The SEC published a proposed regulation yesterday with potentially far reaching importance to anyone involved in raising equity investments in the U.S.
I’m assuming most readers aren’t securities law experts, so I’ll start with a bit of background. Generally speaking, federal securities laws prohibit companies from offering or selling securities (such as corporate stock) unless the company first “registers” the securities with the Securities and Exchange Commission (SEC). Registration is what people commonly refer to as “going public.” In other words, it’s not really an option in raising money for startups and other private companies. That means that private company financing usually requires an exemption from the registration requirement.
The main exemption used by startups issuing stock is a statutory exemption for securities issuances “not involving any public offering.” Those simple words have been interpreted by the courts and the SEC much more narrowly than many people trying to finance their companies would want. Essentially, you’re only completely safe under this exemption if you sell to financially sophisticated people who already know you and your team pretty well before you approach them and who have access to all the information (the team, financial and technical documents etc.) they want. Thirty years ago, the SEC helped everyone out by enacting a regulation (“Reg D” or “Rule 506”) that gave an exemption for any offering that is sold only to “accredited investors” (it can include a few non-accredited investors but that’s generally not advisable), does not involve “general solicitation or general advertising,” and meets a few other less important requirements. Without going into the details, an “accredited investor” means either an institutional investor meeting certain criteria (the criteria vary, depending on the type of institution) or an individual who either had $200,000 of annual income (or $300,000 combined with a spouse) for the last two years and expects that to continue next year or who has $1,000,000 in net assets (excluding equity in a residence). “General solicitation or general advertising” includes what you’d expect: facebook postings, e-mail blasts, banner ads, radio and TV spots etc. It also includes a lot more, potentially covering any effort to market your stock to people with whom you don’t already have a substantive business relationship.
Despite their restrictions and uncertainties, both the general statutory private offering exemption and Rule 506 are very handy for standard “friends and family” rounds and raising equity from professional investors and investment funds. But the restrictions and uncertainties can definitely get in the way.
In this context, Congress passed the Jumpstart Our Business Startups (JOBS) Actin March, requiring the SEC, among other things, to revise Rule 506 toallow “general solicitation or general advertising” in offerings if all purchasers are accredited investors. That’s the revision that the SEC published on Wednesday.
The SEC took a minimalist approach. It revised Rule 506 to allow general solicitation and advertising if all purchasers are accredited investors. The JOBS Act said that the new rules had to “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” The SEC declined the invitation to determine methods and just copied the “reasonable steps to verify” language into Rule 506.
The only real elaborations on the JOBS Act are (1) a clarification that companies can still use the old Rule 506 (no general solicitation and advertisings, but no verification requirements), and (2) a requirement that companies using the new exemption check a box on the “Form D” that has to be filed with the SEC in connection with a Rule 506 offering, to let the SEC know they’re using the new exemption.
The worrying points in this new rule are the open-ended requirement to take “reasonable steps” to verify that investors are accredited and the need to flag your offering for SEC scrutiny (filing a Form D otherwise almost never attracts SEC attention).
On the verification issue, the SEC’s explanation of the rule has some useful discussion. First, it’s worth emphasizing that the SEC says clearly that simply asking investors to sign a piece of paper declaring themselves accredited investors won’t cut it unless the company already has enough information about them to make that credible. It also makes clear that what’s reasonable depends on the circumstances and that something less than a complete audit will often suffice.
Although the SEC didn’t bless any particular verification method, it did specify that getting a third party (such a brokerage, an accounting firm, or an outfit like AngelList or SecondMarket) to certify that it has determined a person to be an accredited investor might be a reasonable verification method, assuming there was some reason to rely on that third party. That’s useful, because not only do investors often not want to disclose lots of private financial information to random companies, but really making sure you know that a person is accredited can be a little tricky. It seems likely that serious individual angels will get certified with one or two credible third parties and then use that credential to establish their status when they invest. The potential that the third-party could end up with liability for bad verifications and/or the need to find a profitable business model could still prevent the service from developing. If widely-accepted third-party credentials do emerge, however, it will make the new exemption much more comfortable for companies and investors alike.
The SEC resisted suggestions that a high minimum investment amount could automatically establish that an investor is accredited, but helpfully acknowledged that a high minimum investment amount could be an important element in verification. The reason the SEC refused to make a simple rule is that it’s hard to be certain how a particular investor financed the investment and how the investor’s other finances might affect net worth. To give an easy example, say Company A proposes to sell preferred stock with a minimum investment of $1,000,000. You might think that if individual B plunks down $1,000,000 in cash, she must have at least $1,000,000 in net worth. But what if she refinanced the $1,800,000 mortgage on her house in 2006 and is now $1,000,000 underwater on that mortgage? Are you still sure having $1,000,000 in cash establishes her minimum net worth? The point is that the SEC is right that no minimum investment amount can definitively establish net worth. So what more is needed if the investor makes a minimum investment that tends to establish a requisite net worth? One approach might be to only require that investor to give the company a representation that the investor has the minimum net worth and that investment wasn’t financed. Unfortunately, it’s too soon to know if that would be enough.
It’s worth emphasizing that these are preliminary rules. They are not in effect and may never be. The SEC will be taking comments for 30 days and will probably release final rules a few months after that. Those final rules might be identical to the preliminary ones or could be very different.
That said, if these rules do go into effect, they’re a mixed bag. The ability to raise money through truly general solicitations (tweets, facebook postings, e-mail blasts, website postings) may be very valuable to a few businesses and could make life a little easier for a lot more. The ability to discuss your offering with anyone you want, without having to worry about whether you’ve gone over the line into a general solicitation could be valuable to most companies. That said, the uncertainty of what constitutes reasonable verification and the requirement to flag yourself for SEC scrutiny could discourage use and make the exemption much less valuable.