RALEIGH – Jim Verdonik and Benji Jones, Co-Founders of Innovate Capital Law and regular contributors to WRAL TechWire, discuss recent changes to SEC rules that give businesses new freedoms to communicate with investors and conduct multiple offerings. This is the second of a two-part report. (Part one can be read here.)
MARKET RESEARCH: TESTING THE WATERS
JIM: Businesses don’t want to spend a lot of time and money to comply with complex offering rules if they have no idea whether any investors will want to buy the securities they want to sell.
BENJI: The problem is that if you ask one single person if they would be interested in buying 100 shares for $1 per share, the SEC says you have made an “offer”. And, according to the SEC, this one single offer starts a new “offering” or continues a previous offering (even if that person never actually buys your stock). Each offering (even if no sales are made) needs an exemption from registration and, as discussed above, that single offer restarts the 30-day “Timeout Period” between offerings for integration rule purposes.
Ideally companies want to check in with potential investors to assess how much money they can raise, what types of securities they should sell, the probable valuation, what types of investors are most interested and the best way to communicate efficiently with interested investors. These factors affect both whether the issuer will make an offering and the exemption from registration the issuer will choose for its offering. Unfortunately, this kind of market research activity was prohibited before the adoption of new Rule 241.
JIM: What does new Rule 241 allow?
BENJI: Rule 241 allows issuers to test the waters before they know what exemption they will use as long as the following conditions are met:
- The issuer has not decided which exemption to use for a later offering.
- No money is being solicited and if any money is sent by investors it will be returned.
- No offer to buy can be accepted and no money can be received until the issuer decides on the offering exemption and complies with that exemption.
- An investor’s response involves no obligation or commitment of any kind.
- The response may indicate interest and the investor’s name, address, telephone number and email address.
JIM: So, if the issuer does not know what exemption it will use, are there any risks to “testing the waters”?
BENJI: Of course, offering securities is never without risk. Consider the following before you test the waters:
- Federal and state anti-fraud rules apply to the materials you send investors. So, any description of the issuer that accompanies the test the waters document should avoid false or misleading statements of material facts.
- If you communicate your solicitation of interest in a way that constitutes a general solicitation, you have to either later use an exemption that allows general solicitation or comply with the integration rules in Rule 152(a)(1) discussed above. That means it may be difficult to do a Rule 506(b) offering (or use another exemption that prohibits general solicitation) to purchasers you obtained through the test the waters materials.
- You also may need an exemption from state law for the testing the waters materials. The SEC decided not to preempt state regulation of test the waters communications, which may be an “offer” under the laws of some states. However, if the issuer subsequently chooses to use an exemption from registration that preempts state law, then, unless the communication violated the antifraud rules of a state, the risk to the issuer seems relatively low.
JIM: Is that all we need to know about testing the waters”?
BENJI: No – we’re not done yet. Regulation CF Crowdfunding also has its own “test the waters” rule. New Rule 206 permits an issuer to “test the waters” before it files Form C with the SEC. Note, however, testing the waters must stop AFTER the Form C filing. (Similarly, Regulation A allows testing the waters before filing Form 1-A with the SEC, but it also permits testing the waters to continue AFTER the Form 1-A is filed.)
DEMO DAYS AND PITCH EVENTS
JIM: Demo days and pitch events have presented challenges to securities lawyers advising clients. These kind of events – where a sponsor hosts a conference or seminars at which businesses seeking to raise money make presentations to an audience of investors – typically involve the conference organizer/sponsor broadly advertising and soliciting conference attendees.
BENJI: Issuers are often making “offers” at these presentations, because the SEC rule is that if your presentation is likely to induce someone to make you an offer, then you have made an offer even if you don’t mention offering terms. Sometimes presenting companies also include a slide outlining the specific terms of its current offering. These “offers” to an audience solicited through advertising and email blasts would ordinarily constitute a general solicitation, which would make Rule 506(b) unavailable for their offering. But clients often want to get in front of potential “active” investors and make demo day presentations without using an exemption that permits general solicitation. Clients think if everyone else is doing it, then it must be OK.
JIM: So, has the SEC said its OK?
BENJI: The SEC has clarified that demo days and pitch events can trigger general solicitation issues, but the SEC is offering relief in the form of new Rule 148. New Rule 148 creates a new exemption for certain conference presentations. The most noteworthy thing about Rule 148 is that it does not say that such presentations are not “offers.” So, the timing of demo day presentations needs to be analyzed when we look at whether two offerings are integrated. Rule 148 only says that the issuer’s communications at the event will not be considered a general solicitation or advertising if the following criteria are satisfied:
- More than one issuer must make presentations at the conference.
- The event sponsor must be a college, university or other institution of higher education, a State or local government or instrumentality, a nonprofit organization, or an angel investor group, incubator, or accelerator; Not every group of angels is an “angel group” that can sponsor an event. Rule 148 requires the “angel investor group” be a group of accredited investors that holds regular meetings and has defined processes and procedures for making investment decisions, either individually or among the membership of the group as a whole, and is neither associated nor affiliated with brokers, dealers, or investment advisers.
- Advertising for the event cannot refer to a specific offering of securities by a specific issuer.
- Sponsors cannot make investment recommendations or provide investment advice, participate in negotiations, charge more than a reasonable administrative fee, be compensated for making introductions or for negotiations, or be compensated like a broker-dealer.
- Companies making presentations must limit what information they share about the offering to notification that an offering is in process or planned, the type and amount of securities being offered, the expected uses of proceeds and the remaining unsubscribed offering amount. Nothing more can be discussed about the offering.
JIM: Are there any other requirements?
BENJI: Yes, many conferences are virtual these days – using Zoom or other communications tools. New Rule 148 says that if the event is virtual or online, online participation in the event must be limited to members or associates of sponsor organizations, persons the sponsor reasonable believes are accredited investors and individuals who have been invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event. So broad social media invitations or posts inviting a broad group of people to a virtual demo day is problematic and any “offer” made by an issuer participating in the event in that context would be viewed to be “general solicitation”.
JIM: It sounds like sponsor organizations need to be careful in planning events so that they don’t hurt the businesses they are trying to help.
BENJI: Absolutely. The risk here is not for the group sponsoring the event, it is for the participating companies. They may not be aware of the complexities of these new rules, or that there is even risk that what they are doing could complicate their capital-raising efforts.
SPVs FOR REGULATION CF CROWDFUNDING OFFERINGS
JIM: SEC rules have permitted issuers and lead investors in Rule 506 offerings to form a limited liability company or other entity (often called special purpose vehicles or “SPVs”) to own the securities that investors purchase, but have prohibited this practice in Regulation CF offerings. This means that only one shareholder (the SPV) appears on the company’s cap table.
BENJI: The new SEC rules offer partial relief. New Rule 3a-9 under the Investment Company Act now allows issuers conducting Regulation CF offerings to form an SPV. The SPV is treated as a “co-issuer” in the offering, which has liability implications for both the issuer and the SPV.
Unlike in Rule 506 offerings, however, Regulation CF SPVs will need to operate by new rules specified by the SEC.
- The Regulation CF issuer must pay the expenses for forming and operating the SPV.
- The SPV must invest in only one issuer and must issue only one class of securities with the number of securities issued matching the number of securities the SPV purchases.
- Individual SPV owners retain decision making powers. The SPV manager operator has to assert rights as instructed by each SPV owner that each owner would have if they owned the company’s stock directly instead of the SPV manager making such decisions or a majority of the owners deciding for all owners of the SPV.
- Compensation for the manager of the SPV is limited.
If the SPV operates under these rules, the SPV will not be an investment company.
JIM: I guess some progress is better than nothing, but new Rule 3a-9 doesn’t solve the problems SPVs are designed to solve. Passing through voting and other rights directly to SPV owners makes voting by 100 owners just as complex as if they owned stock individually. In Rule 506 offerings, a lead investor can form an SPV and be compensated with a percentage of the SPV’s profits. The inability to do that in Regulation CF offerings will limit the number of people who have incentive to manage SPVs. We expect, however, that the people who operate funding portals (i.e. the internet platforms that are licensed to Regulation CF deals) will add SPV organization and management as a service to attract businesses to sell through their platforms.
CHANGE TO SEC RULES 506(b) AND RULE 506(c) TO PROMOTE FUND GRAZING
JIM: Some other changes promote constant capital grazing.
BENJI: Yes, Rule 506(b) has long limited the number of unaccredited investors to 35 purchasers during the entire offering, but the SEC changed this to recognize that businesses continually raise capital. Now you can sell to up to 35 non-accredited purchasers in any rolling period of 90 days. So, it matters less whether two Rule 506(b) offerings are integrated.
JIM: And the SEC added a new paragraph to Rule 506(c)(2)(ii) that says if an issuer takes reasonable steps to verify accredited investor status within the past five years, the issuer can rely on self-certification from the purchaser that they are still accredited in later Rule 506 offerings.
BENJI: So, this makes it easier for shareholders to invest in reinvesting in later offerings without having to disclose private financial information.
BENJI: The SEC made other rule changes, but that finishes our summary of the most relevant changes the SEC made in early November.
JIM: WOW! That’s a lot of rule changes!
BENJI: Yes, it took a long time for us to understand how the new rules work together. Now its time use these new rules to help our clients.
JIM: The new rules aren’t perfect, but they do provide securities lawyers like us with new tools to help our clients achieve their capital raising goals. We love talking to people about how we can help them raise the capital they need to grow their businesses
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