The SEC released the final rules on an important change to the way small businesses and start-ups can raise funds.
The changes will create two tiers for Reg A offerings. Tier 1 will allow for offering up to $20 million in securities in a single 12-month period with no more than $6 million of that coming from security-holders that are affiliates of the company. For tier 2, those limits are raised to $50 million and $15 million, with some new disclosure requirements included. The previous cap was set at $5 million raised in one year, making this a major shift in the SEC rules.
Also, importantly, the SEC eased restrictions on who could invest, allowing non-accredited investors the opportunity to invest in Reg A offerings at levels limited by their income and/or net worth.
New Options for Start-Ups and Private Companies
Reg. A has long been an important loophole that could allow growing companies to delay the costly and labor-intensive process of an IPO without having to sacrifice their access to important seed money they need to expand. The loophole contained in Reg A has been around for years, but it’s small size means it’s rarely used. However, the opportunity is distinctly different at $50 million a year than it was at $5 million.
"Regulation A+ will likely go into effect 60 days after publication in the Federal Register (June 2015). Here are the highlights of the new Regulation A+ exemption:
High Maximum Raise: Issuers can raise up to $50,000,000 in a 12 month period for Tier 2 and $20,000,000 for Tier 1.
Anyone can invest: Not limited to just “accredited investors” – your friends and family can invest. Tier 2 investors will, however, be subject to investment limits described below.
Investment Limits: For Tier II, individual investors can invest a maximum of the greater of 10% of their net worth or 10% of their net income in a Reg A+ offering (per offering). There are no investment limits under Tier 1.
Self-Certification of Income / Net Worth: Unlike Rule 506(c) under Title II of the JOBS Act, investors will be able to self-certify their income or net worth for purposes of the investment limits so there will be no burdensome documentation required to prove income or net worth.
You can advertise your offering: There is no general solicitation restriction so you can freely advertise and talk about your offering, including at demo days, on television, and via social media.
Offering Circular Approval Required: The issuer will have to file a disclosure document and audited financials with the SEC. The SEC must approve the document prior to any sales. The rules indicate that the Offering Circular may receive the same level of scrutiny as a Form S-1 in an IPO. This is the biggest potential drawback of using Reg A+.
Audited Financials Required: For Tier 2, together with the Offering Circular, the issuer will be required to provide two years of audited financial statements. Tier 1 offerings require only reviewed financials (not audited).
Testing the Waters: An issuer can “test the waters” and see if there is interest in the offering prior to spending the time and money to create the Offering Circular. This would be “Preview” mode on SeedInvest where investors can express interest, but can’t yet invest. This is important so that companies don’t have to gamble on their fundraise and can see if there is interest prior to investing in legal and accounting fees.
Ongoing Disclosure Requirements: For Tier 2, the issuer will be required to make an annual disclosure filing, a semi-annual report, and current reports, each of which are scaled back versions of Form 10-K, Form 10-Q and Form 8-K, respectively. These reports will also require ongoing audited financials. These disclosures can be terminated after the first year if the shareholder count drops below 300. There are no ongoing disclosure requirements for Tier 1.
State Pre-Emption: As discussed above, the old Regulation A (now Tier I) was never used because it required registering the securities in every state that you make an offer or sales. New Reg A+ Tier 2 preempts state law – again – this is huge. Tier 1 Reg A+ again does not have state pre-emption but will be a testing ground for NASAA Coordinated Review.
Shareholder Limits: In a welcome departure from the proposed rules, it appears that the Section 12(g) shareholder limits (2,000 person and 500 non-accredited investor) will not apply to Reg A under certain circumstances. This fixes a major problem from the proposed rules which would have limited the potential for very small investments (i.e. $100).
Unrestricted Securities: The securities issued in Reg A+ will be unrestricted and freely transferable, though many issuers may choose to impose contractual transfer restrictions. Many believe this will pave the way for a secondary market for these securities in the form of Venture Exchanges.
No Funds: Investment companies (i.e. private equity funds, venture funds, hedge funds) may not use Reg A to raise capital.
Integration: There are several safe harbors so it seems that you can use Reg A+ in combination with other offerings. There are safe harbors for the following:
No integration with any previously closed offerings
No integration with a subsequent crowdfunding offering
No integration where issuer complies with terms of both offerings independently – can conduct simultaneous Reg D – 506(c) offering."
As such, plenty of companies have begun to find themselves trapped in a donut hole. They need to raise more money to pay for expansion, but they aren’t ready to go public and take on the new responsibilities that entails. Many of the changes written into the 2012 JOBS Act were geared towards addressing this issue. This included increasing the number of shareholders a private company could have from 500 to 2,000 and a so-called “IPO on-ramp” that eased certain requirements for companies with less than $1 billion in revenue.
The increase in the Reg A cap was a key piece of this, offering a new option to many companies stuck between private and public markets.
Smaller Investors Now Have New Options
Which brings us to what many will see as the biggest piece of actual news in the SEC's release: non-accredited investors will be able to invest in Reg A offerings. Accredited investors, defined as inviduals with an income exceeding $200,000 annually or a net worth of $1 million, have long been the only people that could invest in unregistered securities. It was a rule that was put in place to protect smaller investors from investing in a risky private company that could ruin them if it went under. However, it also wound up being a rule that prevented companies from accessing captial from the majority of the population and prevented investors from getting a shot at the huge returns that could come from getting in on the ground floor of a company that ultimately takes off.
These "mom-and-pop" investors would be limited to investments that wouldn't exceed 10% of either their annual income or net worth, whichever is greater, theoretically keeping anyone from getting in too deep on an unregistered private placement. It's seems like a bit of an about-face from the SEC's position when it proposed rules for Title III of the JOBS Act that dictated the process for equity crowdfunding. When the bill was first passed, there was a lot of excitement surrounding this portion of the bill. The thought being that now platforms like KickStarter or IndieGoGo could now offer straight equity, allowing companies to raise large sums of start-up money from a wide investor base.
However, the initially proposed rules took a lot of wind out the sails of that enthusiasm. Any company relying on crowdfunding to raise capital would be subject to a lot of onerous regulations, making the cost of raising money in this fashion so high that it exxentialy precluded anyone from doing so. What's more, it limited the money that could be raised that way to $1 million a year. The rules would basically ensure that raising captial through crowdfunding wouldn't make sense for anyone.
Now, it appears that the SEC is essentially approving the concept contained in Title III but moving it out of Title III. Large capital raises from a broad base of non-accredited investors will be possible, it's just going to happen under a different portion of securities law. It could also mean that the complaints about how onerous the proposed Title III rules would be did not fall on deaf ears, prompting the SEC to provide this compromise. Either way, this is something that opens up a portion of our capital markets to millions of investors who were previously frozen out. On the one hand, that could mean a lot of less-educated investors are going to lose money on risky bets. On the other, it may also mean that millions of people will get their crack at getting in on the ground floor of the next Twitter (TWTR) or Facebook (FB) and reap the tremendous benefits that can come with that.
Modernizing Regulations for Modernized Markets
We’re in an interesting place right now in terms of securities law. Essentially, the laws that dictate how one can sell some portion of their business are rooted in the Securities Act of 1934. In the aftermath of the Roaring Twenties, it became clear that stock markets needed to be reformed to protect investors, many of whom had gotten burned by unscrupulous traders prior to the crash. They essentially created a divide where, in order to sell stock to the general public, a company needs to register their offering with the authorities (the newly created Securities and Exchange Commission (SEC)). A company that registered its stock had to operate within certain legal requirements, including regular disclosure of key financial information. This protected investors from companies perpetrating outright fraud (most of the time).
Private companies could still sell unregistered equity, but they were much more limited in doing so. Because these private offerings weren’t as closely monitored by the SEC, and didn’t have to release as much financial information, one had to be an accredited investor to be able to buy up shares. Again, this was to protect smaller investors from losing money in companies that weren't held to the same legal standards as those that were registered. Private companies had more freedom to operate, but ultimately less access to capital because they couldn't raise cash from non-accredited investors.
On the whole, this was a divide that made a lot more sense in the 1930s when information was hard to come by, meaning that figuring out details about private companies could be really hard. But times have changed.
With the internet, information is cheap and plentiful. Today, you can get more information about a company in an hour than you could in a year in 1934. As such, the JOBS Act appears to be a step towards reforming and updating regulations to better fit the reality of today. With the advent of things like crowdfunding and peer-to-peer lending, it’s clear that our investing ecosystem is fundamentally different than it was when much of our securities law was written.
So, it does appear that the SEC might be ready to take the plunge and accept that it's a different world than the one the organization was born out of. Given how easily anyone with an internet connection can access information, there's a lot less need to "protect" smaller investors from getting burned by bad actors. Plenty of people out there are going to be able to do their own research and make their own choices, even if that means taking some big risks. As such, opening up markets so that these smaller investors can opt in where they see opportunity and access major returns when they pick the righ horse may simply represent progress. Only time will tell.
Updated on March 26, 2015.
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