Crowdfunding Lawyers

Understanding Structuring, Incentives, and Securities

January 13, 2023
Understanding Structuring, Incentives, and Securities

In a previous blog, you received the basic explanation of structuring a deal and the typical terminology that goes along with it. What changes when you work with larger amounts of money and a more complicated structure? Things get more complex, and that’s when you start bringing or considering different ways to structure your investment.

Structures and Incentives

You want investors to feel compelled to make the largest, fastest investments possible so you can get your project funded more quickly than the next guy. Ask yourself, “How should I structure it? What should I be thinking to begin with?” Then do your research. What do you need to offer that’s reasonable and realistic but will be competitive with the next best offer? There are a few structuring options out there that can be the answer, so look at your project and decide what makes the most sense.

Multiple Waterfalls

A multi-waterfall scenario tends to be attractive to investors. In case you don’t recall – a “waterfall” essentially means that you pour the profits on top and let the legal terms filter out who receives what until those profits get to the bottom of a waterfall. In this setup, multiple waterfalls are created through multiple classes. Here are a few examples of what those terms may look like:

 

  • If somebody invests earlier (say the first million dollars in the fund) they get a higher preferred return.
  • If they invest before the end of the year they’ll get specific terms, but the preferred interest rate will be reduced by 1% if they invest after January.
  • Instead of receiving 80% of the profits for being the first $5 million in, it’ll be reduced to 75%.

 

There are good reasons why to do this. The first million dollars is difficult to bring in since you’re trying to convince your investors to trust you while you have no operations. Similarly, the first $5 million is harder to obtain than the second $5 million. You generally have some operations set up and going by the time you get to the end of raising capital, so there are things in place to get that trust from investors.

 

This is mainly a consideration if you have a certain investment time horizon and aren’t bringing in the capital, so you’re looking at a situation where you have a month before you must shut down the fund or something similar. Often, you’ll see a wave of capital. It’s attractive to be the last money going into a general fund. Why take less risk? At that point, the assets have been acquired and the operations have been going.

 

When you set up a fund, one of the worst mistakes you can make is to go in saying something like, “We’re going to do a 25-million-dollar fund, and we’re going to capitalize over the next year.” The response you’re going to get from investors is to call them back in six months so they can see how it’s performing at that point. If that happens, that’s when you start adding in the multiple waterfalls. Sure, you can call them in six months, but current terms might not be available to them, so if they invest immediately, they’ll see a better return. Besides, in six months it might be fully funded. These are important things to consider when you’re creating different classes or different kinds of triggers that can change the investment return and structure for investors.

Blind Pool

A blind pool, essentially, means that you can’t tell investors what you’re going to acquire. You can tell them what type of real estate you’re going after or what you’ll be targeting for purchase. You can convey that they’ll be receiving an extra return because of the higher risk with their investment since they won’t know what it is you’re buying. Once that’s identified and there’s more certainty involved, later investors receive less of a return and investment terms change.

Series Offering

A series offering is like an umbrella offering and creates a series of different opportunities beneath it. Every series can be unique when it comes to distribution. You can structure and restructure to ensure that, at the end of the day, you get a great return on your time and effort and you’re prioritizing investors’ interest and experience, too.

Securities Regulations

When you’re putting together these types of deals, you want to make sure you can do so without finding yourself in trouble. Security regulations play a huge role in this, so understanding them is the best way to keep yourself and your project out of hot water.

 

First thing is first – what is security? According to the Supreme Court case SEC vs. WJ Howey, a security is an investment of money into a common enterprise with an expectation of profits from the efforts of others. There’s a four-factor test to determine if something qualifies. If you hit all four factors, you’re dealing with security or securities. If you make an offer to someone and they are paying money for it, you’re selling securities and will be dealing with all the regulations that come with that.

 

An easier way to think about it is as an intangible passive investment. If you are offering someone an intangible passive investment, like a business opportunity, loan, or stock in your business, or a real estate investment (not the real estate itself but the investment into it), you are most likely dealing in securities.

What Makes Up Securities?

There are obvious ones like stocks and bonds, annuities, oil and gas royalties, notes, and LLC membership interest. Those all follow the theme of intangible passive investments, as opposed to physical things like houses, apartments, commercial buildings, fancy cars, fine art, and gold bars, which have value in themselves and not the investment. Those are not securities.

 

Cryptocurrency and NFTS are tricky ones that appeared a few years ago. The jury is still out on whether cryptocurrency is a security, though the SEC is trying to shoehorn it into securities. Some people disagree and think that crypto is more of a commodity than a security. The return on your investment is not so much from the effort of others, as the Howey Test says, but from the value of the cryptocurrency itself, its utility, and making exchanges because it’s got an excellent picture of an ape attached, for example. The SEC is fighting hard to fit them all under securities regulations, but it might play out as certain cryptocurrencies or NFTs are securities and certain ones aren’t.

Basic Investment Scheme

A basic investment scheme consists of an investment – a business, real estate, a stack of notes or bad credit card debt people invest in, or whatever else the investment is composed of. A business entity is formed to fund that investment, which is commonly an LLC, a corporation, or a limited partnership.

 

If you’re talking about an LLC, there are two groups of parties involved on one side: a manager or management entity. It could be an individual or a group of individuals. On the other side, we have members, which in an LLC means owners. In a corporation, they’d be stockholders or shareholders, and in a limited partnership, they’d be called partners. It’s the same concept – you have the manager or the general partner, with the board of directors exercising control over this entity. The members put in the money and then that money is used by the LLC to invest in the business, real estate, or whatever is on the table with the hope that it’s going to manifest a lot of money for everybody.

 

That’s the basic structure, but how do you determine if it’s a securities offering? Apply the Howey Test. Is there an investment of money with an expectation of profits off the efforts of others? The manager is giving the effort. The LLC is going to spin off profits for the members who made that initial investment of money, and now this is a securities offering.

Why Does It Matter?

So, you’ve determined that you’re working with or have structured a securities offering. Why should you care? Until the 1929 stock market crash, nobody did, but then stocks went down to nothing, and people lost an incredibly large amount of money. There was unemployment, bread lines, Dust Bowl poverty, and people dying in the streets. In response, Congress gave us the Securities Act of 1933 and the Securities Exchange Act of 1934.

The Securities Act

The Securities Act is about selling securities for the first time, and the Securities Exchange Act is about selling them again, so there are two different sets of rules. The sum and substance of these two rules are this. Selling securities is illegal, except when it’s not. What Congress came up with is “securities registration”. Securities registration works like this: all securities offered in the US must be registered with the SEC, and within state regulators, or they must qualify for an exemption.

What are those exemptions? The Securities Act has an exemption that says that you don’t have to register if a transaction does not involve any public offering. Since that language can be confusing and has led to court cases, enter the SEC with more guidance. The SEC has crafted a series of detailed regulations and rules that to follow to demonstrate that something is exempt from registering.

Conclusion

When you’re structuring an investment, larger projects and bigger sums of money will change the kind of incentives you need to offer to attract investors. Whether you opt to create multiple waterfalls, a series offering, or a blind pool, you need something to draw people in and make them believe that the return they get is going to be worthwhile, but possibly also exclusive to them. By creating a sense of scarcity – do it now or you might lose your chance – it’s possible to entice investors and drum up the money that you need to move forward.

 

Assuming you manage to do that successfully and get things off the ground, you’ll be left with the question of whether what you’re working with qualifies as a security. Assuming that it does, there will be a whole stack of regulations to accompany it. If you’re hoping to find an exemption to keep that from happening, there’s more information to wade through to determine whether your project qualifies.

 

You’ll be able to dive into those SEC regulations later, but for now, you’ve had a solid look at the more complex deal structures and incentives and an overview of securities, regulations, and what might (or might not) qualify as a security.

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