The JOBS Act Creates New Opportunities for Middle-Market Companies to Access the U.S. Public Capital Markets and to Raise Private Capital
President Obama signed into law on April 5, 2012, the Jumpstart Our Business Startups Act (the “JOBS Act”). The JOBS Act includes a number of changes to fundamental U.S. federal securities law policies. Middle-market private companies may rethink the U.S. capital markets when considering their alternative financing methods, and middle-market underwriters and arrangers should expect heightened capital markets activity once the market and its market makers understand how the JOBS Act changes some well-established rules.
When deciding when and where to raise capital, the JOBS Act affords middle-market company CEOs, CFOs and their investment bankers a spectrum of opportunities to consider including:
- raising small amounts of money using the Internet, a technology that was only initially being commercially exploited during the dot-com boom of the late ‘90s
- staying a private company longer and raising money in private placements from sophisticated investors
- raising significant sums of money, up to $50 million, in a 12-month period in a new Regulation A+ hybrid offering mechanism
- tapping the U.S. capital markets in an initial public offering sooner than management may have considered doing so in light of the federal securities regulatory environment
Now middle-market companies may no longer need to look to overseas markets (such as the AIM), choose debt over equity or go to the well too many times by approaching the same array of private equity investors without tapping into the broader U.S. investing public.
The process of conducting an initial public offering in the U.S. will change for most new issuers.
The JOBS Act significantly changes federal securities law to create an on-ramp for middle-market, non-public companies to access the IPO markets. The JOBS Act grants a number of important holidays from some key Dodd-Frank and Sarbanes-Oxley regulations for a large number of newly designated “Emerging Growth Companies” (EGCs) and loosens a number of critical restrictions on underwriter marketing activities on behalf of EGCs.
In enacting the JOBS Act, Congress believed that reducing the barriers to capital formation would fuel jobs growth. As a result, Congress defined an EGC broadly to include an incredibly large swath of the economic landscape. A business need not be small to qualify as an EGC. In fact, middle-market companies with pre-money valuations ranging from approximately $200 million to approximately $600 million can qualify as an EGC and stand much to gain (based on key assumptions on growth, dilution and the company’s capitalization table). We expect a significant percentage of U.S. IPOs in the near future will come from EGCs.
What is an EGC?
An EGC is an issuer that, for its most recently completed fiscal year, had total gross revenues less than $1 billion and had not closed an IPO on or before December 8, 2011.
An EGC may remain an EGC for up to five years after closing its first sale of common equity. During that time an EGC would prepare to comply with the provisions of Dodd-Frank and Sarbanes-Oxley that were temporarily suspended for the EGC by the JOBS Act. Management, underwriters and investors, though, should consider carefully how long a company might enjoy the holiday. There are ways for companies to exit the EGC superhighway and become obligated to comply with those provisions of Dodd-Frank and Sarbanes-Oxley before the five-year holiday expires.
Some exits are brightly lit and well within the foresight of management. For example, if a company were to exceed $1 billion in gross revenue or sell more than $1 billion in non-convertible bonds over a three-year period, then a company would lose its EGC status on the last day of the fiscal year in which its gross revenues eclipsed $1 billion or immediately upon closing the tipping bond issuance.
Another exit from the EGC superhighway is not always in management’s sole control. If the company becomes a large accelerated filer, generally meaning that the issuer has an aggregate worldwide market value of common equity (consider public float a suitable proxy) held by non-affiliates of $700 million or more and has been a reporting company for one full year, then the company would also lose its EGC status. Depending on the multiple applied to gross revenue applicable to a particular EGC’s industry or a particular EGC itself, an EGC’s float could exceed $700 million well before the EGC exceeded $1 billion in gross revenue.
Management of EGCs and its underwriters must therefore carefully project the company’s revenues, needs for long-term debt and potential for the company’s public float to increase post-IPO to understand completely the potential benefit the JOBS Act may have for a particular company. Because companies will be able to raise up to $50 million in the new hybrid Regulation A+ offering classification and because the $700 million float cap limits the time companies may be an EGC, the JOBS Act creates a window of greatest opportunity for companies with pre-money valuations ranging from approximately $200 million to $600 million assuming strong growth and that founders and controlling shareholders would not want the IPO to amount to a change of control or result in out-of-market dilution for them. Some financial managers may consider issuing securities other than common equity potentially to retain EGC status indefinitely, subject to SEC regulatory adjustments.
IPOs will become a more attractive option for EGCs which will experience a reduced initial compliance burden and greater flexibility in marketing their securities.
The JOBS Act changes both pre-IPO offering rules and post-IPO compliance obligations for EGCs. Prior to completing the IPO, the JOBS Act permits:
- underwriters and issuers to test the waters without running afoul of well-established gun-jumping rules
- issuers to file a registration statement with the SEC for confidential review
- issuers to include two rather than three years of audited financial statements in its IPO registration statement and prospectus
- issuers to provide summary financial disclosure for two rather than five years
- issuers to include reduced MD&A and executive compensation disclosure in an IPO registration statement and prospectus
- research analysts working at the same financial institution as lead and managing underwriters to communicate directly with potential investors
Reversing well-established federal securities laws on gun-jumping, the JOBS Act permits underwriters and EGCs to meet with qualified institutional buyers (QIBs) and institutional accredited investors (IAIs) before the EGC files its registration statement in connection with either an IPO or a secondary offering to determine whether the QIBs and IAIs have an interest in the EGC’s offering as long as any written materials delivered in that meeting meet the definition of a statutory prospectus. Pre-road show meetings will likely become standard operating procedure prior to taking the time and incurring the expense of filing a registration statement, and EGCs will quickly learn whether a capital markets transaction will be a feasible option for them based on early reactions from investors most likely to purchase significant blocks of the EGCs securities.
Confidential Submission of Draft Registration Statement
Once an issuer and its lead underwriters conclude a market may exist, the JOBS Act permits an EGC to file a draft registration statement with the SEC and seek confidential, nonpublic review by the Staff prior to releasing the filing for public viewing. Filing a registration statement confidentially will temporarily preclude potential investors and competitors from viewing it until after the underwriter learns whether a market for the company’s securities exists and the underwriter and issuer resolve material comments to the registration statement from the Staff. While the SEC’s rules have historically permitted issuers to seek confidential treatment of selected disclosure in a registration statement or periodic report to protect highly sensitive information which could affect its competitiveness or national security, the JOBS Act permits an EGC to seek confidential treatment for the entire submitted registration statement. The JOBS Act also includes a FOIA exemption making it unlikely that those on the Street who learn the EGC submitted a registration statement can force the SEC to release the submission to them.
EGCs and their underwriters may be able to resolve material Staff legal and accounting comments before investors have an opportunity to read the submitted registration statement. However, no less than 21 days before an underwriter may initiate a road show with an EGC’s management, the issuer will need to file an amendment making the registration statement and all of its amendments publicly available. As a result, while an EGC cannot shield investors from material comments from the Staff if the offering proceeds, an EGC can pull an offering before conducting a road show without its competitors potentially learning about its business, prospects and financial health.
The SEC quickly announced initial guidelines for EGCs considering submitting a registration statement on a confidential basis including:
- submitting a draft registration statement in text searchable .PDF form on a CD or DVD or submitting an unstapled and unbound paper filing
- transmitting the draft registration statement to:
Draft Registration Statement
U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Upon receipt, the SEC will advise which office will review the draft submission. No registration fee is required at the time of submission, and because the submission is not a public filing, the draft registration statement is not filed for purposes of Section 5 of the Securities Act. Foreign private issuers who seek to file an EGC registration statement must follow the same guidelines as domestic EGCs.
The SEC released on April 10, 2012, FAQs on the confidential submission process which can be found at www.sec.gov/divisions/corpfin/guidance/cfjumpstartfaq.htm. In it, the Staff noted that a submission need not be signed; nor need it include consents from auditors or other experts, although a signed audit report is required. The Staff also stated that pre-filing test-the-waters meetings with QIBs and IAIs will not be treated as commencing a road show. Finally, because a confidential submission is not filed, an EGC cannot make the limited public communications available pursuant to Rule 134.
Investment Banks Permitted to Provide Pre-Filing Research
Prior to the JOBS Act, investment banks providing research reports on companies about to file a registration statement ran the risk of gun-jumping. The JOBS Act now provides a safe harbor for investment banks participating in an offering to give research reports to potential investors before an EGC files an IPO or secondary offering registration statement. Even though providing research reports on EGCs will not constitute an “offer,” analysts writing reports and investment banks disseminating them must nevertheless still ensure that the reports satisfy the federal antifraud standards.
Underwriters May Provide Post-Offering Research Reports
The JOBS Act requires the SEC and FINRA to lift restrictions on investment banks managing or participating in an underwritten offering of an EGC from providing research reports on the EGC after the closing of the offering and prior to the expiration of lockup agreements. Even though investment banks may now publish research reports on EGCs they just brought to market, investment banks will nevertheless need to continue to comply with other securities laws and FINRA rules that regulate activities post-closing that can have an effect on market pricing such as Regulation M.
Analysts May Attend Meetings with EGC Management Arranged by Underwriters Before an IPO
The JOBS Act also prohibits the SEC and FINRA from restricting an underwriter’s ability to arrange meetings between EGC management and research analysts before an IPO and an analyst’s ability to attend these meetings. These prior restrictions were designed to protect against certain conflicts of interest between an investment bank’s underwriting operations and its research analysts. Some investment banks entered into a global settlement with the SEC and the Department of Justice in 2003 requiring them to separate their investment banking and research functions; those investment banks will need to consider carefully the effect of the JOBS Act on their individual settlement.
Nevertheless, the JOBS Act may provide a competitive advantage to those middle-market investment banks not subject to the settlement that can make their research functions transparent, excel at creating relationships and have industry specialized knowledge. The JOBS Act was designed in part to promote long-term investing by sophisticated investors based on an EGC’s fundamentals for growth rather than high frequency, short-term trading based on market volatility and minute changes in the price of an issuer’s stock. In addition, the JOBS Act will afford investment bankers an early access point to EGCs and potential investors permitting investment bankers to speak with QIBs and IAIs early in the process and then meet with EGC management and their research analysts to set reasonable expectations for a capital raise. After the JOBS Act, issuers should consider selecting an underwriter with experience in the issuer’s industry and that has contacts with institutional investors with a long-term investment horizon. Issuers now should have clearer expectations when commencing the offering process subject to market fluctuations and material adverse changes.
EGC IPOs will proceed differently than how IPOs have historically proceeded.
The JOBS Act changes the IPO process for EGCs and their underwriters. Below is a sample timeline which shows what will be permissible for EGCs and their underwriters and the associated timing before, during and after an offering.
The JOBS Act permits EGCs to include reduced disclosure in their registration statements and prospectuses.
In its IPO registration statement and prospectus, an EGC need only present:
- two years, rather than three years, of audited financial statements
- MD&A corresponding to the two years of audited financials presented
- substantially reduced executive compensation disclosure
The JOBS Act permits an EGC to disclose two years of audited financial statements rather than three years. By decreasing the number of years required for audited financial statements, the JOBS Act should reduce the cost of going public for EGCs and encourage them to access the public capital markets sooner. Also, the reduced amount of financial information presented in a registration statement should reduce the cost of obtaining comfort letters from the issuer’s auditor in connection with the IPO. Each company and each offering are of course different, and it remains to be seen whether institutional investors will accept consistently two rather than three years of audited financial statements for an IPO.
The JOBS Act also reduces executive compensation disclosure for EGCs. EGCs need only present the type of executive compensation information that a smaller reporting company must disclose ? even if the value of the EGC’s voting and non-voting common equity held by non-affiliates exceeds $75 million. As a result, EGCs need not include a CD&A in an IPO registration statement and ongoing proxy statements or annual reports, which will substantially reduce the compensation disclosure.
Depending on the market for its securities, EGCs may be required to incorporate financial and other disclosure beyond what the JOBS Act requires if investors require additional information to place their orders.
An EGC may elect to comply with all of the federal securities laws including the Dodd-Frank and Sarbanes-Oxley requirements exempted by the JOBS Act. However, if an EGC elects to do so, it must notify the SEC of its choice at the time the EGC first files its initial registration statement (or 1934 Act report as applicable). An issuer’s lead underwriter should get a sense of whether the institutional investors likely to purchase the issuer’s securities in the IPO will require full compliance during the pre-filing meetings underwriters may have on behalf of an EGC. Moreover, since an EGC may submit a registration statement confidentially, the decision whether to comply fully needs to take place before the EGC files the registration statement publicly (or no less than 21 days before starting the road show). Also, EGCs may not select certain rules to comply with while enjoying an exemption from others. Once an EGC elects to comply with the full panoply of laws and regulations, that decision is permanent and it cannot later retract that decision and enjoy the JOBS Act exemptions.
Reducing transaction costs for an offering may cause EGC management to consider raising capital in multiple U.S. secondary offerings rather than taking more capital up-front in an IPO and diluting founders.
Reducing the number of years of audited financials, eliminating the 404(b) attestation requirement and reducing the number of years of summary financials required in secondary offerings should reduce transaction costs for issuers. Reduced accounting compliance costs alone could increase IPO activity. However, issuers may also find it attractive to raise capital in tranches on an as-needed basis, rather than in larger transactions which would lead to increased deal volume generally in the U.S. capital markets. As an EGC’s valuation rises, each subsequent secondary offering would dilute founders and other early stage investors less, making the multiple tranche secondary offering attractive to them.
Once an EGC closes an IPO, the JOBS Act provides an EGC with up to five years to scale-up to full compliance with Sarbanes-Oxley and Dodd-Frank.
For up to five years post-closing, an EGC will:
- remain exempt from the say-on-pay, say-on-frequency and the golden parachute regulations of Dodd-Frank
- remain exempt from the pay ratio and pay versus performance rules (once promulgated by the SEC) under Dodd-Frank
- enjoy scaled MD&A disclosure obligations in go-forward periodic reports and future registration statements
- enjoy scaled executive compensation disclosure obligations
- not have to prepare a CD&A in go-forward proxy solicitations
- remain exempt from the 404(b) auditor attestation of internal controls requirement of Dodd-Frank
- remain exempt from PCAOB future rules requiring mandatory audit firm rotation and other matters
Ongoing Reporting Requirements for Emerging Growth Companies
The JOBS Act offers EGCs an on-ramp to the U.S. capital markets in part because it affords EGCs an opportunity to scale-up their ongoing Dodd-Frank and Sarbanes-Oxley disclosure in a number of critical areas. Plus it affords EGCs a break from some PCAOB rules which the PCAOB may issue in the future. Some estimates suggest that the scaled on-ramp regulations will reduce EGC’s internal and external compliance costs by 30 percent to 50 percent while it remains an EGC.
EGCs will not need to obtain a SOX 404(b) auditor attestation of their internal controls over financial accounting.
As long as an issuer remains an EGC, it will remain exempt from the Sarbanes-Oxley requirement to obtain an auditor attestation of management’s assessment of its internal controls over financial accounting. CEOs and CFOs of EGCs will still need to provide the mandatory 302 certification, but reducing the hard costs associated with a 404(b) attestation should make becoming a public company less burdensome for EGCs.
EGCs will not need to comply with changed auditing standards until FASB makes the standard applicable to private companies.
Changes in auditing standards applicable to issuers cause comptrollers to spend significant time understanding how the new standards apply to the presentation of a company’s financial information. Changed standards can cause differences in the presentation of the same financial performance, and can cause companies to spend significant time and assets addressing the changed standards. If accounting rule makers like FASB elect to phase-in accounting standard changes for private companies, the JOBS Act would provide EGCs with the same opportunity to phase-in compliance with the new auditing standards. EGCs would not need to comply with a new auditing standard until the standard also applied to privately held companies.
EGCs will remain exempt from future PCAOB rules designed to require audit firm, and not just audit partner, rotation as well as rules requiring an auditor discussion and analysis.
EGCs will remain exempt from future PCAOB rules requiring mandatory audit firm rotation or auditor discussion and analysis. If the PCAOB were to adopt new rules requiring issuers to rotate their audit firms periodically, the JOBS Act would exempt EGCs from those rules. While the PCAOB has been concerned about creating a regulatory environment designed to promote auditor independence, many have voiced concern about future PCAOB rules requiring audit firm rotation and added auditor discussion and analysis. If the PCAOB were to require issuers to change auditing firms periodically, issuers would lose the benefit of the institutional knowledge about the issuer built up by the audit team over time, audit costs would certainly increase as new firms would need time to get up to speed and the market would lose the benefit of an important signal: when an issuer files a Form 8-K and discloses a change in auditors, investors know they should pay careful attention to an issuer’s historic and projected financial performance. In addition, auditors clearly would be concerned about increased liability if they were required to prepare a narrative about an issuer’s internal controls over financial accounting, and not just an audit opinion, and have that narrative incorporated into securities filings. However, the JOBS Act does leave the door ajar to apply new PCAOB rules to EGCs if the SEC determines that the rules protect investors and promote efficiency, competition and capital formation.
The JOBS Act suspends an EGC’s obligation to comply with the say-on-pay, say-on-frequency and golden parachute requirements of Sarbanes-Oxley.
Many middle-market CEOs and CFOs have pointed to the say-on-pay and say-on-performance expanded disclosure requirements as reasons not to take a company public. These CEOs and CFOs may reconsider the U.S. capital markets as a viable alternative to private equity and debt in light of a hiatus from the say-on-pay and say-on-frequency votes. EGCs may enjoy relief from these Dodd-Frank requirements for up to three years after the EGC’s IPO if the EGC was an EGC for less than two years or, if an EGC remains an EGC for the full five years, the company may enjoy one additional year of exemption after it ceases to be an EGC.
The SEC has not yet released rules in connection with Dodd-Frank’s pay ratio and pay versus performance requirements. The JOBS Act would exempt EGCs from those rules once released.
Expansion of Private Placements and Rule 144A Offerings
The JOBS Act makes private offerings for both private and public middle-market companies more attractive and, for those desiring to remain private, allows them to attract more shareholders than previously permitted and still remain private.
Elimination of Prohibition on Advertising and General Solicitation
The JOBS Act will fundamentally change the way issuers can conduct private placements. Prior to the JOBS Act, issuers could not use advertisements or general solicitations to market their private placements under Regulation D and Rule 144A. For example, an issuer could not post on its website that it was about to conduct a private placement. Now, companies can use general solicitation in offerings under Rule 506 of Regulation D as long as the securities are actually purchased only by accredited investors. Similarly, general solicitation is permissible in a Rule 144A offering provided the actual purchasers are QIBs. Sales to non-accredited investors in a Rule 506 private placement and sales to non-QIBs in a Rule 144A transaction will not be permitted if the issuer uses general solicitation to advertise its offering. The issuer will need to take reasonable measures, to be determined by future SEC rulemaking, to verify that purchasers are indeed accredited investors or QIBs, as the case may be. Issuers will therefore have a choice to make when initiating discussions with a placement agent: to use or not to use general solicitation. If an issuer believes it can raise the capital necessary solely from accredited investors, it can use its website, for example, to announce its capital raising intentions. However, if the issuer believes that non-accredited investors will subscribe to the offering, the issuer should choose to conduct its offering in accordance with Regulation D as it existed prior to the JOBS Act without employing any general solicitation.
Loosening of Broker-Dealer Registration Requirements
The JOBS Act also revised Regulation D broker-dealer status under the Exchange Act. A person that meets certain conditions will not be required to register as a broker-dealer under the Exchange Act solely because that person:
- maintains an exchange platform or mechanism that permits the offer and sale of securities pursuant to Regulation D
- co-invests in Regulation D exempt securities
- provides certain ancillary services to such offerings
This new exemption from broker-dealer status is conditioned on the following:
- no compensation is received in connection with the purchase or sale of securities
- the person is not subject to statutory disqualification of broker-dealer status
- the person does not have possession of customer funds or securities in connection with the purchase or sale of securities
These changes loosen the classification of broker-dealer status, limiting the title to those falling under the fundamental requirement of receiving compensation for the transaction.
What This Means for Issuers
Increased Access to Potential Investors. Both private and public companies will be able to send out advertisements regarding Rule 506 offerings, advertise the offerings in the media, make offers over the Internet, and use social media such as Facebook and Twitter to offer securities, as long as all purchasers are accredited investors (for Rule 506 offers) and QIBs (for Rule 144A offerings). As a result, companies will have greater access to investor pools.
No Broker-Dealer Registration. Services that provide due diligence and documentation for Rule 506 private placements or provide a platform for matching small companies with potential investors for the offer and sale of Rule 506 privately placed securities, will not be subject to broker-dealer registration as long as they do not hold client funds or securities, do not receive compensation for the transaction and are not subject to disqualification provisions.
The SEC must adopt rules by July 4, 2012, implementing the elimination of the prohibition of general solicitation. The revisions to the broker-dealer provisions are effective upon adoption of the JOBS Act.
Title III of the JOBS Act creates a new exemption from the registration requirements under the Securities Act. So called “crowdfunding” allows U.S. private companies to raise up to $1 million dollars over a 12-month period from an unlimited number of investors, including “unsophisticated investors.” Crowdfunding, which has become popular in recent years with the growth in Internet usage and social media, typically involves raising funds for a common cause or venture through small contributions from many investors that are pooled together, usually through Internet solicitation.
Crowdfunding may provide a way for issuers to raise small amounts of capital from a wide array of disparate sources. However, Congress also saw crowdfunding as a potential tool to commit fraud on unsophisticated investors. Before embarking on a crowdfunding campaign, companies should understand that the JOBS Act imposes a significant number of restrictions on crowdfunding capital raising activities including:
- the aggregate amount of securities sold to all investors within any 12-month period cannot exceed $1 million, however, an issuer can raise additional capital pursuant to other exemptions or registered offerings
- the aggregate amount of securities sold to an investor with annual income or net worth less than $100,000 cannot exceed the greater of $2,000 or 5 percent of annual income or net worth
- the aggregate amount of securities sold to an investor whose annual income or net worth exceeds $100,000 is limited to 10 percent of the investor’s annual income or net worth, up to a maximum of $100,000
- the issuer may not be a foreign private issuer, a reporting company already subject to Section 13 or 15(d) of the Exchange Act or an investment company
- the issuer must file with the SEC and provide to investors and intermediaries, basic corporate information, including information about its officers, directors, 20 percent shareholders, risks related to the offering and financial statements
- the securities will be restricted for one year, and during such period, may only be transferred (1) to the issuer, (2) pursuant to a registered offering, (3) to an accredited investor, or (4) to family members in the case of a death or divorce of the purchase, or similar circumstances
- companies must use either a registered broker dealer or entity registered with the SEC as a “funding portal” that will act as a platform for investors to review the company information and handle investments; a “funding portal” is a newly-defined entity that cannot solicit purchases or sales of the securities offered or displayed on its website or portal, or offer investment advice or recommendations; registered broker-dealers are not subject to these same restrictions
- issuers would be prohibited from advertising the offering except for providing general notice to investors of funding portals or brokers
- issuers will be subject to liability to purchasers of the securities comparable to that under Section 12(a)(2) of the Securities Act for material misstatements or omissions
- issuers would be required to file annual reports with the SEC describing their results of operations and financial condition
Broker-dealers and funding portals participating in crowdfunding offerings will be subject to certain requirements, including the following:
- registration with the SEC and any applicable self-regulatory organization as a broker or funding portal
- providing disclosures and questionnaires to investors as the SEC may determine, which include risks and other investor education materials
- ensuring that investors have reviewed the disclosure information provided and have answered questionnaires confirming their understanding of the information and have affirmed their risk of loss
- making certain information provided by the issuer available to investors and the SEC at least 21 days before the day the securities are sold
- ensuring that offering proceeds are provided to the issuer only when the target offering amount has been achieved
- performing background checks on the issuer’s officers, directors and significant shareholders
- protecting the privacy of investor information
- not compensating generators, promoters or finders for providing the intermediary with personal identifying information about potential investors
- ensuring that no investor has exceeded the aggregate investment level allowed under the crowdfunding exemption
- prohibiting insiders from obtaining a financial interest in an issuer using that intermediary’s service
Title III also directs the SEC to establish “bad actor” disqualification provisions for issuers, brokers and funding portals similar to what has been proposed under Rule 506 of Regulation D and the current regulations under Regulation A. Title III also amends Section 12(g) of the Exchange Act and directs the SEC to promulgate rules to exclude crowdfunded securities from the newly proposed 2,000 shareholder limit for private companies. Nevertheless, issuers should also take into account the administrative burdens and costs imposed on companies needing to communicate with a large number of shareholders and consider the challenges involved in selling a company with a lengthy shareholder register.
Issuers participating in crowdfunding offerings will be required to file with the SEC and disseminate information to investors and intermediaries. The information includes:
- annual reports and financial statements, reviewed or audited depending on the total offering size
- names and information of officers, directors and shareholders owning more than 20 percent
- risks related to offering and issuer
- use of proceeds from offering
- target amount of offering
- deadline to meet target of offering
- updates of progress in reaching target
- disclosure of compensation to solicitors
Crowdfunding offerings meeting the requirements of the exemption under the JOBS Act will be exempt from state blue sky regulations relating to registration, documentation and offering requirements. States will retain jurisdiction over claims arising from fraudulent, deceitful and unlawful conduct in connection with a crowdfunding offering.
The crowdfunding exemption is effective immediately upon adoption of the JOBS Act. The SEC must adopt rules by December 31, 2012, implementing various rules under the crowdfunding exemption.
What Crowdfunding Means for Companies
This exemption will provide start-up companies with access to capital from unsophisticated investors who otherwise are not be able to participate in private placements, which are traditionally made only to accredited investors. However, the crowdfunding exemption is very limited in that it is available only to U.S. private companies raising no more than $1 million over a 12-month period. Since the securities can be offered to unsophisticated investors, the crowdfunding exemption contains very detailed issuer and intermediary disclosure requirements, SEC filing requirements and annual disclosure requirements. Further, the securities can only be offered through a broker or a funding portal. The broker-dealers and funding portals will need to comply with significant regulatory restrictions to offer crowdfunding services, which will increase the cost and slow the pace of a crowdfunding capital raise. These restrictions may create practical limitations and challenges for issuers seeking to use this exemption, and founders may need to pay for these regulatory requirements through additional dilution.
Small Company Capital Formation
The JOBS Act strengthens the often overlooked Regulation A by providing a new Regulation A+ exemption which will allow issuers to raise significant amounts of capital - up to $50 million.
Regulation A offerings are currently capped at $5 million, and Regulation A requires that the offering must be approved in each state where the securities are intended to be sold. The state qualification requirement has historically deterred many issuers from relying on this exemption. The so-called Regulation A+ under the JOBS Act is a hybrid of Regulation A. Regulation A+ increases the limit of Regulation A offerings from $5 million to $50 million, allowing the SEC to review and increase the limit every 2 years.
The legislation also allows Regulation A+ offerings to be treated as “covered securities,” and thus exempts the offerings from state securities laws as long as the securities are offered or sold on a national securities exchange or sold to a qualified purchaser (to be defined by the SEC). A national securities exchange would not include the over-the-counter bulletin board (OTCBB). However, since securities that are listed on national securities exchanges are already “covered securities,” the additional covered security designation for securities offered or sold on a national securities exchange appears to be superfluous.
Like current Regulation A offerings, under Regulation A+, the securities may be offered and sold publicly and will not be restricted securities under Rule 144. Regulation A currently allows issuers to “test the waters” by making solicitations before filing the Form 1-A. Under Regulation A+, issuers can also “test the waters,” on terms and conditions to be prescribed by the SEC. It is unclear whether these terms and conditions will be more or less restrictive than currently provided.
While the JOBS Act may expand the use of Regulation A+ exempt offerings, it will also subject them to increased SEC regulation including:
- Issuers will be subject to liability under Section 12(a)(2) (currently, Regulation A offerings are not subject to 12(a)(2) liability)
- The SEC must adopt rules requiring that the issuer file audited financial statements annually (currently, there is no requirement for companies relying on Regulation A to file annual audited financial statements)
- The SEC may adopt rules regarding:
- that the offering circular be filed electronically on EDGAR (currently, the offering circular is filed in paper form)
- the form and content of the offering circular, which may include audited financial statements, description of the issuer’s business, financial condition, corporate governance principles, use of investor funds and other matters (currently, audited financial statements are not required, although information regarding the other items is currently required by Regulation A)
- expanded disqualification provisions on participants
- filing of periodic disclosures regarding the issuer, its business operations, its financial condition, its corporate governance principles, use of investor funds and other matters (currently, issuers have no ongoing reporting requirements under Regulation A)
- the termination or suspension of the requirement to file periodic disclosures
What the New Regulation A+ Means for Companies
New Regulation A+ will afford companies an opportunity to raise significant amounts of capital - up to $50 million - without going through a complete IPO process while at the same time permitting them to engage in general solicitation and producing securities at closing which are unrestricted - all without the need for state level approval if the securities are sold to qualified purchasers or on an exchange. Companies with pre-money valuations less than $200 million (again assuming founders do not wish to dilute themselves more than customary levels or accept a change in control) may think seriously about using the new Regulation A+ instead of conducting a traditional IPO raising approximately $50 million or slightly more.
Of course the new benefits also come with a price: investors must balance the ability to raise significant amounts of capital under Regulation A+ against the SEC review process, increased regulation, the requirement for audited financial statements, periodic SEC reporting and increased potential liability. Companies whose securities are not listed on an exchange would only benefit from Regulation A+ if the securities were sold to “qualified purchasers.” Although the JOBS Act does not define “qualified purchasers,” we may find that the SEC’s definition will be similar to the definition of an accredited investor.
As a result, conducting an offering to accredited investors under Rule 506 may be more appropriate, particularly given the relaxation of the prohibition on general solicitations allowing companies to reach more investors.
Institutional Investors May Invest. Since the securities will not be restricted securities, they will not be subject to holding period requirements of Rule 144 and institutional investors should be able to make an investment free from customary liquidity requirements in their funds’ charters and corporate governance documents, providing additional sources of capital to the company.
Rule 144A Offerings. Regulation A+ may also be attractive for smaller debt offerings. Since the notes will not be restricted securities, there would be no requirement to conduct a SEC registered Exxon-Capital exchange offer to provide institutional investors liquidity. As a result, there would be no need to exchange registered notes for the originally issued restricted notes saving issuers substantial amounts of resources, cash and time.
These provisions are not effective until the SEC adopts implementing rules. There is no deadline by which the SEC must adopt the new Regulation A+ rules. Given the rulemaking required by Dodd-Frank and other provision of the JOBS Act, it is unlikely that the SEC will adopt these rules in the near future.
Higher Record Shareholder Thresholds for Exchange Act Registration
While many of the provisions of the JOBS Act were designed to encourage certain companies to access the public capital markets, the JOBS Act also provides companies, including banks and bank holding companies (as defined in the Bank Holding Company Act), an opportunity to remain a private company longer while at the same time significantly growing the company’s shareholder base.
Before the JOBS Act, companies were required to register under the Exchange Act and begin filing annual, quarterly and other periodic reports disclosing material financial and other information about the company when the company’s assets exceeded $10 million and it had more than 500 record shareholders. According to recent reports, the registration requirements under the Exchange Act may have forced Facebook, Inc. into going public much sooner than it would have otherwise preferred.
Under the revised rules, any issuer (other than banks and bank holding companies) will now be required to register under the Exchange Act within 120 days after the last day of its first fiscal year in which its total assets exceed $10 million and a class of equity security is held of record by either (1) 2,000 or more persons, or (2) 500 or more persons who are not accredited investors. Additionally, the definition of “held of record” is being revised so as to not include securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from the registration requirements of the Securities Act. This means that persons holding such securities should not be counted towards the 2,000 person threshold. The SEC must adopt rules to revise the definition of “held of record” and must also adopt safe harbor provisions for determining whether holders of securities received the securities pursuant to an employee compensation plan in exempt transactions under the Securities Act.