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.

The market for venture backed IPOs in the U.S. in the first quarter of 2015 was box IPOthe weakest in two years, both in terms of number of deals and aggregate proceeds, according to pre-IPO institutional research firm Renaissance Capital, as well as a separate exit poll report by Thomson Reuters and the National Venture Capital Association. There were only 17 IPOs of venture-backed companies, compared with 30 in Q4 of 2014 and 40 in Q1 2014.  Venture backed IPOs raised only $76 million in average proceeds in Q1 2015, compared with $147 million and $80 million in Q4 and Q1 of 2014, respectively.

So what’s the reason for the overall weakness in venture backed IPOs?  According to Emily Chasan of the Wall Street Journal, venture backed companies are resisting going public because they’re receiving better offers in the form of late-stage private equity funding.  She cites a survey performed by BDO USA in which over half of the investment bankers surveyed attributed the IPO decline to widespread availability of private funding for companies at attractive valuations.  Basically, all the funding but without the hassle of being public.  This would be especially true of venture backed technology companies.  The $1.2 billion that technology companies raised in first quarter IPOs pales in comparison to the estimated $10 billion raised in private equity rounds during the same period of last year.

Another contributing factor may be a section of the JOBS Act that allows companies to stay private longer.  Title V of the JOBS Act passed in 2012 generally increases from 500 to 2,000 the threshold number of shareholders of a class of equity securities that triggers registration and reporting requirements under Section 12(g) of the Securities Exchange Act of 1934 for companies with more than $10 million in assets.  This generally allows companies with fewer than 2,000 shareholders to choose to stay private longer, enabling them to defer the cost, public scrutiny and increased liability of being publicly-traded and increasing their ability to time their initial public offerings based on market conditions.

Deliberately postponing an IPO until some point down the road could be risky.  IPO markets have short windows which often close quickly and are unpredictable.  A company opting for late-stage private equity funding and deferring an IPO may find the IPO market closed later on when the company is otherwise ready.

Another explanation for the relative weakness in small company IPOs is a series of reforms by the SEC generally referred to as decimalization. The regulatory efforts by the SEC to modernize the securities trading system beginning in 1997 may have had the unintended consequence of removing the financial incentive for underwriters, analysts, market makers and others to transact in and provide support services for issuers of small company stocks.  This is a theory long asserted by leading capital markets reform advocate David Weild.  My previous blog about decimalization and David’s theory could be found here.

It remains to be seen whether the weakness in venture-backed IPOs will have any short or long term impact on VC fund investments in startups and emerging companies.  Investors need to be confident that there’s a strong likelihood they’ll be able to exit their investments successfully.  The traditional VC exit strategy consists of either an IPO or an acquisition.  Making matters worse for VCs is that total exits for venture-backed companies, including mergers and acquisitions, in North America also dropped in the first quarter to 181 deals totaling $4.91 billion from 255 deals totaling $14.07 billion in value in the first quarter of last year, a 65% decline, according to PitchBook Data Inc..

SEC Chairman Mary Jo White

SEC Chairman Mary Jo White gave her state of the Commission speech on Friday at the “SEC Speaks 2014” conference in Washington, D.C.  But if you were distracted for a moment by the sight of hoodie-clad Mark Cuban live-tweeting at the conference, you may have missed this one paragraph in the speech:

“In 2014, we also will prioritize our review of equity market structure, focusing closely on how it impacts investors and companies of every size.  One near-term project that I will be pushing forward is the development and implementation of a tick-size pilot, along carefully defined parameters, that would widen the quoting and trading increments and test, among other things, whether a change like this improves liquidity and market quality” (emphasis added).

This is actually big news, especially given that the SEC in 2012 recommended against any increase in tick sizes, and the SEC’s Investor Advisory Committee as recently as January recommended against a pilot program to do so.  So what’s all the fuss about anyway?  Some background is in order here.

For hundreds of years prior to 2001, U.S. equity markets used fractions as pricing increments.  Out of concern that the fractional interval system was putting U.S. markets at a competitive disadvantage to foreign equity markets that used decimal pricing, the SEC promulgated a series of regulatory changes[1] beginning in 1997 that collectively shifted our markets from a quote-driven to an electronic-order-driven market and from minimum increments of 1/16th and 1/32nd of a dollar to one penny and below. These regulatory changes are often referred to collectively as the process of  “decimalization”.

Although these changes were intended to benefit investors, many prominent market structure experts have asserted that decimalization has dramatically harmed small company capital formation by destroying the economic infrastructure that previously supported those companies.  In 2011, my good friend and former NASDAQ Vice-Chairman David Weild characterized decimalization as a “death star”, contending that the current one penny tick size regimen as applied to less liquid stocks is at the root of the systemic decline in the U.S. small company IPO market.  According to Weild, it nearly eliminated the economic incentive to trade in small cap stocks by taking “96 percent of the economics from the trading spread of most small cap stocks – from $0.25 per share to $0.01 per share”. Weild has convincingly connected the dots (quite literally in a series of dramatic charts) between the decimalization rule changes and the small company IPO market falling off the cliff promptly thereafter. Weild has advocated for an increase in tick size for smaller cap stocks which he believes will encourage financial institutions to spend more resources covering these issuers and their securities.

David Weild IV

Momentum for tick-size reform has been building.  Section 106 of the JOBS Act required the SEC to study the impact that decimalization has had on IPOs, and gave it the power to designate a tick size greater than one cent but less than ten cents for quoting and trading emerging growth company securities if the SEC concluded that was necessary to provide sufficient economic incentive to support trading operations in these companies. In its 2012 report to Congress, however, the SEC determined not to increase tick sizes at that time, and instead elected to solicit the views of investors, companies, market professionals, academics and others on the broad topic of decimalization and the impact on IPOs and the markets.  Last November, the Equity Capital Formation Task Force proposed a mandatory five-cent increment program for companies with a market capitalization below $750 million. Earlier this month, the U.S. House of Representatives passed a bill requiring the SEC to create an optional five-cent or 10-cent increment for companies whose market cap is under $750 million.  The fate of the proposed legislation is unclear, however, because the Senate hasn’t proposed a companion bill.


[1]  Order Handling Rules (1997) required specialists and market makers to give investors their most competitive quotes, resulting in more competition between dealers, and set the stage for the shrinking of trading spreads and tick sizes from the longstanding levels of one-quarter and one-eighth of a dollar.  Regulation ATS (1998) enabled electronic networks to link orders with registered exchanges, subjecting traditional trading markets to fierce competition and resulting in tick sizes dropping down to as low as 3.125 cents.  Decimalization (2001) required stocks to be quoted in decimals instead of fractions and allowed a minimum tick size of one cent.  Regulation NMS (2005) allowed quoting and trade execution in sub-penny increments for dark pools, algorithmic trading or broker-dealers providing price improvements to a customer order, exceptions that eventually became the rule.