LEGAL LANDSCAPE FOR EQUITY FUNDRAISING CHANGING FAST... SORT OF
July 15, 2014
The last 12 months have seen a flurry of activity surrounding the laws governing the ability of private companies to raise funds and sell equity stakes to investors. The Securities and Exchange Commission has issued and proposed several rules in this area, and several states (most recently, Maine) have enacted their own "crowdfunding" bills. Making sense of all these regulatory changes can be challenging, and unfortunately much published information about these laws has been more confusing than helpful. This advisory attempts to summarize the current legal landscape and show why, for many companies, nothing much has changed.
The SEC Liberalizes Advertising Rules
First, on September 23, 2013, new SEC rules took effect that allow companies engaged in a private securities offering (i.e., an offering of stock, LLC interests or bonds that is not registered with the SEC) to engage in what is called "general solicitation and advertising." Previously, a company in a private offering could only approach "accredited investors" about investing, essentially meaning that the company could only talk to rich people about investing in the company. The new rules allow companies to talk to anyone they want, meaning that a company can now advertise its securities offering in the newspaper or online, or it can start knocking on doors. However, there are a few important caveats. First, the rules prohibit a company, if the company engages in general solicitation and advertising for the offering, from actually selling securities in a private offering to anyone but accredited investors. So while a company can put an ad in the newspaper saying it is seeking investors, only those wealthy or institutional investors that meet the SEC's definition of "accredited investor" will be allowed to actually buy the company's stock. Second, any company that advertises its private securities offering will be required to verify that each investor is, in fact, an accredited investor, such as by reviewing the investor's tax returns or obtaining a letter from the investor's accountant. It is expected that many companies will not wish to engage in this level of intrusion into their investors' personal finances and as a result will choose to forgo the opportunity to advertise their private securities offerings. Finally, the SEC has said it is considering additional rules that would place significant procedural hurdles on companies that use general solicitation and advertising in a private securities offering, including additional filing requirements with the SEC. These additional rules have not yet been adopted, but most analysts think the SEC will end up adopting some form of them.
In short, the SEC now allows companies privately selling securities to use advertisements to seek investors, but only certain wealthy or institutional investors are allowed to actually invest, and soon the SEC may implement additional rules that might create burdensome requirements for companies that use advertising for their private securities offerings. So the liberalization of the advertising rules may not actually change much.
SEC Crowdfunding Proceeds in Fits and Starts
The SEC also has proposed, but not yet issued, rules permitting private companies to engage in "crowdfunding," which is essentially the practice of seeking a large number of small investments from individuals over the internet. Congress passed a law as part of the JOBS Act in 2012 providing for crowdfunding, but the SEC was required to issue implementing rules before any crowdfunding could take place. To date, the SEC has only proposed those rules but has not yet enacted them. Importantly, note that the "crowdfunding" discussed here is substantively different than the crowdfunding that already occurs on websites like Kickstarter and Crowdfunder. The former and sites like it facilitate only donations without any opportunity for an investment return. The latter facilitates investments but only for accredited investors. The SEC's proposed crowdfunding rules are designed to allow sites like Crowdfunder to take investments from all investors, regardless of wealth.
The JOBS Act and the proposed (again, not yet enacted) rules would allow companies to raise up to $1 million from investors by using an internet-based crowdfunding platform, with limits on how much any individual person could invest depending on their net worth or annual income. Significantly, the JOBS Act and the proposed rules would impose significant disclosure and filing requirements on companies that use crowdfunding to gain investors, which in practice may deter many companies from using crowdfunding. These requirements include filing with the SEC information about the company's business, officers, directors, principal shareholders, capitalization, debt, and financial performance, as well as requiring companies to prepare and have audited their financial statements in accordance with U.S. generally accepted accounting principles (GAAP) if the company is offering more than $500,000 of securities. So the takeaway with crowfunding is that (1) it is not yet actually allowed, and (2) when it is allowed, a company will have to carefully weigh the benefits against the burdens.
Maine Jumps on the Crowdfunding Bandwagon
Tired of waiting for the SEC, several states have enacted their own crowdfunding laws, most of which rely on federal laws that largely exempt from SEC regulation securities offerings that occur only in one state. On March 2, 2014, Maine became the most recent state to enact its own crowdfunding law. The Maine law is available only for companies located in Maine. Unlike the crowdfunding laws in other states, the Maine law contemplates the ability to solicit investors outside of Maine. However, existing SEC rules are likely to make that option difficult to achieve for the average company, so in practice the law will likely require all investors to be located in Maine, as well. Under the Maine law, a Maine-based company can use crowdfunding to raise up to $500,000 from investors if the company provides the investors with financial statements reviewed by a public accountant, and up to $1 million if the company provides audited financial statements. The law also limits investments to $5,000 per investor, unless the investor is an accredited investor under SEC rules. All offerings under the law have to be registered with the Maine Office of Securities, which likely will require public disclosure of certain information about the company and its owners. The analysis of the existing crowdfunding laws in other states has generally shown that such state-based crowndfunding regimes are not being widely used, possibly because of the geographic limitations and the low per-investor maximums.
The Maine Office of Securities must still publish implementing rules before the Maine crowdfunding law can be utilized.
The Forgotten Child - The SEC Attempts to Revive Regulation A
Regulation A, a little-used provision of the SEC rules, currently allows companies to conduct public offerings of securities without registering such offerings with the SEC, meaning that the offering can be made to just about anyone, and just about anyone can invest. However, in the past very few companies have used Regulation A because, among other reasons, it requires significant filing and disclosure requirements, and the SEC must individually approve each company's offering documents. It also has been limited to offerings of no more than $5 million. The SEC has now proposed (but not yet enacted) rules that seek to amend Regulation A to allow for offerings of up to $50 million and to modernize some of the filing and disclosure requirements. Nevertheless, the proposed rules still would require SEC approval of company offering documents, and they still contain significant filing and disclosure requirements. It remains to be seen whether, if the proposed rules are adopted, many companies will choose to use them.
The Good News - Old Fashioned Regulation D
Despite the promise and potential disappointment of all these new rules, the old regulatory regime through which companies have raised funds in private offerings for years is still in effect. Under the SEC's Regulation D, and, specifically, Rule 506 of Regulation D, companies generally can sell an unlimited amount of securities in a private offering as long as they do NOT use general solicitation and advertising, and all offers and sales are made only to accredited investors. There are some technical exceptions to the previous statement, but in practice this is the route most smaller companies take. Notably, using Regulation D the old-fashioned way does not require the issuing company to verify that each investor is an "accredited investor," as the company would have to do if it advertised. Rather, if a company does not advertise its private offering, it simply must take "reasonable steps" to verify accredited investor status, which is a much lower threshold and does not require nearly as large an intrusion into the investor's personal finances. There also are a few additional requirements concerning how the offering must be conducted, but in general the filing and disclosure requirements are minimal and inexpensive. The major drawback of Regulation D has always been that it essentially limits the universe of potential investors to only accredited investors, i.e., institutions or wealthy individuals. The new and proposed crowdfunding rules discussed above attempt to scale back this limitation but add significant procedural requirements and hurdles.