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Under the Securities Act of 1933, the offer and sale of securities must either be registered with the SEC or meet an exemption from registration. In April 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law to facilitate new ways for startups and small businesses to raise capital. The Act required SEC to update, expand, and write more flexible rules on capital formation, disclosure, and registration requirements. The JOBS act was revolutionary, because it allowed businesses to solicit to raise capital, permitted non-accredited investors to invest, and regulated the equity crowdfunding practice allowing private companies to use online platforms to offer equity and debt.
The JOBS Act offered companies various different possibilities to use funding platforms to launch equity crowdfunding campaigns. Some of the questions that founders should consider when deciding under which regulation they want to raise are:
The three newly introduced or updated exemptions under the JOBS Act that allow startups and small businesses to raise capital via online funding platforms are:
Regulation Crowdfunding under Title III has gained popularity and media hype over the last year and many Regulation CF funding portals have launched allowing “crowds” to invest. It has a raise limit is only $1.07 million.
There are both benefits and drawbacks of raising capital under Regulation D versus Regulation A+. Some of the factors to take into consideration include: estimated costs, the average time to raise, disclosure requirements, preference towards accredited or unaccredited investors, restrictions on resale of the securities, and general solicitation.
Two kinds of intermediaries may conduct equity crowdfunding offerings and transactions:
Regulation D is a set of rules adopted by the SEC in 1982 to clarify the conditions of certain exemptions from registration under the Securities Act of 1933. Regulation D contains three rules (504, 505, and 506) that provide exemptions from registration requirements, allowing companies to offer and sell their securities without having to register the securities with the SEC. Of the three rules, Rule 506 is by far the most popular; it accounts for 99 percent of the capital raised in Regulation D offerings and 94 percent of the number of successful raises. Rule 506 is considered a “safe harbor” for the private offering exemption of Section 4(a)(2) of the Securities Act.
Title II of the Jumpstart Our Business Startups (JOBS) Act went into effect in September 2013. Under Title II, the SEC split Rule 506 of Regulation D into two parts: Rule 506(b) of Regulation D is the “traditional” part, still allowing up to 35 non-accredited investors, prohibiting general solicitation, and letting accredited investors self-certify. Rule 506(c)of Regulation D is the “new” part. It lifts the ban on general solicitation and limits an offering to accredited investors only. It also requires Reg D platforms to “take responsible” steps to verify each investor’s accredited ok status. For example, an offering platform can require investors to submit tax returns or bank statements or a confirmation letter from a lawyer, banker, or financial adviser. Companies that decide to offer securities through a Reg D platform must choose whether they want to use Rule 506(b) or Rule 506(c).
There are many benefits for startups and small businesses to raise capital under Regulation D Rule 506. First, it does not limit the size of an offering in terms of dollars. Second, it doesn’t restrict the type of securities offered. Third, it does not limit the amount raised in a year or the amount each investor can invest. Fourth, it requires a very minimal disclosure from issuers if only accredited investors are targeted, which helps keep the overall issuing costs low. Fifth, Rule 506 offerings are exempt from compliance with state securities laws, making it ideal for online offerings which potentially reach investors in all 50 states.
Furthermore, there’s a lot of upside for both issuers and investors with the new Rule 506(c) which allows general solicitation. When issuers advertise their offering, they broaden their reach. They can raise more money, faster, by appealing to a wider range of investors. They don’t have to rely on their own personal and business network or the traditional gatekeepers to help them find suitable investors. Now they can make their case directly to the market and let the strength of the offering speak for itself. From the investor’s perspective, an advertised 506(c) placement is a huge new opportunity as well. Investors can more easily search for placements that suit their needs, and they don’t have to have any kind of insider connections to uncover the best offerings.
The main disadvantage of the new Rule 506(c) is the stricter requirement to verify investor’s accredited status. It requires issuers to take reasonable steps to verify that its investors are accredited investors, which could include: reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports, and so on. Some investors might be unwilling to submit to the “reason steps” 506(c) platforms to verify their accredited status or might feel discouraged by the need to submit documentation or engage their professional advisers to verify their accredited status.
A major drawback of Rule 506 overall is that it mainly allows raising capital only from accredited investors, which undermines the many benefits of Regulation D Rule 506 exemption. A small number of accredited investors with a higher stake in the company could also mean giving away voting and control rights to investors.
Moreover, Rule 506(c) specifically restricts raising capital from accredited investors. While it is technically true that Rule 506(b) allows up to 35 unaccredited “sophisticated” investors, it is not really practical to do so. Rule 506(b) requires that an issuer must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. The rule goes on to strongly suggest that if an issuer provides such information to non-accredited investors, but not to accredited investors, it could be deemed in violation of the anti-fraud provision of securities law. The practical effect of this requirement is that, if an issuer includes just one non-accredited investor in its offering, they will need to prepare very thorough documentation and have the company’s financial statements audited. The combined legal and accounting costs of which could easily add up wiping out any benefits of including non-accredited investors in the capital raise.
According to a report published by SEC, in 2014, there were 33,429 Regulation D offerings reported, accounting for more than $1.3 trillion raised. Issuers in non-financial industries reported raising $133 billion during 2014. Rule 506 accounted for 99% of the amounts reported sold through Regulation D, including 97% of capital raised below the Rule 504 or Rule 505 offering limit thresholds, suggesting that issuers continue to value the preemption of state securities laws provided for offerings conducted pursuant to Rule 506.
The median offer size of non-financial issuers was less that $2 million. Approximately 301,000 investors participated in Regulation D offerings during 2014 and non-accredited investors were present in only 10% of Regulation D offerings. Amount raised under Rule 506(c) was 2% of the capital raised under Regulation D since the rule became effective in September 2013, suggesting that most issuers of unregistered securities were not yet seeking investors through general solicitation.
A report published by Crowdnetic in September 2016, three years after the Title II of the JOBS Act became effective, indicates that equity continues to be the most popular security type, leading in both the number of offerings and total capital commitments in the aggregate. Equity was the chosen security type in two-thirds of all offerings, generating more than 50% of total capital commitments in the aggregate. Convertible debt and debt were next in line.
In April 2012, Title III of the Jumpstart Our Business Startups (JOBS) Act directed the SEC to facilitate a new way for startups and small businesses to raise capital from the general public through the sale of securities, a method known as “crowdfunding”. Title III amended Section 4 of the Securities Act by adding Section 4(a)(6) and creating an exemption from registration for Internet-based securities offerings of up to $1 million over a 12-month period. Title III was intended to help small and startup businesses conduct low-dollar capital raises on the Internet. It can be thought of as an Internet-based method of raising seed financing from accredited and unaccredited investors. The JOBS Act included a number of investor protection provisions, including investment limitations, issuer disclosure requirements, and a requirement to use regulated intermediaries.
According to a recently published white paper by SEC, between May 16, 2016 - December 31, 2016, there were 163 unique offerings by 156 issuers, seeking a total of $18 million based on the target amount. The median (average) offering targeted approximately $53,000 ($110,000). Almost all offerings accepted oversubscriptions up to a higher amount close to $1 million.
Most issuers were relatively small companies. The median issuer had under $50,000 in assets, under $5,000 in cash, $10,000 in debt, no revenues, and 3 employees. About 40% of issuers reported non-zero revenue and 9% of issuers reported a net profit in the most recent fiscal year. A typical offering was due to close within 4-5 months of initiation.
Distribution of Securities: the most popular security issued was common or preferred equity, accounting for 36% of offerings. Debt accounted for 20% and there were various other security types, such as units, convertibles, SAFEs, and others (including revenue sharing and membership / LLC interest). It is possible that as crowdfunding issuers grow, they may attempt to raise additional financing via intrastate or regional crowdfunding, Regulation A, or Regulation D exemptions.
Estimate cost to raise: according to Bevilacqua PLLC, a boutique transactional law firm, assuming an $1,000,000 equity crowdfunding offering, the “all-in” cost ranges from $60,000 on the lower end of the scale (assuming a good amount of DIY work) to $150,000 on the higher end. The good news is that many of the fees can be deferred until the closing of the offering as many service providers are willing to accept some fees up front and defer the balance until the closing. In most cases, a company will be able to launch an equity crowdfunding campaign for as little as $15,000 to $25,000 with the balance of the fees deferred until capital is raised at the closing. Review this link for a more detailed cost estimate.
Regulation A+, updates and expands Regulation A, an existing exemption from registration for smaller issuers of securities. It creates two tiers of offerings: Tier 1 offerings may not exceed $20 million in a 12 month period and Tier 2 offerings may not exceed $50 million in a 12 month period.
Regulation A+ fundraising exemption became active in June 2015. It is sort of an intermediary step between being private and going fully public and is sometimes referred to as a “mini IPO”. It is designed for later stage private companies who want to raise more funds, but don’t want to do an IPO yet. It is best suited for companies that are structured properly and have their intellectual property secure enough that they feel comfortable releasing information to the public. Companies should be far ahead in their business development and have a proper infrastructure in place to meet ongoing reporting requirements. At the very least, it entails having a financial officer on the team who is knowledgeable and experienced with SEC accounting rules. The burden on a company to address investor relations will also expand, because of a larger investor base and resale of securities activities in the secondary market.
Regulation A+ offering is generally recommended for companies if their product is deeply appealing to consumers and they already have a large number of followers. Consumers are early adopters and will invest if they love what your company does. Research shows that customers who have a vested interest in the future of a business are more likely to recommend that company to others and increase the amount they spend with the company. Not only would they invest, but they are more likely to evangelize the brands they have invested in which means a much wider marketing reach than if the company was spreading the word on its own. In addition to advocating for the brand, they will also likely want to test out the products or services themselves. This can lead to feedback that improves what the company offers to the public.
Since Regulation A+ options are still being realized by the people who are now able to tap this investment potential, there is enthusiasm and momentum that is certainly to the advantage of the startups and growth-stage companies. With a support from followers and early adopters turned investors, startups don’t need to spend as much time trying to win over large investors and can focus instead on getting the company ready for the next level. Another benefit of raising funds under Regulation A+ is that it allows issuers to “test the waters” before presenting a formal offering to invest in.
Raising capital from a large pool of investors allows an entrepreneur to spread out ownership of the company more broadly. Often times, institutional investors require a certain level of control alongside their investments which can even result in an entrepreneur getting kicked out of their own company. In a typical Reg A+ offering, a company will not need to cede board seats or agree to other potentially adverse mechanisms that are typical when raising venture capital or private equity.
One of the important features of Regulation A+ is the ability of selling security holders to participate in the offering, known as secondary sales. The SEC hopes to encourage investment in startup companies by giving investors access to liquidity through security sales as part of a qualified Regulation A+ offerings. This point is very important because it creates a liquidity moment and potential exit for pre-seed and early stage investors. The SEC warns investors that, even though there is no resale restriction, they may need to hold their investment for an indefinite period of time. If the securities are not to be listed on an exchange where they can be quickly and easily trade. Investors will have to locate an interested buyer when they seek to resell their investment. (Source: SEC, McGuireWoods LLP)
However, Regulation A+ offerings won’t necessarily work for every company. For both tiers under Regulation A+, companies are required to submit offering circular and disclose financial statements to the SEC for a review and can only proceed with capital raising and accept payment for the sale of its securities once its offering materials have been qualified by the staff at the SEC. The disclosure requirements, and associated legal and administrative costs mean they are best suited for later-stage private companies that are on a trajectory to go fully public.
Tier 1 is theoretically easier because the financial statements disclosed in an offering do not have to be audited by an independent accountant and companies do not have ongoing reporting requirements other than a final report on the status of the offering. Additionally, there are no limitations on how much investors can invest in an offering relying on Tier 1 of Regulation A+.
A major drawback of Tier 1 that undermines all of its benefits is that companies that are conducting a Tier 1 offering must have their offering materials qualified by state securities’ regulators in the states in which the company plans to sell its securities. Each State has a different system and some are very slow. Tier 1 only makes sense if the company can raise all the capital from outside the USA or from one or two states that are easy to satisfy for Blue Sky filings. Notably, California is one of the most difficult to qualify for, as they require an audit and a Merit Review in which they judge the risk versus return level of the business. Some early stage businesses might simply not get the green light. The cost of satisfying the states could easily double the legal fees of filing with the SEC and could take much longer or be impossible in the Merit Review States - versus 60 days for the SEC filing.
The primary benefit of Tier 2 offerings is that they are exempt from review by the state securities regulators. However, financial statements disclosed in a Tier 2 offering have to be audited by an independent accountant and companies are subject to ongoing reporting requirements which include filing a semiannual and annual report as well as interim current reports.
In a Tier 2 offering, if an investor is not accredited and the securities are not going to be listed on a national securities exchange upon qualification, the individual investors are limited to how much they can invest to no more than 10% of greater than the person’s income alone or together with a spouse, annual income or net worth (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence).
In the short term, issuers may prefer this new method to traditional method, because selling small stakes to more investors could mean giving away fewer control rights to investors. Less sophisticated investors with less stake in the game will not have the same incentives to influence the issuer as a more concentrated group of sophisticated investors would. By eroding the incentives of investors to actively protect their investments through due diligence, monitoring and advice to the issuer, the critical feedback loop between relatively inexperienced management and knowledgeable investors may be lost.
In November 2016, SEC published a white paper summarizing broad market trends and patterns in offering and issuer characteristics. Table 1 below shows the Regulation A+ offering amount sought. The median (average) amount sought by a Tier 1 issuer in a given offering was $6 ($10) million among all filings and $5 ($7) million among qualified offerings. In comparison, the median (average) amount sought by a Tier 2 issuer in a given offering was $20 ($26) million among all filings and $20 ($26) among qualified filings. As expected a typical Tier 2 issuer was seeing to raise a larger amount.
Table 2 shows the Regulation A+ offering characteristics. Equity offerings accounted for 90% of qualified offerings. For qualified Tier 1 offerings, equity accounted for 85%, debt 9%, and other type of securities 6%. For qualified Tier 2 offerings, equity accounted for 94%, debt 4%, and other securities 2%.
Approximately 16% of all issuers and 22% of issuers in qualified offerings filed a draft offering statement. The majority (around 80%) of offerings did not involve testing-the-waters. However, Tier 2 offerings accounted for the majority of testing-the-waters solicitations (the difference was statistically significant).
The nationwide solicitation was relatively common, particularly for Tier 2 offerings. The median filed (qualified) Tier 2 offering statement disclosed that the issuer would solicit investors in 50 states.
Equity offerings accounted for 90% of qualified offerings. The median filed (qualified) Tier 1 offering statement disclosed that the issuer would solicit investors in 4 (8) states.
Across qualified offerings, the median time from initial public filing to qualification was 78 days. Tier 2 offerings were associated with longer qualification time than Tier 1 offerings. The time to qualification depends on the length of time required for SEC staff review as well as the time that issuers require to make revisions related to staff comments if any.
Table 3 shows the estimated cost of raising under Regulation A+. According to SEC, a typical issuer incurred the median legal cost of approximately $40,000 ($50,000) based on all filings (qualified offerings). The median audit cost was reported at approximately $15,000 for filled and qualified offerings. The median intermediary fee, when reported was approximately $150,000 among all offerings and approximately $100,000 among qualified offerings. Tier two offerings were generally associated with higher fees in dollar terms.
Table 1 shows the breakdown of costs:
Table 4. shows Regulation A+ issuers characteristics. A typical issuer had median assets of approximately $0.2 million across all qualified filings. Average assets were approximately $79 million across issuers in qualified offerings. Approximately 87% of qualified filings were from issuers with total assets not exceeding $100 million.
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