The 99 Investor Problem

When the JOBS Act was finalized, one of the rule changes that had a lot of fanfare around it was the increase in the number of shareholders a private company could have. Prior to the JOBS Act, it was 500, after which point the company had to register and report to the SEC just like it was a public company (even if it hadn’t gone public.) This was a major issue for many fast growing companies that either went through strange contortions not to have 500 investors, or filed with the SEC to get no-action letters. There were plenty of nuances around this rule and I was in the middle of several situations that structured around it legally. Each time it was a lot of overhead for the company in question, none of which added anything to the system except fees to the lawyers.

Lifting the number of investors to 2000 seemed to make sense. In the situations I was involved in it would have immediately solved the specific problem. So that’s good.

But ever since we started working with AngelList on FG Angels, we’ve been wrestling with something called we’ve been referring to as the 99 Investor Problem. We structure our investment in companies via an LLC that has all the individual FG Angels syndicate members in it. This simplifies life for the company as they only end up with 1 investor – the FG Angels syndicate LCC – rather than a bunch of individual investors. At this point we have 217 backers in our syndicate, so with us each company would end up having 218 separate investors if we didn’t use the LLC.

If everyone was on the cap table, the company would have to chase down 218 signatures for everything. Instead, using our approach, they have effectively two investors – our FG Angels syndicate (one investor) and Foundry Group (another investor). Two signatures. Much easier. We handle the Foundry Group signature. AngelList handles the syndicate signature.

Except it doesn’t work that way. The SEC limits an LLC to having 99 investors. So we can only have 99 of the 217 syndicate members participate. Now, there’s a nuance that excludes “qualified purchasers” (QPs) – individuals with $5M in assets and firms with $25M in assets – from the 99 investor count. Overall our QPs + the top 99 investors in our syndicate represent $321,000 based on committed amounts to FG Angels. If you include the balance of the 237 members, we end up at a syndicate of $439,000. The company then gets our commitment of $50,000 on top of that.

As a result of this 99 investor limitation, we have two disappointing problems. First, we have over 100 investors who would like to invest in our syndicate with us who get excluded because of the 99 investor rule. Next, there is $118,000 per investment that we’d like to include in each syndicate that the companies we are investing in won’t get. Bad for the companies and bad for the investor.

We’ve spent lots of time over the past 60 days trying to solve the 99 investor problem. At this point, we’ve run into a dead end. We’ve tried multiple LLCs – that doesn’t work as they end up getting viewed as a single entity. We’ve tried other structures – that doesn’t work. We’re certainly open to ideas at this point.

In the mean time, until we solve this, AngelList is making the following changes to their Syndicates product.

- Qualified Purchasers: AngelList will include all Qualified Purchasers (individuals with $5M in assets and firms with $25M in assets) in each syndicated deal as they are exempt from the SEC’s 99-investor limit. We will soon email your backers to determine if they are Qualified Purchasers (QPs) and we will update your syndicate management interface to indicate the QPs.
Top 99 Backers: The next time you syndicate a deal, we will include all QPs and the top 99 non-QPs by commitment amount. You can override this default to include specific backers who are not in the top 99. The top 99 backers will change dynamically as backers adjust their backing amounts.
Funds: We are working on new funds products to allow additional investors who are not in your top 99 backers or QPs to participate in your syndicated deals.
Notifying Backers: Finally, we will notify your backers of the SEC’s 99-investor restriction this week and give them the opportunity to change their backing amounts.

We are bummed about this because part of our goal is to build a very large angel network as a result of the FG Angels activity. The 99 investor rule directly undermines this, and limits the amount of investment and support for the companies we are investing in. It’s another example of the challenges of the JOBS Act and another discovery on our part of the “miss” between the goal of the new law and the implementation.

  • Sean Killeen

    [disclaimer: I know next to nothing about these aspects of business, and am purely spitballing, so apologies if this is unworkable] A thought: instead of splitting up the investors into groups, could you split up what they’re investing in into groups? If you have ~300 investors, could you create three entities for them to invest in that are all controlled by the syndicate, which would allow 99 per? Trying to turn the problem on its head to see if it makes more sense to shuffle things around on the flip side.

    • jasonmendelson

      the SEC is too smart for that and will consider them as one entity. Sigh…..

  • David Brooks

    Very interesting. I would assume this will lead to a small number of very large syndicates. Hopefully AngelList creates enough transparency among smaller investors so that they know where they stack up in a syndicate, and have flexibility to move to others with less backing. But will investors do that, or is the idea of a superstar lead too compelling?

    • jasonmendelson

      Trying to post again…. I agree with your take. Large syndicates will need to have higher investing followers. No idea what investors will do, but it’s a serious bummer that we can’t truly have crowdfunding here.

  • http://www.themusingsofthebigredcar.com/ JLM

    .
    Potential solution:

    Investors form GP or LP with unlimited number of investors and with conditions determined by investors en masse. This effectively mirrors the AngelList syndicate rules. You are effectively moving the AngelList rules upstream.

    GP or LP forms LLC with a single managing member and the GP or LP as other member.

    LLC — with single managing member and GP or LP member — joins AngelList as investment vehicle.

    New LLC makes investments and complies with all SEC/JOBS Act and AngelList rules.

    Variation on theme: Each investment uses a mirror image but “one off” LLC in order not to commingle different investments. This would also be a bit of legal insurance against spill over legal liability.

    JLM
    .

    • http://angel.co/ Millie Tadewaldt

      Good ideas. The issue here is that the SEC is too smart for that :) and it “looks through” all investment vehicles that are formed specifically for the purpose of buying the same portfolio company, counting all of the individual investors in those special purpose vehicles against the investor limit.

      It is possible for form a more “fund-like” investment vehicle that deploys capital across multiple deals without triggering the look-through.

  • DaveJ

    Have you looked into setting it up as a mutual fund?

    • jasonmendelson

      We haven’t because as mutual fund managers, we’d be liable to all of the syndicate members if we chose bad investors. Our investors in the our main venture funds would not allow this and we are generally scared of lawyers. (Which is why I stopped looking in mirrors long ago).

    • http://startuplawblog.com/joewallin Joe Wallin

      DaveJ–cost of being a mutual fund is prohibitive. So, it is not a practical solution.

  • http://www.mentortechventures.com Brett Topche

    It’s an issue for small traditional funds as well. Depending on which SEC exemption you use to raise your fund, you are typically limited to 99 LPs. Not an issue for larger funds with fewer, larger institutional commitments, but for smaller funds raised primarily from high net worth individuals, it can be a pain in the ass. Also, from the company standpoint, if the LLC is formed solely for the purpose of investing in that company (i.e. your syndicate forms a new LLC for each investment, which seems likely given that the syndicate changes over time), all of the investors in the LLC count towards their 2,000 limit. Not necessarily a huge deal for one syndicate investing in a company, but if you have a couple of syndicates involved, even though you only have to chase down one signature, you can start eating into your 2,000.

    • jasonmendelson

      Agreed.

  • tubby_bartles

    This issue is more difficult than other AngelList issues. Elsewhere, AngelList is meeting the spirit of the law, but needed to find a clever way to meet the letter of the law as well given the new technologies.

    In this case, the spirit of the 99 investor rule is to prevent large number of investors from acting as a coordinated group without “being public”. So the SEC has had many, many years to plug every possible letter-of-the-law loophole.

    The specific legal language doesn’t refer to funds – it refers to “organized groups” and the SEC considers that to mean they look through any legal structure you pick to see whether the group is organized as a single group or not.

    Splitting investments (into parallel funds or by groups of “upstream” funds as suggested in the comments here) is already said by the SEC to count all investors.

    I suspect this one may need a law change to address.

    • jasonmendelson

      I agree. The integration issues that SEC makes part of the issue kills us. Perhaps a no-action letter is due?

      • Sean Schantzen

        Have you found a way that a no action letter could help with this? The limit comes from the Investment Company Act and is in the statute itself (which I don’t think a no action letter could change). I don’t know anyway around it without running into integration issues (maybe a creative no action letter that addresses just integration, since integration isn’t in the statute, but the SEC would really have to be on board with syndicates). We’ve been trying to find a work around for this too, but came to the same conclusions. If someone goes down the no action letter road, we’d be happy to be involved and help out.

        • jasonmendelson

          I haven’t found a way, it’s just a theory. If the SEC won’t bust us, we are clean but this is a very broad topic that a no action letter might not work for.

          • Sean Schantzen

            Thanks. The whole 99 investor limit seems like a relic just like the 500 investor reporting limit. It would be great to at least increase it by the same 4x the 500 investor limit was, regardless of whether by no action letter or statute change.

          • jasonmendelson

            agreed

  • DL

    JLM outlined the direction SproutrHouse is looking for a solution. Brad, where has this path led you?

    Since Angel List began offering Syndicates, I have been working to solve a variation of this problem to serve early-stage companies privately at SproutrHouse. SproutrHouse offers natural CPG brands a simple crowd funding solution but it’s a $125-$400k investment that the market is seeking and one SproutrHouse is well-suited to address.

    • jasonmendelson

      We’ve actually only been led to the ideas that Brad describes above. I have a feeling we are headed toward a request for a SEC no-action letter, but the issue might be too broad and need legislative action.

  • Carlos

    Does a Series LLC work? Not available in Cali, but who wants to do business there anyway ;) #stackexchange. I am exploring using a series LLC in a novel way to promote investment into a core technology, where each individual “app” of this core technology could be its own company. Separates investors, liability, minimizes paperwork, and above all fees right? Would this be something you guys would entertain in funding in my case? Hoping that this could be useful in this case as well. This afterall was given birth via the mutual fund industry, per wikipedia: http://en.wikipedia.org/wiki/Series_LLC

    • jasonmendelson

      Well, unfortunately we need to be able to do business in CA, so no. And if you make the company split up like that you get pass through taxes to the investors which doesn’t work, either. Thanks for the idea!

  • JMN

    If section 3(c)(1) is not amended, the 100 investor
    limit could severally undermine the JOBS Act’s on several levels. The accredited
    investor verification requirements, as defined by the JOBS Act, should be
    sufficient foundation to argue a 2,000 investor cap – in line with the max. number
    of AI’s a private company can introduce as shareholders. A no-action letter may
    work if the SEC’s fully aware its efforts surrounding the JOBS Act could be
    vein.

    • http://www.feld.com bfeld

      Yup. It feels like one possible solution is a no-action letter, but this ultimately is a one-off per organization (e.g. AngelList) so it doesn’t really solve the overall problem.

      • JMN

        Although a one-off result, the outcome would set a precedent assisting other organizations, startups, small investors. The other option is a collective effort to force an amendment to section 3(c)(1). If common sense prevailed, the upside benefits far outweigh the downside risk if the investor cap was increased in line with allowable shareholders (letting companies decide the weighting) subject to AI’s being certified pursuant to Title II.

  • riverland

    could this be relevant or helpful? http://verifyinvestor.com/

    • http://www.feld.com bfeld

      Sort of. AngelList is doing this for free however – see http://www.feld.com/archives/2014/01/angellist-accreditation-report.html

      • Jor Law

        Hi, Co-founder of VerifyInvestor.com and AngelList fan here. What we do is similar to what AngelList provides, but they have a limited use case while ours is a more reliable and comprehensive solution. Their solution is great for their platform, I think, but ours is something that can be relied upon by companies, their advisors/professionals and investors who need certainty of compliance.

      • Jor Law

        Somehow my other post got removed, but I did want to add that http://verifyinvestor.com doesn’t currently address the Investment Company Act and 100 invest limit issue. It’s more a solution relating to general solicitation and 506(c).

  • ObjectMethodology.com

    Sounds like we need an “OWNERSHIP Act”? Something that let’s people in the US (a country based on freedom) be free to do as they please.

  • Scott

    Welcome to my world, Brad. The Company Act and the investor slot issues are a real pain in the ass. As you’ve discovered, if you structure your vehicles as 3(c)7 vehicles by including only QPs, you’ll be ok. It’s actually pretty easy. If you must accommodate accredited investors, look into Registered Investment Company (“RIC”) structures. A closed end RIC (essentially a ’40 Act, closed-end mutual fund structure) allows you to aggregate accredited investor capital in a private vehicle. It’s not a free lunch – you’ll need to be registered, have an independent board, have third-party admin, etc. On the plus side, its fairly permanent capital (liquidity with gating), is flexible, and offers the ability to reinvest proceeds or dividend out proceeds, and is well traveled ground. You should look into it. There is a cost, but if the money you’re aggregating is big enough, it could make sense.

    • http://www.feld.com bfeld

      Yup – we know this well – and have no interest in going down this path. That’s not – in our mind – the goals of the JOBS Act, nor is it how we approach our world in general, which is why (a) we’ve never done this sort of thing in the past and (b) we are intrigued and excited about the ground AngelList is plowing.

  • Felix Dashevsky

    This issue arises because you are (double-) pooling investors. Given the electronic/easy nature of AngelList closing process, I question the need for a separate syndicate LLC. Let the investors invest directly into Startups. And play with Startup funding docs to ensure streamlined future interaction with investors (or use power of attorney, advisory contract, or solve it technologically).

    The issue such direct structure would highlight is your (and AngelList’s) fee. However, I think you can structure around it (options/warrants at OpCo, investment advisory contract, something else creative). If it is an advisory contract, you’ll run into Investment Advisory Act and “qualified client” issues… but frankly I am not sure how you (or AngelList) have avoided these so far.

    • http://www.feld.com bfeld

      If I was on the startup side, I wouldn’t want this. Regardless of the legal docs, there will be at least one situation where you have to chase down signatures and that could be the nightmare.

      We’ve focused very hard on the legal dynamics around IAA and are very comfortable, but really understanding it has been non-trivial.

      • Felix Dashevsky

        But isn’t that what the JOBS Act was about? Like the 2000 limit you alluded to in the opening paragraph (“a lot of fanfare around [...] the increase in the number of shareholders a private company could have”). Or the crowdfunding bits. It wasn’t about broader access to fund-like structures, but to startups. If startups want just a couple of big investors… well, we don’t need the JOBS Act at all. If we step back, nothing we are discussing was in fact affected by the JOBS Act–FG Angels is using the “old” 506(b) pathway.

        • http://www.feld.com bfeld

          Since we are using 506(b), you are correct. Which means that the JOBS acts is not accomplishing the goal!

          • Felix Dashevsky

            Which was what?

          • Felix Dashevsky

            My point is that neither the JOBS Act, nor any other rule on startup fundraising is causing any issue here. The “99-problem” is not endemic to startup investing (like the “500-problem” is).

          • http://www.feld.com bfeld

            I guess I just disagree. If you’ve been following what we’ve tried to do with FG Angel, it’s very much about democratizing startup investing, and the 99 investor rule is a huge disconnect from the JOBS Act goals, especially in raising the private investor cap from 500 to 2000.

          • Felix Dashevsky

            Fair enough. I am following FG Angel by backing it. Although not sure if I will make it into the 99 the next time!

          • JMN

            Brad, I concur with your position. The question is what can be done to resolve this hurdle? There’s always a solution. Jason Best and team at Crowdfund Capital Advisors (http://crowdfundcapitaladvisors.com/about-us/our-team/jason-best.html), may be a starting point.

          • JMN

            It appears my previous comment was removed because a link to a third party’s website was included? A private company found on the net that was involved with pushing the JOBS Act legislation through. My point was there’s sure to be a solution to this problem. But it’s going to take some digging and talking to the right people who can push for change at the legislative level. Otherwise, the “99 investor problem” is here to stay, there’s no way around it.

  • Eddie Wharton

    Could you have a 99 person Brad-FG Angels LLC, another 99 person Jason-FG Angels LLC, etc.? Instead of combining them off the cap table just include 3 different LLC’s. It would be a bit more work, is not a scalable solution past a certain point and relies enormously on the trust that you have built to make sure all of the FG Angel LLC make the exact same investments with the same terms.

    This is not an effective solution for everybody and one part of the law seems to undermine the spirit of another. Big picture, that needs to be fixed. However, this could be a way to keep FG Angels growing and still have a low single digit number of additions to the cap table.

    • jasonmendelson

      I wish. SEC would look into “who is Brad / Jason” and realize we are partners and then game over. They integrate and we are “done”

      • http://startuplawblog.com/joewallin Joe Wallin

        I think we ought to just repeal the investment company act…

  • http://www.behappyandfree.com Steve Consilvio

    Stop investing and give your money away!
    I love it how rich prigs think they are helping others by lending them money and then sucking the blood out of a new business. You guys should be ashamed of yourselves.

  • http://www.freddestin.com Fred Destin

    My personal view is that we do this one step at a time and prove we are responsible actors on a functional platform. The 99 investor problem could also refer to 1999 when retail investors were left holding cats in bags prepared for them by professional investors. Let’s build a strong platform with good diligence tools, social signals, evidence of track record and then go back and propose the next regulatory evolution. I am convinced there is a day where crowdfunding will apply to startups as it applies to products on Kickstarter, but we need to make sure it’s done well. Let’s celebrate the deregulation, demonstrate our platform works, and then fight for the next step.

    • http://www.feld.com bfeld

      Fair enough.

      However, when the 500 shareholder limit was raised to 2,000, I don’t think anyone was paying attention to the 99 LLC rule. If there was thoughtful discussion about it, that’s cool. But my instinct is that there wasn’t. And that’s what’s frustrating / disappointing to me.

      I think the gang at AngelList was just as surprised by this based on all of our work together. Since you are investors directly in AngelList, realizing that their initial view was there was no problem having larger syndicates is probably important as part of understanding how this all evolves.

      As we planned from the beginning, the FG Angels experiment is just that – an experiment – so we are happy to find all the limitations, edge cases, and problems. I don’t think our behavior or performance is – or should be – a proxy for regulators as we are merely one data point, so I’m happy to be public about all the challenges we run into.

  • http://www.twitter.com/stevenkane Steven Kane

    Hi Brad. Re the chasing signatures issue. Couldnt the startup simply require angels who invest directly to submit to some kind of “drag along” right? Meaning, once the angel’s money is invested, no signatures are ever required ever again?

    • http://www.feld.com bfeld

      Possibly. It’s one of the approaches we’ve looked at. We – and some of the companies we’ve talked to – aren’t comfortable with it since it still ends up with a huge number of individual investors on the cap table.

  • lunarmobiscuit

    The Investment Act and SEC seems to have thought through every straightforward workaround. Given that, it seems the best path is to go back and questions the assumptions. You set up this LLC to: (a) simplify the paperwork for the investees, (b) centralize the decision making of the syndicate, (c) prove out the AngelList crowdfunding model.

    Of these, only (a) is limited by the rules. I saw in the comments that the rules don’t allow you to run one LLC and any of your Foundry partners to run a second LLC. But what stops any of the other 216 people in the syndicate from setting up a second LLC? A “Not-FG Angels LLC”, whose manager receives no communications from you, but who watches AngelList to see what FG Angels invests in and follows along.

    You pick 98 others to be part of FG Angels, and someone from the other 119 others not picked can choose 98 more for Not-FG Angels LLC, and so on with Truly-Not-FG Angels, until you hit the 2,000 investor limit, which I believe really has no workaround.

    • http://www.feld.com bfeld

      That’s a valid hack and certainly open to anyone who wants to do it.

    • rxdxt

      This is Richard Titus, founder of Prompt.ly (Foundry Syndicate investment 2) -chiming in… I agree this is a real problem. Prompt.ly was super excited about the opportunity & the democratic innovation in investment – but we were surprised the final investment amount was so much lower than commitments. (it all worked out as we were significantly oversubscribed via direct investment.)

      Perhaps syndicates could “back each other up”? i.e. each syndicate could act as a “sub-manager” to investors who are interested in a deal, but cannot fit into the 1st 198 investors of the original syndicator? I’d be happy to serve in this capacity for Foundry.

      It should be noted we (and I hope you don’t mind we did this) “picked off” some of the obviously QP investors and invited them to invest directly to allow more people into the deal – but until the SEC & IRS solve this that seemed the best way to preserve access. – to our view the purpose of Angellist is to level the playing field for investors – particularly smaller ones and diversify the investment landscape.

      Based on my fantastic experience as an entrepreneur being backed by Foundry & it’s syndicate – I’ve started my own!

      Thanks again!

      • http://www.feld.com bfeld

        We’re glad you picked off additional QP investors to invest directly. All good…

  • Henry Glover

    What if the 217 members pooled together to form a firm with $25m in assets making one “qualified purchaser” Might be silly for one deal but if you had a lot of people in a “firm” it basically makes the firm a really large syndicate. Im guessing it would require either bigger checks, more people + a lot of deals for it to scale… vc firm

    • http://www.feld.com bfeld

      That won’t work as the entity will have > 99 investors.

  • Scott Kosch

    Brad, I’m in your syndicate and make the 99 cut-off because of my per-deal amount, but I also qualify as a QP. Just got around to getting a letter from a financial institution to attest to this, but in the online form it also mentions that they might periodically run my credit history. I don’t like the idea of having my credit run frequently (like possibly for every deal or even a few times per year), because this negatively impacts credit scores (which I think is crazy). Can you say anything about this? I hate to fill an accredited spot, when I could be included as a QP, but the periodic credit check gave me pause.

    • http://www.feld.com bfeld

      I don’t know the answer to this specifically but will check.

      • Scott Kosch

        Brad, thanks for asking AL about this. Here is what I learned, so that others don’t shy away from validating their QP status. The credit check they perform is called a “soft pull.” Add your own joke to that. It does not impact your credit score, unlike a “hard pull.” Nevertheless, if you still want to avoid this repeated credit check for each deal, there are two ways AL may not need to check as frequently. First, if you invest through an entity, which is wholly-owned by one or more QPs, then that entity is a QP, and they shouldn’t need to run your credit personally. Second, if you can verify that your Net Worth is greater than $5M and not just your Net Assets (i.e., your Net Worth would be less debt and other liabilities), then credit checks aren’t necessary. Anyway, happy that I can make room for one more investor by changing my status.

    • http://www.tejdhawan.com/ TejDhawan

      That’s an interesting observation. You’re correct that the credit score would likely by hit by the credit check. The credit report would generally affirm the salary based qualification requirements, but not the remaining 8 or 9, as financial assets, non-profit work, institutional mgmt etc. don’t make it into credit checks. The criminal/bankruptcy items that do make it into credit checks would apply to the companies raising the funding through FG Angels+syndicate.

      Interesting question to send to AL directly as well, and this is making me think that the company raising the funds should also be providing representations that they clear the ‘bad actor disqualification’ test.