Practical Considerations and Implications of the Jobs Act for Capital Raising by Early and Growth Stage Companies
On April 5, 2012, President Obama signed into law the Jumpstart our Business Startups (JOBS) Act (H.R. 3606). The recently enacted JOBS Act is a collection of laws designed to transform the process through which early and growth stage companies access capital and comply with disclosure obligations. Certain highlights of the Act for the early and growth stage investment community include the following:
Synopsis of the Relevant Law
The Jobs Act provides the ability for certain startups to raise money from “crowdfunding” sources under the following circumstances:
- Can sell up to $1,000,000 of securities (including all other securities sold through similar offerings in the preceding 12 months).
- Investors may only purchase (i) the greater of $2,000 or 5 percent of their annual income or net worth, if annual income is less than $100,000, and (ii) 10 percent of the annual income or net worth up to $100,000, if income or net worth exceeds $100,000.
- Transaction must be conducted by a broker or through a funding portal which is registered and complies with requirements to be set by the SEC .
- Issuers must comply with Section 4A(b) of the Securities Act.
Possible Industry Impact
Crowdfunding may be a useful source of seed capital for entrepreneurs if it can be accomplished cost-effectively using platforms that truly automate and streamline the process and if there is adequate oversight to avoid abuse of the system. A common complaint from entrepreneurs is that they don’t have the resources to build the prototype or to obtain proof of concept that institutional investors require. If controls imposed by Congress and the SEC do not result in prohibitive costs, the system promulgated under the Jobs Act could be an efficient means of raising small amounts of money to fund such endeavors, including funding for more traditional businesses that are not in the high growth areas usually funded by angel groups and venture capital funds. In the best of all possible worlds, a high quality group of crowdfunding platforms will join together to create a viable self-regulatory body that will provide confidence in this market. Many of the existing players in this field are already coordinating efforts, but there will be many more jumping into the fray.
Unfortunately, the current market sentiment is that there will be a bifurcation of those that will operate and participate in crowdfunding platforms for the general public and those that will participate in closed platforms available only to accredited investors. If this occurs, then the “wisdom of the crowd” may be of little use to the publicly available crowd funding platforms. Further, these platforms may never gain traction not only as a result of costly and time-consuming compliance requirements for companies but also due to lack of significant resources among non-accredited investors to invest in these types of opportunities. In this scenario, these platforms may become similar to kickstarter or indiegogo which fund smaller projects that attract niche interest. Worst of all, the potential for boiler room style fraud and abuse abounds.
Lifting of General Solicitation Ban on Rule 506 offerings:
Synopsis of the Relevant Law
The Jobs Act also provided for significant changes related to Rule 506 private placements as follows:
- SEC directed to remove the prohibition against general solicitation or general advertising for offers under Rule 506 provided that all purchasers of the securities are accredited investors.
- Similar rules are to be promulgated for qualified institutional buyers under Rule 144A.
- Certain entities acting as intermediaries for private placements under Rule 506 will not be required to register as broker-dealers and can provide services such as due diligence and standardized documents.
- Changes must occur within 90 days of enactment of the Act.
Possible Industry Impact
The removal of the ban on general solicitation for private placements under Rule 506 is probably the one piece of the legislation upon which most people agree. Allowing entrepreneurs to reach a broader base of sophisticated investors through use of 21st century communication and technology tools will expand financing opportunities, particularly for businesses that are not based in Silicon Valley, Boston and New York. The new rules will also allow for more syndication of deals among sophisticated angel investors and funds and will facilitate investment from investors not affiliated with formal angel groups. Platforms such as Gust and Angelist already assist in outreach to angel investors, but, to date, prohibitions on general solicitation restricted the role of these platforms absent registration and/or affiliation with broker-dealers.
However, the text of the Jobs Act also states that the rules created by the SEC shall “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors.” Traditionally issuers have been able to rely on investor self-certification through an accredited investor questionnaire and representations. Any additional conditions imposed by the SEC could create significant impediments for issuers raising capital. For example, will investors want to disclose detailed information about financials or tax returns and will such information be confidential?
Changes to Regulation A and the IPO On Ramp
Synopsis of the Relevant Law
Companies may have an easier time going public due to new rules which have lessened certain reporting requirements:
- Creates a new class of public companies called “Emerging Growth Companies” for issuers who had total annual gross revenues of less than $1 Billion (as indexed for inflation) during its most recently completed fiscal year.
- Allows Emerging Growth Companies to make oral or written offers to qualified institutional buyers and institutional accredited investors before or after filing of registration statement.
- Provides for confidential submission of registration statements to the SEC.
- Emerging Growth Companies are required to provide less information in registration statements including only 2 years of audited financial statements.
- Emerging Growth Companies are subject to reduced reporting requirements including reduced executive compensation disclosure, omission of the Compensation Discussion & Analysis, exemption from independent auditor attestation requirements, and delayed adoption of new audit and accounting standards and rules. Additionally Emerging Growth Companies are not required to hold shareholder advisory votes on executive compensation, golden parachutes etc.
- Private Companies may also have greater access to capital raising through an expanded offering cap in Regulation A.
- New Cap on Regulation A offerings raised to $50 Million from current $5 Million level. However, there are some additional requirements for Regulation A offerings including imposition of civil liabilities of persons offering or selling the securities and requirements for annual audited financial statements.
Possible Industry Impact
Sarbanes-Oxley went to one extreme in imposing what some would consider onerous rules and inefficiencies on the system. Recent years have seen a substantial decline in IPOs caused in part by compliance costs. The changes in the JOBS Act may ease the IPO process for companies with annual revenues below $1 billion. However significant burdens and costs remain. Further, the JOBS Act also increased the threshold number of shareholders at which a company must register as an SEC reporting company to either 2,000 shareholders of record or 500 shareholders of record who are not accredited investors which actually may encourage some companies to remain private.
While Regulation A may be a viable option for some companies, the increased burdens continue to make it less attractive to issuers. Additionally, the Act delegates the creation of the new rules regarding Regulation A to the SEC and does not set a time frame for the creation of such rules.
Concerns of Opponents of the Act
What makes the JOBS Act so troublesome to its opponents is that the US regulatory scheme is disclosure based. It does not regulate who can sell securities. It regulates the manner and method in which a company engages in these activities, requiring full and truthful disclosure of all facts that a reasonable person would find material to their investment decision. Many of the Act’s critics are driven by a concern that lessening the disclosure and reporting burden will taint the system which will have an adverse affect on capital raising generally as it will undermine investor confidence. Our regulatory scheme takes the position that the average person cannot fend for herself, but that someone whom the government deems to have the wherewithal to fend for herself – the so called “accredited investor” or qualified purchaser” - is less in need of protection as such person is supposedly more sophisticated and capable of bearing the loss of her investment. The oversight provided goes to the quality of the disclosure made to those who are the remainder of the market. These are the people that have in large part been shut out of the early stage market because of the current rules. Whether opening the markets to those that don’t meet the accredited investor standard has any real impact, however, won’t just be driven by regulations. The reality is that many of these people don’t have the wherewithal to invest significantly and the risks of investing to this group are higher for many reasons, not least of which is that the economics of investing requires diversification.
Full Impact of the Jobs Act Uncertain
For the accredited investor, the JOBS Act is not groundbreaking. From the viewpoint of the angel investment community, much of the changes implemented in the JOBS Act are just codifying what has been happening for the last several years as angel groups organized around the world and shared deals and resources. The lifting of the general solicitation restriction and the rules regarding use of intermediaries provide clarity for this segment of the market and should therefore facilitate more deal flow. For the venture capital and private equity community, the hope is that these rules will create more significant deal flow, allowing entrepreneurs and early stage companies to find the capital to get past initial proof of concept as well as create more exit opportunities by once again making the public markets a viable exit strategy.
The Act has engendered much debate in the press regarding the good, the bad and the ugly buried in the details of its text. The reality is that the impact of the Act on the various constituencies that will be affected remains to be seen. The devil will be in the rule making and the implementation – both from a regulatory and practical standpoint. This is to be expected from what is arguably the largest overhaul of securities regulation in the last 25 years. Prior to passing the bill, the Senate already added many safeguards to the provisions relating to crowdfunding that will make this much less groundbreaking than originally anticipated (and perhaps much less useful to the entrepreneurs who lobbied hardest for its enactment). Most of the investment and legal community anticipates that the SEC and FINRA will substantially curtail many of the benefits of the Jobs Act through their rule making.
Some of the Questions to Be Resolved
- Will issuers be able to use standard forms and automated structures for crowdfunding to minimize the administrative cost and burden?
- How will crowdfunding deals be structured to address the potential administrative burden of having hundreds of investors?
- Will institutional investors be open to investing in crowdfunded companies with hundreds of unsophisticated investors?
- Will there be integration issues between crowdfunding deals and Rule 506 offerings if the same security is offered?
- Will the sites have immunity as portals or will they seek indemnity from users ? How will companies protect confidential ideas and information on publicly accessible platforms and how will this interact with intellectual property and trade secret law?
- Will the SEC hinder private placements through onerous verification standards for accredited investors?
- How will the “new” Rule 506 interact with old Rule 506? Since the lifting of the general solicitation ban only applies if all purchasers are accredited, what does this mean for the ability to use Rule 506 for sales to up to 35 non-accredited investors?
- How will state law interact with these changes? Not all of the changes are subject to federal preemption.
 Title III of the Jobs Act
 Section 4A(b) states that issuers must provide certain information to the SEC and to investors including but not limited to: (i) names of officers, directors and 20 percent shareholders, (ii) description of the business, (iii) income tax returns for the most recently completed year and financial statements (for offerings of less than $100,000), financial statements reviewed by an independent public accountant (for offerings between $100,000 and $500,000), or audited financial statements (for offerings in excess of $500,000), (iv) intended use of proceeds of the offering. Issuers are also restricted from compensating promoters of the offering and are also subjected to certain annual filings of reports of results of operations and financial statements to the SEC and investors as the SEC determines through its rule making.
 Title II of the Jobs Act
 Title I of the Jobs Act
 Sarbanes-Oxley Act of 2002, Pub. L. 107-204. 116 Stat. 745.
Originally published in imPACT Times, June 2012; a publication of the Greater Philadelphia Alliance for Capital and Technologies (PACT).