Owning Securities Won't Make Your Funding Portal An Investment Company - Crowdfunding & FinTech Law Blog

Republished By Plato

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Funding portals are allowed to receive part of their compensation in securities of the issuer, as long as the securities are of the same class being offered to investors. For example, if an issuer raises $2M selling Series A Preferred Stock and the funding portal charges a 7% commission, it may take all or any part of the $140,000 as Series A Preferred Stock rather than cash.

Before long, the value of these securities might exceed the value of the funding portal’s business. Inquiring minds would wonder whether owning all those securities will turn the funding portal into an “investment company” within the meaning of the Investment Company Act of 1940.

It’s a good question, but fortunately the answer is No. Section 3(c)(2) of the Investment Company Act provides an exception for:

Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, acting as broker, and acting as market intermediary, or any one or more of such activities, whose gross income normally is derived principally from such business and related activities.

Funding portals are engaged in the business of distributing securities issued by other persons (issuers) and should therefore fall within that description.

Two related issues.

Effect of Upstream Distribution: The owners of the funding portal would like to protect the pool of securities from the potential liabilities of the funding portal business (e.g., if the portal has been using a series LLC as a crowdfunding vehicle). Their first thought might be to distribute the securities upstream to the parent company and then put them into a new, wholly-owned subsidiary. But be careful. The new subsidiary might cause the parent to be treated as an investment company.

Effect on Option Pool: Suppose the funding portal continues to own the securities, either directly or in a wholly-owned subsidiary. On one hand, the potential value of the securities would be attractive to employees and others holding options in the funding portal. On the other hand, the fair-market-value rules of section 409A of the tax code would require the funding portal to place a value on the securities frequently and, as the value of the securities climbs in relation to the value of the funding portal’s business, the value of the options would be less and less correlated with the success of the business, defeating the purpose.

Questions? Let me know.