On April 5, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), which aims to promote economic growth and job creation by lowering the barriers to raising capital for emerging businesses. The JOBS Act facilitates financing across the spectrum, from seed capital to public offerings, by:
- permitting "crowdfunding";
- easing restrictions on fundraising from "accredited investors";
- easing mandatory reporting triggers under the Securities Exchange Act (Exchange Act);
- increasing the amount companies may raise in mini-IPOs; and
- reducing the burdens on "emerging growth companies" going public.
The JOBS Act creates a new provision in the Securities Act of 1933 (Securities Act), Section 4(6), that will allow companies to raise up to $1 million in any 12-month period by selling securities through authorized intermediaries, subject to limitations on the manner of the offering and the amount any person is permitted to invest. Crowdfunding will allow companies to sell securities to anyone - not just those wealthy enough to qualify as "accredited investors" - without being compelled to provide copious information required by existing federal law. Securities sold in a crowdfunded offering will also be "covered securities" exempt from state "blue sky" registration requirements, though states will still have authority to take enforcement action against companies for fraud or other unlawful conduct perpetrated through crowdfunding.
The Securities and Exchange Commission (SEC) has 270 days to issue regulations implementing crowdfunding, but the JOBS Act sets out the basic framework:
Requirements for Issuers. Companies seeking to raise capital under Section 4(6) will be required to provide certain information to potential investors about the company; its business; its officers, directors and major (greater than 20%) stockholders; the terms of the offering; and the securities being offered for sale. Significantly, the JOBS Act requires that companies provide more robust financial disclosures for larger offerings. If the aggregate amount of the offering is $100,000 or less, the issuer need only provide tax returns for the company's most recently completed year, if any, and financial statements certified by the company's principal executive officer. If the aggregate amount of the offering is $100,000 to $500,000, the issuer must provide financials reviewed by an independent public accountant. If the offering exceeds $500,000, the issuer must provide audited financial statements.
Requirements for Intermediaries. The JOBS Act requires that crowdfunded offerings be conducted through authorized third party intermediaries. Intermediaries must register with the SEC as either a "broker" or a "funding portal" (a new classification to be defined by the SEC) and will also need to register with a "self-regulatory organization" approved by the SEC and be a member of a "national securities association," such as the Financial Industry Regulatory Authority that already regulates brokers. Intermediaries must supervise offerings to ensure investors receive the information companies are required to provide and do not invest more than the Act permits. Intermediaries must also take specific steps to try to reduce the risk of fraud, including obtaining a background check on each officer, director and major stockholder of every company.
Other Limitations on Offerings. In addition to requirements for issuers and intermediaries, crowdfunded offerings have several other important limitations:
- The maximum amount any person may invest through crowdfunded offerings during a 12-month period may not exceed: (a) the greater of $2,000 or 5% of the investor's annual income or net worth, if either is below $100,000; or (b) 10% of the investor's annual income or net worth, up to a maximum of $100,000, if either is $100,000 or more. Each threshold is subject to adjustment for inflation.
- Crowdfunding is not available to non-U.S. companies, public companies or investment companies (including companies exempt by Section 3(b) or 3(c) of the Investment Company Act of 1940).
- Securities sold in a crowdfunding may not be transferred for one year from the date of purchase, except in limited circumstances.
Companies interested in taking advantage of crowdfunding will need to proceed carefully. Crowdfunding promises to give emerging companies a new source of growth capital, but its utility, particularly for startups, may be limited by the direct and indirect costs of complying with the regulations imposed by the JOBS Act unless the company carefully structures the offering.
Fundraising from Accredited Investors (Rule 506 of Regulation D)
The JOBS Act makes it easier for companies to raise money from accredited investors by requiring the SEC to revise Rule 506 of Regulation D - the Rule under which most private offerings are conducted - to remove the prohibition on general solicitation and advertising if all purchasers in a financing are persons the issuer has taken reasonable steps to verify are accredited investors. This will allow companies to solicit investors with whom they have no pre-existing relationship through their websites, Facebook, Twitter and other social media outlets, as well as conventional media, without fear of losing the protection of the safe harbor provided by Rule 506.
The JOBS Act also provides that a person connecting issuers and potential investors will not be required to register with the SEC as a broker or dealer if the offering is being made pursuant to Rule 506, the person does not receive compensation in connection with the purchase or sale of the securities, and the person never takes possession of customer funds or securities in connection with the financing transaction. This clarifies the ways in which an unregistered broker (i.e. a "finder") may assist in fundraising without giving investors a rescission right.
These changes will further facilitate access to capital by emerging companies, particularly those located in areas of the country where early stage financing is scarcer, by making it easier for them to reach out to potential investors.
Rules Compelling Companies to Go Public
The JOBS Act makes it easier for companies to put off becoming a reporting company by easing the mandatory reporting trigger in Section 12(g) of the Exchange Act. Previously, a company was compelled to register a class of equity securities with the SEC and file periodic reports once it had at least $1 million in assets and shares "held of record" by at least 500 shareholders at the end of its fiscal year. The JOBS Act increases the Section 12(g) thresholds to $10 million in assets and 2,000 shareholders, of which up to 500 may be nonaccredited investors.
The JOBS Act further limits Section 12(g) of the Exchange Act by excluding from the definition of "held of record" holders who acquired securities (a) in a crowdfunded offering under the new Section 4(6) of the Securities Act or (b) pursuant to employee compensation plans in transactions exempted from registration under Section 5 of the Securities Act. This would include shares issued under a standard equity incentive plan (aka an "option plan") that meets the requirements of Rule 701 of the Securities Act.
These changes will allow emerging companies, which often compensate employees and others with equity, to stay private longer and choose the opportune time to go public.
The JOBS Act also makes it easier for a company to raise a more substantial amount of capital without becoming an SEC reporting company by amending Section 3(b) of the Securities Act to exempt from registration any class of equity, debt or convertible debt securities sold in an offering where the aggregate offering amount does not exceed $50 million in any 12-month period, provided the issuer files audited financial statements each year following the offering and complies with any other rules to be developed by the SEC.
This amendment effectively expands the existing exemption under Regulation A, which allows a private company to raise up to $5 million from the public using more streamlined disclosure than in a typical IPO and without registering the offering with the SEC or becoming an SEC reporting company . Regulation A already has a number of compelling features not available in a private placement: (a) the offering may be publicly announced; (b) there is no need to prequalify the investors as accredited; (c) there is no holding period before investors can resell the securities; and (d) an issuer is permitted to "test the waters" before the offering. Regulation A is rarely used, however, because even complying with the streamlined disclosure requirements is generally not cost-effective for an offering limited to $5 million, particularly when companies have the option to raise an unlimited amount from accredited investors under Rule 506 without any mandated disclosure obligation and without being subject to state "Blue Sky" laws. By raising the limit to $50 million, the JOBS Act makes the expenses associated with a Regulation A offering relatively more moderate.
The increased limit does come with new requirements: (a) companies must file an offering statement containing disclosures required by the SEC, and must file annual audited financial statements and other documents the SEC may require; (b) the Act expands the scope of "bad actors" who may not make use of Regulation A; and (c) the Act extends the liability provisions of Section 12(a)(2) of the Securities Act to offerings under new Regulation A. In addition, offerings under new Regulation A will be exempt from Blue Sky laws only if they are listed on a national securities exchange (such as Nasdaq or NYSE) or are sold only to "qualified purchasers" (a term to be defined by the SEC). The JOBS Act requires the comptroller general to submit a study in 90 days on the impact of Blue Sky laws on Regulation A offerings, which could influence the SEC's rulemaking.
Although not so suitable for early stage companies, new Regulation A should be attractive to companies that need to raise tens of millions and are sufficiently "mature" to have or procure audited financial statements but do not want the ongoing expense and vigilance required to be a full-fledged SEC reporting company. Whether new Regulation A becomes a viable alternative may depend on how the SEC defines "qualified purchaser." Companies generally want to steer clear of Blue Sky law because state regulations are not always uniform, and regulatory review can be unpredictable and expensive, except perhaps for an offering conducted in only a few states. If the definition of "qualified purchaser" is not too restrictive and the rules for determining which investors satisfy the definition are not too onerous, Regulation A will again be well worth considering.
Emerging Growth Company IPOs
Finally, the JOBS Act makes it easier for companies with less than $1 billion in annual gross revenue - referred to in the Act as "emerging growth companies" - to raise capital in the public markets by exempting them from a number of current and proposed regulations applicable to companies doing IPOs and once they are public. A company will continue to be classified as an emerging growth company until the earliest of: (a) the last day of the fiscal year in which the company's total annual gross revenues are $1 billion or more; (b) the last day of the fiscal year following the fifth anniversary of the company's initial public offering; (c) the date on which the company has, during the previous three-year period, issued more than $1 billion in nonconvertible debt; or (d) the date the company is deemed a "large accelerated filer" under Rule 12b-2 of the Exchange Act (requiring, among other things, that the company have a public float of $700 million or more). The $1 billion annual gross revenue threshold is to be adjusted for inflation every five years, and a company that went public or was in registration on or before December 8, 2011, is not eligible to be an emerging growth company.
Under the JOBS Act, emerging growth companies will have a simpler path to going public than larger companies:
- Emerging growth companies may prefile confidential registration statements in order to begin the SEC review process without publicly revealing sensitive commercial and financial information. A company must publicly file the original registration statement and all amendments at least 21 days before it begins a pre-IPO road show.
- The publication or distribution by a broker or dealer of research reports about an emerging growth company that is the subject of a proposed public offering will not be considered an offer to sell securities, even if the broker or dealer is participating in the offering.
- An emerging growth company may communicate with qualified institutional buyers and with accredited institutional investors to determine their interest in a contemplated IPO both prior to and following the filing of a registration statement.
- Emerging growth companies are required to present only two years of audited financial statements in order to register for an IPO, and in any other registration statement are not required to present selected financial data for any period prior to the earliest audited period presented in connection with the company's IPO.
- Emerging growth companies are also exempt from compliance with new or revised financial accounting standards until such standards apply to private companies.
Once public, emerging growth companies are also exempt from several ongoing obligations that apply to larger companies:
- Emerging growth companies are exempt from Section 103(a)(3) of the Sarbanes-Oxley Act of 2002 (SOX), including from any rules adopted by the Public Company Accounting Oversight Board (PCAOB) mandating audit firm rotation, and from any future PCAOB rule unless the SEC determines it is necessary in the public interest.
- Emerging growth companies are not required to comply with Section 404(b) of SOX, which requires a report by an outside auditor on management's assessment of the company's internal controls over financial reporting, although management must still establish and report on its assessment as to the effectiveness of its internal controls.
- Emerging growth companies are also exempt from Section 951 and Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 951 requires public companies to hold a nonbinding shareholder vote on executive compensation arrangements at least once every three years. Section 953(b) requires that public companies disclose the median compensation of all employees compared with that of the company's CEO.
By reducing the burdens of going public for emerging growth companies and allowing them to file confidential registration statements and test the waters through prefiling communications with potential purchasers, the JOBS Act will likely encourage more companies to access the public markets, and allow them to do so when they know the offering is more likely to succeed.
The JOBS Act represents an acknowledgment by Congress that a one-size-fits-all approach to securities regulation creates too many impediments to capital formation. Emerging businesses will now have more options at all levels of financing, but also face new rules and regulations.