With bipartisan support, the “Jumpstart Our Business Startups Act” (JOBS Act), was approved in both houses of Congress, and signed into law by President Obama on April 5, 2012. Though short in length, the JOBS Act is designed to provide significant new benefits to emerging companies – both those seeking to go public and those seeking to avoid the public markets. Among other things, the JOBS Act:
- creates a new class of company contemplating going public, the “emerging growth company,” which will be able to avail itself of liberalized communications restrictions and scaled disclosure requirements for a period of time, including exemptions from certain provisions of the Sarbanes-Oxley Act and the Dodd-Frank Act;
- opens up additional capital raising pathways, subject to certain restrictions discussed below, by (1) lifting the prohibition on general solicitation and advertising in Rule 506 offerings, where securities are sold only to accredited investors, (2) permitting crowdfunding, and (3) increasing the offering amount for Regulation A type offerings from $5 million to $50 million; and
- raises the threshold level of the number of shareholders above which a company must go public, whether desired or not.
Certain provisions of the JOBS Act are effective immediately, while others are subject to rulemaking by the Securities and Exchange Commission (SEC). Given that the SEC is still working through its obligations under Dodd-Frank, we cannot be certain whether the SEC will meet the tight timelines set forth by Congress.
REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH COMPANIES: THE “ON RAMP” TO THE IPO
Under the JOBS Act, an “emerging growth company,” is defined as a company that had total annual gross revenues of less than $1 billion (indexed for inflation every five years) during its most recently completed fiscal year. A company that qualifies as an emerging growth company as of the first day of that fiscal year will remain qualified as such until the earliest of (1) the last day of the fiscal year during which the company’s total annual gross revenues reach $1 billion; (2) the last day of the fiscal year following the fifth anniversary of the company’s first sale of common equity securities pursuant to an effective registration statement; (3) the date on which such company has, during the previous three-year period, issued more than $1 billion in non-convertible debt; or (4) the date on which such company is deemed to be a “large accelerated filer” (generally, a company with above $700 million of common equity held by noninsiders that has been public at least a year). Any company that qualifies as an emerging growth company may immediately take advantage of the benefits described below; however, companies that went public on or before December 8, 2011 are not eligible to be considered emerging growth companies, regardless of their size.
Reduced financial statements and auditing standards
Pursuant to the JOBS Act, emerging growth companies are only required to provide two years of audited financial statements in a registration statement with respect to an initial public offering of common equity securities. Further, in any other registration statement or report to be filed with the SEC, an emerging growth company need not present selected financial data for any period prior to the earliest audited period presented in connection with its first effective registration statement, and emerging growth companies need only discuss the periods for which financial statements are presented in their Management’s Discussion and Analysis of Financial Condition and Results of Operations. In addition, an emerging growth company will not be required to comply with any new or revised financial accounting standard until such date that a company that is not a public company is required to comply with such new or revised accounting standard.
Internal controls audit and auditor rotation exemptions
Emerging growth companies are exempt from the annual auditor attestation requirements of the Sarbanes-Oxley Act with respect to the effectiveness of their internal control over financial reporting. Further, should the Public Company Accounting Oversight Board (PCAOB) enact rules currently under discussion that would require mandatory audit firm rotation or a supplementary discussion and analysis in auditor’s reports on financial statements, such rules will not apply to emerging growth companies.
Reduced disclosures about executive compensation
The JOBS Act exempts emerging growth companies from certain provisions of Dodd-Frank, including (1) requirements related to shareholder approval of executive compensation, commonly referred to as “say on pay” and (2) disclosures (under rules yet to be adopted by the SEC) of the relationship between executive compensation and the financial performance of the company and the ratio of employee median compensation compared to CEO compensation. Further, with respect to executive compensation disclosures, emerging growth companies are permitted to take advantage of the scaled disclosure available to smaller reporting companies, which would mean emerging growth companies would be able to significantly reduce the number of tables and level of analysis regarding compensation contained in their proxy statements and annual reports.
Ability to “test the waters”
An emerging growth company may “test the waters” or engage in oral or written communications with potential investors that are qualified institutional buyers (QIBs) or institutions that are accredited investors to determine whether such investors might have an interest in a contemplated securities offering, either prior to or following the date of filing a registration statement with the SEC. Prior to the JOBS Act, such actions likely would violate “gun jumping” restrictions on pre-IPO communications.
Availability of confidential review of IPO registration statement
The JOBS Act also provides that any emerging growth company, prior to its IPO, may confidentially submit to the SEC a draft registration statement, for confidential nonpublic review by the SEC staff prior to public filing, provided that the initial confidential submission and all amendments are publicly filed with the SEC not later than 21 days before the date on which the emerging growth company conducts a road show for the IPO.
Research reports not offers
Under the JOBS Act, the publication or distribution by a broker or dealer of a research report about an emerging growth company that is the subject of a proposed public offering of common equity securities pursuant to a registration statement will not constitute an offer to sell a security, even if the broker or dealer is participating, or will participate, in the offering. Further, the Act prohibits the SEC and national securities associations from having any rules barring any broker, dealer or member of a national securities association from publishing or distributing any research report or making a public appearance with respect to the securities of an emerging growth company during the time period surrounding an emerging growth company’s IPO and the expiration of the related lock-up period after the IPO.
Greater IPO analyst communications
The JOBS Act prohibits the SEC or any national securities association from adopting or maintaining any rule or regulation in connection with an IPO of an emerging growth company (1) restricting which associated persons of a broker, dealer, or member of a national securities association may arrange for communications between a securities analyst and a potential investor; or (2) restricting a securities analyst from participating in any communications with the management of an emerging growth company that is also attended by any other associated person of a broker, dealer, or member of a national securities association whose functional role is other than as a securities analyst.
Opting out of emerging growth company status
An emerging growth company may choose not to avail itself of the benefits described above and instead comply with the more stringent requirements that apply to non-emerging growth companies. However, with respect to the extension of time to comply with new or revised financial accounting standards, if an emerging growth company chooses to comply with such standards to the same extent that a non-emerging growth company is required to comply with such standards, the emerging growth company must (1) make such choice at the time the company is first required to file a registration statement, periodic report, or other report with the SEC and notify the SEC of such choice; (2) comply with all standards applicable to a non-emerging growth company to the same extent that a non-emerging growth company is required to comply with such standards; and (3) continue to comply with such standards to the same extent that a non-emerging growth company is required to comply with such standards, for so long as the company remains an emerging growth company. For those companies that went public after December 8, 2011 but prior to the enactment of the JOBS Act, and are thus eligible to be considered emerging growth companies, it is not clear whether they will be deemed to have elected to comply with financial accounting standards by virtue of the fact that they have already done so.
Further review of disclosure requirements
Congress mandated that the SEC conduct a review of the extensive disclosure requirements in Regulation S-K and submit a report to Congress within 180 days, with the report to include specific recommendations on how to streamline the registration process in order to make it more efficient and less burdensome for the SEC and for prospective emerging growth companies.
ACCESS TO CAPITAL FOR JOB CREATORS: LIFTING THE BAN ON GENERAL SOLICITATION AND ADVERTISING IN CERTAIN PRIVATE PLACEMENTS
Current rules prohibit companies, public and private, relying on certain registration exemptions to raise capital in a non-public offering from engaging in “general solicitation” or advertising to gain access to potential investors. The JOBS Act will eliminate this restriction with respect to sales to only accredited investors and large institutional investors. Specifically, the Act requires the SEC within 90 days of enactment to revise (1) Rule 506 of Regulation D to provide that the prohibition against general solicitation or general advertising does not apply to offers and sales of securities thereunder as long as all purchasers of the securities are “accredited investors,” and the company has taken reasonable steps to verify that the purchasers are accredited investors, and (2) Rule 144A to provide that securities sold under such exemption may be offered to persons other than QIBs, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe to be QIBs.
Further, the JOBS Act provides that certain platforms, co-investors and those providing ancillary services (e.g., due diligence, provision of standard documents) in connection with offerings under Rule 506 will not be required to register as brokers or dealers with respect to the securities offered and sold. This exemption will apply if (1) such person, and each person associated with such person, receives no compensation in connection with the purchase or sale of such security; (2) such person, and each person associated with that person, does not have possession of customer funds or securities in connection with the purchase or sale of such security; and (3) such person, and any person associated with that person, is not subject to a statutory disqualification (for example, being expelled or suspended from membership or participation in a stock exchange).
As a result of these liberalizations of the restrictions on securities offering platforms, which would essentially permit crowdfunding by angel investors, we expect to see more platforms springing up, which may change the way angel investment rounds, and potentially even venture rounds, are conducted. Further, lifting the ban on general solicitation to accredited investors and QIBs may have the effect of allowing companies to conduct certain previously prohibited private offerings simultaneously with public offerings.
CROWDFUNDING: CAPITAL RAISING ONLINE WHILE DETERRING FRAUD AND UNETHICAL NON-DISCLOSURE ACT OF 2012
Crowdfunding occurs when people pool their money and other resources together to support efforts initiated by other people or organizations. Such pooling of money and resources typically occurs via the internet for any variety of purposes, including funding political campaigns, disaster relief, small loans (micro credit), artists, and even startups. In the United States, crowdfunding has occurred largely on a donation basis or as a loan, where the lender can only expect to be repaid principal. The JOBS Act permits crowdfunding of private companies by amending the Securities Act to exempt from registration certain transactions involving the offer or sale of securities by a company, provided that:
- the aggregate amount sold to all investors by the company, including any amount sold in reliance on the crowdfunding exemption, during the 12-month period preceding the date of such transaction, is not more than $1,000,000;
- the aggregate amount sold to any investor by a company, including any amount sold in reliance on the crowdfunding exemption, during the 12-month period preceding the date of such transaction, does not exceed (1) the greater of $2,000 or 5% of the annual income or net worth of such investor, if either the annual income or the net worth of the investor is less than $100,000; or (2) 10% of the annual income or net worth of such investor, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;
- the transaction is conducted through a crowdfunding intermediary (broker or funding portal) that complies with certain requirements, such as registering with the SEC as a broker or a funding portal, providing certain disclosures, including disclosures related to risks and other investor-education materials, obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every company whose securities are offered by such person, and making efforts to ensure that no investor in a 12-month period has purchased securities offered pursuant to a crowd funded offering that, in the aggregate, from all companies, exceed the investor’s limits. Any advertising of the offering must direct potential investors to the intermediary;
- funding portals may not, among other things, offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal; compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; or hold, manage, possess, or otherwise handle investor funds or securities; and
- the company provides certain disclosures, to be filed with the SEC, to investors and the relevant broker or funding portal regarding, among other items, pricing and valuation information, capital structure, risks factors and the financial condition of the company. The disclosures must include, for offerings that, together with all other crowdfunding offerings of the company within the preceding 12-month period, have, in the aggregate, target offering amounts of (1) $100,000 or less (a) the income tax returns filed by the company for the most recently completed year (if any); and (b) financial statements of the company, which must be certified by the principal executive officer of the company to be true and complete in all material respects; (2) more than $100,000, but not more than $500,000, financial statements reviewed by a public accountant that is independent of the company; and (3) more than $500,000, audited financial statements.
Most of the crowdfunding parameters will be subject to further SEC rulemaking within 270 days of enactment of the JOBS Act. The crowdfunding exemption will not apply to public companies or investment companies. Crowd funded securities will be exempted from state blue sky laws regulating securities offerings, though the states will still have enforcement authority. Certain “bad actors” will be disqualified from offering or selling securities pursuant to this exemption. During the first year after their issuance, securities issued pursuant to the crowdfunding exemption may only be transferred back to the company, accredited investors or certain family members or sold in a public offering. Holders of securities acquired in a crowdfunding transaction will not be considered record holders that count for purposes of the threshold triggering SEC registration discussed below.
Further, a company, its directors, partners and certain officers may all be liable in connection with a crowd funded offering, if the company makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading, provided that the purchaser did not know of such untruth or omission. Purchasers of crowd funded securities may bring an action against a company to recover the consideration they paid (plus interest) or for damages if they no longer own the securities.
Raising capital from a large number of shareholders in small amounts raises potential challenges for a company, such as increased record keeping responsibilities and difficulties in fully knowing the interests and agendas of what may suddenly become a large, diverse array of shareholders. Further, even though state securities laws will be preempted, shareholders will still have various rights under state corporate laws and may be able to compel an annual meeting, block certain transactions, delay a possible exit event, exercise a high level of appraisal rights, and institute shareholder derivative suits. For startups that are typically funded by founders in the first instance and friends and family in the second, having a large number of unknown shareholders may prove to be an extreme administrative burden fraught with potential liability. It also remains to be seen whether VCs and other later stage investors will be repelled by crowd funded companies or, if not, how crowd funders will react to later dilution or lower priority resulting from later rounds of financing.
SMALL COMPANY CAPITAL FORMATION: INCREASING MAXIMUM OFFERING AMOUNT UNDER REGULATION A TYPE OFFERINGS
While Regulation A of the Securities Act was enacted in 1936 to increase capital raising opportunities for small businesses by allowing companies to raise capital without complying with the registration process and becoming subject to public company reporting requirements, with its $5 million annual cap and lack of exemption from state blue sky laws, few Regulation A offerings take place.
Subject to future SEC rulemaking (no time frame is set forth), the JOBS Act amends the Securities Act to require the SEC to create a class of exempted securities for offerings with aggregate offering amounts in a 12-month period of up to $50 million (subject to adjustment every two years). The securities may be offered and sold publicly and will not be restricted securities within the meaning of the federal securities laws. In addition, a company may “test the waters” or solicit interest in the offering prior to the offering. If a company proceeds with the offering, it must file audited financial statements with the SEC annually, and comply with such other terms, conditions, or requirements as the SEC determines to be necessary in the public interest and for the protection of investors, which may include:
- a requirement that the company file with the SEC and distribute to prospective investors an offering statement, including the audited financial statements, a description of the company’s business operations, its financial condition, its corporate governance principles, its use of investor funds, and other items; and
- disqualification provisions for “bad actors,” similar to those contained in Dodd-Frank, under which the exemption will not be available to the company or its predecessors, affiliates, officers, directors, underwriters, or other related persons.
Further, the SEC may require a company to make available to investors and file with the SEC periodic disclosures regarding the company, its business operations, its financial condition, its corporate governance principles, and its use of investor funds and other matters.
Securities issued pursuant to the amended Regulation A will be exempt from state blue sky compliance provided that the securities are (1) offered or sold on a national securities exchange; or (2) offered or sold to a qualified purchaser, a term to be defined by the SEC. However, within three months of the enactment of the JOBS Act, the Comptroller General is required to conduct a study on the impact of blue sky laws on offerings made under Regulation A.
RAISING OF THE THRESHOLDS FOR GOING PUBLIC: PRIVATE COMPANY FLEXIBILITY AND GROWTH/CAPITAL EXPANSION
Until the JOBS Act, companies with more than $10 million of assets and more than 500 shareholders had to register with the SEC within 120 days after the end of the year in which they first crossed these thresholds, and thereby become public companies, whether or not they so desired. The JOBS Act raised the shareholder threshold such that companies will only required to become publicly reporting companies if they have assets exceeding $10 million and a class of equity security (other than an exempted security) held of record by either (1) 2,000 persons, or (2) 500 persons who are not accredited investors (for banks and bank holding companies, the threshold will be a flat 2,000 holders of record, with deregistration permitted if the number drops below 1,200).
The JOBS Act requires the SEC to exclude holders of securities received pursuant to an employee compensation plan in exempt transactions. Further, as noted above, holders of securities acquired in a crowdfunding transaction will not count as record holders (assuming they do not hold other securities).