mergers & acquisitions

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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.

Since 2014, many private company mergers and acquisitions intermediaries have chosen not to register as broker-dealers. That’s because a 2014 SEC no-action letter took the position that intermediaries that limited their activities to representing private companies in M&A deals were not required to register with the SEC as broker-dealers.  But as a no-action letter, the relief provided was limited to the specific facts presented, and the letter implied that such relief would not be available to any intermediary that engaged in any of several listed activities. Greater certainty may be on the way, however, in the form of a small part of proposed legislation recently passed by the House of Representatives that would effectively codify the SEC’s 2014 no-action position and even expand on it.

Background

Section 15(a) of the Securities Exchange Act of 1934 requires any broker-dealer engaging in interstate commerce to register with the SEC and be subject to its regulatory regime. The term “broker” is defined broadly in Section 3(a)(4) of the Exchange Act to include any person who effects transactions in securities on behalf of others, and the SEC has historically interpreted the meaning of “effects transactions in securities” to include anyone engaged in significant aspects of a securities transaction, including solicitation, negotiation and execution. The inclusion of a transaction based or success fee has long been interpreted as a strong presumption that the intermediary receiving the fee must register as a broker-dealer.

So is an acquisition of a company considered to be a securities transaction such that intermediaries should have to register as broker-dealers? The broker-dealer regulations were designed to prevent abuses in the form of high pressure selling tactics and third party custody of funds, two aspects that typically don’t apply to M&A deals. Moreover, in a typical M&A transaction, unlike a stock trade, the acquiror usually engages in its own exhaustive due diligence of the target and the intermediary does not custody funds. Nevertheless, the U.S. Supreme Court thought otherwise and in 1985 opined that an M&A transaction involving a target’s stock is a securities transaction, and consequently many M&A advisors began registering as broker dealers.

The 2014 No-Action Letter

In the 2014 no-action letter, the SEC Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if an intermediary were to effect securities transactions in connection with the transfer of ownership of a privately-held company. The letter listed a bunch of deal activities that would make the relief unavailable, however, including providing financing for the deal, custodying funds or securities, arranging for a group of buyers and sale of a company to a “passive” buyer.

Financial CHOICE Act of 2017

On June 8, 2017, the U.S. House of Representatives passed the Financial CHOICE Act of 2017, which repeals or modifies significant portions of Dodd-Frank but also includes a broad range of important provisions aimed at facilitating capital formation pro-growth policies generally, including an exemption from broker dealer registration for private company M&A intermediaries.   Like the 2014 no-action letter, the Financial CHOICE Act would deny the exemption to any broker intermediating an acquisition of a shell company or a transaction involving the public offering of securities or engaging in the custody of funds or securities. But unlike the 2014 no-action letter, the Financial CHOICE Act would not exclude brokers that put together groups of buyers or provide acquisition financing, or intermediate a sale of a company to a passive acquiror.  One feature present in the Financial CHOICE Act that was not included in the 2014 no-action letter is a size of target test. Specifically, under the Financial CHOICE Act, the exemption is only available if the target has gross revenues below $250 million and EBITDA below $25 million in the fiscal year ending immediately before the fiscal year in which the services of the M&A broker are initially engaged with respect to the transaction.

The legislation has moved to the Senate, and hopefully any final version would include some form of private company M&A broker-dealer registration exemption. Of particular significance in the proposed legislation is the apparent allowance for a non-registered broker to organize groups of buyers which would enable private equity club deals. Nevertheless, even if the legislation passes, private company intermediaries should consider carefully the consequences of non-registration (or withdrawal of those already registered). These would include complications under certain state regulatory regimes and exclusion from the possibility of intermediating public company deals or deals involving targets exceeding either the gross revenue or EBITDA thresholds.