Capital Markets Reform

It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

Accredited Investor Definition: Fair Investment Opportunities for Professional Experts Act

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

VC Fund Exemption – Investment Advisor Registration: Developing and Empowering our Aspiring Leaders Act

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder.  VC funds should have the flexibility to be able to buy those shares.  Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an 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. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules.  Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser.  Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board.  Retail investors don’t enjoy these benefits under Reg CF.

Buried in new legislation mainly intended to ease Dodd-Frank restrictions on small banks is an expansion of Regulation A eligibility to include SEC reporting companies. Previously, such companies were not eligible. The new access to Regulation A will create a viable mini-public offering pathway for SEC reporting companies, particularly those not eligible for registering securities on the streamlined Form S-3 registration statement.

Regulation A is an exemption from registration requirements for offerings of up to $50 million in any 12-month period, subject to eligibility, disclosure and reporting requirements.  The exemption, often referred to as Regulation A+, provides for two tiers of offerings: Tier 1 for offerings of up to $20 million and Tier 2 for offerings of up to $50 million, in each case during any 12-month period. Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements, but consequently benefit from preemption of state securities law registration and qualification requirements. As originally adopted, SEC reporting companies were not eligible to use Regulation A+.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which primarily is intended to ease the burdens on smaller banks under Dodd-Frank. Buried in the Act is Section 508, entitled “Improving Access to Capital”, which expands the availability of Regulation A+ by requiring the SEC to remove the requirement that the issuer not be an SEC reporting company. Section 508 also requires the SEC to amend Regulation A+ so that any company subject to Section 13 or 15(d) of the Exchange Act will be deemed to have met the periodic and current reporting requirements of Regulation A+ if it satisfies the Section 13 reporting requirements.

Currently, public companies seeking to conduct small public offerings in the range of up to $50 million would likely register such offering with the SEC through a streamlined registration statement on Form S-3, which has certain significant benefits. Form S-3 is a short-form registration statement which allows the issuer to update the registration statement’s disclosure prospectively through incorporation by reference of the issuer’s subsequently filed current reports on Form 8-K and periodic reports on Form 10-Q and Form 10-K. This “evergreen” feature means that a company generally will not need to file any post-effective amendments to the registration statement, a time and cost saving advantage.

The process of completing a registered offering on Form S-3 is generally quicker and cheaper than even a Reg A+ offering. So as a practical matter, it’s unlikely that S-3 eligible issuers will opt to do a Reg A+ offering over S-3.

But use of Form S-3 is subject to several stringent issuer and transaction eligibility requirements, including that the issuer be organized and have its principal business operations in the United States and that it have a public float, i.e., aggregate market value of common equity held by non-affiliates, of at least $75 million (unless it’s a listed company, limits the offering amount to not more than one-third of the company’s public float during any 12-month period and is not a shell company).

So issuers that are not S-3 eligible may decide that a Reg A+ offering is an attractive alternative for raising up to $50 million. The benefits of Reg A+, even to an SEC reporting company, could be significant: freedom to “test the waters” with investors prior to launch, faster SEC review relative to registered offerings and preemption of state blue sky registration in Tier 2 offerings.

A recent report on the state of Regulation Crowdfunding published by a major crowdfunding advisory firm is cause for both celebration and renewed reform efforts. The $100 million aggregate funding milestone and the prorated year over year growth data indicate that the market, while still in its infancy, is growing at a nice pace. Nevertheless, a closer look at the data suggests that Regulation Crowdfunding in its current framework is not reaching its potential and remains in serious need of reform.

The Report

The 2017 State of Regulation Crowdfunding, published by crowdfunding advisory firm Crowdfund Capital Advisors, contains several helpful points of data and analysis. The data in the report were retrieved from the various forms that are required to be filed by issuers in Regulation CF equity crowdfunding transactions under Title III of the JOBS Act, which are publicly available on the SEC’s EDGAR website. These include offering statements on Form C, amendments to those statements on Form C/A, offering progress updates on Form C-U and annual reports on Form C-AR.

The report could be downloaded for free here. Some of the key findings are as follows:

  • The number of unique offerings increased 267% from 178 in 2016 to 481 in 2017.
  • Proceeds increased 178% from $27.6 million in 2016 to $49.2 million in 2017.
  • As of today, there are $100,072,759 in aggregate capital commitments.
  • The number of successful offerings increased 202% from 99 in 2016 to 200 in 2017
  • The total number of investors in Reg CF investments increased 158% from 28,180 in 2016 to 44,433 in 2017.

The foregoing data need to be put into some context. First, Reg CF only went live on May 16, 2016, and so the year against which 2017 is compared is only slightly over one-half of a calendar year; data from that year should be annualized to reflect the fact that deals were only happening for approximately 65% of the year. Also, on the advice of funding portals, issuers are setting extremely low target offering amounts, in some cases as low as $10,700 (1% of the maximum allowed in any rolling 12-month period). Accordingly, the above data on successful offerings may need to be viewed somewhat skeptically to the extent “successful offering” is determined based on whether or not an issuer exceeded its own stated targeted offering amount.

The report also offers the following points of analysis:

  • The market is growing at a rapid pace.
  • The pace of capital into funded offerings appears to be steady without showing signs of abnormal activity or irrational investor behavior.
  • The rapid increase in the number of offerings and investors proves that there is appetite for Reg CF from both issuers and investors.
  • Given the lack of irregularities or fraud, Reg CF (and the structure under which it provides for transparency) should be advocated by policy makers and government organizations.

The report does not offer data to support the premise of that last point, i.e., that there exists a lack of irregularities or fraud.

But We Still Need Further Reform

While the $100 million milestone should be cheered, there are objective reasons to believe that Reg CF is grossly underperforming as a capital raising pathway and failing to meet its potential. It was intended to democratize startup investment, to enable hundreds of millions of people who were effectively shut out of private offerings because of their lack of accredited investor status to invest in these deals for the first time. It’s believed that over 90% of the U.S. population would fall into that category and that there’s an estimated $30 trillion socked away in their savings accounts. If only 1% of that were to be reallocated to Reg CF deals, we’d be seeing a market of $300 billion dollars, which would dwarf the $72 billion in U.S. VC investment in 2017.

Which leads me to the need for further reform. Much has already been said about the low $1.07 million cap on issuers. Although the cap should certainly be raised to balance out the amount raised with the disclosure, filing and other burdensome requirements as well as to make Reg CF more competitive with other available pathways, the reality is that most Reg CF offerings are not even reaching the existing cap. That suggests that there must be other impediments in the rules that should be addressed to help companies raise permissible amounts.

Chief among these impediments in my view is the exclusion of investment vehicles from Reg CF. 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. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

Reg CF should also be reformed to raise the investment caps for investors. Currently, investors are capped based on their income or net worth, with a separate hard cap irrespective of net worth or income. At a minimum, there should be no hard cap for accredited investors. Makes no sense that Mark Zuckerberg be capped at $107,000.

Finally, under current rules, any Reg CF funded company that crosses a $25 million asset threshold would be required to register with the SEC under the Securities Exchange Act and become an SEC reporting company. This would have the potential to create a perverse incentive for a company not to grow, and seems inconsistent with the spirit of Reg CF, which for the first time allows companies to fund their growth by offering securities to the public without registering with the SEC. The asset threshold triggering Exchange Act registration should either be raised or eliminated.

Although Reg CF is still in its infancy and the data in the report could be read to indicate steady growth in a seemingly healthy emerging market, there is also reason to believe that the market has not even begun to tap its potential, a potential that may never be realized if perceived impediments are not mitigated or removed.

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.

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.

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

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.

Beginning on May 16, issuers for the first time will be able to offer and sell securities online to anyone, not just accredited investors, withoutTitle III Crowdfunding registering with the SEC. The potential here is breathtaking.  Some $30 trillion dollars are said to be stashed away in long-term investment accounts of non-accredited investors; if only 1% of that gets allocated to crowdfunding, the resulting $300 billion would be ten times bigger than the VC industry.   But the onerous rules baked into JOBS Act Title III and the SEC’s Regulation Crowdfunding (the statutory and regulatory basis, respectively, for public equity crowdfunding), leave many wondering if Title III crowdfunding will prove to be an unattractive alternative to other existing exemptions and become a largely underutilized capital raising pathway – a giant missed opportunity.

Patrick_McHenry_OfficialBut help may be on the way. Congressman Patrick McHenry recently introduced new legislation to address certain defects in Title III.  The Fix Crowdfunding Act (H.R. 4855)  would seek to improve the utility of Title III crowdfunding by raising the issuer dollar limit, simplifying the Section 12(g)(6) exemption, clarifying portal liability, permitting special purpose entities to engage in Title III offerings and allowing issuers to “test the waters”.  The House Financial Services Committee’s Subcommittee on Capital Markets recently held hearings on the Fix Crowdfunding Act labeled “The JOBS Act at Four: Examining Its Impact and Proposals to Further Enhance Capital Formation”, with witnesses such as Kevin Laws (Chief Operating Officer of AngelList) and The Honorable Paul S. Atkins (Chief Executive Officer of Patomak Global Partners) testifying.  Congress should pass this proposed legislation, and the sooner the better.

Here’s a summary of the proposed legislation, identifying the defect in the original Title III and the proposed fix.

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 new legislation would increase the issuer cap from $1 million to $5 million in any rolling 12 month period.

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. By comparison, a plaintiff in a Rule 506 offering must allege not just a material misstatement or omission but that the issuer either knew or should have known if it made a reasonable inquiry.  Title III defines “issuer” to include “any person who offers or sells the security in such offering.”  In its final rules release, the SEC considered but refused to clarify that intermediaries were not issuers for purposes of the liability provision.  As it currently stands, Title III exposes intermediaries (i.e., funding portals and broker-dealer platforms) to possible liability if issuers commit material inaccuracies or omissions in their disclosures on crowdfunding sites.  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 Fix Crowdfunding Act would make clear that an intermediary will not be considered an issuer for liability purposes unless it knowingly makes any material misstatements or omissions or knowingly engages in any fraudulent act. Presumably then, as proposed, a plaintiff would have the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time.

Section 12(g) Registration Exemption

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) that triggers Exchange Act registration. It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC exempted crowdfunded shares from the shareholder calculation under Section 12(g), but conditioned the exemption 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 new legislation would remove from the 12(g) exemption the condition that an issuer not have $25 million or more in assets.

Special Purpose Vehicles

Several portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in SPVwhich investors invest into an SPV which in turn makes the investment into the company as one shareholder. Because of the SPV exclusion, many growth-oriented startups might avoid Title III crowdfunding if they expect to raise venture capital in the future, as VC firms don’t like congested cap tables.

The proposed legislation would make “any issuer that holds, for the purpose of making an offering pursuant to [Title III], the securities of not more than one issuer eligible to offer securities pursuant to [Title III]” eligible for Title III offerings.

Testing the Waters

testing the watersSecurities 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.  The concern is that allowing issuers to do so would enable unscrupulous companies to prime the market before any disclosure became publicly available. Without the protection of public disclosure, issuers may be able to use selective disclosures or overly enthusiastic language to generate investor interest.

The Fix Crowdfunding Act would specifically allow 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 are highlighted to potential investors in the information filed with the SEC.