Tuesday, July 23, 2013

Effect on Startups of SEC Changes Eliminating the Prohibition on General Solicitation in Certain Offerings

[A Russian-language version of this article may be found on Firrma.ru]

In April 2012, Congress passed the much-awaited Jumpstart Our Business Startups Act (JOBS Act), which directed the SEC to draft regulations removing the prohibition on general solicitation and general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors.

On July 10, 2013, more than a year later, the SEC has finally issued the final rules that will implement the JOBS Act legislation.

Securities Laws Overview. Under the current U.S. federal securities laws, companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Rule 506 of Regulation D is the most widely-used exemption from registration. In an offering that qualifies for the Rule 506 exemption, an issuer may raise an unlimited amount of capital from an unlimited number of "accredited investors" and up to 35 non-accredited investors.

"Accredited investors," as defined in Rule 501 of Regulation D, are individuals who meet certain minimum income or net worth levels, or certain institutions such as trusts, corporations, or charitable organizations that meet certain minimum asset levels. A person qualifies as an "accredited investor" if he or she has either (a) an individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence; or (b) an individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

Changes to Rule 506 Generally. The final rules approved by the SEC make changes to Rule 506 to permit issuers to use general solicitation and general advertising to offer their securities provided that (a) the issuer takes reasonable steps to verify that the investors are "accredited investors"; and (b) all purchasers of the securities qualify as "accredited investors" or the issuer reasonably believes that the investors so qualify at the time of the sale of the securities. In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities, if general solicitation or general advertising is used as a means of capital raising. Nevertheless, issuers conducting Rule 506 offerings without the use of general solicitation or general advertising may continue to conduct securities offerings in the same manner as they did previously and aren't subject to the new verification rule.

Changes to Form D Filing. Prior to new regulations going into effect, an issuer selling securities using Rule 506 was required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. Under the new rules, issuers that intend to engage in general solicitation as part of a Rule 506 offering would be required to file the Form D (a) at least 15 calendar days before engaging in general solicitation for the offering and (b) within 30 days after completing an offering to update the information contained in the Form D and indicate that the offering has ended.

The scope of Form D is also being expanded to include such additional information as:

  • identification of the issuer's website;
  • expanded information on the issuer;
  • the offered securities;
  • the types of investors in the offering;
  • the use of proceeds from the offering;
  • information on the types of general solicitation used; and
  • the methods used to verify the accredited investor status of investors.

Solicitation Materials. Under the new rules, as part of SEC's monitoring process, issuers will be required to submit written general solicitation materials used in the offering on the SEC website. Materials submitted in this manner would not be available to the general public.

Verification of Accredited Investor Status. The final rules provide a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors. For instance, an issuer may review copies of any IRS form that reports the income of the purchaser and obtain a written representation that the purchaser will likely continue to earn the necessary income in the current year. Alternatively, an issuer may receive a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status.

Disqualification for Bad Acts. A restriction in the new rules states that an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a "disqualifying event." Persons covered by the rule include directors and certain officers, 20% beneficial owners, promoters, and persons compensated for soliciting investors. A "disqualifying event" may be a criminal conviction in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries within 10 years of the proposed sale of securities, or other types of misconduct relating to the securities and trading markets. However, an exception from disqualification exists when the issuer can show it did not know and, in the exercise of reasonable care, could not have known, that a covered person with a disqualifying event participated in the offering.

Disqualification for Failure to Make Timely Filings. An issuer is disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering. The disqualification would continue for one year beginning after the required Form D filings are made.

Impact of Changes on Startups. The JOBS Act sought to make it easier for a company to find investors and thereby raise capital. Have the regulations that have been adopted by the SEC faithfully followed legislative intent, improving the capital raising experience for companies? Only time will provide us with a definitive answer, but in the meantime, here are some factors that will weigh on the success of the legislation as a game-changer in the industry:

  • Demand by Investors: whether there in fact exists a large pool of "accredited investors" who would invest (more frequently and in greater amounts than they are currently) given better access to a pipeline of private offerings;
  • Longevity: whether, even if there is an initial spike in investments by new accredited investors, the novelty and excitement will not wear off, especially as initial investor optimism faces the harsh realities of investing in early-stage emerging technology companies;
  • Non-Accredited Investors: whether the "either/or" nature of the new rules, preventing companies from engaging in general solicitation along-side other fundraising activities, potentially to non-accredited investors, will cause companies not to take full advantage of the new rules;
  • Compliance Hardships: whether the requirements for additional filings (e.g., expanded Form D, solicitation materials), state securities laws, as well as the burden placed on the companies to reasonably ascertain the status of their investors as "accredited investors," coupled with disqualification from use of the exemption for failure to timely file, will hamper widespread use of general solicitation as a means of raising capital;
  • Publicity: whether the public disclosures which would be made in the solicitation materials and the associated loss of stealth-mode advantage will have a chilling effect on early-stage companies;
  • Involvement by Sophisticated Investors: whether sophisticated investors, such as VCs and super-angels, will engage in, or be deterred from, participating as investors in offerings through open solicitation;
  • Later Stage Follow On Rounds: whether successful later-stage startups will consider this an appealing alternative to additional rounds of venture capital or institutional investment;
  • New Investments Instruments and Goals: whether access to different types of investors than typical market players will allow previously "unfundable" companies to raise capital - e.g. LLCs, companies with solid revenues, but no exit opportunity, etc.;
  • Higher Valuations: whether increased competition for companies that stand-out in the open fundraising process will drive valuations, such that this will be the preferred means of raising capital even for companies that have access to venture capital money; and
  • Crowdfunding: whether the successes of crowd-funding platforms like Kickstarter and Indiegogo will be repeated on a larger scale with equity investment in the mix.

The rule amendments become effective on September 23, 2013 (60 days after publication in the Federal Register).

Happy company making!


White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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