On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

Earlier this year, Union Square Ventures Managing Partner Fred Wilson famously referred to corporate VCs as “The Devil”, when he asserted that companies should not be investing in other companies, that they should be buying other companies but not taking minority positions in them, that the “access” rationale for corporate venture is a reason why entrepreneurs should not want them in the room and that startups who take investment from them are “doing business with the devil”.  Ouch!  So why the hostility?

Corporate venture capital refers to venture style investments in emerging companies made by venture capital divisions of large companies, as distinguished from venture investments made by the more google Vtraditional investment funds that most people associate with venture capital. I’ve been seeing corporate VC term sheets with greater regularity lately, so I decided to blog about some of its characteristics, advantages and disadvantages relative to institutional venture capital.

Indeed, corporate VC appears to be on the rise. According to the National Venture Capital Association, corporate venture deployed over $7.5 billion in 905 deals to startups in 2015, a fifteen year high and representing 13% of all venture capital dollars invested for the year but 21% of all deals consummated.  From 2011 to 2015, the number of corporate VC divisions in the United States rose nearly 50% from 1,068 to 1,501   And according to CB Insights, the average corporate VC deal size has consistently been larger than the average institutional VC deal size over the last 14 quarters ended June 2016, with corporate VC deal sizes averaging above $20 million over the previous five quarters.

intel capitalBig technology and healthcare companies have long made venture style investments in startups. Google Ventures, Intel Capital, Dell Ventures and Cisco Investments are veteran corporate VCs that immediately come to mind. But it’s the relatively recent cisco investmentsarrival of new corporate investors that have driven the growth in corporate VC, in sectors ranging from transportation (e.g., GM’s $500 million investment in Lyft) to financial services to convenience stores.

Corporate VC programs have dramatically different overall objectives than institutional VC funds. Primary among these objectives is bolstering internal research and development activities and gaining access to new technologies that complement the corporation’s product development efforts. Venture investments are also a way for corporations to gain intelligence on disruptive products and salesforce vtechnologies that could pose a competitive threat.  A minority investment could also be the first step toward an eventual acquisition of the portfolio company.  More limited objectives might include establishing an OEM partner, a channel for additional company product sales or even a product integration that might drive sales for the investing company.  And yes, there’s also the objective of financial returns.

If a company is considering launching a venture capital program, it’s important to choose a structure that will align with its investment objectives. Corporate VC programs can either be structured internally, where a company invests from its own balance sheet, or externally.  Generally speaking, internal divisions are more comcast venturesappropriate for strategic investments intended to support a corporate sponsor’s core business.  One downside of internal structures is that they tend to be more bureaucratic and slower in decision making. Another is that the financial capacity to invest is basically a function of the corporate sponsor’s financial health, which could fluctuate over time.

External structures are more nimble in making decisions and generally have greater flexibility to make investments that may be disruptive to the investing company’s core business. Since investments are made microsoft venturesoff the corporate sponsor’s balance sheet, external structures allow companies to pursue riskier and more disruptive R&D. They also tend to attract more experienced investment managers and so are often better able to achieve both strategic as well as financial objectives.

In terms of exit strategy, corporate VCs seek a wider range of possible outcomes from an investment. Maximizing proceeds is typically not the exit strategy.  A corporate VC may just as likely view as a successful outcome the portfolio company becoming an acquisition target, an OEM partner, a channel for GE Venturesadditional company product sales or even a product integration that would drive sales for the investing company.  VC funds, on the other hand, seek one type of exit: a multiple return on their investment dollars from either an acquisition or a sale of shares following an IPO.

Advantages

As I mentioned above, investments by a corporate VC are funded by the corporation’s own balance sheet, and are thus not subject to the ongoing pressure from limited partners and the ten year time restrictions of a typical VC fund’s limited partnership agreement. The result is that corporate VCs are generally more patient and have longer time horizons than VC funds.

Corporate VCs generally negotiate for less control over their portfolio companies than do VC funds. This is largely because when the investor company is deemed to have the power to influence the operating or financial decisions of the company its investing in, the investor company is required to account for its investment under the equity method of accounting, under which the investor recognizes its share of the profits and losses of the investee. If the investor has 20% or more of the voting stock of the investee, the investor is presumed to have control.  Consequently, corporate VCs generally avoid taking 20% or more of a portfolio company’s voting shares.  The need to avoid indicia of control is also why corporate VCs often decline board representation.

Another advantage is that, as I mentioned above, an investment from a corporate VC may be the first step toward being acquired by that corporation, thus giving the portfolio company and its founders a clear exit pathway without having to go through a prolonged investment banking process. It can also create instant credibility in the industry, which can then be leveraged to attract talent and customers.  Finally, it can provide channel access, product integration and other benefits to help accelerate market penetration.

Disadvantages

Investment from a corporate VC may have certain disadvantages, however. First, a corporate VC’s strategic objectives may conflict with a portfolio company’s financial goals, which for example may motivate the corporate VC to block a proposed acquisition or subsequent investment if the transaction does not align with the strategic goals of the corporate VC’s parent. Second, corporate VCs often negotiate for a right of first refusal or option to acquire the company which would limit the company’s options going forward and have a chilling effect on other potential acquirers.  Third, it could antagonize potential customers or business partners who view themselves as competitors of the corporate VC. Fourth, corporate VC divisions often receive an annual allocation of dollars to invest, as opposed to an aggregate commitment of dollars that a fund receives to invest during the fund’s investment period, which means that the availability of follow-on funding may be tied to the financial capacity and whims of the parent company. And finally, a strategic may set the valuation higher than what the market will bear, which could make it difficult for the company to secure co-investors, which in turn could leave the company under-funded and, as mentioned just above, could leave the company vulnerable if the corporate VC parent isn’t able or interested in making follow-on investments.

Final Thought

So back to Fred Wilson’s choice words for corporate VCs.  Perhaps the root of the antagonism is the tendency for corporate VCs to drive up valuations, which makes deals more expensive for institutional funds and may crowd them out of certain deals entirely.  Wilson sort of implied as much when he stated in the same interview that a startup would only do a deal with a corporate VC if it couldn’t secure funding elsewhere or if the corporate VC was paying a higher price than he would pay.

On October 26, 2016, the Securities and Exchange Commission adopted final rules intended to make intrastate and regional offerings more viable pathways for smaller raises. The new rules (i) amend Rule 147 to simplify the “doing business” SEC logostandard, (ii) create a new intrastate exemption, Rule 147A, which allows use of the internet and other forms of general solicitation as well as out-of-state incorporation and (iii) increase the 12-month offering cap under Rule 504 from $1 million to $5 million.  This post will address all three of these significant reforms.

Amendments to Rule 147

The statutory exemption for intrastate offerings appears in Section 3(a)(11) of the Securities Act of 1933, which exempts from registration “any security … offered and sold only to persons resident within a single State … where the issuer … [is incorporated] and doing business within … such State …”.  Rule 147 is the safe harbor for Section 3(a)(11), and has not been amended in any significant way since its adoption in 1974.

One of the primary impediments to the use of Rule 147 has been the difficult test that issuers have been required to meet in order to establish sufficient nexus with the state in which the offering is made. To satisfy the doing business test, issuers were required to derive at least 80% of their consolidated gross revenues in-state, have at least 80% of their consolidated assets in-state and use at least 80% of net proceeds from the offering in connection with the operation of an in-state business.  Requiring an issuer to derive most of its revenue, maintain a majority of its assets and invest most of the capital it raises all in one state could create inefficient constraints for many emerging companies to operate and grow.

The final rules modify the current “doing business” in-state requirements in Rule 147 by requiring issuers to satisfy only one of four specified tests. Under amended Rule 147 (and new Rule 147A), in order to be deemed to be “doing business” in a state, an issuer will have to satisfy only one of the following requirements:

  • 80% of consolidated assets located in-state;
  • 80% of consolidated gross revenues derived from operation of a business or of real property located in or from the rendering of services within such state;
  • 80% of net offering proceeds intended to be used, and are in fact used, in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state; or
  • Majority of employees are in such state.

The final rules take a side-by-side approach, adopting amendments to modernize Rule 147 and also establishing a brand new intrastate offering exemption under the Securities Act, designated Rule 147A, which will be similar to amended Rule 147 but with no prohibition on offers to non-residents and allowing issuers to be incorporated out of state. Under the final rules, issuers will be able to choose between utilizing Rule 147 and Rule 147A for intrastate offerings based on their preferences for communicating with investors. The SEC elected to keep and modify Rule 147 as a safe harbor under Section 3(a)(11) to allow issuers to continue to rely on state law exemptions that are conditioned upon compliance with Section 3(a)(11) and Rule 147.

New Rule 147A

In addition to the overly restrictive doing business requirements, two other features have served to dissuade issuers from taking advantage of the intrastate exemption. The first is the requirement that issuers be incorporated in-state, which disqualifies many emerging companies all over the country that choose to incorporate in management friendly confines like Delaware (or are forced to do so by their investors).  Second is the prohibition on making offers to out-of-state residents, even if sales are made only to in-state residents, which effectively eliminates the use of the internet, social media and other methods of general solicitation in conducting the offering.

New Rule 147A corrects these shortcomings. First, there is no requirement that the issuer be incorporated in-state.  So, for example, a company incorporated in Delaware that has its principal place of business in New York may sell to New York Delawareinvestors.  Second, it permits offers to out-of-state residents so long as all sales are limited to in-state residents, and more broadly allows general solicitation and general advertising (including use of unrestricted websites).  When using space-constrained social media like Twitter to solicit, the issuer may use an active hyperlink to the offering disclosure.   Rule 147A does require, however, prominent disclosure in all offering materials that sales will be made only to residents of the same state as the issuer.

Features Common to Amended Rule 147 and New Rule 147A

Both amended Rule 147 and new Rule 147A contain the following common features:

  • Issuer “principal place of business” must be in-state, and issuer must satisfy at least one “doing business” requirement that would demonstrate in-state nature of issuer’s business;
  • New “reasonable belief” standard in determining purchaser’s residence;
  • Issuers must obtain written residency representation from each purchaser;
  • Resales limited to state residents for a six month period;
  • Integration safe harbor that would include prior offers or sales of securities by the issuer, as well as certain post-offering offers or sales; and
  • Legend requirements to offerees and purchasers about resale limits.

Amendment to Rule 504

Rule 504 of Regulation D exempts from registration offers and sales of up to $1,000,000 of securities in any rolling 12-month period. Two of Rule 504’s general requirements, the prohibition on general solicitation and securities sold being deemed “restricted” securities, do not apply if the offer and sale are made:

  • exclusively in one or more states that provide for the registration of the securities, and require the public filing and delivery to investors of a disclosure document before sale;
  • in one or more states that require no registration, filing or delivery of a disclosure document before sale, if the securities have been registered in at least one state that provides for such registration, filing and delivery; or
  • exclusively according to state law exemptions that permit general solicitation so long as sales are made only to “accredited investors”.

Several states have instituted coordinated review programs to streamline the state registration process for issuers seeking to undertake multi-state registrations in reliance upon Rule 504. Because these offerings are typically limited to a few states, review of these offerings is undertaken on a regional basis. These programs establish uniform review standards and are designed to expedite the registration process, thereby potentially saving issuers time and money.

The new rules amend Rule 504 to increase the aggregate amount of securities that may be offered and sold from $1 million to $5 million. The SEC is hoping that the higher offering cap will promote capital formation by increasing the flexibility of state securities regulators to implement coordinated review programs to facilitate regional offerings.

The final rules repeal Rule 505 of Regulation D, which exempts offers and sales of up to $5 million and is now rendered obsolete by amended Rule 504. The rules also apply bad actor disqualifications to Rule 504 offerings, consistent with other rules in Regulation D.

Effective Dates

The foregoing reforms have the following effective dates:

  • Amended Rule  147: 150 days after publication in the Federal Register
  • New Rule 147A:  150 days after publication in the Federal Register
  • Amended Rule 504:  60 days after publication in the Federal Register
  • Repeal of Rule 505:  180 days after publication in the Federal Register

In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing by angels and early stage VCs.  In Part I, I addressed seed rounds structured as equity, the two most common forms of which involve the issuance of modified versions of preferred stock designated as Series AA or Series Seed.

As I explained in Part I of this Series, the more complex, time consuming and expensive to negotiate deal documentation associated with Series A and later rounds can be justified when a company is raising several millions of dollars, but makes little sense for a seed round of a few hundred thousand dollars. The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents.  This Part II of the Series will address seed round structures fashioned as convertible notes or alternative instruments that functionally resemble convertible notes.

Convertible Notes

Convertible Notes advance the objective of deal document simplification and cost effectiveness even more than Series Seed and Series AA structures because they allow parties to defer negotiation of the thorniest issues to a next significant equity round.

Technically, convertible notes provide for payment of principal and interest on a maturity date of typically one to two years, but in reality these notes are not expected to be repaid.  Instead, the principal and interest is intended to get converted into the security issued in a next equity round meeting some minimum dollar amount, albeit typically at a discount to the next round’s pricing in an effort to reward the seed investors for the additional risk they’re assuming by investing at a more vulnerable juncture for the company.   In recent years, it has also become common for the valuation at which the seed investment is converted to be capped, in which case  the conversion price would be the lower of the discounted rate or the price based on the capped valuation.  Less sophisticated angels will focus on the interest rate and try to negotiate that higher; those more experienced in startup investing will understand that the conversion terms will have a far more significant impact on the value of their investment and thus focus on discount and cap.

Another way the practical reality departs from the technical is that if a qualified funding has not occurred and the note is not converted prior to maturity, the note is rarely paid at that point. Instead, a difficult conversation takes place between the company and the seed investor in which the company seeks to extend the maturity date.  The price for any such extension is usually in the form of more generous conversion terms for the investor.

Simple Agreement for Future Equity or “SAFE”

In 2013, the legendary accelerator Y Combinator introduced an alternative to theY Combinator convertible note which it called a Simple Agreement for Future Equity or “SAFE”. Although it looks like a convertible note in that it converts the investment amount into the next round’s security and typically features discounts and caps, it is not a promissory note for the simple reason that, unlike a note, there is no basic promise to repay the invested amount.  Essentially, a SAFE is a contract that provides for the type and amount of shares that will be issued in a qualified next round, if there is such a round, along with an option to receive either common stock or a return of the invested amount if the company is acquired prior to a qualified round.

The absence of a payment on maturity date feature is a major advantage to companies and a serious drawback for seed investors relative to convertible notes in that it removes an important source of leverage that the investor would otherwise have as a convertible noteholder if the company has been unable to raise a qualified next round before maturity. If that were to happen in the context of a convertible note, the note holder could demand payment and force the company into dissolution or bankruptcy.  That leverage would allow the investor to negotiate for an increase in the conversion discount or decrease in the cap.

The lack of a maturity date means that the SAFE is really only appropriate for a technology based startup that could scale quickly and achieve rapid growth. Conversely, a non-technology based startup could theoretically prosper and enrich its shareholders without the SAFE holder receiving anything for a long time, if ever.  In other words, a company may be able to grow organically without the need to do another significant raise, and may even be able to dividend out cash to its stockholders (not shared by the SAFE holders because they’re not yet stockholders), and the SAFE holders would not receive anything until the company gets acquired, if ever.

Keep it Simple Security or KISS

The Keep it Simple Security or KISS was created by another accelerator, 500 500 startupsStartups, in 2014, in reaction to resistance to SAFEs because of their lack of investor protections. KISSes more closely resemble traditional convertible notes, i.e., promise to pay on a maturity date, etc., and contain certain other important investor protections such as an option at maturity to convert into a newly created Series Seed (see my discussion of Series Seed in Part I of this two-part series), information rights and the right to participate in future funding rounds.  But inasmuch as the impetus for convertible note alternatives was a desire for simplification, cost effectiveness and time saving, it’s unclear whether the KISS, which actually contains a few more deal points to negotiate than convertible notes, will gain significant traction among seed stage companies and investors.

The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build serversinfrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the first outside round of investment in an Internet-based startup was typically a Series A round of $3 million or more from one or more VCs. With the emergence of open-source software, however, startups for the most part were no longer forced to acquire software packages bundled with hardware. Another issue, though, was that startups had to acquire and maintain bandwidth to accommodate peak loads, resulting in expensive underutilization. But this all changed with the advent of cloud computing, which enabled entrepreneurs to launch an Internet startup with minimal upfront IT costs and to pay only for used bandwidth. In real dollars, the cost of starting up has declined from a few million dollars to a few hundred thousand dollars.

With the precipitous drop in the cost of launching an Internet-based startup came a significant rise in interest in seed investing by angels and early stage VCs. But the typical Series A document package (amended and restated certificate of incorporation, stock purchase agreement, voting agreement, cloudinvestor rights agreement, right of first refusal and co-sale agreement) is complex, time consuming and expensive to negotiate, and contains several economic, management and exit provisions that don’t become relevant until much later (e.g., if and when the company goes public). This level of complexity can be justified when a company is raising several million dollars, but not so for a seed round of a few hundred thousand.

The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents. Seed rounds are either structured as a simplified version of a priced Series A preferred stock or as debt that converts into the security issued in a next round of equity, typically at a discount. This Part I of a two part blog series on seed round investing will focus on priced equity structures; Part II will address convertible debt.

There are currently two alternative open sourced sets of equity seed round deal documents to choose from, each with the common goals of term simplification, cost reduction, transaction time compression and document standardization. Both feature terms similar to those found in a typical Series A deal, but stripped down from the robust set of economic, voting and exit rights usually contained in a Series A. The two deal document products are:

Series AA: Created by Cooley cooleyfor accelerator Techstarstechstarsfenwick
Series Seed: Created by Fenwick & West

The main terms of Series AA and Series Seed are as follows:

1X Non-Participating Preferred: Both Series Seed and Series AA feature 1X non-participating preferred stock, meaning on a sale of the company the investor must choose between his liquidation preference of 1X (i.e., one times his investment amount) or the proceeds he would receive on an as converted basis, but not both. In other words, the investor calculates which would yield the bigger payout and choose that one. On the other hand, participating preferred would give the investor two bites of the apple: first his liquidation preference, and then his share of remaining proceeds as a common shareholder on an as converted basis.

Antidilution Protection: Series Seed provides no antidilution protection. Series AA, however, has broad based weighted average antidilution protection. Most notably, antidilution protects the investor from the economic dilution resulting from down rounds. Weighted average is the type of protection that is more fair in that it factors in the dilutive effect of the actual down round (i.e., the conversion price doesn’t adjust all the way down to the lower down round price but rather takes into consideration the number of additional shares issued at the lower price relative to the number of shares outstanding), and broad based requires inclusion in the number of shares outstanding all outstanding options and options reserved for issuance (as opposed to narrow based which would not include options).

Board Composition: Both Series AA and Series Seed provide for boards consisting of 2 common and one preferred, except that Series AA conditions the preferred board member on the Series AA shares constituting at least 5% of the outstanding equity on a fully diluted basis.

Protective Provisions: These are veto rights in favor of the preferred. Series AA gives vetos over only changes to the Series AA. Series Seed includes vetos over changes in the Series AA, but also includes vetos over mergers, increasing or decreasing authorized shares of any class or series, authorizing any new class or series senior to or on a parity with any series of preferred, stock redemption, dividends, number of directors and liquidation/dissolution.

Right of First Offer on New Financings: Both Series Seed and Series AA give investors the right to purchase their pro rata share of new issuances.

Right of First Refusal: Series Seed gives investors a right of first refusal on shares held by key holders. Series AA does not.

Drag Along Rights: Series Seed gives Series Seed holders and founders the right to require common holders to include their shares or vote for any transaction approved by the board, by a majority of the common and by a majority of the Series Seed. No drag along in the Series AA.

So what standard Series A terms are missing from Series Seed and Series AA? Missing are dividend preference (not a big deal here inasmuch as the overwhelming majority of startups will not pay out dividends), registration rights and tag-along rights (also not a big deal inasmuch as founders rarely have an opportunity to sell their shares).

Overall, Series Seed and Series AA are worthy efforts to simplify terms and reduce transaction costs. There will certainly be situations, however, where investors will resist the weaker investor protections such as the absence of participating preferred and anti-dilution protection and stripped down protective provisions. Any effort to negotiate some terms back in will undercut the objective of diversification and simplicity.

On July 5, the House of Representatives passed a watered down version of the Fix Crowdfunding Act (the “FCA”) that was initially introduced in March.  The bill seeks to amend Title III of the JOBS Act by expressly permitting “crowdfunding vehicles” and broadening the SEC registration exclusion, but leaves out three important reforms that were part of the original version of the FCA introduced in March and about which I blogged about here. The House bill is part of the innovation initiativeInnovation Initiative which was jointly launched by Majority Leader Kevin McCarthy and Chief Deputy Whip Patrick McHenry.  The bill was passed by the House with overwhelming bipartisan support, so it’s likely to be passed quickly by the Senate.  This post summarizes what was left in the bill from the original and what was dropped from it.

What’s In: Special Purpose Vehicles and the Section 12(g) Registration Exclusion

Special Purpose Vehicles

Title III of the JOBS Act excludes from crowdfunding eligibility any issuer that is an “investment company”, as defined in the Investment Company Act, or is exempt from investment company regulation by virtue of being owned by not more than 100 persons. Several accredited investor-only matchmaking portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in which investors invest into a special purpose vehicle (“SPV”), which in turn makes the investment into the issuer as one shareholder. Because Title III did not permit issuers to sell shares through SPVs, many growth-oriented startups may be dissuaded from engaging in Title III crowdfunding offerings if they expect to raise venture capital in the future, as VC funds don’t like congested cap tables.

The FCA would create a new class of permitted crowdfunding issuer called a “crowdfunding vehicle”, which is an entity that satisfies all of the following requirements:

  • purpose (as set forth in its organizational documents) limited to acquiring, holding and disposing crowdfunded securities;
  • issues only one class of securities;
  • no transaction-based compensation received by the entity or any associated person;
  • it and company whose securities it holds are co-issuers;
  • both it and company whose securities it holds are current in ongoing Regulation Crowdfunding disclosure obligations; and
  • advised by investment adviser registered under Investment Advisers Act of 1940

Section 12(g) Registration Exclusion

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) of the Securities Exchange Act that triggers registration with the SEC, which subjects the company to periodic reporting obligations (e.g., 10-Ks, 10-Qs, etc.). It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC provided that shareholders that purchased crowdfunded shares would be excluded from the shareholder calculation under Section 12(g), but conditioned the exclusion on, among other things, the issuer having total assets of no more than $25 million.

The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The original version of the FCA would have removed from the 12(g) exclusion the condition that an issuer not have $25 million or more in assets.

The version of the FCA passed by the House removes the $25 million asset condition but replaces it with two other conditions: that the issuer have a public float of less than $75 million and annual revenues of less than $50 million as of the most recently completed fiscal year.

What’s Out: Issuer Cap, Intermediary Liability and Testing the Waters

The House version of the FCA unfortunately dropped a few of the reforms that were contained in the original version introduced in March, apparently the price paid for securing votes of opponents of the FCA.

Issuer Cap                                                                                    

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The original version of the FCA would have increased the issuer cap from $1 million to $5 million in any rolling 12 month period. This was scrapped from the House version.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. Title III also exposes an intermediary (i.e., funding portal or broker-dealer) to possible liability if an issuer made material inaccuracies or omissions in its disclosures on the crowdfunding site. It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The original version of the FCA would have clarified that an intermediary will not be considered an issuer for liability purposes unless it knowingly made a material misstatement or omission or knowingly engaged in any fraudulent act. Presumably then, as proposed, a plaintiff would have had the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time. The House version dropped this relief for intermediaries.

Testing the Waters

Securities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC, out of concern that unscrupulous companies could prime the market before any disclosure became publicly available.

The original version of the FCA would have allowed Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest is highlighted to potential investors in the information filed with the SEC. This too was left out of the version approved by the House.

Although it was disappointing to see the foregoing three reforms dropped from the eventual House bill, half a loaf is better than no loaf. Perhaps the dollar cap, intermediary liability and testing the waters could be revisited at some point down the road.

Ever since the Federal securities laws were enacted in 1933, all offers and sales of securities in the United States had to either be registered with the SEC or satisfy an exemption from registration. The commonly used private offering exemption, however, prohibited any act of general solicitation. The JOBS Act of 2012 JOBS Act signingcreated a new variation to the private offering exemption under Rule 506 of Regulation D that permits online offers and other acts of general solicitation, but issuers selling under this new Rule 506(c) may sell only to accredited investors and must use reasonable methods to verify investor status.

Starting today, companies will be permitted to offer and sell securities online to anyone, not just accredited investors, without SEC registration. This is pursuant to Title III of the JOBS Act and the final crowdfunding rules promulgated by the SEC called Regulation Crowdfunding.  The potential for Title III Crowdfundingequity crowdfunding is enormous and potentially disruptive.  It is believed that approximately 93% of the U.S. population consists of non-accredited investors who have an estimated $30 trillion stashed away in investment accounts.  If only one percent of that amount got redirected to equity crowdfunding, the resulting $300 billion dollars invested would be ten times larger than the VC industry.  Hence the potential.

The reality, however, is not as encouraging. In the interest of investor protection, Congress in JOBS Act Title III and the SEC in Regulation Crowdfunding created a heavily regulated and expensive regime that many fear will severely limit the prospects of equity crowdfunding.  The rules include a $1 million issuer cap, strict dollar limits on investors, disclosure requirements and funding portal liability, registration and gatekeeper obligations.

wefunderSEC registration for funding portals began on January 29. But as of last week, only five portals had completed the registration process: Wefunder Portal LLC, SI Portal LLC dba Seedinvest.com, CFS LLC dba seedinvestCrowdFundingSTAR.com, NextSeed US LLC and StartEngine Capital LLC.  Over 30 others are apparently awaiting approval.  Of the two best known and most successful non-equity crowdfunding portals, only Indiegogo has declared an intention to get in the Title III funding portal business; Kickstarter has so far declined.

The likely reason for the apparent lackluster funding portal activity so far is the restrictive regulatory regime referred to above, the burden of which falls disproportionately on funding portals. None of this should be a surprise.  Several key aspects of the crowdfunding rules were contentiously debated at the Congressional level and later during SEC rulemaking.  Opponents asserted that retail equity crowdfunding is an invitation for massive fraud against those who can least afford it and so believe Title III is a mistake.  Proponents advocated against several of the more restrictive rules but conceded on these points in order to get Title III passed.  And because the legislation itself was so prescriptive and granular, there was only room for marginal improvement in the final SEC rules relative to those proposed in the initial release.

Regrettably, there’s painful precedent for securities exemptions so restrictive that no one used them.  Regulation A allowed for a mini-public offering through a streamlined filing with the SEC.  But issuers were capped at $5 million and were forced to go through merit review in each state where they offered the securities.  The result:  hardly anyone used Reg A.  In recognition of this, Title IV of the JOBS Act reformed Reg A by increasing the cap to $50 million and, more importantly, preempting state blue sky review for so-called Tier II offerings which must satisfy investor protection requirements.

In an effort to prevent Title III from a fate similar to pre-reform Reg A, legislation has been introduced in Congress to increase the issuer cap, allow for special purpose vehicles, remove the $25 million asset cap on the exemption from the 500 shareholder SEC registration trigger and allow issuers to test the waters. See my previous blog post here on the proposed Fix Crowdfunding Act.

It may seem somewhat premature to advocate for reform when the rules have barely gone live. But given the time necessary for the legislative process to run its course, and inasmuch as the indications are already fairly clear that both issuers and funding portals remain skeptical about Title III crowdfunding, it makes sense to begin the process now of introducing necessary common sense reform of Title III.