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The JOBS Act - Title II: Online Solicitation of Accredited Investors The Platform as a Dating Service

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


The Platform as a Dating Service

To this observer, the amendment to Rule 506 of Regulation D in Title II of the JOBS Act repealing the ban on general solicitation and advertising is potentially the most significant of the five principal initiatives in the Act. The hope and intent of online solicitation is that it will enable deserving issuers (nicknamed "Gazelles") who are on the trip "from the embryo to the IPO (or a trade sale)" to bridge what is called, in another piece of jargon in this sector, the Valley of Death.

Critical background to this paper is an article entitled, "From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest)" (http://www.sandw.com/news-687.html) [1], which celebrates the process by which Gazelles, often originating as spin outs from academic centers and exploiting game changing technology, [2] will be carried forward by the Conveyor Belt through the founders, friends and family and then the angel rounds of financing, the VC round(s) and then the exit. The Valley of Death is the capital gap between the proceeds of the angel round, presumably Series A, on the one hand, and the other necessary raise of a significantly larger amount ... e.g., as in healthcare ... which must be sourced from the suppliers of "growth" or "mezzanine" capital, traditionally the venture capitalists. If and when the mezzanine rounds are successfully closed, then, courtesy of a significant reform of the IPO process labeled the On-Ramp IPO (see Title I of the JOBS Act), the Gazelle can reach maturity, with potentially enormous impact on the U.S. economy and the availability of transformational goods and services.

All very romantic and full of enormous promise, of course, but the Valley of Death has now proven to be a problem. There has grown up a significant distance between the angel rounds of financing (and angels currently dominate early stage financing of Gazelles in percentages approaching 85% to 90%) capped usually in the area of, say, $3 million in capital infusion and the institutional / venture capital round, which provides capital in the tens of millions as needed ... i.e., the gazelle can get there. The hope is that new Rule 506 will provide enough of a booster shot, in the form of capital raised online from accredited investors (which can be in any amount), to get the Gazelle across the Valley and headed toward the finish line (pardon the excessive metaphors).

That said, as we await the SEC's rule making, there is a fear that online solicitation and advertising, even limited to accredited investors, will prove to be counterproductive and perhaps fatal to the Title II initiative. The Internet may be engulfed with an undifferentiated clutter of investment proposals and interested investors will have no way of navigating from one glowing business proposition to another. Perhaps the most dramatic (e.g., a "cure for cancer") and therefore the least reliable, pitches get the accredited version of hoi polloi's attention. The odds are, of course, that a significant percentage of the Gazelles on the belt under any scenario will disappoint investors. If the clutter, even for the most discriminating investors, proves to be impossible to navigate, then reasonable people will start to wonder whether the reform in Title II is worth it. In that case, one can count on a chorus of the scandal-prone media plus State securities administrators (left out of the picture because the Rule 506 securities are covered securities) and opportunistic politicians to start shouting for a repeal. There is no better way to protect investors if, in the first instance, the investors are not in a position to be shown any investment opportunities; the rate of failure goes to zero.

In light of the foregoing, this veteran, speculating that the glass can be made to be half full, is working with clients planning to launch an initiative entailing the establishment of intermediaries to serve as chaperones in Rule 506 offerings and perform functions which make the game worth the candle. Intermediaries employed to smooth the investment process are built into Title 3, crowdfunding (which is not of interest in this paper), and contemplated, although not required, by Title II, the intermediaries providing, as stated in Title II, "ancillary services." In both cases, the legislation contemplates platforms which are not registered broker / dealers, charging success fees. In fact, the mere fact of a success fee compromises any claim by the intermediary of objectivity. Hence, the desk which I will call the "Platform Manufacturer" at Sullivan & Worcester contemplates broker / dealers as sources of organizational financing of Title II Platforms only as affiliates, as outlined below.

A better name for the platform in this context could be "chaperone" and the overlay is that the chaperones are designed to operate at a level higher than simply recruiting any and all accredited investors with access to the Internet to invest in companies of indeterminate shape and form. For purposes of indicating the elevated character of the platforms described herein, the label Super Platform will be used.

The (Contemplated) Super Platform

The distinctive features of the Super Platform include the following, designed to maximize the potential of the bridge over the Valley and the chances of successful outcomes which justify the risks entailed in exponentially opening the depth and width of the Conveyor Belt to accommodate as many Gazelle herd members which "qualify" by meeting the Super Platform's criteria. Multiple Super Platforms can and will be managed by a single team of sponsors assisted by cadres of experts on a deal-by-deal basis, the vehicle charged with organizing the Super Platforms for each vertical and coordinating the efforts and resources of the same is known (in this memo at least) as the Mother Ship..

Step One is the Super Platform's selection processes, both of eligible Gazelles and investors, listed in protocols labeled the Qualification System. More below.

Step Two is ad hoc Specialization, in aid of enhancing and channeling the flow of investor interest to and into those verticals which fit a given investor's bias. Thus, each Super Platform will aggregate investment opportunities by specific categories ... e.g., medical devices; robotics; solar power; wind power; bio clean tech; spin outs from a specific academic center's lab; e.g., the University of Utah, with the Center having skin in the game; subsequent rounds (or the remainder of an existing round) of a Gazelle in which specific angel networks have previously invested; Israel high tech, etc.

Step Three (all the Steps are designed to occur at once, prior to the launch of a Super Platform) is Affiliation ... optional on a case-by-case basis. Each Super Platform may affiliate, through a minority investment, with one or more investment banks (explicitly not controlled by any of the same) in order that the bank(s) and the Gazelles can get to know one another during and after the closing of the Platform round in anticipation of the fact that the ultimate exit / liquidation event, for example, will necessitate banking services.

Step Four is Transparency, the result of the efforts of the Super Platform and its allies/consultants (VC Experts, for example) to provide the maximum amount of relevant information at reasonable cost. The Super Platform will not purport to assume any responsibility for accuracy and completeness of information it posts, other than the threshold vetting for which the Super Platform expressly admits responsibility (see below).

Step-by-Step

Elaborating and illustrating the Steps

Step One starts with qualifying eligible investors. From the earliest days of securities regulation, the search for exemption from registration of the offered securities depended on limitation of exempt offers to those investors able to "fend for themselves," which in turn depended on whether the investors were "smart" and/or "rich." The Super Platform's investor qualification process requires investors to satisfy the Super Platform they are accredited (the start of "rich") and, in addition, either (a) "smart," meaning investors which in turn are advised, as per Rule 506(b)(2)(ii), by financial advisers (purchaser representatives) which are registered as such with the Super Platform and are FINRA members or registered investment advisers, or (b) "rich," meaning Qualified Purchasers as defined in the `40 Act. This, of course, limits the pool of investors but does so in a way which is deemed constructive because, among other things, investors, like people in general, prefer to be known by the company they keep. The Super Platforms are proud of being snobs (cf. Seinfeld's Soup Nazi) and advertise that fact as enhancing the likelihood of Qualified Gazelles (see below) successfully crossing the Valley.

A further note on this Super Platform function: the good news is that the process of upgrading the threshold of eligible investors through a Platform selection process, which can be generic but may, in many if not most cases, ad hoc, is driven by economics and common sense. If (see below) the Platform is a form of dating service, the idea is to find mates who are highly likely to be compatible. The window is open for all applicants who are willing to self-certify accredited investors status to send in their indications of interest but the issuers selected by the Platform are counting on the Platform to select compatible investors. That said, there is, or may be, a compelling regulatory reason for a customized investor selection process. Assuming the SEC Rules insist that the issuer (or its proxy) take "reasonable steps to verify" accredited investor status before checks are accepted and those steps go beyond customary self certification in current 506 offerings, the costs may be prohibitive if the issuer pitches a "come one, come all" invitation to invest. Assume "reasonable steps" beyond self certification cost $500 per person (a low likely number) and 20 candidates agree to fund...that's $10,000 someone has to absorb. A show stopper? Maybe not at $500, per but what about $1,500, when the rubber meets the road. On the other hand, if the Platform is choosy and there are, say, 10 issuers signed up, then the investor qualification cost is split 10 ways. Moreover, again if the Platform qua dating service is smartly selective, the status of many if not most of the investor applicants will likely be obvious ... a phone call or two clicks on the internet.

For the lucky Gazelles presented by the Super Platform, a/k/a Qualified Gazelles, the Super Platform has adopted an ad hoc set of procedures (with the potential for exceptions) enabling the Gazelle and its adviser to pass muster by filling out a scorecard to be displayed online, the answers in a password protected site. The information to be set forth in the scorecard is in fact the gist of Step Four.

1. A fully filled out Bad Actor questionnaire (once the SEC sets the rules).

2. At least a full year of audited statements and the auditor's opinion.

3. If IP is a principal asset, a freedom to operate opinion at the low end of the range of legal expense. [3]

4. A certified and pro forma cap table.

5. A complete digital bucket, responding item-by-item to a digital due diligence checklist available on the Super Platform's site, the checklists customized for the vertical in question.

6. An explanatory opinion of counsel on due organization, plus a certificate of good standing or like government report.

7. An undertaking by the founder(s) to: (i) on request, agree to three years reverse vesting; (ii) accept responsibility for the representations and warranties (or, in lieu of that exposure, a policy of representations and warranties insurance if size warrants the same) ... the exposure limited to the purchase price and qualified by a "small knowledge."

8. A fully filled out disclosure schedule or schedule of exceptions to the representations and warranties section in the NVCA Model Forms, from the last round, if extant, or pro forma for the instant round.

9. The VC Experts report password protected on comparable valuations [4] and, if appropriate, a PCAT analysis of existing and suggested deal terms.

These items will be listed on the Super Platform's web site. The Super Platform, with the consent of the Mother Ship, may waive any one or more of the above disclosures in individual cases, with full disclosure, and, again with disclosure, may add additional items.

The Gazelle will also be urged to tender its NDA language and the length of the no shop/no solicit agreement clause in the Gazelle's model term sheet; and (b) the Gazelle's desired version of the terms (other than pre- and post-money) as listed in the NVCA model term sheet, indexed to the Fenwick & West Deal Terms Survey.

Step Two is as described above.

Step Three includes an optional feature, a side car SPV or a Business Development Company ("BDC") in light of the recent `40 Act amendment(s) [5] available for investors wishing to diversify risk by spreading their capital commitments over all the Qualified Gazelle investment opportunities aggregated by the Super Platform in a specific vertical. The SPV or BDC will be organized if at all, by the sponsors managing and owning the Mother Ship.

Each Super Platform will charge fees to the Gazelles and qualified investors, the amounts pegged at meeting the Super Platform's G&A costs plus a cost of money return. No success fees will be charged but out-of-pocket expenses incurred in effectuating the trades ... escrows, insurance, transfer agents, law and accounting ... will be billed to the parties in a ratio developed on the basis of experience.

The Mother Ship expects to negotiate arrangements with secondary trading platforms to list Qualified Gazelle securities the issuance of which were enabled by the Platforms, on the basis of revenue share arrangements with the secondary trading platforms.

The Mother Ship will provide, on request, cost-plus services to its Super Platforms such as accounting, administration, health insurance etc. for the Super Platform's personnel, etc. and engage investigative consultants to conduct basic background checks on each Gazelle (including academic credentials of Board and management), FINRA and other electronic records on the Gazelle executives and Nexis searches of other public files the information is being supplied to qualified investors, prominently disclosing the scope and limitations of the introductory checks. The Mother Ship's primary profit opportunity is (i) managing an independent side car fund (or a BDC) for investing in Gazelles prior to the Qualification process; and (ii) a wholly owned subsidiary enjoying FINRA membership and `34 Act registration in order to participate in financial advisory services to Qualified Gazelles which have closed the Rule 506 transaction, completed their filings and are considering the next stages in the Conveyor Belt ... subsequent rounds; Reg A+; an On Ramp IPO or a trade sale.

The Mother Ship will also sponsor information events for incipient Gazelles, investors and their counsel in conjunction with VC Experts, the ACA and Sullivan & Worcester and team with investment banks, NGOs and government agencies around the world on matters such as Valley of Death avoidance and the availability of capital under the JOBS Act.

At a well attended even on June 20th in New York City, courtesy of GUST, there was discussion of Rule 506 platforms along the lines outlined above ... by sheer coincidence but indicative of a common sense conclusion. Pretend the Super Platform (my term) is in fact structured like a dating service, enabling the buy and sell sides to find each other economically in terms of time and energy, with full and complete disclosure before the parties spring for drinks and dinner on the first date. Thus, at GUST, the idea of "Production Platforms surfaced," assembling teams of experts (a/k/a analysts) to contribute analysis and opinions, courtesy of the Platform, to attract suitors. Neither the Platform, nor indeed any respectable dating service, guarantees results. Due diligence is the responsibility of the buy and sell sides, the real parties in interest, but the Platform's game is to bring two parties to the table with a robust likelihood of a successful marriage based on their respective and individual preferences.

In the final analysis, it might be useful to compare the Super Platforms with dating services along the following lines.

  • Dating services bring together two participants who are as much alike as possible at the outset ... hetero; gay; Jewish; Christian, etc. That's the idea of Step One and Step Two above.

  • The end result desired by the major dating services is the participants' successful marriage. See E. Harmony's claim in that regard ... an investment of time and money which generates happiness for both the issuer and the investor.

  • The better dating services promote as much accurate information on each participant as possible because that, in turn breeds success. See Step Four

  • In both cases, the core idea is matching like-to-like efficiently ... better than cruising 100 saloons or websites in hopes that lightning will strike or checking out, one-by-one 1000 pitches on the Internet

Is this analogy helpful in shaping and structuring the 506 Super Platforms, or just a lame joke? I suggest the former.

Finally, the root question for Super Platform organizers is, of course, how do we cover expenses ... indeed make money? The answer is not yet clear, pending SEC rules which are likely to be proposed this coming August ... and maybe not entirely settled until counsel have worked with the Staff in dotting the I-s and crossing the T-s. That said, a July 11th client alert from Kaye Scholer has optimistic language respecting compensation from the gazelles on the platform as long as it is not transaction based, a/k/a success fees. The relevant text reads:

"The Jumpstart Our Business Startups (JOBS) Act of 2012 has garnered much attention for its private offering reforms, particularly, the use of general advertising in Rule 506 offerings sold only to accredited investors (Als) and qualified institutional buyers (QIBs), as well as for the scaled disclosure and other IPO concessions extended to emerging growth companies. Less attention has been paid to provisions in the JOBS Act which creates significant opportunities for broker-dealer and financial firms outside the US, and for financial firms inside the US to take a commercially meaningful role in the capital raising process while avoiding the need to register s broker-dealers here - typically a time consuming (six months), expensive and burdensome result.

"[A]lthough the JOBS Act speaks of a platform or mechanism serving as a 506 intermediary, the explicit reference to assistance in the negotiations should be read as an affirmation that Congress did not intend for 506 intermediaries to be solely passive websites as in the case of Funding Portals involved in crowdfunding activitires."

How lush that compensation in fact may turn out in anybody's guess but the cash / stock possibilities are intriguing assuming the Super Platform managers can help deliver the goods to the client gazelles ... passage over the Valley of Death.


July, 2012

[1] The Journal of Private Equity, Winter 2011

[2] See Diamandis & Kotler, The Future is Better Than You Think, Free Press, pp. 54-58, on technology's "exponential growth in today's environment."

[3] A typical IP legal expert will quote a freedom to operate opinion in terms of a "range," which can vary from $10,000 to $250,000 ... the opinion being "sized" by the amount of sweat expended. The range is stupefying for its breadth; but, for this purpose and without more, only the $10,000 option, which works in many if not most cases, is initially required.

[4] Note. These are benchmarks and not valuation opinions. See www.vcexperts.com and click on Data Center: Valuations & Deal Terms Data Base., plus Frequently Asked Questions.

[5] Of interest in the fact that the SEC's alerts post enactment alerts, in the form of answers to FAQs, specifically mention BDCs raising investment capital under Title II. For the BCD regulatory makeover see Dechert, June 2012 Special Alert on H.R. 5929

[6] Mason, "New Opportunity to Participate inCapital Raises in the United States and Avoid Registration as a Broker-Dealer." Kaye Scholer LLP, July 11, 2012.

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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