The finalization of the JOBS Act Title II Regulations is introducing, potentially, a revolutionary change in U.S. small and mid-cap private capital markets for equity securities, resulting from the opening of the worldwide internet as the global platform for introducing emerging growth companies to investors and vice versa. Scrubbing the ban on general solicitation and advertising from the rules governing U.S. private placements on securities’ amounts to a sea change in securities regulation; the possibilities … good or bad but unlikely in either event to be trivial … beggar the imagination.
Thus, the hope of the proponents of Title II is that the U.S. economy (and consequent job opportunities) will take off like a rocket. This is not a utopian fantasy, at least not necessarily. The evidence is compelling that small business is the growth engine of our economy, small business in this context meaning high growth start-ups a/k/a “Gazelles” … David Birch’s label for companies undertaking the journey from the “embryo to the IPO” (or a trade sale). If Gazelle access to what we can call internet investment capital were to increase to the extent the herd of successful Gazelles in the U.S. were to double or triple, our GDP, job creation, tax revenues, new product introduction and the rest of our vital statistics will take off exponentially; the math is non-controversial. And what’s not to like about millionaires getting a look, if only for purposes of comparison, at a multitude of deals? Sophisticated venture capitalists spend hundreds of thousands each year in trolling for deals. Why not eyeball the web, if only to get a feel for the landscape, and pick a winner if something strikes your eye?
On the other hand, the chronic cynics and pessimists already are forecasting, as is their wont, a classic disaster, the playing field opened up to fraudsters who will pick our pockets by pushing get-rich-quick proposals from, e.g., the Nigerian royal family.
The pessimists, of course, have one irrefutable statistic on their side. As investment in early stage Gazelles is opened up to the accredited hoi polloi, a lot of good people will lose a lot of money. The reason is, of course, simple. Even the elite venture capital funds in the U.S. invest in numerous losers, particularly those (well fewer than in the past) VCs which remain open to early stage investing. And the portfolios of Angel investors, including but not limited to Angel networks operating under the umbrella of the Angel Capital Association, show a high percentage of disappointing would-be Gazelles. That is the nature of the game. The critical question is whether the hits which the early stage investors will also generate are sufficient to make the game worth the candle. Will, in short, investors, captivated by internet pitches, get a fair chance at competitive returns for their money?
The question is unanswerable at this juncture, of course, at least until we have experience with the impact … facts on the ground … of Title II. That said, there is likely to emerge a vehicle, the managers of which will attempt to chaperone selected deal flow onto the web and which will function as a dating service matching like to like … investors curated (another word for chaperoned) to deals in the vertical in which the investors have expressed interest, perhaps involving further specificity … size, maximum investment, relative maturity, etc. I use the word “chaperone” to signify that deal flow will not only be introduced by the managers of the vehicle I am positing but also mentored along the journey to a profitable exit for each deal (if possible, of course) by the managers the same way the principals of a conventional venture fund tend to their flocks. The vehicle suggested is, indeed, a venture fund, a Hybrid in my jargon, functioning as a pledge fund … deal-by-deal investing … and sourcing the capital for each deal from investors arriving by way of general solicitation … on the internet (or otherwise) … and qualifying as owners in the Gazelle by meeting whatever criteria the managers establish. The following sets out the specifics of the hybrid vehicles which are currently on the assembly line at McCarter & English.
THE SUPER HYBRID FUND: Guidelines on Organization
We put together a vehicle, an LLC known (in my jargon) as a Hybrid Venture Capital Fund. The Hybrid is, in fact, a pledge/venture fund in the sense that it finds, like a pledge fund, attractive deals, then tees up each favored Gazelle for presentation to a pool of accredited investors, and organizes a Portfolio LLC or a limited partnership agreement (no difference for this purpose) to invest in each portfolio company, described in this material according to industry jargon as a Gazelle. The Hybrid is the general partner of each Portfolio LLC, enjoys the carried interest and the 2% management fee … in other words a conventional pledge fund format, the difference being that the investors can be assembled for each deal through online pitches. Alternatively, or indeed in addition to online pitches, the Hybrid can obtain one or more mailing lists and send the placement memo to all, or some, of the names on the list. To repeat, the analogy is to an online dating service, matching like to like courtesy of input as to verticals and preferences (in addition to verticals) on size, maturity, location, cash flow break-even date) from both the issuers and the investors.
We are working on enough of these deals so that we are getting the documents rounded into shape to serve as template models. I do insist that my clients do some homework and I attach some materials in that regard, a part of my program on “meeting clients halfway”. (see http://joebartlettvc.com/publications/meeting_clients_halfway).
If a registered broker is loosely affiliated, as several are, with the Hybrids, e.g, for purposes of assisting in the process of verifying investors’ status as accredited,  its economic incentive may well be the ability to pick and choose the portfolio companies it would like to assist as an on-going financial adviser, once the Hybrid has invested, for the remainder of the trip down the Conveyor Belt.  That trip will often involve the financial adviser arranging the B, C and D rounds, for example …the “mezzanine” or “growth” capital, euphemisms for late stage capital … and then the ultimate exit. The broker dealer will have the option to select the clients it want engage with, having been introduced to them in the course of their successful A round raises, either 506(b) “Quiet 506” (see Quiet 506: A Study in Irony, https://vcexperts.com/buzz_articles/1306) or Rule 506(c).
The sponsors of a Hybrid Fund typically need organizational funding, of course, in order to get started and, as opposed to a conventional VC fund, there is not an initial dry closing with committed limited partners from which that cost can be reimbursed. For that component, the Hybrids are typically bringing in an outside capital investor, which buys a piece … 4 t 5 points (+/-) … of the 20 point carried interest in, say, the 10 to 15 deals that the Hybrid Fund successfully closes. The organizational process should not take more than 60 (+/-) days from start to finish, assuming a capital investor is close at hand or the founder(s) pony up and the expense is commensurately lower … no three years in the foyer waiting for the LPs to commit for 10 years to a conventional blind pool.
There is always the possibility of converting down the road to a conventional fund but, assuming that this system works as planned, I see no compelling reasons why a Hybrid with a satisfactory track record would switch to a conventional structure. So much the better if it can publicize its track record online and enjoy the fruits of that notoriety. As long as emerging growth companies (“EGCs”) are comfortable with pitching online, the Hybrid Fund can wind up its initial portfolio once it has reached the practical limit its managers can handle as “value add” investors (assuming such is the business model), then regroup for the next edition … Fund II, Fund III et al. … or Fund IA: Israeli High Tech; Fund IB: Medical Devices; Fund IC: solar, wind and bio; Fund ID: spin-outs from Cornell labs; etc. The investment committee of each Fund will share in common one or two senior manager/members … the founders … and each of the funds will be staffed with two or three up-and-coming managers specific to that Fund. Moreover, as with pledge funds generically, the funds investing deal by deal are significantly better for the principals, the members of the GP. The so-called hurdle is measured against only the capital contributions invested in the Gazelle existing in the portfolio vs. the entire amount of committed capital. Much earlier carry realization and no clawback.
FUTURE (POST-SEPTEMBER 23RD) FORECAST
If all of this looks too easy, it may well be. The September stampede of EGCs and hybrid funds raising “web capital” could turn off sophisticated issuers and investors. Too many wannabees and dreamers enchanted with their own importance … meaning it could be impossible to separate the sheep from the goats. To repeat, once an EGC craters (as most will even if Greylock is in charge) and grandpa and/or grandma loses the family jewels, scandal starved media types will begin to shriek that more protective rules are needed. Indeed, they could succeed; the ultimate way to insure no one is hurt by investing in web deals is strangulation by regulation. If there are no deals up on the web, no investor can be hurt by a web enabled deal.
The answers in this corner to the “sky is falling” include the following:
First, of course, almost everyone is a loser in the state supported lotteries but no one howls … in fact, equally inevitable is grandpa and grandma hitting a 10x win if the Hybrid picks correctly. As with the lottery, that’s what is keeping, e.g., Chicago Cubs fans buying tickets.
Further, as indicated above, the Hybrid (call them the Super Hybrids) are dating services in the best sense of the word. Interested investors troll not so much for single deals on the web but for the verticals they like and then they can check out the Hybrid managers. What do those guys know about medical devices? What’s the track record of the principals in investing OPM in the past?
Next, the Super Hybrids shift the focus and direction of their search. The investors are out there … thousands, even millions, of them … but the trick is to create a Hybrid which attracts the best of the best in the investor census … rich, experienced, knowledgeable on the metrics of start-up investing (maybe even “value add”), patient. To that end, the Hybrid managers do two things. They try to fix the specific deal and the eligible investor pool into the like-for-like category; if the EGC is plausibly raising $15 (+/-) million, the investor threshold can be elevated accordingly … minimum investment of $500,000, say. Then, they turn around 180 degrees on the theory investors are always in the wings and ready to pounce if one can capture their attention for a few micro-seconds, given literally millions of potential investors right at hand. The idea is to maximize the quality and quantity of the Hybrid’s deal flow … given the desired intake of high quality issuers investors will fall into line. There are various methods which conventional VCs use to pursue deal flow (if and when they are still interested in early stage). Much of the effort is focused on outreach … attend the industry events, trade shows where entrepreneurs meet and greet; join the informal syndicates whereby funds link to one another (“you show me yours, I’ll show you mine”); visit the front ranks of incubators and accelerators (100 in NYC at last count) and patrol the specialized media and blogosphere for write ups of advances in science and technology, plus Gazelle success stories. The Super Hybrids will do the same of course and more on this point in the Conclusion.
POTENTIAL ADDED ATTRACTIONS
The Hybrid will adopt various strategies to stand out from the crowd above and beyond the pedigrees of the principals. Thus, the Hybrids I am working on convening will spend time and effort organizing, motivating and utilizing advisory boards composed of heavyweights in the vertical or verticals in which the fund specializes … cyber-security being one example on my radar. The Advisory Board in that case is heavily laced with military and civilian experts in anti-terrorism initiatives. An LLC houses the carry percentage in which the advisory board members share, the interests in which are annually adjusted by the fund principals to take each board member’s relative contribution into account. And, as with some conventional VC funds, the Super Hybrids take on part time partners labeled, for example, entrepreneur in residence.
The Super Hybrid is open and receptive to syndicated opportunities, the remaining or “back end” of angel deals being a prime example. Under this system, an angel network and/or affiliated side car fund can play in a $5 million A or B round even though the network realistically tops out at, say, $2 million. The network managers play in the round by syndicating the remaining $3 million horizontally … to other angel networks … and, in the case I am citing, vertically, to Hybrids which have made it known they are interested in “back ends.” The beauty, to the Hybrids, is that, as in any back end, the deal has already been vetted, diligenced and negotiated by the angels … all the cards are on the table. Time is of the essence in back ends, of course; the Super Hybrids make a point of cultivating a number of angel groups, employing a strategy again outlined in the Conveyor Belt paper http://joebartlettvc.com/node/89. That is, the Hybrids and the angel networks they partner with compare and agree on: master due diligence checklists (get it done once … and right) template deal terms, and other items, including preferences as to exit time lines. Further, there are tools the syndicators and syndicatees can share … www.vcexperts.com illustrative data tools on deal terms and valuations, for example. The process can thusly be win/win for the angel network (which can bid on larger deal flow) and the Hybrid (pre-vetted deal flow). Angels have been, historically, wary and suspicious of the conventional VCs, scarred by cram downs in the B, C, etc. rounds. I forecast the Super Hybrids will take the opposite tack … make love not war, a win/win strategy which, again, is designed to elevate the Super Hybrids above the teeming mass of unchaperoned (or uncurated, another popular label) online pitches.
In fact, there are also Super Hybrid options in managing deal flow. The Hybrid can, a la AngelList, experiment with inviting a given investor in a portfolio opportunity to act as the “lead,” the rewards including the ability to match the investment in the Portfolio LLC with co-investment in the deal on the basis of no carry and no management fee. And, further, the Super Hybrids in our queue are exploring liquidity options with the secondary exchanges, which have historically solicited listings from the portfolios of conventional VCs. Thus, SharesPost is now the third level of NASDAQ liquidity and secondary liquidity can be an attractive feature for investors happy with 2x. SecondMarket is also geared up in several interesting ways displayed on the web site.
The Hybrids will take advantage of specific opportunities to attract value add investors using, for example, the Gazelle’s list of satisfied customers and, on occasion, the opportunity for investors to sample the products while pondering an investment decision. The Gazelle’s founders, executives and board members can submit their respective rolodexes as prospects for an elevator pitch. Old timers will recall that Ben and Jerry, on the eve of the Ben & Jerry’s IPO, lusted to print selections from the prospectus on their ice cream containers. Advertising per se is unlikely to draw the right crowd but PR can be major … the right news story on a Gazelle can be money in the bank, plus blogs, Twitter, YouTube, et al., featuring, for example, celebrity endorsements. Check writers will need to be supplied the truth, the whole truth, and nothing but the truth, of course, but to get them into the corral in the early stages of the process, anything except fabrication should be legal. In fact, we will not be surprised to see a link in the online presentation to a draft IPO prospectus … a preview of coming attractions (no guarantee, of course).
The favored investors of High Class Hybrids can get special benefits, including discounted subscription access to the VC Experts deal terms and valuation tool and, in satisfaction of a persistent unfulfilled craving on the part of even the most sophisticated investors, “compacted” template documents. There are hosts of models, some annotated (the NVCA, VC Experts, e.g.) available for papering the investment terms. The High Class Hybrids can arrange that their models be compacted, i.e., comprehensive provisions covering all the bases but stripped of 50% (+/-) of their turgid and unnecessary verbiage.  Investors also get checklists to be reviewed and filled out as necessary … a means of avoiding the classic traps for the unwary. 
Some possibilities remain to be seen once 506(c) is in effect, viz:
What if the founders of a hot Gazelle want to use the web as a means of auctioning off the Series A round? An auction implies the winner’s curse … you win the prize but you have overpaid. The High Class Hybrids likely will not play at pre-money valuations the managers deem too high, but that is when the “Work Horse” structure can be useful … a convertible note convertible at a discount from the next round. 
As a deal appears online, social media may provide background data and/or pseudo data? e.g., “I know the founder and she couldn’t run a three car funeral.” The Hybrid may, a la Amazon, set up, or affiliate with, a social media site and offer deals to all unique visitors who sign in as “members.” Members can give ratings and can discuss each issuer amongst themselves.
Could ‘double bottom line’ investing thrive under 506(c)? Any number of investors are convinced that double bottom line is not a contradiction in terms. Will not the canny Gazelles add that feature if possible to their pitch material in hopes of exponentially advancing the size of the audience?
Can the barnacles on 506(c) … reasonable steps to verify, Advance Form D, the penalty box as Joe Wallin describes it, legends … be disposed of for relatively modest expense as the lawyers (including yours truly) and advisers adapt to the new environment? One possibility is that techies inside and outside law firms devise the equivalent of GPS systems for issuers and their counsel: “click here and you get: (i) an automated web survey of every investor on the theory this process will cough up enough data that it has to be “reasonable;”  (ii) a monthly checklist for the issuer to mark up and return and Advance Form D will be amended accordingly; (iii) the issuers and/or investors file the transaction documents in a pre-assigned bucket and the computer will generate quasi-boilerplate such as names and addresses, necessary legends, etc. My assumption, based on long experience in this business, is that certain lawyers and firms will adapt to the system vis-à-vis most 506(c) issues. Some legal opinions will be published and become “law” … in the land of the blind, the one-eyed man is king. State filing documents will circulate and residents in certain states might either be disqualified or charged special fees.
Indeed, if the Hybrid elects, a la AngelList, to invest in a plethora of small startups, the round sizes averaging under $1 million, the managers need to worry that the 2% management fee will not pay for administration of a big number of companies. However, it looks like several firms blessed with techies in their main line of business are creating digital machine shops which can handle most administrative chores and, assuming the requisite quantity of customers with similar needs, can do so at affordable prices. SecondMarket is a prime example.
And, trade sale exits can become more efficient. In the life sciences, for example, the Big Pharmas have outsourced research to the Gazelles. Why wouldn’t every Big Pharma charge an in-house techie with the chore of assembling deal inventory by packaging the online aspirants into buckets … Alzheimer’s, Bi-polar, arthritis? High Class Hybrids can elect to deposit consenting Gazelles into J&J’s bucket. Presentations at the trade shows, demo days, accelerator open houses, and the like, in fact, can be both in person and online, with the Gazelle pitches videotaped for one and all to check out.
Speculation at this stage can go on indefinitely but only time will tell. What is certain, in my opinion is that the SEC Staff will tweak the regs as evidence piles up. The Staff has acknowledged that facts on the ground may produce surprising results … the good, the bad and the ugly. The undertaking to explore and adjust has been given both orally and in writing. The Agency has to balance the JOBS Act objective … financing for promising small business … against the likelihood of vaporware deals dangled online by shabby promoters. There will be some of the latter, of course, but the primary challenge is to help channel investors into deals which have a shot and the Staff will, in my view, lean in that direction.
The track records of the Hybrids, at least those prepared to answer the necessary inquiries, may be available, prepared by one or more experts in tracking track records and perhaps by social media. We may even see analysts offering their analyses to subscribers along with aggregators, the latter avoiding success fees or adviser type recommendations but, rather, functioning as dashboards for, e.g., investors pursuing a 'spray and play' strategy.
THE FUNDAMENTAL ADVANTAGE
The above ramblings may be no more than an exercise until the story has played out. That said, there is one prediction which, if it gets traction, will enhance the process from the ground up and it has to do with the imperatives to which the Hybrids will answer. Today, if one waits to be involved as an intermediary in supporting worthwhile ideas, an extraordinarily high percentage of one’s time is spent in trying to line up an adequate complement of investors. As the SEC has done a 180, how about another 180 on the part of Hybrids?
Thus, the Hybrid founder(s) assembles all hands, venture capital veterans among them, and lays out the model. Forget, she says, about lining up limited partners who will commit to a blind pool for ten to twelve years. Your job, she mandates, is to drill down one hundred percent of your time in trolling for the best deals in the verticals in which we specialize. The motto is: “If we build it, they (the investors) will come.” And all hands clap and cheer. What a glorious way to spend one’s time and get paid for what each genuinely wants to do … pick the winners and get them into the Hybrid’s SPVs.
The story, in short, will play itself out over time. In this corner, the maxim is to share our knowledge with Hybrid aspirants and help them in the elevation process, lifting themselves by their bootstraps on the web so as to stand out from the crowd of one-off look-a-likes barking for internet capital. The track records of the Hybrids, at least those prepared to answer the necessary inquiries, may be available, prepared by one or more experts in tracking track records and perhaps by social media. We may even see analysts offering their analyses to subscribers along with aggregators, the latter avoiding success fees or adviser type recommendations but, rather, functioning as dashboards for, e.g., investors pursuing a ‘spray and play’ strategy.
 The conveyor belt, as I have styled it, is the pathway emerging growth companies traverse from the embryo to the IPO (or trade sale). Bartlett, "From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest)," Journal of Private Equity, Summer 2011.
 A model Client Checklist can be supplied on request.
 See, Bartlett, "Commentary on Convertible Debt, Next Round Pricing: The Work Horse In Early Stage Financing," at https://vcexperts.com/encyclopedia/chapters/the-work-horse-in-early-stage-financing.
 The GPS system can automatically send check the box inquiries to references an investor supplies in the questionnaire: "Do you know Sheila? Can you estimate her income and net worth? Any reason to doubt her veracity in that regard?" See my due diligence published checklist at https://vcexperts.com/encyclopedia/chapters/due-diligence-checklist.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
Joseph W. Bartlett is special counsel in the Corporate, Securities and Financial Institutions practice. A recognized pioneer of the national private equity and venture capital bar, Mr. Bartlett contributed to the original models for private equity and fund of fund partnerships. His experience extends to alternative investments, venture capital, emerging companies, corporate restructurings, private equity and buyouts. Mr. Bartlett's practice includes serving as counsel to asset managers, including those of major public and private equity funds, with a focus on technology companies, and he has also served as trustee of a series of public mutual funds and chair of a public REIT. His venture fund work began with the first Greylock fund, and he has drafted documents for several of the largest and most successful LBO funds.
Full Bio (http://www.mccarter.com/Joseph-W-Bartlett/)
McCarter & English, LLP
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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Joseph W. Bartlett. This work reflects the law at the time of writing October 2013.