The SEC recently gave its blessing to a marriage of old and new: traditional private placements conducted via the Internet. In doing so it lifted the veil on how VC firms can create "pre-existing, substantive relationships" with initially anonymous web-based investors.
Something Old: Three years ago the JOBS Act lifted the long-standing prohibition on "advertising or broadly soliciting interests in privately held securities." However, for a variety of reasons firms and issuers generally prefer the tried and true approach, a private sale of securities known as a 506(b) offering. To qualify for the 506(b) safe harbor, the offering cannot include a general solicitation and general advertising. But if issuers can show a "pre-existing, substantive relationship" with the prospective investor, the offering is not considered a general solicitation or advertisement.
Something New: Enter the modern, "Add to Cart, Click" anonymity of the Internet. Potential investors from around the world are just a Google search away from a VC firm's web-based portfolio, creating opportunity...and risk. How does a VC firm take advantage of an online platform and still establish a pre-existing, substantive relationship with prospects?
Catch Me a Catch...But How?: In a recent no-action letter, Citizen VC, the SEC's Division of Corporation Finance helped bridge the gap. Citizen VC, Inc. is an online venture capital firm that facilitates through its website indirect investment in private companies from seed to late-stage. In a letter to the SEC, Citizen VC outlined its procedures for developing pre-existing, substantive relationships with its online investors, and the SEC did not disagree with its methods.
Citizen VC set forth a two-step process for establishing pre-existing, substantive relationships. First, visitors to Citizen VC's password-protected site must register and be accepted for membership. Prospects complete a generic online "accredited investor" questionnaire. Depending on its evaluation of the questionnaire, Citizen VC will initiate the "relationship establishment period," which is not limited to a specific time period. According to Citizen VC, this period is a "process based on specific written policies and procedures created to ensure that the offering of Interests is suitable for each prospective investor." (Citizen VC, Inc., Incoming Letter p.2). Citizen VC connects with and collects information from prospects in a variety of ways, assessing each prospect's sophistication, financial circumstances, and ability to comprehend investments and their risks. Citizen VC's relationship-building activities include:
- offline telephone introductions and conversations to discuss investing experience, goals and strategies, financial suitability, awareness of risks and other matters;
- an introductory email;
- online interaction to answer questions about Citizen VC, its website and its investments;
- confirming a prospect's identity and gathering financial information and credit history using third party services;
- encouraging the prospect to review the website and ask questions regarding investment strategy, philosophy and objectives; and
- fostering online and offline contacts between the prospect and Citizen VC.
Prospects are finally admitted as members when Citizen VC determines 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 [website], and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor." (Citizen VC, Inc., Incoming Letter p.3)
Specifically, the SEC agreed with Citizen VC that the most important factor when determining whether a "substantive" relationship exists is the "quality" of the relationship between the issuer and the investor. It also agreed that issuers cannot rely on a specific duration of time or particular short form accreditation questionnaire to establish such a substantive relationship.
Citizen VC shows that building the right relationship between issuer and investor is a process of communication and evaluation at multiple steps. Matchmakers looking to bring investors and portfolio companies together online now have greater certainty of how to structure their activities to satisfy the 506(b) safe harbor.
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