Crowdfunding: Creative or a Curse?
- Mar 18, 2015
Crowdfunding through funding platforms (portals) for real estate projects is clearly catching fire. However, a key concern for investors is whether platforms need to register as broker-dealers based on their current activities; and the matter isn’t simple with defined and clear-cut answers.
What is startling is there isn’t really clear guidance. Currently, securities attorneys are giving widely divergent advice on what funding platforms need to do to be compliant. Before digging deeper, let’s examine the three main models of funding platforms that exist for investors.
First, there’s the Ad Platform Model. It obtains compensation as listing fees, consulting fees and other fixed costs in no way tied to the offering; project-driven issuers favor this model to make use of sites for raising money for projects.
Second, the Investment Advisor (IA) Model takes compensation as a “management fee” and “carried interest” generally in a manner consistent with the 2/20 Model, which is common in similar industries. Third is the Broker-Dealer Model; it receives compensation based on the amount of the offering. This model also prevents the funding platform from participating in the offering.
The majority of the industry is increasingly migrating to the IA model, presumably to avoid the regulatory hurdles of FINRA and to allow the funding platform to participate with a carried interest in projects where it makes sense. A compelling argument can also be made that it’s good for the industry to create alignment between the funding platform and project investors as more of the compensation to the platform is tied to the ultimate success of the project.
What is unclear is where the line is drawn for transaction-based income. The 2 percent fee in the 2/20 IA model is arguably transaction-based compensation, which seems to fit much more squarely in the broker-dealer model.
Recently, the authors of both the AngelList and FundersClub no action letters seem to avoid any appearance of taking transaction-based income. In fact, escrow accounts were proposed in each of these letters to the SEC where any fees not paid to third parties would be distributed back to investors.
Absent the ability to take current income from fees, many of the platforms wait until projects sell in order to recognize profits, which has pushed some platforms toward the broker-dealer model. Others have also raised venture financing rounds, presumably to bridge the cash flow conversion cycle while operating under the IA model, which can be a strategic decision for the portal.
Retaining the right to take a carried interest in projects and be compensated in this fashion while creating alignment with investors is more important to some companies than others. And, as a whole, the industry is quite diverse from a founder’s standpoint.
There are developers who have started their crowdfunding portals to initially locate more investors, but the portal then turned into a whole new business. Other portals have been started by folks with a technology background who then acquired the necessary real estate personnel to supplement what they see as primarily a technology play.
Lawyers and former commercial brokers have also served as crowdfunding portal founders. With the current diversity of founders, the value centers today in the business generally revolve around marketing, technology, real estate expertise and law.
In the coming years, it will be interesting to see how the SEC responds to the industry and if any of the portals seek clarification via a new no action letter for whether small amounts of transaction-based income is permissible under the IA model. In order for the industry to succeed, portals definitely need to be able to take profit soon enough to support their growth.
The creation of alignment between the portal and investors is most ideal under the IA model today. The best of both worlds is a model with clear guidance on what small amount of income the portals can take up front while taking a carried interest in the project and using the 506(c) exemption with accreditation checks; this allows the portals to operate while reducing the need for venture capital and creating investor alignment where all investors are verified as truly accredited investors.