (including startup companies), trying to raise money in compliance with the SEC’s new 506(b) and 506(c) rules.
We can thank Dan DeWolf from Mintz Levin and his colleagues for obtaining this guidance from the SEC. Dan wrote a post about the meaning of CitizenVC here.
You can find the no-action letter here.
Citizen VC is an online portal. It forms special purpose LLCs to invest in early stage companies.
CitizenVC did not want to be considered to have generally solicited their offering of these special purpose LLC interests. Instead, it wanted to be able to rely on Rule 506(b) for the offering of those interests. To rely on Rule 506(b), a company cannot generally solicit or generally advertise its offering. If a company has a pre-existing, substantive relationship with its investors, that is one means of showing that general solicitation or general advertising did not occur.
But how does a company like CitizenVC establish a pre-existing, substantive relationship with investors who sign up to use its Internet platform?
Here is how CitizenVC posed the above question the SEC:
The Site is hosted on the publicly accessible Internet and CitizenVC is cognizant of the fact that prospective investors may search the Internet and land on its Site. CitizenVC wants to be prepared to accept membership applications from prospective investors with whom-a pre-existing relationship has not yet been formed, but with whom it will establish a relationship prior to offering Interests.
Here is how the CitizenVC site goes about establishing a substantive, pre-existing relationship with folks who show up on their web site wanting to join.
First, prospective investors have to to fill out a generic accredited investor questionnaire. Once they have done that, and have averred that they are accredited, Citizen VC puts the prospective investors through a process designed to establish a “substantive relationship.”
As the SEC has written:
A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship. [August 6, 2015]
As described in its request letter to the SEC, Citizen VC does the following, after receiving a generic accredited investor questionnaire from a prospective investor:
- Contacts the prospective investor offline by telephone to introduce representatives of CitizenVC and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication,
- sends an introductory email to the prospective investor,
- contacts the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments,
- utilizes third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability,
- encourages the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives, and
- generally fosters interactions both online and offline between the prospective investor and CitizenVC.
After CitizenVC does all of the above, here is what else it does:
After CitizenVC is satisfied that (i) the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the Site, and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor, only then will CitizenVC admit the prospective investor as a Member of the Site. Thereafter, CitizenVC will provide the new Member access to the password protected sections of the Site, where the new Member can investigate investment opportunities curated by CitizenVC and the offering materials related thereto. The relationship with a new Member will exist prior to any offering of securities to such new Member.’
Here is how the SEC responded:
We agree that the quality of the relationship between an issuer (or its agent) and an investor is the most important factor in determining whether a “substantive” relationship exists. As the Division has stated before, a “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. See, e.g., Bateman Eichler, Hill Richards, Inc. (Dec. 3, 1985). We note your representation that CVC’s policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. We also agree that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship. Whether an issuer has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances.
In expressing these views, we note your representation that the relationship with new Members will pre-exist any offering, consistent with the Division’s previous guidance. In this regard, we note that a prospective Member is not presented with any investment opportunity when being qualified to join the platform. Any investment opportunity would only be presented after the prospective investor becomes a Member. Further, we understand that CVC creates SPVs for investment in particular Portfolio Companies and not as blind pools for a later investment opportunity.
What Is the Significance of CitizenVC?
What is the significance of the CitizenVC ruling? It provides a road map on how to develop a substantive relationship with a prospective investor. As the SEC has said, “a ‘substantive’ relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.”
The CitizenVC no-action letter contains good guidance for all issuers of securities trying to rely on Rule 506(b). You don’t have to be an online portal for this guidance to apply to you. If you are a startup company, and you are trying to raise money from investors, do you need to have a “substantive, pre-existing relationship” with those investors to avoid being considered to have generally solicited your offering?
The SEC has said a “substantive, pre-existing relationship” is one means, but not the exclusive means of demonstrating the absence of general solicitation:
“The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering.”
The fact that a “substantive, pre-existing relationship” can demonstrate the absence of a general solicitation in a Regulation D offering is really significant. Especially when the rules around what constitutes general solicitation and general advertising are imperfect and make it relatively easy for a company to inadvertently generally solicit or advertise an offering.
As Dan DeWolf summarized in his blog post:
As set forth in the CVC Letter, an issuer can now develop a specific set of policies and procedures that will take the offering outside of being considered a “general solicitation.” The key is that certain procedures are created and followed which enable the issuer and the potential investor to develop a “pre-existing, substantive relationship” before any securities are offered. These procedures are designed to enable the issuer to evaluate the prospective investor’s financial sophistication, circumstances, suitability, and his or her ability to understand the nature and risks of a potential investment. If there is no general solicitation, then the issuer is not required to obtain independent verification of the accredited status of the investor.
Thank you Dan and team for helping to obtain some clarity on difficult issues for issuers trying to raise money from investors.