In perhaps the only successful bipartisan effort in 2012 to remove barriers to economic growth, Congress passed and the President signed on April 5, 2012 the most comprehensive set of laws to facilitate small company capital raising since the Federal securities laws were first enacted in the 1930s. In a nutshell, the JOBS Act (acronym for the Jumpstart Our Business Startups Act) creates an on-ramp for small company IPOs, removes the prohibition on general solicitation and advertising from certain private offerings, creates a new equity crowdfunding exemption, sharply raises the cap for the small company offering exemption under Regulation A from $5 million to $50 million in any 12-month period and significantly raises the shareholder number trigger for Exchange Act registration. Some provisions are immediately effective, but others require SEC rulemaking.
Outgoing SEC Chairman Mary Schapiro has criticized the JOBS Act for allegedly gutting investor protections, which she believes will lead to an increase in securities fraud. The JOBS Act’s impact on capital raising will depend largely on the choices the SEC makes in fashioning new rules. NYVentureHub will keep readers up to date on SEC rulemaking and other JOBS Act developments. For now, here’s a summary of the key JOBS Act reforms, including important practical implications for startups.
Title I: IPO On-Ramp for “Emerging Growth Companies”
- Background: Small company IPOs have fallen off the cliff over the last ten years. Main culprits are overregulation (think Sarbanes Oxley and Dodd Frank) and the transition to decimalization in the early 2000s (shares trading in one cent tick-sizes instead of larger tick sizes expressed as a fraction), which in turn reduced profitability of making markets in small-cap securities and lowered demand for smaller company stocks which are less liquid. Research indicates that 90% of job creation for public companies occurs after they go public.
- Reform: Relaxation of regulatory burdens associated with going public (e.g., confidential initial registration statement filing, two years of audited financials instead of three, pre-filing offers to investors to “test the waters” without violating “gun-jumping” rules) and phased disclosure and compliance obligations over a period of time following an IPO (e.g., no “say-on-pay votes, no auditor attestation of internal controls, more limited executive compensation disclosure) for companies with less than $1 billion of revenue, newly classified as “Emerging Growth Companies” or EGCs.
- Effectiveness: Immediate.
- Impact on Startups: EGCs will be able to commence the IPO process with a confidential filing with the SEC, allowing them to resolve issues with the SEC privately without exposing their dirty laundry to the media and competitors, and also “test the waters” with potential investors to gauge levels of market interest. EGCs who choose to avail themselves of the relaxed disclosure obligations will avoid the expense, diversion and liability exposure associated with the full-blown SEC disclosure regime, but will need to weigh this benefit against possible stigma inherent in reduced transparency.
Title II: General Solicitation Permitted in Certain Accredited Investor-Only Private Offerings
- Background: Every sale of securities in the U.S. must either be registered with the SEC or be exempt from registration. By far the most popular securities exemption is found in Rule 506 of Regulation D, which exempts certain private offerings that comply with its specific disclosure, qualification and manner of offering requirements, including the prohibition against any general solicitation or advertising.
- Reform: The SEC is instructed to amend Rule 506 to lift the general solicitation and advertising prohibition for any Rule 506 offering where the issuer takes reasonable steps to ensure that all purchasers are “accredited investors”.
- Effectiveness: Upon promulgation of final SEC rules. The SEC released proposed rules on August 29, 2012.
- Impact on Startups: Startups will be permitted to avail themselves of social media, the internet, blogs, email and other communication technologies to disseminate information on their Rule 506 private offerings and reach a potentially wider pool of otherwise qualified investors, provided they meet the accredited investor purchaser requirement. Startups will need to consider the nature and quality of any such means of solicitation in terms of potential impact on their credibility and image.
Title III: Equity Crowdfunding
- Background: Artists, musicians, not-for-profits and even entrepreneurs have raised funds in small amounts from large groups of donors typically through the internet and social media. Some startups have used this crowdfunding technique without violating the securities laws by offering gifts instead of stock.
- Reform: Companies allowed to raise up to $1 million in the form of equity over a 12-month period from an unlimited number of investors, with individual investors limited during any 12 month period to the greater of $2,000 or 5 percent of the investor’s annual income or net worth for investors with net worth below $100,000, and for investors with net worth of at least $100,000, 10 percent of annual income or net worth, not to exceed $100,000 in total. The crowdfunded offering must be conducted through an intermediary registered with the SEC and FINRA, which must provide disclosures to investors. Issuers must file financial statements with the SEC and provide them to investors and intermediaries.
- Effectiveness: The SEC made clear that until they promulgate final rules, equity crowdfunding would violate the securities laws. The JOBS Act requires the SEC to issue rules within 270 days after enactment (January 2013), but the SEC has been behind schedule on rulemaking and has given no indication when it will issue crowdfunding rules.
- Impact on Startups: Crowdfunding creates new alternatives to angel and VC funding transactions and allows startups for the first time to raise small amounts from large groups using the internet and social media. Antifraud rules still apply and exposure is always greater with large numbers of unsophisticated investors. A large base of unsophisticated shareholders also may make corporate governance more difficult (e.g., obtaining requisite shareholder approvals) and the company less attractive to VCs. The limited amounts that may be raised may not justify the expense associated with the financial statement and other disclosure requirements.
Title IV: Increase of Regulation A Offering Cap to $50 Million
- Background: Regulation A under Section 3(b) of the Securities Act allowed small public offerings of less than $5 million if certain conditions were met and filings made. The $5 million offering ceiling, together with the lack of corresponding state “blue sky” exemptions and the offering document requirement, have made the Reg. A exemption an unattractive capital-raising alternative for small companies.
- Reform: The JOBS Act directs the SEC to raise the offering cap to $50 million within any 12-month period and exempt these “Regulation A+” offerings from state blue sky laws (but not state antifraud laws), provided that the securities are offered and sold on a national securities exchange or to a “qualified purchaser” as defined by the SEC. Issuers will need to prepare an offering statement annual audited financial statements and such other periodic disclosures as the SEC may require.
- Effectiveness: Not effective until final SEC rulemaking, for which there is no timeline. A bipartisan bill was introduced in the House in February (H.R. 701) to impose an October 31, 2013 on the SEC deadline to finalize Regulation A rules.
- Impact on Startups: May be more attractive to later-stage companies seeking up to $50 million where the added costs of the offering statement and audited financials are not as proportionately significant as they might be for an earlier stage company, and particularly if selling to unaccredited investors is likely.
Title V: Increase in Private Company Shareholder Cap from 500 to 2,000
- Background: Before the JOBS Act, companies with total assets of at least $10 million were required to register with the SEC under Section 12(g) of the Exchange Act and be subject to its periodic reporting regime if it had any class of equity securities held of record by 500 or more shareholders. The concern with avoiding the shareholder threshold was considered an impediment to small company capital raising, particularly for high growth companies that had raised large amounts in multiple rounds and had compensated employees with stock.
- Reform: JOBS Act sharply raises the shareholder trigger from 500 to 2,000 excluding shareholders who received their shares in equity-based compensation arrangements or in crowdfunding transactions, but provided that no more than 499 are unaccredited investors.
- Effectiveness: Immediate.
- Impact on Startups: High growth startups will have greater flexibility to base decisions about capital raising, equity compensation and timing of “going public” on prudent business and market considerations. The ability of startups to remain private longer will likely lead to more robust trading of such companies’ shares in secondary trading markets, which in turn should cause these companies to seek to place more restrictions on resales of their shares.