For most startups and emerging companies, fundraising continues to be challenging. With the passage of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), Congress tasked the Securities and Exchange Commission (the “SEC”) with revamping federal securities laws to make fundraising more accessible for small companies in attempt to help create jobs. Recently, the SEC has implemented and proposed new and revised securities laws to achieve this mandate. While not all of these rule changes make life easier for small companies seeking to raise capital, some of the rules do potentially provide new fundraising alternatives for small companies. Companies and investors should also be aware that certain new rules impact established practices and, predictably, there are new pitfalls to avoid. This post briefly introduces some of the recent developments in unregistered offerings and provides some key takeaways for companies and investors to consider.
Background: The JOBS Act
As a reference point, the JOBS Act consists of the following five parts or Titles: Title I is the so-called “on-ramp” to the initial public offering (“IPO”) process for emerging growth companies that introduced certain relaxed disclosure and audit requirements (this topic is not covered in this post); Title II tasked the SEC to promulgate rules to lift the ban on general solicitation in effect under existing private placement exemptions; Title III created an exemption for crowdfunding offerings; Title IV tasked the SEC with improving the Regulation A offering exemption; and Title V increased the limit on the number of shareholders a company may have before it triggers public reporting requirements.
Traditional Regulation D Private Placements
Companies seeking to raise capital through the offer and sale of securities must either register the securities offered with the SEC under the Securities Act of 1933 (the “Securities Act”) or rely on an exemption from registration. Historically, when small companies raised funds from private investors in unregistered offerings, such offerings were generally conducted as private placements exempt from registration under Rule 506 of Regulation D under the Securities Act, which allows an unlimited amount of capital to be raised from an unlimited number of accredited investors (and up to 35 sophisticated non-accredited investors).(1) One of the requirements of former Rule 506, now revised Rule 506(b), is that a company cannot engage in general solicitation or advertising in connection with the offering.
New Rule 506(c): Lifting the Ban on General Solicitation
Effective September 23, 2013, there is a new rule that permits general solicitation and advertising in connection with an unregistered offering. Pursuant to Title II of the JOBS Act, the SEC promulgated new Rule 506(c), which permits the use of general solicitation and advertising in connection with unregistered securities offerings to accredited investors only. However, for many companies, the benefits of Rule 506(c) are likely outweighed by the compliance requirements. Companies that choose to generally solicit or advertise to attract capital under this new rule will have to take steps that were not required in the past, such as verification of the accredited investor status of purchasers, making an advance filing with the SEC on Form D at least 15 days before any general solicitation or advertising, submitting to the SEC written solicitation materials no later than the day of first use and including specific legends in written solicitation materials.
The arrival of Rule 506(c) and its allowance of general solicitation in connection with unregistered offerings raises new issues for companies and their advisors to consider. For example, organizers of, and participants in, demo days, pitch events and meetups that are popular within startup communities should consider whether such events involve engagement in general solicitation under new Rule 506(c) and trigger the related compliance requirements. Also, potential investors may not be comfortable with sharing the level of information with startups and event organizers that is needed to meet the accredited investor verification standards under Rule 506(c), although broker and CPA certifications may become the general practice.
On the other hand, the ability to engage in general solicitation and advertise in an unregistered offering, coupled with the effect of Title V of the JOBS Act raising the limit on the number of shareholders a company may have before it triggers public reporting requirements from 500 persons to 2,000 accredited investors could lead to private companies implementing new methods of mass marketing securities to investors other than through a traditional SEC registered IPO.
Expansion of Regulation D Requirements
To rely on the exemptions under Rule 506, companies must file a Form D with the SEC within 15 days after the first sale of securities in a Rule 506(b) offering, or at least 15 days before any general solicitation in a Rule 506(c) offering. The SEC also added a check box for companies to indicate whether they are relying on Rule 506(c). The SEC also revised Rule 507 to significantly change the law by disqualifying a company from relying on Rule 506 for one year if the company did not comply with all the Form D filing requirements within the last five years. Additionally, a new Form D closing amendment may need to be filed after terminating any Rule 506 offering.
“Bad Actor” Disqualification
The SEC adopted new so-called “bad actor” rules under Rule 506(d) that apply to all Rule 506 offerings, including those relying on Rule 506(b). In order to rely on Rule 506, the “bad actor” rules require that neither the company nor any “covered person” have committed certain securities-related violations. The “covered persons” includes officers, directors, general partners, managing members, 20% shareholders, investment managers, promoters and compensated solicitors. For companies relying on Rule 506 it is advisable to obtain questionnaires or representations from such actual and potential covered persons to protect against disqualification under Rule 506(d).
In October 2013, the SEC proposed for comment amendments to the Securities Act to implement a crowdfunding exemption from registration in accordance with Title III of the JOBS Act. The SEC proposed new Section 4(a)(6) of the Securities Act, which would govern the offer and sale of securities through internet websites and provide a framework for the regulation of registered funding portals and broker-dealers that companies would be required to use as financial intermediaries in connection with crowdfunding offerings. Companies cannot use the proposed crowdfunding rules until the SEC adopts final rules, expected to occur in the first quarter of 2014. It is worth noting that non-equity crowdfunding sites currently in operation, such as Kickstarter, may expand into equity crowdfunding platforms under the new rules.
There are several specific crowdfunding compliance requirements that likely will limit the attractiveness of crowdfunding for many companies, and complying with the rules may be cost prohibitive. A company that is crowdfunded and, as a result, has a crowded cap table, may be less attractive to later stage investors interested in taking a large position when the company matures. The proposed rules are extensive, and the following is a brief summary of certain notable provisions.
Under the crowdfunding rules, a company may raise up to $1 million during any rolling 12-month period. This does not include amounts raised in other exempt offerings in the same period, which are permitted to occur simultaneously with the crowdfunding offering, provided that all conditions for all exemptions are satisfied. Securities sold in crowdfunding offerings are except from counting towards the number of shareholders that would require SEC issuer registration (note that companies will be required to establish a means for tracking its shareholders). Crowdfunding offerings must be conducted exclusively online through a platform operated by registered fundraising portals or broker-dealers (who are subject to their own set of rules). The company must establish a target or maximum amount to be raised and investors can cancel their investment up to two days prior to the closing of the offering. Investors will be notified when the target offering amount is met, and if the target offering amount is not met, then no securities will be sold and all funds will be returned to investors.
In a crowdfunding offering, companies may sell securities to an unlimited number of both accredited and unaccredited investors, subject to maximum individual investment limitations and the aggregate $1 million offering size restriction. If an investor’s income and net worth are both lower than $100,000, an investor may not invest more than the higher of $2,000 or 5% of the investor’s income or net worth in a 12-month period. If an investor’s income or net worth is higher than $100,000, an investor may not invest more than the higher of $100,000 or 10% of the investor’s income or net worth in a 12-month period. Companies must comply with extensive disclosure requirements including filing information with the SEC. Depending upon whether a company seeks to raise less than $100,000, between $100,000 and $500,000, or more than $500,000, it must provide financial information that is certificated by its CEO, reviewed by a CPA, or audited, respectively. Progress reports during the offering must also be filed periodically with the SEC. Companies themselves may not advertise the offering, other than directing potential investors to the financial intermediaries. Annual reports need to be filed until all the securities sold in the crowdfunding offering are redeemed or resold to a third party or the company dissolves.
In December 2013, the SEC proposed for comment rules to implement Title IV of the JOBS Act by amending Regulation A under the Securities Act and creating a new Section 3(b)(2) exemption (for so-called Regulation A+ offerings), which permits private companies to conduct a “mini-IPO” to raise up to $50 million from the general public in a 12-month period by selling unrestricted securities that can be re-sold immediately. Regulation A+ offerings may be a viable financing pathway for emerging companies either as a bridge to, or even as an alternative to, an IPO. Companies cannot use Reg A+ until the SEC adopts final rules.
For most companies, the existing Regulation A exemption is cost prohibitive given its relatively small offering size limit, and it is rarely used. Exiting Reg A permits companies to sell up to $5 million of securities to accredited and unaccredited investors, but requires that the company file a mini-registration statement with the SEC and comply with state securities law registration requirements in each state where securities are offered.
Reg A+ offerings would be exempt from state law registration and qualification requirements. Reg A+ would require stricter offering statement disclosure requirements, including the requirement to provide audited financial statements. Companies would also be subject to ongoing reporting obligations after completing their offering, including the obligation to file annual and periodic reports with the SEC. An investor in a Reg A+ offering would be permitted to invest only up to the greater of 10% of that investor’s annual income or net worth.
Under Reg A+, companies would be allowed to discuss the potential offering with potential investors to “test the waters” and gauge investor interest, both before and after the company files its registration statement with the SEC.