A striking development in the venture capital business has been given a boost by the SEC's recent No-Action Letters in the case of AngelList and FundersClub. Let me quote at some length from an informative legal insight by Rob Rosenblum of K&L Gates, Rob having represented AngelList in connection with its No-Action Letter, and refer readers of this piece to the entire text of Rob's memorandum.
"Last week, in two separate "no-action letters" issued to AngelList and FundersClub, the Staff of the Securities and Exchange Commission [permitted] platforms to use a "venture fund" model to facilitate investments, and [further permitted] a registered investment adviser affiliated with the platform to receive incentive compensation (that is, compensation that is paid only if the value of the investment increases), and to be reimbursed for documented expenses.
"In general, the letters permit the platform to collect non-binding expressions of interest from accredited investors who are interested in investing in a particular early stage company. If the platform receives a sufficient amount of investor interest with respect to a particular company, an adviser affiliated with the platform may then create a limited liability company or other "transaction vehicle" that will accept money from the participating investors. The transaction vehicle then invests all or substantially all of the money in the specified company. Upon the sale or other disposition of the investment the adviser may receive incentive compensation if the value of the investment has increased. The transaction vehicle also may pay for organizational and other documented third-party expenses. Notably, neither the platform nor the adviser may handle customer money or securities, instead, all money and securities must be held by a bank or other financial institution.
"In addition to providing an approach that platform sponsor can use to receive meaningful compensation, these letters also may suggest that the SEC Staff could be willing to consider other compensation arrangements, provided that the compensation reasonably is unrelated to any purchase or sale of a security through the platform. For example, in the AngelList and FundersClub no-action letters, the SEC Staff seemed to accept the argument that incentive compensation is tied to the investment performance of a particular security, and not to the purchase or sale of that security"
It is noteworthy, as Rob points out, that the SEC's recent direction in enforcement proceedings and FAQs in anticipation of the JOBS Act Title II regulation has been expansionary; even officers of an issuer who receive no transaction related compensation as such can be attacked if not sufficiently alert to the issue posed by an unregistered finder. See https://vcexperts.com/buzz_articles/1351.
The fact of the matter is that the funding and management of venture capital funds has suffered grievously in the last decade. The number of VC funds raised and the amount of capital committed to the same have each been going south at an alarming rate, a threat in the eyes of those of us passionately interested in this Country's innovation economy and support of emerging growth companies ("EGCs" or, as sometimes referred to, "Gazelles"). One of the pivotal factors is the extraordinary length of time and amount of expense involved in raising venture funds. With the exception of a small slice of the VC community which is exempt from the law of gravity, the game appears to be no longer worth the candle. For first time funds, the period required to get to an initial closing can be as long as three years and, in some cases, longer. For funds with respectable but not sensational track records, even organizing Fund IV or Fund V has proven to be burdensome and many existing Fund complexes are winding down. Indeed, without sensational returns, it is difficult to persuade institutional investors to commit capital for a 10 to 12 year period.
There are a number of reasons for the shrinkage, including (in my view at least) closure of the IPO window due to unnecessary pressures on public companies, ranging from predatory class action plaintiffs, to "activists," to Sarbanes-Oxley and 'say on pay' regulations. The burdens on public companies have fueled the "eclipse"  of the public exchanges in this country, accompanied by the rise in what Chancellor Leo Strine calls "short termism." The IPO was, in the good old days … up until 2001 … the "portfolio maker," the rising tide which floated all boats. But, the seemingly permanent semi-closure of the IPO window, for venture-backed companies at least, has now reached the stage of a chronic disease (although this may be improving a bit due to JOBS Act Title I improvements).
The question then addressed in this material is why and how the FundersClub and AngelList No-Action Letters are likely to be game changers. And, I have concluded that the economics will drive this bus.
Thus, I do not believe there is any shortage of attractive EGCs or Gazelles in the U.S. innovation economy. There is a high level of agreement among scientists and techies with the proposition that the next few decades (and, of course, beyond) will experience a worldwide (and principally in the U.S.) explosion of inventions and discoveries capable of giving birth to a multitude of promising Gazelles. The curve is accelerating upwards, approaching a 90 degree angle. The advances in communications, information technology, manufacturing, robotics, alternative energy, biotech, nanotechnology, agribusiness, mental health, transportation, etc. are multiplying geometrically, as theorists, physical scientists, mathematicians and technicians continue to expand the envelope to realms which once were the province of science fiction writers. You needn't go to the limits (or, better, the lack thereof) to which Ray Kurzweil's Singularity University is pushing the boundaries to accept the premise of the science and tech expansion, continuing a curve which has been building since the Enlightenment.
Indeed, given the so-called Valley of Death … the gap between the angel round and the institutional rounds from increasingly conservative VCs … there is abundant deal flow dialing for dollars, namely Gazelles which have passed many, if not most, of their milestones on the way to the finish line but are stalled by the Valley of Death.
And, here is where I believe the new breed of VC funds can and will fill the vacuum which nature abhors. The reasons are as follows:
The core of the new model VC fund is a system by which the investors are offered the opportunity to invest on a deal-by-deal basis. In some of the models … which some call Club Deals and others style as pledge funds … the investors are a discrete group of (mainly) institutions which have been invited, one by one, to join as dues-paying members of the fund complex, entitling each to invest on a deal-by-deal basis as the management of the enterprise locates attractive opportunities. In the AngelList and Funders Club models, and presumably those platforms which mimic their structure, the membership of potential investors is an almost infinitely larger cohort … any and all investors who qualify as accredited in Rule 501 and accept the invitation, which is presented online, to engage in what I call "Quiet 506 Two Step," funding.  The 'two step' is (i) presentation by the Platform of online materials disclosing teaser elements … typically identification of earlier deals which have been chaperoned over the Platform and then (ii) current Gazelle pitches to those individuals and institutions who and which have been willing to fill out a questionnaire and otherwise submit to background checks (if any) which qualify each as an accredited investor sufficiently knowledgeable to participate in Reg D, Rule 506(b) offerings … which I call "Quiet 506" because the Title II Regs have not as yet been adopted and Rule 506(c) (allowing one stop pitches) is, therefore, not yet available.
In point of fact, we are, typically, talking about presentations per Quiet 506 to pools of accredited investors inside the curtain, pools which can number in the thousands. That being the case, it is not clear what the practical difference amounts to between Quiet and Noisy 506 for this purpose … but, no matter. The point is that there are likely to be an ample pool of investors interested in companies chaperoned across the Valley of Death … e.g., the B and C round … who will readily commit expeditiously to review the deals which the sponsors of what I will call the Multiplex VC funds present to the pool of online investors who have entered inside the firewall.
There is, of course, a fear that many of the Platforms will be providing shabby deal flow to investors. My hope in that regard is that the Platforms favored by investors will be will be those which qualify as "Super Platforms," i.e., those which undertake special initiatives in order to rise above the oncoming glut of presenters which do no more than hoist their flag online. In an earlier piece, I made suggestions on some of the extra efforts needed if a Platform wants to join the Super Platform ranks https://vcexperts.com/buzz_articles/1237, because it speaks to the question of Platform quality; see also http://finance.yahoo.com/blogs/the-exchange/middle-paradigm-shift-private-equity-capital-markets-195031909.html.
Let me repeat one, and only one, such initiative to illustrate my thoughts on Super status.
"The label is ad hoc Specialization, meaning an effort to channel the flow of investor interest to and into those verticals which fit a given investor's bias. Thus, each Super Platform will aggregate investment opportunities by specific categories … e.g., medical devices; robotics; solar power; wind power; bio-pharma; clean tech; spin outs from a specific academic center's lab; e.g., the University of Utah, with the center having skin in the game." 
The result of all this is that the general partner of a Multiplex Fund, a/k/a Multiplex Super Platform, can wind up as, in fact, a general partner in, say, 15 or 20 one-off vehicles … limited liability companies in which the general partner (the "GP") enjoys a carried interest and which, let's assume, is the traditional 20%. And the 2% management fee may be available as well, assuming the economics of the Multiplex scrupulously track the historic VC fund model. To be sure, as Rob Rosenblum has reported,
"Significantly, the SEC Staff did not address whether there are any circumstances under which a fee based on assets under management would be permissible." 
But, there is scuttlebutt around that the 2% element of the 2 and 20 model might well have been OK'd if the question is squarely put. To get to that point, however, in my view a Multiplex Fund will have to make it clear that the sponsors' compensation is only 2 and 20; and that the 2% management fee is for, and only for, managing the assets after the LLC housing the target company (the "Portfolio LLC") has been formed, the investors in the deal recruited and the deal closing has occurred. Any compensation prior to closing may undergo SEC scrutiny as transaction related and will need to be paid from the sponsor's resources, including capital from an outside investor who buys a piece of the carried interest in each Portfolio LLC. 
At the risk of repeating myself, let me emphasize the economics looked at from 20,000 feet, are essentially the same … conventional venture funds vs. the Multiplex two steppers. A group of, say, three to five principals invest other people's money (let's say) totaling $150 million in 10 investments … average investment of $15 million, including follow ons. This requires 15 Portfolio LLCs in which investors inside the firewall have agreed to invest. Economically, the animal looks and acts like a conventional fund … the same carried interest in the GP, the GP members managing each investment, serving on boards and, presumably, screening investors with, e.g., minimum investment size requirements. The GP is, like its conventional VC counterparty peers, an Exempt Reporting Adviser under Dodd-Frank (a cut down version of registrants under the 1904 Investment Advisers Act) but not a broker-dealer. It may take a little longer to line up the capital for each Multiplex deal but, given smooth processes, and a big investor census, hopefully not much longer. While the conventional VC custom of calling capital from the LPs as of the first, sometimes dry, closing in order to recoup agreed Multiplex organizational expenses is unlikely to be available, the very good news is that, since we are talking deal-by-deal, the carried interest proceeds get into the pockets of the VCs at an earlier date in the proceedings. They don't have to wait for a hurdle which recovers the entire accumulated LP capital that has been invested in all the Fund's positions before they see a dime. There is a hurdle (and often a catch up) but it is measured only by the LPs' cost basis in that particular Portfolio LLC. And since the investors in each Portfolio LLC are diverse, it is hard to see how a generic clawback will work.
In short, let's add up the economics between Multiplex and conventional funds:
Now, let's do the math. My view: Three out of four is not a bad score for the Multiplex, particularly since the IRR from the carried interest in Multiplex deals, given the time value of money, can be a good deal more attractive. And as for fear the Multiplex VC Platforms will be buried in a glut of industrialized second raters? Read the attached article on Super Platforms, with which I started this series (Appendix A).
Let me turn, finally, to the issue of fund raising online and the issue whether it is a good idea. There is a certain lack of dignity about raising money online for venture capital funds. On the other hand, in 1980 Ned Heizer and Dick Testa did their best to help open up the highly popular venture capital space to the public at large … a democratic idea; everybody gets to play in what was, at that time, an enormously popular asset class. Hence, the advent of the Business Development Companies under what I am calling the Heizer amendments to the Investment Company Act. Business Development Companies, or BDCs, did not in fact accomplish the core objective for a variety of reasons unfortunately; but, it may be that the Multiplex Funds are at last going to fill the gap in constructive ways … democracy in action. Pure democracy? No. That has to wait for the crowdfunding regulations but a step in the right direction.
Thus, VCs will be able to wander back into the money raising business as soon as they can find deals which are attractive to investors inside the firewall. The consequence of bringing VC battalions onto the stage, including dragging some out of retirement, will, hopefully, be to stretch bridges across the Valley of Death. In fact, with my rose colored glasses on, I see angels and VCs (the multiplex version) coordinating deal flow amongst themselves, the angels serving as scouts for the VCs according to arrangements I have been rooting for in print: http://www.sandw.com/assets/htmldocuments/JPE_winter_2011_SandW.pdf.
Indeed, as the asset class opens up to accredited investors sourcing deal flow on the web, the dream of Dick Testa Ned Heizer, et al., in 1980 can be satisfied at long last. All this if we do it right and don't allow strangulation by regulation on the one hand and rampant fraud to invade the territory on the other. The end result can be a significant boost to a country like ours which has grown to depend, since World War II, mightily on the innovation economy to keep the music playing.
 FundersClub Inc. and FundersClub Management LLC (SEC No-Action Letter), March 26, 2013.
 Rosenblum, "The SEC Staff Permits Sponsors of Securities Trading Platforms to Receive Incentive Compensation," K&L Gates, Legal Insight, April 2013. In a footnote Rob makes the point that, "The no-action letters technically do not interpret Section 201(c) of the JOBS Act, but instead appear to take the position that the sponsors of the trading platforms described in these letters are best viewed and regulated as investment advisers rather than as broker-dealers.
 One additional "advantage" of the 5000 (+/-) member pool of accredited investors looking at a individual deals inside the curtain … social media allowing everyone in the pool to express opinions, a la Zagat and Amazon vis-à-vis what is on the table.
 The lawyers legal expense for setting up the Multiplex structure will come out of these funds; expense for setting up and closing the Portfolio LLC and operating the same will, like the management fee, all in the "partnership expenses" category and be called from and paid by the Portfolio LLC investors.
Joseph W. Bartlett, JBartlett@McCarter.com
McCarter & English, LLP
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