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Due Diligence / Learning

This One Due Diligence Question Will Make You a Better Crowdfunding Investor

due diligence illustrated: magnifying glass and pen over book page

We’ve grown accustomed to breezing through the fine print on websites—especially from our phones—but when it comes crowdfunding investment due diligence, each platform’s fine print can tell you some critical information about the due diligence that different types of investment platforms give (or don’t give!) their offerings.

So even if you’ve learned the ins and outs of the various kinds of offerings you’ll find across the growing ecosystem of online crowdfunding investment and alternative investment platforms—and perhaps begun evaluating the investments themselves—hiding in that fine print is one more critical piece of information you should know about the platforms themselves before making an investment: how is the platform regulated?

Here’s two examples of the fine print from EquityMultiple (a real estate investing platform) and from CircleUp (which helps fund retail and consumer businesses).

If you don’t find those particularly easy to understand, don’t worry, they’ll make a lot more sense by the end of this post.

Most platforms fall into one of four main categories:

  • Broker-dealers
  • Registered Investment Advisers
  • Title III Funding Portals
  • Other

The following sections describe each category in more detail.

Broker-Dealer

A Broker-Dealer is registered with the SEC, and subject to a range of regulations and restrictions, including the obligation to “recommend only those specific investments or overall investment strategies that are suitable for their customers.” Broker-dealer platforms collect more detailed information on both the investments and on their customers, and have an obligation to make sure both are accurate and up to date.

Note: You can verify a firm is indeed a registered broker-dealer at FINRA’s Broker Check website.

While many platforms advertise the quality of their curation or due diligence process, only broker-dealers are subject to specific due-diligence requirements to ensure an investment is “suitable” for their registered customers, or they can face fines and civil action. (Platforms that are not broker-dealers may indeed be analyzing their offerings just as closely–or more so–but you might want to ask how their due-diligence compares to that required by broker-dealers.)

So while a broker-dealer platform will typically disclaim that they do not offer formal financial advice (even though they are entitled to), you can still expect that the investments they offer have been thoroughly screened, including thing like criminal background checks on key executives and a detailed review of financial statements. You should of course do your own due diligence (including research outside of what you find on the platform.)

In some cases the platform itself is not a broker-dealer, but has a contractual agreement with another firm that is. For example, here’s the disclaimer from RealtyMogul, which has that kind of relationship with a firm called North Capital Private Securities Corp:

(Note that second highlighted entry, referring to RealtyMogul’s “MogulREIT”, which is actually a Reg A+ offering with its own SEC filing.)

North Capital Private Securities, the affiliated broker-dealer, is actually a provider of, among other things, “Marketplace as a Service” offerings, and they also have a relationship with RealtyShares.

A broker-dealer may offer any of the types of securities commonly found through online crowdfunding investment and alternative investment platforms, including Reg D, Reg A+, and Reg CF.

Registered Investment Adviser

Many broker-dealers are also registered investment advisors, but they are distinct categories, with important differences when it comes to online investment platforms.

While a registered investment advisor is held to a higher “fiduciary” standard when it comes to the advice they give their customers, in the context of an online investment platform you, the investor, are not their customer.

Huh?

Well, most of the platforms that are Registered Investment Advisors operate by pooling investor money into investment funds (“Special Purpose Vehicles”, or SPVs) like an LLC, which then does the actual investing. Those SPVs are the actual “customer” of the investment advisor, to whom they provide primarily administrative services.

AngelList and FundersClub are examples of this type of platform (and both of those sought and received a special ruling from the SEC exempting them from needing to register as a broker-dealer, which would have subject them to those more rigorous due-diligence standards.) When it comes to you, the individual investor, the platform is just acting as an intermediary between you and the SPV. So how could that good for you? Well, it reduces the overhead on the platform, which means they can facilitate a higher volume of deals.

As with broker-dealers, the fine print usually says that these platforms do not provide investment advice. And although they are registered with the SEC, advisor platforms are not held to the same standards for due diligence as broker-dealers, so be sure to consider that in light of your own experience and comfort with due diligence of potential investments.

Here’s the note about “not providing investment advice”  from FundersClub:

An investment advisor platform may not offer Reg CF investments — only broker-dealers, or the new category of “Funding Portal” (described below) may currently offer Reg CF investments.

Title III Funding Portals

These are the new kids on the block, born from the 2012 JOBS Act, and first put into practice in 2016. Title III Funding Portals were specifically created to facilitate online crowdfunding investments (Reg CF offerings). There are extensive limits and restrictions on how they can operate, but they are much cheaper and easier to start than a broker-dealer platform (broker-dealers can also offer Reg CF investments).

Unlike Reg A+ or Reg D offerings, which a company can offer directly to investors, Reg CF offerings can only be sold through an intermediary (a broker-dealer or a Funding Portal). And unlike broker-dealers, Funding Portals are prohibited from offering any investment advice or making any recommendations at all about the investments they offer. (They’re intended to function as simple, if regulated, marketplaces between businesses and investors.)

That “marketplace” model does not, however, mean you’re entirely on your own. Funding Portals are required to perform specific due diligence on their offerings, including criminal background checks on key executives and owners, and checks to prevent fraud (some rely on third-parties like Crowdcheck specializing in these kinds of services, which are also used by the other categories of platforms). David M. Freedman and Matthew R. Nutting cover all the details about Funding Portals over at Financial Poise, including what criteria the portals can use to select or reject offerings:

Funding portals and broker-dealer platforms can use both objective criteria (e.g., industry, geographic location, or number of employees) and subjective criteria (e.g., experience of management team, chances for success) in deciding which offerings list on their platforms. When issuers submit applications to an intermediary, the latter can “curate” offerings, i.e., determine which to accept and reject, based on whatever criteria they choose. The intermediary must not claim that its selection criteria make its offerings better or safer than any other’s. Nor can an intermediary use its selection criteria as a way of giving investment advice to its registered investors.

Funding Portals are also required to provide investor education resources, along with forums in which prospective investors can discuss offerings. Both should supplement your other due diligence efforts when evaluating an offering listed on a crowdfunding investment Funding Portal.

A crowdfunding investment Funding Portal may currently offer only Reg CF investments.

None of the Above: Other Platforms

The other key category of online crowdfunding investment and alternative investment platform is essentially “none of the above”, and includes three groups:

While many of these platforms advertise the level and quality of their curation in selecting offerings for investors, it’s important to keep in mind that those criteria may not be as thorough as those done by either broker-dealers or Title III Funding portals. In other words, another layer of due diligence before investing in one of these platforms is to be sure you understand the platform’s diligence criteria in selecting their offerings. (For example, while EquityNet offers a wide range of investment options, they do not perform any review at all before a new listing goes up on their site — caveat investor!)

EquityNet’s disclaimer:

All/Some of the Above: Parallel Offerings

As if all of this wasn’t confusing enough already, there’s also the special case of so-called “parallel offerings”, which is when a company simultaneously offers two (or more!) types of securities. For example, a company may wish to do a Reg CF offering to appeal to non-accredited investors and evangelical brand supporters (limited to $1M per year), while also wanting to take in the unlimited money possible with a Reg D offer to accredited investors.

Because the rules are different for each type of offering, the platforms have begun implementing a range of separate workflows and systems for each kind, and that also extends to the entities themselves. For example, one of the most aggressive at lining up all of the offering types (Reg D, Reg A+, and Reg CF) is SeedInvest, and their disclaimer reflects the underlying complexity surrounding the platform types:

Notice that “SeedInvest Technology LLC” explains that it’s not a registered broker-dealer, but does reference an affiliate, “SI Securities”, which is. And lo and behold, SI Securities is a single-member LLC wholly-owned by …. SeedInvest:

(And note that another entity, “SI Portal”, is the one formally conducting the Reg CF offerings. Oh, and hey, there’s North Capital Private Securities again…)

Due Diligence on the Due Diligence

Complex business structures are nothing new, especially in the world of finance. So by itself, these kinds of webs of entities aren’t worth spending too much time trying to parse. The important point to remember is that before you pull the trigger on a particular investment, make sure you know which kind of entity is behind it, so you can make an informed judgment about the level and quality of due diligence that’s gone into the offering.

You can search and sort our database of online crowdfunding and alternative investment platforms by Platform Type and see which ones are broker-dealers, funding portals, investment advisers, or other. Want to learn more but aren’t sure where to start? Ask other investors on our investor forums.

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