SPVs (Crowdfunding Vehicles) vs Custody: What’s the Best Solution to Manage Your Shareholders?
CORRECTION (September 2023): StartEngine no longer uses PrimeTrust as a custody solution.
On January 14, 2021, the SEC adopted some really exciting changes to equity crowdfunding that will go into effect on March 15th. Those changes include increasing the limits of what companies can raise via Regulation Crowdfunding (Reg CF) from $1.07M to $5M, and Regulation A+ from $50M to $75M, as well as extending COVID relief measures for an additional 18 months.
An interesting feature that has not been talked about as much is that these changes include permitting Special Purpose Vehicles (SPVs) for Reg CF offerings (called “Crowdfunding Vehicles”). These Crowdfunding Vehicles allow all of a crowdfunded startup’s investors to invest as a single entity, creating only one visible investor on the cap table.
This change directly addresses a concern that we at StartEngine hear about a lot from the companies on our platform – is having thousands of shareholders on your cap table a bad thing? Is an SPV/Crowdfunding Vehicle a better solution than that?
We’ve laid out some of the similarities and differences between Crowdfunding Vehicles and direct custody below to help you decide which option is best for you.
What Is an SPV?
To provide context, a Crowdfunding Vehicle is a type of Special Purpose Vehicle (SPV). An SPV is a subsidiary created by a parent company. An SPV can come in many forms (such as a trust, a limited partnership, or a corporation), but it is often formed as an LLC. SPVs help companies securitize assets, create joint ventures, or perform other financial transactions. For traditional SPVs, there is typically a “manager” or lead investor that acts on behalf of the other investors in the SPV.
Costs of the SPV (including yearly state fees, taxes, management fees, etc.) are borne by the members. In a way, being a member of an SPV is similar to being a limited partner in a fund. Often, the voting is done by the SPV’s general partner (the manager), and the limited partners (individual investors) cannot participate in management, but the specifics of that relationship depend on that particular SPV’s operating agreement.
SPVs are most commonly used by companies to reduce the negative financial impact on the parent company and its investors. They also function as holding entities to collateralize debt.
The alternative to investing through an SPV is simply direct custody – i.e. buying shares directly as an individual investor.
What is a Crowdfunding Vehicle?
The SEC proposed to allow SPVs for Reg CF offerings called Crowdfunding Vehicles. As proposed by the SEC, a Crowdfunding Vehicle will be formed by or on behalf of the company raising capital via Reg CF for the purpose of directly acquiring, holding, or disposing of securities issued by that company in one or more Reg CF campaigns. In other words, you cannot have a multi-tier structure in which one Crowdfunding Vehicle invests in another Crowdfunding Vehicle. The Crowdfunding Vehicle is also required to issue only one class of security from a single issuer.
As you may have noted above, there are differences between SPVs and Crowdfunding Vehicles because these new Crowdfunding Vehicles are designed to function within the specific context of equity crowdfunding. Let’s take a closer look.
Pros and Cons of Crowdfunding Vehicles vs Custody
Crowdfunding vehicles come with a mix of benefits and drawbacks for your company and shareholders, and the below is what we believe at StartEngine. Please discuss these options with your counsel or business advisors to determine how the rules apply to your company.
Liquidity
Perhaps the most important difference between Crowdfunding Vehicles and custody is whether or not your shareholders can freely trade their shares.
Based on our understanding of the proposed solution, Crowdfunding Vehicle members can only make transfers to other Crowdfunding Vehicle members with the permission of the vehicle manager. This means that the members’ shares most likely cannot trade on a public marketplace without removing the shares from the vehicle, which could be difficult or impossible, depending on the terms of the investment.
However, if investors are collectively grouped under a custodian, individual shareholders may have the direct ability to trade the company’s shares on a secondary marketplace, such as an alternative trading system (or ATS for short), provided that the company chooses to launch on such a platform.
We believe that the potential for making a financial return is a major deciding factor when an investor makes an investment decision in a campaign. This ultimately requires liquidity.
If the investor is aware that they may have the opportunity to trade their shares in the near future instead of waiting for a liquidity event (such as an IPO or acquisition) 5-to-7 years from now, we believe the likelihood that they will invest increases significantly.
Only StartEngine’s custody solution allows trading on its ATS, and this is an important reason we believe custody is a more robust solution for crowdfunding.
Cost
Traditionally, SPV members pay carry fees of anywhere from 5-20% to the SPV manager to cover the cost of their professional management. For Crowdfunding Vehicles, the cost of forming and managing the vehicle is paid by the company raising capital.
With StartEngine’s custody solution, there are no additional management costs.
Administrative Burden
Crowdfunding Vehicles are in fact “co-issuers” with the company raising capital, and both are required to make simultaneous filings per the requirements of Reg CF. There also may be tax implications for certain investments and administrative burdens related to how the SPV is structured. For example, a Crowdfunding Vehicle may create a Schedule K-1 burden for the company if the vehicle is organized as an LLC, and in turn, undermine investors by disqualifying them from certain preferential tax treatment.
With StartEngine’s custody solution, there are no additional administrative burdens beyond the filing requirements of Reg CF.
Communication
Using a traditional SPV mitigates the work of dealing with shareholder communication, as all communication is channeled through the manager of the vehicle. For Crowdfunding Vehicles, individual investors retain their decision making powers as if they owned the company’s stock directly. Still, the company raising capital may employ a professional intermediary similar to a traditional SPV manager. Having that professional intermediary to facilitate communication can be a benefit to both the company and the shareholders.
Of course, many investors prefer to have direct lines of communication with management when investing in early-stage startups to feel like they are a part of the company’s journey. At StartEngine, we believe that communication is critical to forming a relationship with investors, and we have built our platform to make it easy to communicate with thousands of investors by posting updates.
One of the biggest benefits of equity crowdfunding is the brand ambassadorship that companies get from having thousands of shareholders—these shareholders are their most loyal customers and can provide feedback on beta products and spread the word about the business. However, in order to maximize that value, we believe companies should communicate with their shareholders directly instead of through a Crowdfunding Vehicle manager in order to build that relationship.
Insurance
As mentioned above, one of the main purposes of a Crowdfunding Vehicle is to limit financial risk and streamline capital formation, and the CFV may offer insurance to investors.
With StartEngine’s custody solution via Prime Trust, the assets are insured as well, which is a benefit to shareholders.
Cap Table
Crowdfunding Vehicles show up as a single line item on your cap table, combining all shareholders into one “holder of record” on your cap table. Similarly, with StartEngine’s custody solution, all investors will be represented as a single holder of record under Prime Trust.
Through StartEngine’s Custody solution, your Reg CF investors will be represented as a group or class of investors, which keeps your cap table clean. However, it is worth pointing out that legally, the custodian is counted as a single record holder of the issuer, even though the individual shareholders are the ultimate beneficial owners of the issuer’s shares.
Voting
In this regard, there is no major difference between Crowdfunding Vehicles and Custody. One of the important differences between a traditional SPV and a Crowdfunding Vehicle is that via the Crowdfunding Vehicle, all individual shareholders still have the right to vote (if those shares have voting rights) when it comes to important decisions regarding the company’s direction, allowing you and other key shareholders to retain decision-making power.
As a general note, in our experience, many companies that issue shares via Regulation Crowdfunding and Regulation A+ hold their shareholders voting rights by proxy. This allows the company to remain in control of business making decisions while the company is private, and those voting rights can be released to the investors should the company become a publicly-traded company in the future.
Conclusion
A Crowdfunding Vehicle does come with some benefits, especially when compared to a traditional SPV, but it also comes with some notable trade-offs, which include increased costs and administrative burdens.
Most importantly, a Crowdfunding Vehicle means that you could restrict your investors access to liquidity on a secondary market in the future.
Because of the factors outlined above, the uncertainty related to implementing these new Crowdfunding Vehicles, and the notable difference that custody may allow investors to trade, the StartEngine team believes custody is a strong option for equity crowdfunding, and can provide a clear established path to accessing potential liquidity for investors.
The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information.
Readers of this article should contact their attorney to obtain advice with respect to any particular legal matter. No reader, user, or browser of this site should act or refrain from acting on the basis of information on this site without first seeking legal advice from counsel in the relevant jurisdiction. Only your individual attorney can provide assurances that the information contained herein – and your interpretation of it – is applicable or appropriate to your particular situation.
