Editor’s Note: Knox Proctor is a member of the Financial Institutions and Business Law Practice Groups at Ward and Smith, P.A.
Having trouble raising capital?
You know you’re not the only one with this problem when Congress and the President agree it’s a problem and agree on the solution.
The Jumpstart our Business Startups (“JOBS”) Act seeks to create jobs by making it easier for start-up companies to deal with securities laws when raising capital. First, let’s review basic securities law principles so we know what problems the JOBS Act is trying to fix.
Remember: Most provisions in the JOBS Act are not yet effective. We have to wait for the Securities and Exchange Commission (“SEC”) to write rules. So, don’t jump the gun and start acting like the JOBS Act is already protecting you.
Basic Securities Issues
When companies, including tech companies, raise capital by issuing shares of stock, debentures, or other securities, they must address:
• The Securities Act of 1933 (” ’33 Act”), which governs securities offerings. The ’33 Act is based on two basic principles: (1) to sell securities, you either have to register the sale with the SEC or qualify for an exemption and (2) you have to disclose all material facts to potential investors.
• The Securities Exchange Act of 1934 (” ’34 Act”), which requires publicly-owned companies to make ongoing disclosures of material facts to the market (on Forms 8-K, 10-Q, 10-K, etc.); and,
• Similar state securities laws that sometimes apply in addition to federal law.
The JOBS Act seeks to create jobs by making it easier for start-up companies to deal with securities laws when raising capital. The major provisions of the JOBS Act address:
• The “IPO On-Ramp,” which provides regulatory relief for “Emerging Growth Companies”;
• Advertising certain private offerings;
• Raising capital through “crowdfunding”;
• Exemptions for “Small Offerings”; and,
• Changes in “34 Act Triggers,” i.e., the number of record shareholders that trigger ongoing reporting requirements;
Why should you care?
Our securities laws are based on the assumption that most people are naïve and should not be solicited to invest in securities until an extensive (and expensive) registration statement has been approved which will, theoretically, at least, explain all possible risks in excruciating detail. And companies that are registered must provide extensive (and expensive) reporting to keep current and potential investors informed.
The securities laws make exceptions for potential investors who are thought to be well-to-do and sophisticated. Therefore, people who know lots of rich people have a big advantage when they raise money. They’re generally allowed to call up their rich friends and business associates. They’re also allowed to hire an investment banking firm which calls up its rich clients. If you don’t know a lot of rich people, or the amount of money you need isn’t big enough to interest an investment banker, securities laws make it difficult to raise money.
One rationale for the JOBS Act is that the Internet has made exchanging information so easy and such a big part of daily life that we should make it easier for businesses raising capital to let other people know about it – within certain limits.
The JOBS Act also tries to make it less burdensome for smaller companies to become publicly-held and remain publicly-held. Conversely, the JOBS Act allows smaller businesses to remain private even if they have a relatively large number of shareholders.
Now that you know why this is important, let’s discuss some of these changes in detail.
Certain companies with less than $1 billion in annual gross revenue will be designated “Emerging Growth Companies.” Unfortunately, a company that made a registered ’33 Act offering of its common equity securities before December 8, 2011, will receive no relief.
Emerging Growth Companies offering securities will be allowed to:
• “Test the waters” for interest with sophisticated investors called “Qualified Institutional Buyers” and “Accredited Investors,” so they can try to ascertain a level of interest before incurring the expense of registration; and,
• Receive a “confidential nonpublic review” from the SEC of draft registration statements, rather than having to make the drafts available to the public in an electronic filing prior to the offering.
Each Emerging Growth Company filing ’34 Act reports will be:
• Given some relief on annual report requirements for years prior to registration;
• Able to save money by being exempt from the requirement that its auditor attest the company’s internal controls report;
• Exempt from certain requirements the Public Company Accounting Oversight Board may impose in the future, including audit firm rotation requirements;
• Exempt from “Say-On-Pay” and “Say-On-Golden-Parachute” requirements; and,
• Exempt from some of the more burdensome executive compensation disclosure requirements imposed on larger companies.
General Advertising for Private Offerings
This change may be very helpful to companies, but not until the SEC issues rules that make it effective.
Most private offerings are currently subject to a prohibition on general advertising and solicitation. The JOBS Act requires the SEC to revise Rule 506 of “Regulation D” to eliminate this restriction and implement additional rules for determining whether investors are “accredited.”
The rules were to have been issued by July 4, 2012, but the SEC did not meet that deadline.
The “crowdfunding” provision will allow unregistered sales of securities in small amounts, but only after the SEC issues rules about disclosures, advertising, limitations on resale, and other conditions.
A company may sell only $1 million in securities in any 12-month period through crowdfunding, and there are strict limits on the amount each crowdfunding investor may invest. For investors with annual incomes or net worth less than $100,000, the limit will be the greater of $2,000 or 5% of the annual income or net worth of the investor. Companies that raise more than $500,000 will have to audit their financial statements and make them public.
Despite the “hype” over crowdfunding, this type of offering may be impractical for many companies. Small companies may not wish to publicly disclose their financial statements or deal with the large number of shareholders the low investment limits may require. And the further requirements imposed by SEC rules may be onerous.
Under the JOBS Act, these rules are due December 31, 2012. The SEC has announced, however, that it does not expect to be able to issue rules by that date.
The JOBS Act requires the SEC to issue rules providing conditions for exemption of “small offerings” of equity, debt, and debt convertible securities, not to exceed $50 million per year (with that amount subject to later adjustments every two years). Once the rules are issued, small offerings may be sold publicly and will be exempt from state law registration requirements. “Testing the waters” with certain investors will be allowed subject to conditions imposed by SEC rules. The SEC will need to issue rules about certain disclosure and periodic reporting requirements, including audited financial statements.
The SEC has no deadline for these rules, so it is unlikely they will be issued soon.
Exchange Act Triggers
Companies with over $10 million in assets and which have a certain number of “record holders” of a class of securities must register under the ’34 Act and file periodic reports (Forms 8-K, 10-Q, 10-K, etc.). In determining how many “record holders” a company has for purposes of triggering the Exchange Act, it is important to note that shares held with brokers generally are held in “street name,” so that only one “record holder” is shown for numerous shareholders.
The JOBS Act raises this triggering limit from 500 record holders to 2,000, or 500 record holders who are not “accredited investors.” It also generally excludes from the computation securities received as employee compensation. However, once the application of the Exchange Act has been triggered, companies may not de-register until they have less than 300 record holders. There are different thresholds for banking companies.
These provisions are effective immediately, but SEC rulemaking will address how some of the changes are implemented and establish some safe harbors for record holder determinations.
The JOBS Act may offer great improvements for capital-hungry companies, including tech companies:
• Whether the IPO On-Ramp’s burden relief substantially increases capital raised by tech companies remains to be seen.
• Allowing general advertising to accredited investors in private offerings may hold the most promise for companies, but the SEC must first adopt regulations.
• “Crowdfunding” has received much hype, but the monetary limitations and offering conditions imposed by the current law and the forthcoming regulations may limit its usefulness.
• The Small Offerings exemption may offer great capital-raising opportunities for companies, but we must await SEC regulations to see if the burden reduction is substantial.
• The Exchange Act triggers may greatly reduce ongoing reporting burdens for some companies.
© Ward and Smith, P.A. 2012
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Knox Proctor concentrates his practice on representing financial institutions and other businesses in securities, regulatory, contractual, and other business matters. Comments or questions may be sent to him at firstname.lastname@example.org.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of legal counsel.