Commentators have lauded the Jumpstart Our Business Startups Act, or JOBS Act, for creating an "IPO on ramp" for emerging growth companies with less than $1 billion of revenue. By easing longstanding "gun-jumping" restrictions associated with pre-IPO offering periods, reducing financial audit and disclosure obligations traditionally associated with IPO prospectuses and creating a five-year transitional period during which certain Sarbanes-Oxley, Dodd-Frank and other governance and disclosure burdens may now be phased in instead of immediately applicable, the JOBS Act should encourage more companies to test and enter the public securities markets.
At the same time, the JOBS Act removes a number of longstanding impediments to non-public capital-raising efforts and may accelerate the formation of online securities markets to facilitate them. In the aggregate, these reforms have the potential to revolutionize the private securities markets. The principal reforms:
- raise the threshold for mandatory Exchange Act registration and public reporting from 500 shareholders of record to 2,000 shareholders of record, or 500 shareholders of record who are not accredited investors, and exclude from these calculations employee participants in stock compensation plans and any "crowdfunding" shareholders;
- restore vitality to the little-used Regulation A small offering exemption by increasing the maximum offering amount from $5 million to $50 million annually and, if certain criteria are met, greatly reducing the blue sky burden related to such offerings;
- eliminate the ban on general solicitation and advertising in Rule 506 private placements and Rule 144A offerings so long as all buyers are accredited investors; and
- permit companies to raise up to $1 million annually through "crowdfunding" offerings.
Some of these reforms require further SEC rule-making, some of which was due in July but was delayed by the SEC, and it remains to be seen how workable they may prove for small businesses, broker-dealers and other intermediaries. However, the potential for a significant increase in the amount and efficiency of private fundraising, both online and through traditional means, is clearly present, as is an enhanced degree of flexibility for small businesses in timing their IPOs or for not going public at all if they wish. What is also clear is that these reforms will work most effectively for small companies if they employ broker-dealers and secondary markets for their fundraising and market activities.
Exchange Act Reporting Threshold
The JOBS Act increases the number of shareholders of record that a company may have before it must register a class of securities with the SEC under Section 12(g) of the Exchange Act and take on the burdens of a reporting company. Previously, reaching 500 shareholders of record would trigger the registration requirement for companies with more than $10 million of total assets. Under the new thresholds provided in the JOBS Act, such a company will need to register only if it has either 2,000 or more shareholders of record in total or 500 or more shareholders of record who do not qualify as accredited investors. In making these calculations, a company may exclude persons who receive stock pursuant to an equity compensation plan in transactions that are exempt from registration under the Securities Act. Further, after the SEC adopts its crowdfunding rules (see below), persons who acquire a company's securities in exempt crowdfunding offerings may also be excluded from the shareholder of record count.
The SEC has traditionally taken the position that only shareholders of record are counted for these purposes and that companies need not look through broker "street name" holdings to count beneficial holders or through partnerships or trusts to count partners or beneficiaries. The JOBS Act is silent about this and, indeed, a proposed Senate amendment that would have required the SEC to adopt rules to mandate such "look-throughs" was considered but not adopted. Accordingly, unless the SEC changes its counting methodology on its own, the enlarged 2000 and 500 shareholder thresholds will retain the potential for even larger numbers of beneficial owners.
This new math may afford small companies greater flexibility to remain private and avoid the burdens of being public for longer periods to build larger shareholder bases before they do go public, if they elect to do so, and to time their IPOs to favorable market conditions with greater facility. The higher thresholds may be particularly helpful in this regard to high growth young companies that formerly might have approached the 500-shareholder limit simply through hiring needed employees and compensating them in part with stock. Now that employees will be excluded from the equation, these companies will be able to maintain attractive employee stock compensation plans while still avoiding public disclosure of information they would prefer to keep secret from competitors.
When this ability to remain private longer is combined with the Regulation D private offering enhancements discussed below, the market for secondary sales of unregistered securities may become more robust. In recent years, this market has become more accessible and regular through the efforts of private exchanges like SecondMarket, SharesPost and others. If companies stay private longer in part because they are able to raise capital through private placements more easily, this should both increase the supply of unregistered shares for secondary markets and the demand for liquidity for such shares that can be met by such markets.
It remains to be seen, however, whether entrepreneurs will be willing to "feed" the secondary sales markets with new shares or will tighten restrictions on resales of their shares in order to maintain control and continued eligibility for the 2,000 shareholder threshold, rather than accept the lower, 500-shareholder threshold for non-accredited investors. This significant difference will force many companies to be more vigilant in determining who of their shareholders and potential investors are accredited investors in order for them to take advantage of the 2,000 shareholder threshold. While the exclusion of many, if not most, employees from the count will be helpful in this regard, vigilant monitoring and control over secondary resales in order to maintain eligibility for the higher threshold may prove burdensome. See below regarding the changes to Rule 506 and general solicitations for further discussion of accredited investor verification.
The JOBS Act amends Section 3(b) of the Securities Act to breathe new life into Regulation A, a long-standing exemption from Securities Act registration for small public offerings. Regulation A has permitted non-reporting companies to sell a limited amount of securities under an offering circular that, while filed with and reviewed by the SEC, is far shorter and easier to prepare than a full-fledged registration statement, and need not include audited financial statements. Securities sold under Regulation A may be sold to any investor, without regard to any income or net worth criteria. Such securities are unrestricted and may be immediately resold, assuming buyers can be found. However, while Regulation A was devised to promote capital formation for small businesses, it has not been up to the task and has been rarely used. This has been attributable in part to the comparative ease of use of Regulation D, which involves no SEC filings, but primarily to Regulation A's modest $5 million offering cap and Regulation A offerings having been subject to compliance with state securities or "blue sky" laws. Particularly in "merit review" states, the time and expense of blue sky compliance for such small offerings has made Regulation A offerings impractical.
To address Regulation A's shortcomings, the JOBS Act directs the SEC to adopt rules establishing what many commentators have dubbed Regulation A+, which will:
- raise the $5 million cap to $50 million of equity, debt or convertible debt securities within any 12-month period;
- treat Regulation A+ securities as "covered securities" exempt from blue sky compliance if they are listed on a national securities exchange or if offers and sales are limited to "qualified purchasers" (a term to be defined by the SEC);
- provide that securities offered under Regulation A+ (as with its predecessor) may be offered and sold publicly by general solicitation to any potential purchaser, and will not be restricted securities; and
- as with old Regulation A, permit issuers to "test the waters" to solicit interest in their Regulation A+ offerings prior to filing an offering circular with the SEC.
At the same time, the JOBS Act expands the investor protection aspects of Regulation A by authorizing the SEC to require Regulation A+ issuers to include audited financial statements in Regulation A+ offering circulars, by requiring Regulation A+ issuers to file audited financial statements annually with the SEC and by authorizing the SEC to require such issuers to file and disseminate periodic reports as to their business operations, financial condition and corporate governance principles, among other items. These reports, if required by the SEC, which seems probable, will in all likelihood be analogous to Exchange Act reports, but on a scaled-down basis. The current Regulation A has no on-going disclosure requirements. Further, the JOBS Act makes applicable to Regulation A+ offerings the risk of civil liability under Section 12(a)(2) of the Securities Act for all persons offering or selling the securities.
While these additional burdens are significant, they will still be comparatively much lighter than full Securities Act registration and Exchange Act periodic reporting and corporate governance requirements. With a $50 million offering cap, Regulation A+ offerings should now be more cost effective, even if the securities offered do not qualify as "covered securities" because they are not listed or are not sold only to "qualified purchasers." It remains to be seen whether exchange listings will be available for very small companies that are not full reporting companies, but there is a fair amount of on-going discussion at the exchanges and NASDAQ regarding the creation of "venture" or similar exchanges geared toward this market. Further, we expect that the SEC will not raise the bar too high when defining "qualified purchasers" but rather will adopt income-based criteria similar to those already in place in certain "merit review" states, such as California and Texas, for certain limited offerings.
Accordingly, we expect that many small companies may view Regulation A+ as a viable alternative not only to more costly registered offerings, but to Regulation D private placements in which, even though the offering may far exceed $50 million, there are restrictions on permissible purchasers (which will not apply to Regulation A+ offerings of "covered securities" that are exchange-listed) and the securities sold are subject to resale restrictions (which will not apply to Regulation A+ offerings of any "covered securities"). This should be especially true for later-stage private companies for which the costs of effecting a Regulation A+ offering and the burden of complying with the new Regulation A+ reporting requirements may not appear daunting. Indeed, a Regulation A+ offering might be viewed by some companies and securities intermediaries as a dress rehearsal and market test for a full-fledged registered offering further down the road. Further, given the absence of mandatory holding periods for Regulation A+ securities, institutional investors in particular may favor investments in such securities rather than those offered in Regulation D private placements since the shares should not be subject to an illiquidity discount on resale. Finally, as noted earlier, with the increase in the shareholder number threshold for Exchange Act reporting, entrepreneurs may see a series of Regulation A+ offerings over a period of years as a very cost-effective method for raising significant capital.
As for investment banks and broker-dealers, particularly those that specialize in small companies, Regulation A+ should provide an opportunity for new business and may be viewed as a chance to lock in future IPO candidates. Balanced against this is the application of Section 12(a)(2) civil liability to Regulation A+ offerings, which to a certain extent will "up the ante" on securities intermediaries who bring these offerings to market. Under Section 12(a)(2), intermediaries may be liable for material misstatements and omissions even if resulting from good faith mistakes without any intention to deceive. The principal defense against Section 12(a)(2) is that the intermediary did not know that a statement was untrue or misleading and had conducted meaningful due diligence and that the exercise of such reasonable care would not have revealed the untrue or misleading nature of the statement. Thus, since small companies typically have less mature internal accounting and reporting systems and controls, intermediaries who wish to underwrite Regulation A+ offerings will need to conduct more thorough due diligence than may have previously been the practice and, among other things, are likely to impose comfort letter procedures comparable to those in the registered offering setting.
Rule 506 and the End of the Ban on General Solicitation and Advertising
The JOBS Act directed the SEC to amend Regulation D within 90 days to eliminate the longstanding prohibition on the use of general solicitation and advertising in connection with offerings under Rule 506 of Regulation D as well as under Rule 144K (which will not be discussed here), but not under Rules 504 and 505 of Regulation D, which are focused on smaller offerings. In order to use these offering means, however, issuers may sell securities only to accredited investors, as defined in Regulation D, and must take "reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as are determined by" the SEC. Recognizing that offers made by general solicitation and advertising will unavoidably be received by non-accredited as well as accredited investors, the JOBS Act does not seek to regulate their dissemination, but only those parties permitted to act on them to purchase securities.
The SEC has missed the 90-day deadline but has scheduled a meeting on August 22, 2012, to consider rules to implement this provision of the JOBS Act.
The general solicitation ban has generally compelled companies seeking to raise substantial amounts in Regulation D offerings to concentrate their sales efforts primarily on institutional investors, relying to a substantial extent on pre-existing relationships between such investors and the company or, more typically, with its placement agent. The elimination of the general solicitation ban, together with the increase in the Exchange Act shareholder number reporting threshold, should enable many companies to expand the focus of their solicitation efforts not only to a broader range of unfamiliar institutional investors but to the more "retail" market of high net worth individuals. This may provide a number of advantages, in that the terms of retail offerings are less likely to be negotiated than those in institutional only offerings, and it is less likely that aspects of control will need to be ceded by founders and management if the percentage ownership of institutional investors is reduced. Further, there are many companies that might not appear attractive for investment to many institutional investors that might be able to sell their securities more effectively to a broader, non-institutional market.
Issuers and placement agents have traditionally established the accredited investor bona fides of investors through "self-certification," that is, the completion of representation and warranty-heavy subscription agreements or online platform access questionnaires. However, it appears that taking "reasonable steps" to verify accredited investor status as the JOBS Act requires is likely to involve a higher degree of diligence than what has been the accepted standard of "reasonable belief" by an issuer as to accredited investor status. The SEC's rule proposal expected later this month will reveal whether the SEC intends to require issuers to take additional steps, such as obtaining financial statements or tax returns from potential investors, as the North American Securities Administrators Association ("NASAA") suggested in a July letter to the SEC, or if the SEC will simply retain something akin to the "reasonable belief" standard. If the SEC opts for more information, we may see, given the additional costs involved and privacy concerns, the development of verification data banks, perhaps managed by broker-dealer groups, to which investors could submit whatever information is required for verification in order to obtain certification as accredited investors. Issuer and placement agent data bank subscribers could rely on such certifications, in addition to standard subscription agreement representations and warranties. Indeed, in its July letter, NASAA suggested that the SEC should allow issuers to rely on verifications by registered broker-dealers. Particularly if the SEC adopts a vague reasonableness standard in this regard, broker-dealers acting as placement agents would likely welcome such certification systems, since the due diligence capacities of small companies are often questionable, and the potential liabilities for Securities Act violations are great if the Regulation D exemption because of accredited investor verification errors.
When the ban on general solicitation and advertising was originally conceived, the SEC had in mind the means of mass communication then prevalent: television and radio advertisements, seminars and newspaper articles, and even cold calling. It is likely, however, that the liberalization contemplated in the JOBS Act will see its greatest use through e-mail and website solicitations through placement agents and by the issuers themselves, and what may develop as "portal" websites where many offerings can be accessed and "sampled" by investors.
In this regard, the JOBS Act creates a new exemption from broker-dealer registration for any party that maintains a "platform or mechanism" that permits offers, sales or purchases of securities, related negotiations, or general solicitations, general advertisements or similar or related activities by issuers, whether on line, in person or otherwise, so long as (i) these activities are in connection with a Rule 506 offering and (ii) the party and its associates receive no compensation in connection with the purchase or sale of a security and do not come into possession or control of customer funds or securities in connection with any purchase or sale. The exemption also permits such parties to co-invest in such securities and to provide as yet undefined "ancillary services" with respect to such securities, but is not available to persons with a "statutory disqualification" as defined in Section 3(a)(39) of the Exchange Act. It should be noted that the JOBS Act does not pre-empt state broker-dealer regulation with respect to such exempt platforms.
We must await SEC rulemaking, the timing of which is uncertain, to know how such "AngelList" type intermediaries may be compensated, but while commissions or fees tied to purchase or sale transactions are clearly prohibited, listing, subscription or access fees charged to issuers and perhaps access or subscription fees charged to potential investors may be permissible. Presumably permissible "ancillary services," while as yet undefined, will be compensable. Whether large-scale platforms are established will depend on whether there is a sufficient economic return to make them worthwhile. On the other hand, there is nothing to stop registered broker-dealers from offering the same kind of platforms and charging placement and other fees to issuers that use such platforms. Indeed, broker-dealers may even be inclined to discount or waive those fees in order to compete with exempt platforms, with the intent to have their platforms serve essentially as "loss leader" drivers of small companies to their longer term, private placement, Regulation A+, IPO and other services.
While we may see issuers make new Rule 506 offerings using their own websites, they will encounter the same problems encountered by any commercial website in driving visitors, let alone investors, to their sites. The likely difficulties may make such "do it yourself" offerings of questionable utility. Accordingly, there should be a demand for issuer-investor matching on exempt platforms as well as for registered broker-dealer online placement services.
The crowdfunding provisions of the JOBS Act have been described as an innovative, if long delayed, accommodation of a demand for social media investing. However, the related investor protections, including the SEC filing, disclosure document and intermediary requirements described below, may make all but the largest permitted offerings impractical and unattractive to issuers and intermediaries. The fear of investor fraud that motivated these protections is clearly legitimate. Yet, Congress might have supplemented the new, protective regulatory scheme for crowdfunding with a simpler alternative that would have lowered the obstacles to very small crowdfunding offerings. Judging by the generally small amounts involved in the "not-for-profit" crowdfunding capital raises at well-known online sites such as Kickstarter, RocketHub and Indigeogo, such offerings would in the aggregate be enough to fund the low capital "seeding" needs of musicians, artists and very small business entrepreneurs seeking to build affinity relationships with consumers, while at the same time permitting people who are not professional investors to "vote with their dollars" or even make small entrepreneurial bets.
The SEC is required by the JOBS Act to adopt rules regarding crowdfunding within 270 days of enactment, and it is anticipated that the SEC will publish proposed rules by the end of 2012. The rules will provide an exemption from both federal and state securities registration of securities and will permit crowdfunding offerings to be made widely using the Internet. The exemption will not be available for foreign issuers, Exchange Act reporting companies or investment companies. An issuer relying on the crowdfunding exemption may raise not more than $1 million in any 12-month period in reliance on the crowdfunding exemption but will not be restricted from raising additional capital pursuant to other exemptions from the Securities Act. The $1 million annual cap applies to all sales made by an issuer and all of its affiliates under the crowdfunding exemption; so for example, an oil and gas company issuer could not get much mileage from the exemption by, for instance, organizing multiple subsidiaries, each of which would mount its own crowdfunding offering tied to a single or small group of oil wells.
There are also limits on how much an issuer may sell to any particular investor during a 12-month period. For investors whose annual income or net worth is less than $100,000, the price of the securities sold by an issuer may not exceed the greater of $2,000 or 5 percent of such investor's annual income or net worth. For investors whose annual income or net worth is $100,000 or more, the price of the securities sold may not exceed 10 percent of such investor's annual income or net worth up to a maximum of $100,000. There is no limit on an investor's ability to make crowdfunding investments with as many companies as he or she wishes. Securities purchased in crowdfunding offerings are subject to transfer restrictions for one year although transfers to accredited investors or back to the issuer will be permitted during that period.
The crowdfunding exemption includes a number of significant burdens on the crowdfunding process which may add significantly to its cost and risks for issuers. First, issuers may make these offerings only through an intermediary, that is, either a registered broker-dealer or a new kind of registered platform to be known as a "funding portal." Second, issuers will be required to file with the SEC and disclose to investors in connection with the offerings, information that comprises a "mini-prospectus" and which in most cases includes financial statements that, for offerings for over $100,000, must be reviewed by an independent accountant, and for offerings over $500,000, must be audited. Third, issuers will be required to provide to investors and file with the SEC annual reports including financial statements. Fourth, issuers, their principals and participating intermediaries will be subject to the risk of civil liability under Section 12(a)(2) of the Securities Act. While it is likely that standardized forms of disclosure documents will be developed, probably by funding portals, for the offering documents and annual reports, the legal and accounting costs that will necessarily be involved will be quite significant in relation to the small amounts that may be raised under the new exemption, and may make smaller crowdfunding offerings impractical.
The requirements for funding portals are similarly onerous and raise doubts as to the ultimate business case for such entities. They will need to register with the SEC and become members of a self-regulatory organization ("SRO") although they will not be subject to state regulation. Preliminary indications are that the Financial Industry Regulatory Authority ("FINRA") will be the SRO for funding portals. Funding portals will not be permitted to offer investment advice or recommendations, solicit the purchase or sale of securities, hold customer funds or securities, be compensated for effecting transactions in securities or compensate their employees based on the sale of securities. Based on past SEC no action letters regarding finders, broker-dealer registration and commission sharing, it appears likely that funding portals will not be permitted to charge fees that constitute commissions that are in any way linked to the size of the transaction. It appears that non broker-dealer funding portals will only be permitted to charge a posting fee. At the same time, it is likely that funding portals will have significant disclosure, due diligence and antifraud, know-your-customer and customer privacy duties, as well as customer education, monitoring and protection obligations, including taking steps to insure that investors review and understand certain investor education materials and do not exceed the investment amount limitations of the exemption. Clearly, legal and compliance costs for funding portals will not be insignificant, but their sources of income will be constrained.
Assuming that these obstacles can be overcome, issuers may find themselves with a large base of relatively unsophisticated investors after a crowdfunding offering. This may entail administrative headaches for businesses that for the most part will not have the resources to communicate adequately with this base and manage it for shareholder meetings and the like. Moreover, if a crowdfunded business wishes to move on to attract venture or private equity financing, will its numerous and largely unsophisticated shareholder base make it unattractive to institutional investors? That seems possible although some leading private equity firms have indicated that they might still invest in a crowdfunded business if all crowdfunding investors have the same rights and no protections beyond those afforded common shareholders. Nevertheless, if a merger, sale or other exit transaction is in the offering, the large number of shareholders involved will almost certainly raise the transaction costs should the acquirer be required to obtain shareholder approval and may even require compliance or the use of exemptions from compliance with various securities laws.
Some of these concerns may be addressed by SEC rule-making. There are a number of crowdfunding platforms and industry groups, including the Crowdfunding Industry Regulatory Advocates, actively lobbying the SEC and Congress with respect to the implementation of the JOBS Act. The potential success of these funding portals will depend in large part on the constraints placed on them by the rules eventually adopted by the SEC.