Almost three years ago the Jumpstarting Our Business Startups Act (“JOBS Act”) was passed with overwhelming bipartisan support. The purpose of this was to make capitalizing and growing small firms easier and less restrictive, and marked the first loosening of regulation in this area since the Great Depression. This is important as by and large, companies have two options to obtain capital; 1) borrow from an institutional lender, or 2) sell shares of equity. The former has become extremely restricted due to lenders’ fears of falling foul of their regulators. The second requires costly registration with the SEC unless it falls in a small group of exemptions.
Despite the much talked about changes, three years have passed and the most significant portions of the JOBS Act for small business are still not in place. The SEC has to date failed to finalize the rule making on Title III and Title IV. Title III is the so-called Crowdfunding provision and requires that the SEC set rules to allow for small businesses utilize an online portal to sell equity in their business to obtain up to $1,000,000. Title IV (Regulation A+) allows firms to raise up to $50,000,000 through a simplified public offering form. Both of these should have a significant impact on small businesses and startups once the final rules are put in place. This is especially important as the current regulatory climate has all but frozen many small businesses’ ability to obtain financing from ordinary lenders. Unfortunately, it doesn’t appear that the final rules will be in place before the end of 2015. Once that occurs we will provide an update on those rules here.
We then are left with much the same options as have been available for many years. Small businesses can still take advantage of Regulation D offerings. These are limited in how they can be offered, to whom, what types of offerings may be made and how much may be raised. There are a number of sections which govern various offerings, however, we will only address Section 506 as it is the one significant change mandated by the JOBS Act that has been implemented. This loosened the restrictions on general solicitation of investors provided certain rules were followed.
Rule 506 generally provides that a company can raise an unlimited amount of capital (Rules 5004 and 505 limit the amounts) as long as the Seller is available to answer investors’ questions, the companies’ financial statements have been provided by an independent certified public accountant or otherwise comply with Rule 505 and the investors receive restricted securities (meaning they are not freely traded in the secondary market). In addition to the foregoing, the company then has two options: 1) a non-general solicitation or marketing; or 2) general solicitation and advertising of private placements under the new Rule 506(c). If a business does so under option 1, then they may sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors although those 35 non-accredited investors must be determined to be “sophisticated”, that is they have to have sufficient knowledge and experience with business matters to make an informed decision about the risks and benefits of investing. If the business chooses to do so under option 2, then it may advertise and market generally however all investors MUST be accredited.
Under Reg D, Rule 501, an accredited investor is one who has “An individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence.
An individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.
Under Rule 506(c) the issuer, must take steps to verify that the investors are accredited investors. As stated by the SEC, “The determination of the reasonableness of the steps taken to verify an accredited investor is an objective assessment by an issuer. An issuer is required to consider the facts and circumstances of each purchaser and the transaction.” Examples of ways in which an issuer might fulfill this requirement as per the SEC include, but are not limited to:
Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.
While the economy is certainly ticking upwards, it is far from clear that it is healthy and the current regulatory climate has made traditional avenues of finance difficult or impossible to obtain for the small business owner. This requires todays’ entrepreneur to think outside the box and seek out alternative methods of financing if he or she wants to finance their businesses growth. NOTE: No offering should be made without incorporating a written disclosure of the risks attendant to the investment. If you would like help preparing disclosures or a private placement memorandum or have questions about this article, please contact our office.