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

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.

SEC 2August 6, 2015 was a productive day for the Staff of the Securities and Exchange Commission’s Division of Corporation Finance on the issue of the prohibition on general solicitation in the context of online private offerings under Rule 506(b). My last blog post, entitled “It’s Complicated”: Establishing “Preexisting Relationships” with Prospective Investors, analyzed the Citizen VC no-action letter delivered that day dealing with establishing pre-existing relationships with investors online to demonstrate the absence of general solicitation in a Rule 506 offering. On the same day, the Staff provided additional guidance on the issue of general solicitation in the form of new Compliance and Disclosure Interpretations (“CDIs”).

Background

Rule 502(c) promulgated under the Securities Act of 1933, as amended, prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings intended to be exempt from registration under Regulation D. The prohibition on general solicitation has been perceived as perhaps the single biggest obstacle to raising capital in the private general solicitationmarkets. In September 2013, the SEC released final rules for a new offering exemption contained in Rule 506(c) that permits general solicitation efforts, provided securities are sold only to accredited investors and the issuer uses reasonable methods to verify that each purchaser is an accredited investor. What constitutes reasonable verification methods will depend on the facts and circumstances of each case, but generally involves a more intrusive inquiry than an offering under traditional Rule 506(b), which is why most private offerings are still being conducted under Rule 506(b) despite the prohibition on general solicitation.

New Guidance

The new CDIs come in the form of Q&As, some of which provide official confirmation of existing practice while others provide new flexibility in online offering activities. Here’s an outline of the new CDIs:

Factual Business Information

Factual business information that does not condition the public mind or arouse public interest in a securities offering is not deemed an offer and may be disseminated widely. In the new guidance, the Staff stated that factual business information is a facts and circumstances concept, but is typically limited to information about the issuer’s business, financial condition, products or services, and generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.

Angel Investors

angelThe Staff confirmed that it is possible for angel investors who have a relationship with an issuer to make introductions to other prospective investors in their personal network and share information about a securities offering without such issuer being deemed to engage in a general solicitation. Whether or not a general solicitation has occurred requires a facts and circumstances analysis, but an issuer could rely on such network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Establishing “Pre-Existing” and “Substantive” Relationships

A relationship with an offeree is “pre-existing” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the relationship was formed prior to the commencement of the securities offering or, alternatively, when it was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participating in the offering. Similarly, a relationship is “substantive” for purposes of demonstrating the absence of general solicitation under Rule 502(c) when the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

Demo Days

Whether or not “demo days” or “pitch days” constitute general solicitation is also – you guessed it – a factsimages12NM2J0D and circumstances question. If the presentation does not discuss the securities being offered, the securities laws are not implicated. Where the presentation does discuss the securities being offered, however, attendance at the demo day or pitch day should be limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or who have been contacted through an informal, personal network as described above under “Angel Investors”. For more on this issue involving demo days, see my previous blog post “Will Your Demo Day Presentation Violate the Securities Laws?”.

In my last post, I blogged about online funding platforms. In that post, I described the typical model of indirect investing through a special purpose vehicle (“SPV”) with the platform sponsor taking a carried interest in the SPV’s profits from the portfolio company and no ourcrowdtransaction fee, as a means of avoiding broker-dealer regulation. I also discussed the concept of a pre-screened password protected member-only website as a means of establishing a preexisting fundablerelationship with prospective investors and thus avoiding the use of any act of “general solicitation,” which would otherwise violate the rules of the registration exemption under Rule 506(b).

SEC logoIn a no-action letter dated August 6, 2015 entitled Citizen VC, Inc., the SEC has provided important guidance on the procedures needed for an online funding platform to establish the kind of preexisting relationship needed to avoid being deemed to be engaged in general solicitation. As an aside, the concern over general solicitation and preexisting relationships is relevant to offerings under new Rule 506(b), but not under Rule 506(c).   Despite the creation in 2013 of an exemption under new Rule 506(c) pursuant to the JOBS Act for general solicitation offerings in which sales are made only to accredited investors, most online funding platforms continue to prefer to conduct portfolio company offerings indirectly through SPVs under Rule 506(b), despite the prohibition on general solicitation, primarily because of the additional requirement under Rule 506(c) that issuers use reasonable methods to verify accredited investor status.

In its request for a no-action letter, Citizen VC described itself as an citizen vconline venture capital firm that facilitates indirect investment in portfolio companies (through SPVs) by pre-qualified, accredited and sophisticated “members” in its site. It asserted to have qualification procedures intended to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the website. Anyone wishing to investigate the password protected sections of the site accessible only to members must first register and be accepted for membership. To apply for membership, prospective investors are required to complete an “accredited investor” questionnaire, followed by a relationship building process in which Citizen VC collects information to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks related to an investment. It does so by contacting the prospective investor by phone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist Citizen VC in understanding the investor’s sophistication, utilizing third party credit reporting services to gather additional financial information and credit history information and other methods to foster online and offline interactions with the prospective investor. In the request letter, Citizen VC asserted that the relationship establishment period is not limited by a specific time period, but rather is a process based on specific written policies and procedures created to ensure that the offering is suitable for each prospective investor.

Citizen VC stated in its request letter that prospective investors only become “members” and are given access to offering information in the password protected section of the site after Citizen VC is satisfied that the prospective investor has sufficient knowledge and experience and that it has taken reasonable steps necessary to create a substantive relationship with the prospective investor. Once a sufficient number of qualified members have expressed interest in a particular portfolio company, those members are provided subscription materials for investment in the SPV formed by Citizen VC to aggregate such members’ investments, the sale of interests of such SPV is consummated and the SPV then invests the funds, and becomes a shareholder of, the portfolio company.

In its request letter, after providing the foregoing background, Citizen VC asked the SEC staff to opine that the policies and procedures described in the letter are sufficient to create a substantive, pre-existing relationship with prospective investors such that the offering and sale on the site of interests in an SPV that will invest in a particular portfolio company will not constitute general solicitation.

sec no-actionIn its no-action letter, the SEC staff concluded that Citizen VC’s procedures were sufficient to establish a preexisting relationship and do not constitute general solicitation. It stated that the quality of the relationship between an issuer and an investor is the most important factor in determining whether a “substantive” relationship exists and noted Citizen VC’s representation that its policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff went on to say that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship, and that whether an issuer has sufficient information to evaluate a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances of each case. The staff also based its conclusion on Citizen VC’s representation that an investment opportunity is only presented after the prospective investor becomes a “member” in the site.

An argument could be made that SPV-based online funding platforms represent the future of VC investing. The Citizen VC no-action letter provides valuable guidance relating to the establishment of the kind of substantive relationship with prospective investors needed to enable the online funding platform to conduct Rule 506(b) offerings without being deemed to engage in general solicitation.

Lately I’ve been approached by current and prospective clients about ourcrowdonline funding platforms, either by folks interested in forming and operating them or those interested in raising capital through them. There seems to be a lot of confusion surrounding how they work and what the legal issues are, so here’s my attempt to bring some clarity to this topic.

Quite simply, an online funding platform is any website that seeks to fundableconnect issuers seeking capital with investors willing to invest. Historically, the prohibition on general solicitation in private offerings meant as a practical matter that an issuer was limited to raising capital only from those with whom it had a preexisting relationship. In fact, the prohibition on general solicitation was considered by many to be the most significant obstacle to private capital formation. It’s for this reason that many private issuers seek the services of a placement agent, on whose preexisting relationships an issuer could piggyback. But securing the services of a decent placement agent by a startup looking to make a small offering (e.g., less than $1 million) could be daunting. Commonly referred to as crowdfunding, the phenomenon of online funding platforms is essentially the internet coming to the capital raising industry, which has the potential to transform it the same way the internet disrupted the publishing, retail and transportation industries.

pitchbookOnline funding platforms also have the potential to address another related problem. If you’re a startup located outside of the three major venture hubs – Bay Area, New York Metro and Boston – your chances of raising capital are even slimmer. According to PitchBook’s analysis of second quarter 2015 venture capital activity by region, those three regions accounted for nearly half of total global venture capital invested. Funding platforms have the potential to reach neglected regions of the world.

So, if you’re looking to create and operate an online funding platform, there are two legal issues to be concerned about: the prohibition on general solicitation, and broker dealer regulation.

General Solicitation

The earliest online funding platforms were launched in the ‘90s long before the JOBS Act created an exemption for private offerings using general solicitation. So from their inception, funding platforms sought to avoid engaging in any act that could be construed to fall within the prohibition. And even to this day, nearly two years after the accredited investor only exemption under Rule 506(c) which allows general solicitation, most funding platforms still rely on the old exemption under Rule 506(b) which prohibits it.

So how does one use the internet to conduct an offering without engaging in a general solicitation? The answer lies in the concept of the preexisting relationship, which a platform may establish under the right circumstances through a process of pre-screening, password protection and cooling off. The practice was blessed by the SEC in its 1998 Lamp Technologies no-action letter, in which the SEC staff found that the pre-qualification of accredited investors and posting of a notice concerning a private fund on a website administered by Lamp Technologies, Inc. (“LTI”) that is password-protected and accessible only to pre-screened accredited investor subscribers would not involve general solicitation. Subscribers who pre-qualified as accredited investors and paid a subscription fee would receive a password granting them access to the site, and subscribers were then subject to a 30-day cooling off period during which they could not invest. The SEC staff noted that (i) both the invitation to complete the questionnaire and the questionnaire itself would be generic in nature and would not reference any of the investment opportunities on the site, (ii) the password-protected site would be accessible to an investor only after LTI confirmed accredited investor status, and (iii) a potential investor could purchase securities only after the 30-day cooling-off period.

Broker-Dealer Regulation

Funding portals must choose between two alternative but mutually exclusive business models: broker-dealer and venture fund. In the former, investors purchase the securities of, and invest directly in, the operating company; in the latter, the platform organizers form a special purpose vehicle (“SPV”), investors buy shares in the SPV and the operating company closes the round with only one investor (the SPV). Among other things, the choice of business model has enormous consequences for the operating company’s cap table.

Many sponsors of funding platforms structure themselves so as to not be deemed to be a “broker-dealer”, which would mean having to register with the SEC as a broker-dealer and be subject to reporting, disclosure and other burdensome regulations.

Under Section 3(a)(4) of the Securities Exchange Act of 1934, a “broker” is defined as any person that is “engaged in the business of effecting transactions in securities for the account of others.” According to the SEC, a person “effects transactions in securities” if he participates in such transactions “at key points in the chain of distribution”, and that a person is “engaged in the business” if he receives transaction-related compensation and holds himself out as a broker. The determination as to whether an entity is acting as a “broker” requires a facts and circumstances analysis, but the SEC attributes great weight to whether transaction-based compensation is paid.

Some funding platforms are operated by registered broker-dealers, or are owned, operated by or partnered with registered broker-dealers. These platforms facilitate sales of the operating company’s securities directly to accredited investors. The broker-dealer model platforms receive transaction-based compensation, typically consisting of a percentage of the funds raised, generally ranging from one to ten percent, depending on the offering amount and type of deal.

Other funding platform operators avoid broker-dealer regulation like the plague. Before the JOBS Act, the SEC provided some guidance in the form of no-action letters that conditioned relief from broker-dealer regulation on the platform not providing investment advice, receiving transaction-based compensation, participating in negotiations or holding investor funds. Section 201 of the JOBS Act provides an explicit broker-dealer exemption for online platforms to broker capital raising transactions under Rule 506 (even with general solicitation), provide ancillary services other than investment advice and provide standardized deal documents so long as the platform does not receive transaction-based compensation or handle customer funds or securities and is not a “bad actor.”

In 2013, the SEC gave further guidance to investment fund model platforms in the form of two no-action letters, FundersClub and AngelsList.

FundersClub sources start-ups for its affiliated funds or SPVs to invest in and fundersclubthen posts information on its website that is only available to FundersClub members, all of whom are accredited investors. The SPV relies on Rule 506 to conduct an offering in the SPV. FundersClub negotiates the terms of the SPV’s investment in the start-up. FundersClub does not receive any transaction-based compensation other than administrative fees; instead, it receives a carry of 20% or less of the profits of the SPV but never exceeding 30%. In stating that it would not recommend enforcement action under Section 15(a)(1) of the Exchange Act, the Staff noted that FundersClub’s activities appear to comply with Section 201 of the JOBS Act, in part because it receives no compensation in connection with the purchase or sale of securities.

In AngelList, the SEC staff noted AngelList’s platform must be “exclusively available” to accredited investors and that AngelList may not receive any transaction-based compensation or solicit investors outside of the website itself. In AngelList, a “lead angel” would source the start-ups and structure terms in exchange for a back-end carried interest that would be shared between an AngelList-affiliated investment adviser and the lead angel. The significance of this letter appears to be in not treating back-end carried interest as transaction-based compensation.

Your company is invited by a local meetup group to present at demo day with other startups, and you accept.  The group announces the demo day lineup of startups in an e-blast, on its website, on its Facebook page and through banner ads on a tech e-zine.  On demo day, the room is packed and you nail your presentation.  The following month, you close on an investment with a few angels who attended your demo day presentation.  Have you just violated the securities laws?

For years, startups and emerging companies have been presenting at capital raising forums organized by accelerators, meetup groups, professional organizations and other similar groups and securing funding from investors they met at such events. But it has never been clear to securities lawyers how issuers could do so without violating the ban on general solicitation in private offerings.

Historically, startups and emerging companies looking to raise capital in the private markets have relied overwhelmingly on Rule 506 of Regulation D, primarily because there is no limit on the amount that may be raised and because the shares offered and sold are deemed “covered securities” and thus exempt from the most onerous requirements under state securities laws.  The ban on general solicitation in Reg D offerings is contained in Rule 502 of Reg D, which states explicitly that:

“[N]either the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

  • Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
  • Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising”

Despite the popularity of Rule 506 offerings, growing criticism of the Rule’s prohibition on general solicitation as an antiquated and overly burdensome impediment to capital raising led to the passage in 2012 of the JOBS Act, which in part called on the SEC to promulgate final rules that would lift the general solicitation ban (among other reforms).  In September 2013, the SEC issued final rules on a new exemption under Rule 506(c) that permits general solicitation so long as certain additional requirements are met, but also left intact as new Rule 506(b) the traditional private offering exemption with no general solicitation (but without the additional requirements).  See my post on the general solicitation rules here.

Accordingly, companies making private offerings of securities under Rule 506 now have two alternatives:

  • Offerings without general solicitation: May sell to up to 35 non-accredited investors and to an unlimited number of accredited investors, with accredited investors being allowed to self-verify (generally by filling out a standard questionnaire).
  • Offerings with general solicitation:  All purchasers must be accredited investors, and the company must use reasonable methods to verify status.  The Rule includes a non-exclusive, non-mandatory list of documents that a company could review to verify accredited investor status.  These include tax returns, bank statements, brokerage statements and credit reports.  The Rule also allows a company to rely on a written statement provided by a lawyer, CPA, investment advisor or broker dealer.

Now that they have a choice, companies will need to consider carefully which route to take.  General solicitation clearly allows the company to reach a far greater audience.  But there are drawbacks.  The additional accredited investor verification requirements could turn off potential investors because of the intrusiveness associated with having to present tax returns or brokerage statements.  There are increased transaction costs (primarily higher lawyers’ fees) and a slowdown in the deal process.  The additional burdens will get even worse if proposed SEC rules are adopted, which would require companies using general solicitation to file a Form D in advance (currently it must be filed within 15 days following the first sale) and include solicitation materials in the filing.

As mentioned above, it is unclear on what basis companies were able to present at demo day events before September 2013 without violating the general solicitation ban.  The SEC may have chosen to look the other way because the events contribute to economic growth and are typically managed by credible organizers, and thus there has not been any urgency for anti-fraud enforcement.   But it stands to reason that now that there is a legitimate path to general solicitation private offerings, albeit with additional requirements, the SEC may begin scrutinizing demo day events more closely to ensure that those additional requirements are satisfied.  Companies may find themselves on the wrong side of an SEC investigation if:

  • they actually sell shares or their presentation is deemed to be an “offer” of securities;
  • the demo day event is deemed to be a form of general solicitation; and
  • not all purchasers are accredited or the company failed to use reasonable verification methods.

So whether or not a demo day presentation could result in securities exposure will depend on the content of the presentation and the manner in which the event is promoted.

The securities laws define the term “offer” fairly broadly to include every attempt or offer to sell a security for value.  Referring in a presentation to the terms of an ongoing offering, to an offering generally or even to the need and/or desire to raise capital would likely be deemed to be an offer to sell securities, even though under the contract laws of most states it would probably be construed as simply an invitation to make an offer or to begin negotiations.  The SEC has long held that statements are deemed to be “offers” if  they may have the effect of conditioning the market or arousing public interest in an issuer or its securities.

Assuming the presentation is an “offer”, the next question is whether it involved general solicitation.  Demo day organizers typically promote such events on their public website, in print, online or broadcast media and in postings to their social media accounts.  Determining whether or not a communication is a general solicitation requires a facts and circumstances inquiry.  Announcing the event on a medium that is accessible to everyone, such as an unrestricted website or a print or online newspaper, is per se general solicitation under Rule 502(c) (see above).  As to social media, even though the universe of people with access to a social media account may be much more limited than an unrestricted website, there is always the danger that a posting on Facebook or tweet on Twitter could be freely forwarded, and therefore in all likelihood would be considered general solicitation.

As mentioned above, there are solid reasons why companies would choose to structure an offering as one without general solicitation under Rule 506(b).  Doing so would avoid the extra compliance hassle and cost associated with a 506(c) offering (with general solicitation), as well as the difficulty of securing from purchasers the bank or brokerage statements or tax returns, or a third party certification, needed to verify status.

In conclusion, the following could be used as rules of thumb when considering an invitation to present at an event:

  • If the demo day is promoted on an open access website, through any print, online or broadcast media or in postings to social media accounts, the presenting company should either refrain from making any references to capital raising (i.e., limit the presentation to its products and services) or treat the effort as a Rule 506(c) offering by limiting sales of securities to accredited investors and obtaining copies of tax returns, or bank or brokerage statements.
  •  If the demo day is by invitation-only, or promoted through a password-protected website, and directed solely to persons with whom the organizers or the company have a financially substantive preexisting relationship, the company should be free to speak about its securities offering or capital raising needs generally and treat the effort as a Rule 506(b) offering.