SEC logoAt an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.   The final rules and forms are effective 180 days after publication in the Federal Register.

Crowdfunding is an evolving method of raising funds online from a large number of people without regard to investor qualification and with each contributing relatively small amounts.[i]   Until now, public crowdfunding has not involved the offer of a share in any Crowdfunding1financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security to the public.  Equity crowdfunding has the potential to dramatically alter the landscape of capital markets for startup companies. It has also been the subject of a contentious debate ever since it was included in the JOBS Act, pitting those who want to allow startups to leverage the internet to reach investors and to permit ordinary people to invest small amounts in them against those that view crowdfunding as a recipe for a fraud disaster.

The SEC had issued proposed rules in October 2013 (see my blog post here), and received hundreds of comment letters in response. When the final rules become effective (early May 2016), issuers for the first time will be able to use the internet to offer and sell securities to the public without registration.  Here’s a brief summary of the new crowdfunding exemption rules and where they deviate from the original proposal.

Issuer and Investor Caps

  • Issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings in any 12-month period.
  • Individual investors, in any 12-month period, may invest in the aggregate across all crowdfunding offerings up to:
    • The greater of $2,000 or 5% of the lesser of annual income or net worth, if either annual income or net worth is less than $100,000, or
    • 10% of the lesser of their annual income or net worth if both their annual income and net worth are equal to or more than $100,000.
  • Aggregate amount an investor may invest in all crowdfunding offerings may not exceed $100,000 in any 12-month period.

Many commenters believed that the proposed $1 million offering limit was too low, but the SEC in the end believed the $1 million cap is consistent with the JOBS Act. The SEC did state in the final rules release, however, that Regulation Crowdfunding is a novel method of raising capital and that it’s concerned about raising the offering limit of the exemption at the outset of the adoption of final rules, suggesting that it would be open to doing so down the road.

As for the individual investment limit, the final rules deviate from the original proposal by clarifying that the limit reflects the aggregate amount an investor may invest in all crowdfunded offerings in a 12-month period across all issuers, and also specifies a “lesser of” approach to the income test.

Financial Disclosure

Financial disclosure requirements are based on the amount offered and sold in reliance on Section 4(a)(6) within the preceding 12-month period, as follows:

  • For issuers offering $100,000 or less: disclosure of total income, taxable income and total tax as reflected in the federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer; but if independently reviewed or audited financial statements are available, must provide those financials instead.
  • Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant, unless otherwise available.
  • Issuers offering more than $500,000:
    • For issuers offering more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by independent public accountant, unless otherwise available.
    • For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by independent public accountant.

The financial disclosure requirements contain a number of changes from the proposal that hopefully will help reduce the costs and risks associated with preparing the required financials. Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer only to disclose total income, taxable income and total tax, or the equivalent line items, from filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the returns.  This minimizes the risk of disclosure of private information which would exist if tax returns had to be provided.  In addition, reducing the requirement for first time issuers of between $500,000 and $1 million from audited financials (as had been proposed) to reviewed financials is a sensible accommodation inasmuch as the concern about the cost and burden of the audit relative to the size of the offering is even greater for first timers who would need to incur the audit expense before having proceeds from the offering.

Intermediaries

  • Offerings must be conducted exclusively through one platform operated by a registered broker or funding portal.
  • Intermediaries required to provide investors with educational materials, take measures to reduce the risk of fraud, make available information about the issuer and the offering and provide communication channels to permit discussions about offerings on the platform.
  • Funding portals prohibited from offering investment advice, soliciting sales or offers to buy, paying success fees and handling investor funds or securities.
  • Funding portals must register with the SEC by filing new Form Funding Portal, which will be effective January 29, 2016.

The rationale behind the requirement to use only one intermediary is that it helps foster the creation of a “crowd”. Having one meeting place enables a crowd to share information effectively, and minimizes the chances of dilution or dispersement of the crowd. This in turn supports one of the main justifications for equity crowdfunding, which is that having hundreds or thousands of investors sharing information increases the chances that any fraud will be exposed, thus the “wisdom of the crowd”. The one platform requirement also helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one platform would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.

One important deviation from the proposed rules is that funding portals will be permitted to curate offerings based on subjective criteria, not just based on perceptions of fraud risk.  A second important deviation is that all intermediaries will be allowed to receive as compensation a financial interest in the issuers conducting offerings on their platforms, which will expand the options available to cash-starved startups.

Preliminary Thoughts

The ink is still wet on the SEC’s 686 page release, but here are some preliminary thoughts. Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach and sell to prospective investors without regard to accredited investor status. The federal securities laws were written over 80 years ago when investors had no access to information about issuers.  In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising companies and ensure that ample information is spread to interested parties.

As I’ve stated before, however, the SEC’s preoccupation with investor crowdprotection has created a disconnect between the potential of equity crowdfunding and its reality, now expressed in the final rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act and the final rules do contain some welcome relief from the original proposal. Nevertheless, I fear that the burden and expense associated with some of the rules will make Regulation Crowdfunding far less attractive to most companies than traditional offerings under Rule 506 notwithstanding the latter’s pro-accredited investor bias. For example, the requirement to produce audited financial statements for offerings above $500,000 (except for first time Regulation Crowdfunding issuers) will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all. It’s also unclear how the burdensome rules governing intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience. Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors. Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.

In the final analysis, though, Title III equity crowdfunding will finally become law, meaning that issuers will for the first time be allowed to leverage the internet to sell securities to an unlimited number of investors without registration and without regard to accredited investor status, and that is decidedly a treat.

[1] The term “crowdfunding” has also been used more broadly as a somewhat generic term for any campaign to raise funds through an online platform.  These include non-equity crowdfunding (i.e., rewards or pre-order based), “accredited” crowdfunding (in reliance on Rule 506(b) or 506(c)) and registered crowdfunding (in reliance on Regulation A+).  This post will use the term only as it applies to small equity offerings to many investors, each contributing relatively small amounts, and soon to be available under Regulation Crowdfunding.

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.

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..

The Regulation A amendments adopted by the Securities Exchange Commission on March 25 are Federal Registerbeing published tomorrow, April 20, in the Federal Register.  That means the final rules and form amendments will officially become effective on June 19, 2015 (by rule, 60 days after such publication).

The new Regulation A, referred to widely as Regulation A+, increases the offering cap from $5 million to $50 million with reasonable investor protection safeguards.  I previously summarized the regulation here.  The main reform features of the new regs are blue sky preemption for Tier II offerings, broader “testing the waters”, scaled disclosure and modified reporting.

Reg A+In theory, Reg A+ has the potential to provide growth companies with a viable alternative to a traditional S-1 IPO, albeit with a more cost effective runway and scaled disclosure than even the streamlined emerging growth company pathway under JOBS Act Title I.  It remains to be seen whether a sufficiently robust small public company ecosystem will develop to support companies that go public through Reg A+.

Importantly, new Reg A+ also reforms the resale rules in a significant respect by eliminating the requirement under old Reg A that issuers must have had net income from continuing operations in at least one of its last two fiscal years for affiliate resales to be permitted.  This is a sensible reform inasmuch as many emerging companies experience net losses for several years due to high research and development costs.  Absence of net income, by itself, is not a sufficient indicator of enhanced risk, and increasing selling stockholder access to avenues for liquidity will encourage investment in emerging companies.

The SEC yesterday issued its highly anticipated final rules amending Regulation A to allow issuers u-s-secto raise up to $50 million in any 12 month period through public offering techniques but without registration with the SEC or state blue sky authorities.  The 453 page rules release features a scaled disclosure regime to provide issuers with increased flexibility with regard to offering size and should lower the burden of fixed costs associated with conducting Reg A offerings as a percentage of proceeds. The new rules go into effect 60 days after they are published in the Federal Register.

Reg A has been one of the most rarely used exemptions for securities offerings because it’s been perceived as cost ineffective: the $5 million maximum is just not worth the burdens associated with blue sky registration and qualification requirements in each state where the securities are offered.  JOBS act 2Fixed costs such as legal and accounting fees have served as a disincentive to use the exemption for lower offering amounts. Congress addressed the problem in 2012 through Title IV of the JOBS Act, which required the SEC to amend Reg A by exempting from Securities Act registration certain securities offerings of up to $50 million in any 12 month period. The anticipated amendment to Reg A has been referred to affectionately by securities lawyers as Reg A+, since it’s intended to be a more useful version of the old Reg A.

Old Reg A

Old Reg A provides an exemption from Securities Act registration for offerings of up to $5 million in any 12-month period, including no more than $1.5 million in resales by selling stockholders.  Reg A transactions have been referred to as mini public offerings because they permit general solicitation and advertising (prohibited in private offerings other than accredited investor-only offerings under Rule 506(c) passed in September 2013) and require a mini-registration statement to be filed and reviewed by the SEC containing the offering statement to be delivered to offerees.  Most importantly, shares sold in old Reg A offerings are not “covered securities” under the National Securities Markets Improvement Act, meaning that issuers  must comply with the registration and qualification requirements of the blue sky laws of each state where the offering is made.  A Reg A issuer was allowed to “test the waters,” or communicate with potential investors to see if they might be interested in the offering, before it made the filing with the SEC (Form 1-A).  Finally, securities sold in Reg A offerings are not restricted securities, meaning they can be freely resold by non-affiliates of the issuer.

New Reg A

The final rules expand Reg A into two tiers: Tier 1 for securities offerings of up to $20 million; and Tier 2 for offerings of up to $50 million.  The new rules preserve, with some modifications, existing provisions regarding issuer eligibility, offering circular content, testing the waters and “bad actor” disqualification.  Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC.  Except when buying securities listed on a national securities exchange, purchasers in Tier 2 offerings must either be accredited investors or be subject to certain limitations on their investment.

The key provisions of the final rules are as follows:

Offering Limitations and Secondary Sales

The final rules establish two tiers of offerings:

  • Tier 1: annual offering limit of $20 million, including no more than $6 million on behalf of selling stockholders that are affiliates of the issuer.
  • Tier 2: annual offering limit of $50 million, including no more than $15 million on behalf of selling stockholders that are affiliates of the issuer.

Investment Limitation

The SEC’s objective with the tiered approach is to scale regulatory requirements based on offering size, to give issuers more flexibility in raising capital under Reg A and to provide appropriately tailored protections for investors in each tier. The rules impose additional disclosure requirements and investor protection provisions in Tier 2 offerings. Issuers seeking a smaller amount of capital (i.e., no more than $20 million) benefit from scaled disclosure. Although Tier 2 offerings will require enhanced disclosure, it’s possible that the reduction in information assymetry will lead to higher valuations. Thankfully, the final rules raised the Tier 1 offering cap to $20 million from the proposed $5 million. The increase in maximum offering size could also contribute to the development of intermediation services, such as market making, as well as analyst coverage, which could have a positive impact on investor participation and aftermarket liquidity of Reg A shares.

In addition, selling stockholders are limited to no more than 30% of the aggregate offering price in an issuer’s initial Reg A offering and any subsequently qualified Reg A offering within the first 12-month period following the date of qualification of the initial Reg A offering.

As mentioned above, the new rules contain certain investor protections in Tier 2 offerings. The proposed rules included a 10% investment limit for all investors in Tier 2 offerings.  The final rules limit non-accredited investors in Tier 2 offerings to purchases of no more than 10% of the greater of annual income or net worth (for natural persons) or the greater of annual revenue or net assets (for non-natural persons), as proposed.  In response to commentator concerns, the Tier 2 investment limit does not apply to accredited investors or to securities that will be listed on a national securities exchange.  This is a sensible approach, inasmuch as accredited investors, due to their level of income or net worth, are more likely to be able to withstand losses from undiversified exposure to an individual offering, and there’s a higher level of investor protection with issuers required to meet the listing standards of a national securities exchange and become subject to ongoing Exchange Act reporting.

Treatment under Section 12(g)

Section 12(g) of the Exchange Act requires that an issuer with total assets exceeding $10 million and a class of equity securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the SEC. In its proposal release, the SEC did not propose to exempt Reg A securities from mandatory registration under Section 12(g), but solicited comment on the issue.  Some commentators questioned the extent to which Reg A securities would be held in street name through brokers, which the proposal mentioned as a factor that could potentially limit the impact of not proposing an exemption from Section 12(g).

The final rules conditionally exempt Tier 2 securities from the provisions of Section 12(g) provided the issuer (i) remains subject to, and is current in (as of fiscal year end), its Reg A periodic reporting obligations, (ii) engages the services of a transfer agent registered with the SEC under the Exchange Act, and (iii) meets requirements similar to those for “smaller reporting companies” (public float of less than $75 million or, in the absence of a public float, annual revenues of less than $50 million).  The transfer agent condition will provide added comfort that stockholder records and secondary trades will be handled accurately.

Offering Statement

The final rules require issuers to file offering statements with the SEC electronically on EDGAR, but permit non-public submission of offering statements and amendments for review by SEC staff before filing so long as all such documents are publicly filed not later than 21 days before qualification.  The new rules eliminate the Model A (Question-and-Answer) disclosure format under Part II of Form 1-A.

Testing the Waters

The new rules permit issuers to “test the waters” with, or solicit interest in a potential offering testing the watersfrom, the general public either before or after the filing of the offering statement, so long as any solicitation materials used after publicly filing the offering statement are preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained. Solicitation materials remain subject to the antifraud and other civil liability provisions of the federal securities laws.

Continuing Disclosure Obligations

Reg A currently requires issuers to file a Form 2-A with the SEC to report sales and the termination of sales made under Reg A every six months after qualification and within 30 calendar days after the termination, completion or final sale of securities in the offering. The final rules eliminate Form 2-A.  In its place, the rules require Tier 1 issuers to provide information about sales in such offerings and to update certain issuer information by electronically filing a Form 1-Z exit report with the SEC not later than 30 calendar days after termination or completion of an offering.  The rules require Tier 2 issuers to file electronically with the SEC on EDGAR annual and semiannual reports, as well as current event reports.

Application of Blue Sky Laws

The final rules preempt state registration and qualification requirements for Tier 2 offerings but preserve these requirements for Tier 1 offerings, consistent with state registration of Reg A offerings of up to $5 million under existing rules.  The SEC had originally proposed to preempt state regulation with respect to (i) all offerees in Reg A offerings and (ii) all purchasers in Tier 2 offerings.  The proposal to preempt blue sky requirements with respect to all offerees in a Reg A offering was intended to allow issuers relying on Reg A to communicate with potential investors via the internet and social media without concern that these communications might trigger registration requirements under state law.

The issue of state law preemption generated a great deal of public commentary.  To address commenter concerns and avoid potential confusion about the application of the preemption provisions in Tier 1 offerings, the final definition of “qualified purchaser” does not include offerees in Tier 1 offerings.  This is unfortunate.  In order to create an attractive alternative to IPOs, Congress mandated preemption for “qualified purchasers”, which it defined as any purchaser in a (new) Reg A offering. As made clear in the 2012 General Accounting Office Report, a primary reason Reg A has been seldom used is the delay, cost and uncertainty of divergent state review of offerings. Perhaps the SEC should have preempted state regulation of Reg A resales as well. One of the greatest benefits of a Reg A offering versus a Rule 506 offering is that the securities sold in the former will be freely tradeable immediately upon closing of the offering. Without clear federal preemption of blue-sky laws governing the resale of Reg A shares, however, investors may be concerned about their ability to resell their shares which will reduce their willingness to purchase these shares in the first place.

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.
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.

 

My partner Steve Melore and I braved the latest New York snow storm to attend the Small Business Investor Alliance’s Northeast Private Equity Conference on January 22, of which Farrell Fritz was a sponsor.  The SBIA is the leading professional organization for lower middle-market investment funds and the LPs that invest in them.

The Conference kicked off with a presentation on SBA goals and priorities for 2014 by Javier Saade, the new Associate Administrator for the SBA’s Office of Investment and Innovation, the division that runs an alphabet soup of programs to provide capital to private investment funds to invest in small businesses (SBIC) and Federal research grant dollars to technology companies (SBIR and STTR).  Mr. Saade announced that the SBA intends to expand the SBIC program’s annual budget from $3 billion to $4 billion.  He stated that another priority for the SBA in 2014 will be the promotion of equity crowdfunding, and in answer to a question posed during the Q&A from your humble blogger about how the SBA might lean on the SEC to finally pass reasonable crowdfunding rules, Mr. Saade said that he believes the SBA could play a constructive informational role in this regard.

Next up was Doug Farren, Associate Director of the National Center for the Middle Market, who deftly filled in for his boss in presenting the results of the Center’s quarterly business  performance and outlook survey.  The report was based on a survey of 1,000 C-suite executives of middle market companies – those with annual revenues between $10 million and $1 billion — on key indicators of past and future performance.  Among other key results, the survey revealed that revenue for these companies increased during the fourth quarter of 2013 and that 57% continue to expect improvement in 2014.  A majority of middle market companies, however, said that “uncertainty” regarding government policies (perhaps a euphemism for an increase or expected increase in burdensome regulation) is hampering their ability to grow and their willingness to hire and invest.  In particular, healthcare legislation continues to be the largest concern.

Brett Palmer, the energetic President of SBIA, delivered an insightful analysis of this year’s midterm elections and an update on key legislative and regulatory initiatives affecting private equity.

The final speaker was the least connected to private equity, but the most talked about during the post-conference networking session.  J.J. French, the founder, lead guitarist and manager of heavy metal band Twisted Sister, was clever and comedic as he regaled the audience with tales of the band’s battles with Murphy’s Law during the 70’s and 80’s in its quest to secure a record contract.

Decidedly a worthwhile conference, and I was particularly impressed with how Brett and his staff were able to control the mix of attendees, tactfully ensuring an overwhelmingly large percentage of fund managers and investors and keeping guys like me to a minimum.  

On January 2, 2014, the Financial Industry Regulatory Authority (“FINRA”) published its annual priorities letter for 2014, chief among which will be IPOs, general solicitation in private offerings, crowdfunding portals and microcap fraud.

IPOs

In the area of IPOs, FINRA intends to focus on “spinning,” a practice in which an underwriter allocates “hot” IPO shares to directors and/or executives of potential investment banking clients in exchange for investment banking business.  An IPO is considered to be a “hot” offering when investor demand significantly exceeds the supply of securities in the offering.  Spinning became the subject of regulatory scrutiny during the dot com driven IPO boom of the late 1990s, and is a prohibited practice under FINRA Rule 5131.  FINRA is also concerned about bad actors being drawn to the IPO market, which often occurs during a robust market.  Finally, FINRA intends to focus on compliance with rules governing the sale and allocation of IPO securities, including whether firms are incenting associated persons to sell cold offerings to obtain client allocations of hot offerings.  Shares in hot offerings often trade at substantial premiums to the offering price.  An IPO is considered to be a “cold” offering when there is weak investor interest in the IPO shares.

General Solicitation in Private Offerings

Private placement abuses by placement agents has long been a primary focus of FINRA. The recent amendments to Rule 506 of Regulation D, which became effective September 23, 2013, remove the prohibition on general solicitation and advertising provided that all purchasers are accredited investors and the issuer takes reasonable steps to ensure they are such. FINRA believes that general solicitation, which before the amendments had been permitted only in connection with public offerings registered with the SEC, provides new challenges for securities firms to ensure that advertisements and other marketing materials are based on principles of fair dealing and good faith, are fair and balanced and provide a sound basis to evaluate the facts about securities acquired in a private placement.

Crowdfunding Portals

Title III of the JOBS Act, enacted in April 2012, fashioned a new exemption in the form of Section 4(a)(6) of the Securities Act for offerings of securities through funding portals with limits on amounts raised ($1 million during any twelve month period) and invested, and instructed the SEC to promulgate rules to implement the new exemption.  On October 23, the SEC issued its proposed rules on equity crowdfunding, and on the same day FINRA issued its proposed rules on crowdfunding portals.  The new equity crowdfunding exemption will not be available until the SEC approves final rules. The objective of FINRA’s proposed rules is to ensure that the capital raising objectives of the JOBS Act are advanced in a manner consistent with investor protection.  Under the proposed rules, a private company raising capital under the crowdfunding exemption will be required to use an intermediary that is either a registered broker-dealer or a newly-created category of intermediary, a funding portal, which must register with the SEC and FINRA. If the intermediary is a funding portal, its activities will be more limited than those permitted for broker-dealers. For example, a funding portal may not solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal; compensate promoters, finders or lead generators for providing information on individual  investors; hold, manage or accept customers’ funds or securities; or offer investment advice or recommendations.  FINRA’s proposed rules attempt to streamline the registration and oversight of funding portals to reflect their limited scope of permitted activity. The proposed rules address a number of topics, including the membership application process, and fraud and manipulation. The proposed rules also contain provisions to ensure that bad actors do not enter the system. In its priorities letter, FINRA indicated that as the rules become effective, and funding portals become FINRA members, it will implement a regulatory program designed to protect investors while recognizing the distinctions between funding portals and broker-dealers.

Microcap Fraud

Offerings of microcap and speculative low-priced over-the-counter securities continue to be an area of significant ongoing concern for FINRA. FINRA is urging securities firms to review their policies and procedures to ensure that activities at the firm related to microcap and low-priced OTC securities are compliant.  FINRA believes that firms should carefully supervise employees who conduct direct or indirect outside business activities associated with microcap and OTC companies, traders involved in trading microcap and low-priced OTC securities and firm activities where an affiliate of the firm is the transfer agent for the microcap or low-priced OTC securities. Finally, FINRA is encouraging firms to monitor customer accounts liquidating microcap and low-priced OTC securities to ensure, among other things, that the firm is not facilitating, enabling or participating in an unregistered distribution.

The Securities and Exchange Commission released helpful guidance on some of the practical aspects of the new Rule 506(c) exemption for private offerings using general solicitation and advertising.  The guidance comes in the form of Questions 260.05 – 260.13 in its Questions and Answers of General Applicability and include the following:

  • Exemption is available to an issuer who takes reasonable steps to verify the accredited investor status of an investor and forms a reasonable belief that the investor is accredited at the time of the sale, even if the issuer subsequently learns that the investor did not qualify as such at the time of sale.
  •  If all purchasers are in fact accredited investors but the issuer did not take reasonable steps to verify their status, the issuer may not rely on the exemption because verification is a requirement separate from and independent of the requirement that sales be limited to accredited investors.
  • Relevant documentation to verify accredited investor status under the net worth test must be dated within three months prior to the sale, rather than prior to the time of verification.
  • Third-party verification may include foreign lawyers and accountants.
  • An issuer that commenced a Rule 506(b) offering may shift to a Rule 506(c) offering so long as the conditions of Rule 506(c) are satisfied with respect to all sales of securities in the offering.
  • If the conditions in a purported Rule 506(c) offering are not met, the issuer could not fall back to a Section 4(a)(2) private offering exemption if the issuer engaged in any form of general solicitation.

Our earlier blog on the rules for general solicitation Rule 506 offerings can be found here.