The SEC's proposed amendments to Rule 506 (the way in which most startups, and VCs for that matter, raise money) have been controversial, to say the least, among the startup community. And with good reason. The proposed amendments at once create a compliance minefield for startups, which often don't have the legal firepower to navigate regulatory minutiae, and impose draconian penalties for non-compliance. In proposing these amendments, the SEC, traditional policeman of Wall Street, has not taken into account the nuances of fundraising in the startup world. In this post, we discuss the flaws in the proposed amendments, as highlighted in comment letters to the SEC, and also offer up a few of our own observations on that score.
Before getting our hands dirty with the substance of the proposal, let's first dispose of the atmospherics. The proposed rules were announced
simultaneously with the adoption of rules lifting the ban on general solicitation
of Rule 506 private placements, which we previously covered
in these pages. To be sure, politics were in play. There were loud concerns over investor protection, the SEC's primary responsibility, in connection with allowing private funds and other issuers to solicit the general public for unregistered securities transactions. In order to get the requisite votes among the SEC commissioners for the general solicitation allowance, a hat tip may have been needed in the direction of investor protection; and that hat tip came in the form of the proposals we discuss today.
The Proposed Amendments
A quick summary of the proposed amendments as compared against the current rules (all with respect to offerings conducted pursuant to the general solicitation allowance):
Issuer required to file
Form D no later than 15 days after first sale.
In addition to current rules,
issuer must file Form D at least 15 days before
engaging in general solicitation.
Within 30 days of completing an
offering, issuer required to update Form D and confirm that offering has
Form D requires
identifying information about the issuer, the exemption relied upon, and
other basic facts about the issuer and the offering.
Additional information would be required, including the
securities offered, more information about the issuer and its ownership,
types of investors, use of proceeds, and types of general solicitation used.
No enumerated penalties
for non-compliance with filing requirements.
Issuer is disqualified from
raising funds under Rule 506 for one
, subject to a 30-day cure period for late filings for non-compliance with filing requirements.
Issuer required to include legends and disclosures in
general solicitation materials (limitation of offering to accredited
investors and risk disclosure).
Issuer required to submit general
solicitation materials to SEC.
The Proposals Are Not Tailored to How Startups Raise Capital
in the startup community to the proposed rules was swift. In the month-and-a-half since the proposed rules came out, the criticism has crystallized around a few salient points, cogently articulated by Naval Ravikant, evAngeList (see what we did there?) for the seed fundraising community, in his comment letter
to the SEC. With the JOBS Act, Congress spoke decisively in favor of easing capital formation by startups. The proposed amendments undermine Congress's primary aim in passing the JOBS Act.
Let's remember the context. Entrepreneurs are often engineers who are not well-versed in legalese and regulatory compliance. As Mr. Ravikant notes, their capital needs are not great (often less than $1 million) and they can't afford the lawyers and advisors the proposed amendments require by implication.
The proposed requirements to file Form D 15 days prior to commencing general solicitation and subsequent to completing a round don't make sense in the startup world. Startups are always fundraising--whether it's done formally or on a "testing the waters" basis. There often is no discrete point in time when fundraising begins and nor is there one when it ends. Or, as Mr. Ravikant put it:
"Chance meetings or opportunities to promote your startup rarely come with a 15-day advance notice built in."
Legends and other disclosure requirements are ill-suited to modern startup fundraising practices. All of a startup's fundraising activities and information dissemination is not limited to a private placement memorandum. Understanding that fundraising is an ongoing activity for a young company, the marketing and diligence materials provided in that effort are disseminated on an ongoing and iterative basis, including through popular social media platforms. And TechCrunch and VentureBeat track fundraising rabidly. In this environment, including legal disclosures and disclaimers in a press release or on your AngelList profile just does not work. Mr. Ravikant neatly pointed out
"... try tweeting boilerplate legal text in 140 characters."
When considering the limited financial and legal resources available to startups, requiring startups that are fundraising to file their marketing materials is setting them up for violation. Compliance hurdles are among the last things a startup needs when dealing with the twin challenges of building a business and convincing people to believe in that business by funding it.
Not only is it counterproductive to require folks lacking financial resources and proper advisors to be subject to filing and disclosure requirements, the consequences of non-compliance can be disastrous to startups, which are already vulnerable by virtue of their youth. The proposed rules would disqualify a startup that did not comply with the proposed Form D filing requirements from raising money via Rule 506 for one year. For companies with limited cash runways, one year without the most common form of startup fundraising can mean bust. Which means that an otherwise worthy idea may not reach fruition and will not create jobs.
What about Investors?
The proposed amendments, when taken with the final rule adopted last month permitting general solicitation, may work to chill the investments that the JOBS Act sought to foster. The penalty for a startup's failure to comply with the accredited investor verification requirements
under the new rules is a right of rescission for all investors. This exposes all investors to uncertainty and risk around their investment. An angel network may be reluctant to recommend an investment to its members with these risks. All it takes is one dissatisfied investor to create problems for both the issuer and the other investors by merely challenging the verification process.
The verification requirement also requires investors to provide personal financial information. Absent a secure third-party system to get this done, it's not far-fetched for an angel investor to decline to participate in a deal that requires them to provide a startup with sensitive personal financial information. And even if a third-party system is in place, this requirement will impose added cost and complexity. Given this, angels may limit their investments to so-called 506(b) offerings, which do not take advantage of the general solicitation provisions, diminishing the effect of allowing general solicitation in the first place.
The SEC proposed the amendments to Rule 506 in order to enhance its ability to assess developments in the private placement market. This seems like a lot of trouble to monitor developments. The proposed amendments don't account for the dynamics of how fundraising works in the startup world. The SEC will review the comment letters and hopefully modify its proposals in a way that suits modern fundraising. Stay tuned.