The Exchange

We’re in the Middle of a Paradigm Shift in Private Equity Capital Markets

The Exchange

By Joseph W. Bartlett

The fundamental thesis is that this country is faced with an opportunity to revitalize the economy in ways that beggar the imagination. Assume that Federal securities laws in this country are in the process of a profound change triggered by the 800 pound gorilla … the Internet … and ripple effects of the Internet on securities regulation and market conditions.

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As a senior member of the SEC Staff and I ruminated recently, the requirement that U.S. public offerings of securities be registered under the Securities Act is dying an Internet-aided death. Offerings limited to accredited investors under Rule 506, even Quiet 506 preceding adoption of Title II regulations, are, in effect, public offerings. The question is whether the Internet marketplace will largely take the place of traditional capital solicitation techniques by entrepreneurs, replacing face-to-face connections with investors, sending over-the-transom pitch materials and road shows arranged by placement agents.

A New Platform

I believe both pre and post Title II private offerings will be chaperoned to the accredited investor public by dating services, aka Platforms, or intermediaries which themselves are not broker dealers but (in most cases) affiliated with broker dealers. Traditional success fees for locating investors will be replaced by the Platform economics.

Since the investors are located through the Internet, the fee for finding investors will no longer be applicable per se. Fees for helping close the transaction? In selected instances, yes. But fees for finding the capital sources? Not logical, if the investors stumble across the pitch on the Internet and self-select themselves inside the Platform’s firewall.

Matching Investors to Deals

How will the Platforms pursue the like-to-like objective, such as Match.com? One method is to segregate deal flow into silos from which investors can pick the categories on which they will drill down. Thus, I expect to see Platforms specializing in deal flow sourced from specific locations. For example, Israeli high tech firms seeking capital in the United States. Locations can run from South Africa, India, Brazil … and, indeed, within the United States: Silicon Valley, Silicon Alley and points in between.

The thought is that investors in that particular region will take the Platform presentations seriously because they can kick the tires themselves. Academic centers are also potential Platform customers, presenting spinouts. Double bottom line companies, I am reliably informed, will be presented on their own Platforms, doing well in the financial sense by doing good in the social sense. Another natural suite of categories will be sector Platforms: medical devices, healthcare information technology, cleantech, etc.

A Selective Process

The home page of the Super Platforms will continue to attract attention with descriptions of completed deals. The Super Platforms will be openly snooty on both the buy and sell side, seeking the best investor census: only the highly-qualified need apply. By the same token without pretending to provide investment advice or to go beyond basic due diligence, the Platform sponsors will exercise discretion as to who and what is invited to post their information, together with quite detailed requirements on what needs to be made available to investors.

The plethora of Platforms will result in a selection process in which Platforms which prosper (as, e.g., AngelList has) will be “rated” by tracking technologies using tech-aided systems approaches to separating the good from the bad and the ugly. One such rating protocol will likely use the Amazon/Zagat methodology by collecting and publishing anecdotes from investors and issuers who have done business with the Platform and formed an opinion of the Platform’s expertise, performance and the ultimate results.

Since the plural of anecdote is data, that methodology for indexing Platform quality will be available to subscribers or, indeed, online. Platforms, as they do now, will advertise their own track records -- their deal numbers and amounts, including specific emphasis -- data that is again checkable by social media conversations.

What About Broker Dealers?

There is a good deal of work to be done in understanding the economics of the leading Platforms since they will not be able to participate as such in success fees, not (generally) being registered as broker dealers. One significant method is likely to be carried interest profits to the principals from the operation of side car funds co-investing in the chaperoned issuers. There are also fees to be charged to both issuers and investors and revenues from what Title II calls “ancillary services.” The most promising will be (in the opinion of this biased observer) benchmark valuation tools offered by VC Experts, annotated model documents which are up to date as “industry standard,” maintenance of due diligence drop boxes and the like.

Broker dealers who “get it” will not be shut out. Indeed, participation of broker dealers, as Platform affiliates, is a no brainer. They get to become BFF with the issuers which successfully raise cash from Platform-admitted investors. The broker gets paid to help in the Title II “reasonable steps to verify” accredited investor status. And, they then can accompany their customers travelling along the rest of the Conveyor Belt, including arranging the exit, IPO or trade sale, which is where the real money is for the broker dealers.

The concern is that online presentation of deal flow is destined to fail unless it is highly regulated, which may well involve strangulation by regulation. However, the fact is that fraud is easier to detect if deals are presented online than if trades are arranged in clandestine fashion by fraudsters.

When we were debating, in the presence of Congressional staff, the merits of certain delirious language in Dodd-Frank, state securities administrators argued that a requirement of advance filings would enable the cops on the beat to intercept fraud. This point of view quickly fell flat on its face. As we pointed out, the very definition of a “fraudster” means that it will cheerfully avoid advance registration requirements of any sort; investments will be solicited from the marks in clandestine fashion the way fraud is universally conducted: under the radar. By definition, it is hard to stay under the radar if the merchandise is on the Internet.

Moreover, Platforms which prosper will attract “followings” of satisfied investors, plus those brought to the Platforms’ accredited investor pool through word of mouth; networking will work its magic: the wisdom of crowds.

Joseph W. Bartlett is of counsel in Sullivan & Worcester LLP's New York office and is a member of the firm's Corporate Department.

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