EquityZen Knowledge Center

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Regulatory Alert: Regulation A+ and What It Means For Startups

JOBS ActSECRegulation

Shriram Bhashyam   March 27, 2015

The SEC voted Wednesday to adopt final rules for amendments to Regulation A, referred to informally as Regulation A+, making relevant a capital raising tool that had long grown dusty on the shelf of deal structures. Think of Regulation A+ as "IPO Lite", allowing companies to raise up to $50 million with disclosure and ongoing reporting requirements that are less burdensome than a full-blown IPO. However, a Regulation A+ offering will require a bit more from the company than a Rule 506(b) private placement, the most common way for startups to raise money. So where will Regulation A+ fit into the landscape? We offer up some preliminary thoughts.


The Basics


Prior to the amendments, Regulation A offerings were capped at a $5 million raise, too small to serve as a meaningful "IPO Lite" or small-cap IPO, but too burdensome to compete with a private placement for a seed or Series A round.  Accordingly, Regulation A was seldom used. As part of the sweeping reforms meant to ease small company capital formation, Congress mandated amendment of Regulation A in Title IV of the JOBS Act.

Regulation A+ will be effective in 60 days. Below are the main parameters of a Regulation A+ raise:

  • Two Tiers with Higher Caps. Under Tier 1, a company can raise up to $20 million in a 12 month period; and under Tier 2, (we'll explain the distinctions below), the cap is $50 million over that same period. These are meaningful increases over $5 million, and makes Regulation A+ worth taking seriously.
  • Light Disclosure. A company seeking to raise via Reg. A+ will need to provide a Offering Circular, which is lighter in disclosure than an IPO registration statement (S-1), and which will be subject to review by the SEC. Additionally, companies raising capital via a Tier 2 offering will be required to provide audited financials along with the Offering Circular. Since a Reg. A+ offering is a public offering, startups can shout from the mountain tops that they are raising. There are no general solicitation issues here.
  • Non-Accredited Investors. Unlike 506(b) private placements, companies raising via Reg. A+ are not limited to the accredited investor universe. Anyone can invest in a Reg. A+ offering.
  • Investment Limits. For Tier 2 offerings, non-accredited investors are limited to investing the greater of 10% of their annual income or 10% net worth.
  • Ongoing Disclosure. Companies raising via a Tier 2 offering will be required to provide semi-annual, annual, and current event reports (lighter versions of 10-Q, 10-K, and 8-K reports, respectively)
  • Sorry VCs. VCs can not use Reg. A+ to raise funds (query whether they'd want to anyway).

Secondary Transactions

Interestingly, an important distinction between Reg. A+ and standard 506(b) offerings are the implications for secondary liquidity, a subject near and dear to our hearts here at EquityZen. We're trying to fix the broken secondary markets for venture-backed equity in a way that appeases all stakeholders--the shareholder, the investor, and the company. It's an uphill battle, but one worth fighting.

Securities issued via Reg. A+ are not "restricted securities," meaning they are freely transferable. Unless contractual restrictions are put in place, liquidity should not be an issue. To be sure, this ought to be done in an orderly manner in which the company's interests are accounted for. The development of exchanges serving the Reg. A+ market is in the offing. No doubt, we're paying close attention and will provide further commentary as all of this evolves.

What Does Reg. A+ Mean for Startups?

Early adoption of Reg. A+ by startups is unlikely. Currently, access to capital via private markets is plentiful across stages. At the early stage, new micro VCs and seed funds pop up daily, and raising your seed round is easier today than in years past. Further, the monetary and time costs associated with a Reg. A+ offering do not make sense for the amount of capital raised at seed or A rounds.

At the later stages, capital also abounds, especially with mutual and hedge funds increasingly investing in late- and growth-stage. And this capital is available at favorable valuations.  There are nearly 80 "Unicorns" now (35 US companies raised at Unicorn valuations in 2014 alone). Until that spigot dries up, there's not much incentive to be an early adopter of Reg. A+. To be sure, Reg. A+ is a step in the right direction, and can be a viable alternative to the mid- to late-stage funding rounds. Bubble or not, should interest rate increases or another catalyst close the private funding window, startups may look to the public markets once again, via Reg. A+, for capital.

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Eye on Washington: JOBS Act 2.0 in the Offing?

JOBS ActSECRegulation

Shriram Bhashyam   June 20, 2014

While the jury is out (NYT, Washington Post, Boardroom Brief) on whether the Jumpstart Our Business Startups Act ("JOBS Act"), passed in April 2012, has been a success, House Republicans may already have their sights on a follow-up ("JOBS Act 2.0").

Although the SEC has yet to finish adopting regulations that would fully implement the JOBS Act, including several key provisions such as the "crowd funding exemption," the House of Representatives Financial Services Committee's Subcommittee on Capital Markets and Government Sponsored Enterprises convened a hearing on June 12, 2013 entitled "Reducing Barriers to Capital Formation."  The Committee Memorandum makes it clear that the focus is on small companies:
Based on the success of the [JOBS] Act (P.L. 112-106), which President Obama signed into law on April 5, 2012, the Subcommittee is continuing its survey to identify legal, regulatory and market impediments to capital formation, particularly for small and medium-capitalized companies.


What was discussed at the hearing?

While the transcript of the hearing is not yet available, the following topics were on the agenda:
  • changing the minimum trading increment or "tick size" for smaller companies (the current system prices shares in one cent increments);
  • authorizing the creation of new equity markets to register with the SEC and then list and trade the securities of smaller companies;
  • improving market quality for smaller issuers;
  • modernizing the regulatory structure of business development companies;    
  • improving capital formation for privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; and
  • and examining disclosure and corporate governance requirements that may be burdensome for smaller companies.

What could JOBS Act 2.0 look like?

While the JOBS Act primarily facilitated capital raising and crowdfunding by small businesses, it appears that JOBS Act 2.0 would have an eye towards the next frontier for small business capital formation--trading markets for securities of small and emerging businesses.  As ever, the parallel goals of facilitating capital formation and investor protection remain at tension.  Lawmakers and the regulators that implement the laws will need to strike the appropriate balance.  As noted securities law expert Professor Donald Langevoort has acknowledged, small companies have smaller market impact than large companies, and accordingly should be subject to less onerous regulatory responsibilities.

One aspect of a possible JOBS Act 2.0 that we at EquityZen are particularly interested in is a potential separate equity market for the trading of securities of small and emerging companies.  In conjunction with this, it is likely that companies whose securities are listed on this market would be subject to lighter reporting and governance standards than their NYSE and Nasdaq-listed counterparts.  In recognition of investor protection and the lighter regulatory touch on companies listed on this market, access to this market may be limited only to accredited investors.

What's next?

The next hearing on "Reducing Barriers to Capital Formation" is expected to take place in July.  EquityZen will monitor these developments and provide updates.  We also geek out on secondary markets of private company securities, so expect a follow up from us on what a separate equity market for emerging company securities may look like.  Don't forget to subscribe to Meditations to get EquityZen's take on new developments.  Feel free to post and questions or comments below.

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What the SEC Giveth with One Hand, It Proposes to Taketh Away with the Other

JOBS ActSECRegulation

Shriram Bhashyam   August 23, 2013


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):


Current Rule 506
Proposed Amendments
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 closed.
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 year, 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

Negative reaction 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.

Conclusion

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.
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