John Millspaugh, Partner, Business Services Group
On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act – also known as the JOBS Act – dramatically changing the landscape for many companies raising capital, hoping to go public or avoid doing so, or dealing with the regulatory burdens of being a public company.
The JOBS Act is intended to stimulate economic and job growth by easing restrictions on certain methods of capital formation and through new measures designed to facilitate initial public offerings (IPOs) for emerging growth companies (EGCs). The Act received broad bipartisan support in Congress, but has generated a fair amount of controversy among investor protection advocates and others.
There is little question that the forthcoming changes to Rule 506 of Regulation D and the new permissive crowdfunding rules will significantly affect startup and growth company funding activities. Less certain is the likely impact of the new IPO on-ramp for EGCs and the increases to stockholder limits for private companies looking to remain private.
Bring in the Mad Men—General Advertising and Solicitations in Rule 506 and Rule 144A Offerings
General advertisements and solicitations have long been prohibited in Rule 506 and Rule 144A offerings. And, in Rule 506 offerings in particular, confusion and frustration over what constitutes a general advertisement or solicitation abounds. This confusion and frustration, along with frequent accidental (or not) public and publicized offering-related disclosures, create traps for the unwary issuer hoping to rely on the safe harbor of Regulation D. Those concerns, in Rule 506 offerings at least, will soon be eliminated; and issuers and entrepreneurs will be able to speak to the public about their companies more freely, advertise Rule 506 offerings on their websites, and stop acting coy when asked about their fundraising plans.
More specifically, the JOBS Act requires the Securities Exchange Commission (SEC) to revise Rule 506 within 90 days of its enactment to allow general advertising and solicitations of investors, provided sales are made solely to accredited investors, and the issuer takes reasonable steps (as yet undefined) to verify that purchasers in fact are accredited investors. Exempt sales to up to 35 non-accredited investors will still be possible if there is no general advertising or general solicitation.
Similarly, the JOBS Act would allow general advertising and solicitation of investors in offerings under Rule 144A, provided sales are made exclusively to qualified institutional buyers.
The JOBS Act will also exempt certain trading platforms used in Rule 506 offerings from broker-dealer registration. This should increase the prevalence of these platforms and enhance the efficient exchange of issuer information, although critics of the JOBS Act point out the potential for an increase in fraudulent activity resulting from impersonal, general solicitations in offerings where extensive disclosure and reporting are not required.
Crowdfunding—A different Kind of Investing Groupthink
The most popular component of the JOBS Act is its embrace of crowdfunding. Crowdfunding is the process of gathering small investments from a large number of investors (typically via the Internet). Startup enthusiasts view the potential for raising seed capital through crowdfunding as a boon to cash-starved, early stage companies with otherwise limited capital access.
Under the JOBS Act, an issuer may utilize the crowdfunding exemption to raise up to $1 million within a 12 month period without registering the sales with the SEC. However, the aggregate amount sold to any investor in a 12 month period by the issuer relying on the crowdfunding exemption must not exceed:
- the greater of $2,000 or 5% of the annual income or net worth of the investor if either the annual income or the net worth of the investor is less than $100,000; or
- 10% of the annual income or net worth of an investor not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.
Crowdfunding issuers will be required to file with the SEC and make enhanced financial, business and risk disclosures at the time of the offering, and to provide annual updates thereafter, with the extent of disclosure dependent on the size of the offering. The JOBS Act also imposes civil liability on issuers and control persons for material misstatements or omissions in connection with a crowdfunding offering and expressly permits rescission claims by investors.
Crowdfunding transactions will be permitted only via a registered broker-dealer or compliant funding portal. Those intermediaries will have enhanced “gatekeeper” obligations designed to prevent fraud and abuse, including ensuring that investors understand investing and its risks, performing background checks on issuer executives, and monitoring investor compliance with individual investment limits.
Again, some critics loathe the new crowdfunding rules, sensing the imminent return to pervasive sham investments marketed through slick-looking websites. Certainly that is a risk that should not be discounted, but the potential liability to the issuers and individuals involved in such a scheme, and the gatekeeper obligations imposed on broker-dealers and intermediaries in crowdfunding transactions, are designed to prevent or ameliorate that risk.
Crowdfunding looks promising for startups, but it will likely not become more prevalent until after the SEC issues its required new rules, which are due 270 days after enactment.
Widely Held Private Companies—New Flexibility in Avoiding Public Company Reporting
Currently, any non-public issuer with assets over $10 million and shares held by 500 or more persons at the end of the issuer’s fiscal year is automatically subjected to public company reporting obligations under the Exchange Act. In other words, these companies essentially have the same expense structure and reporting requirements as companies who have been through an IPO.
The JOBS Act will raise the trigger for public reporting requirements from 500 stockholders to 2,000 stockholders (although not more than 500 of the stockholders can be non-accredited investors). The asset test will remain at $10 million, but the JOBS Act will exclude from the stockholder trigger calculation those who receive shares pursuant to an employer compensation plan and stockholders who acquire their shares via the crowdfunding exemption.
The current 500-stockholder limit has been cited as an impediment to capital formation by companies who rely on multiple rounds of successive investment, and creates problems for large private companies who provide equity-based compensation to employees. Google, for one, rather famously struggled with this stockholder limit as the number of its current and former employees with option shares ballooned. Relatively few companies, however, approach these limits, but for those dealing with hundreds of investors or equity incentive recipients, the increase in the reporting threshold should come as welcome relief. The exclusion of crowdfunding investors from the calculations also prudently avoids creating this issue for even more companies who raise crowdfunded capital.
Making Life Easier Pre and Post IPO—Streamlining the IPO Process and Relaxed Reporting Requirements for Emerging Growth Companies
One of the JOBS Act’s main objectives is to streamline the IPO process and reduce SEC reporting burdens after an IPO for qualifying EGCs. EGCs are defined by the JOBS Act as companies with annual gross revenues less than $1 billion in the most recent fiscal year. An EGC will benefit from less strenuous disclosure and reporting obligations if its IPO is effective after December 8, 2011, until the earlier of the:
- last day of the first fiscal year after annual gross revenues exceed $1 billion (adjusted for inflation);
- last day of the first fiscal year following the fifth anniversary of the IPO;
- date on which it has, during the prior three years, issued more than $1 billion in non-convertible debt; and
- date on which it becomes a “large accelerated filer.”
Among other benefits, the JOBS Act permits EGCs to do the following to:
- “Test the waters” to determine interest from institutional accredited investors and qualified institutional buyers without violating gun-jumping restrictions;
- Provide only two years (instead of the currently required three years) of audited financial statements and cover only two years of financial information in the Management Discussion and Analysis section of the IPO registration statement;
- File a draft IPO registration statement on a confidential basis for SEC review and comment, as long as the submission and all amendments are later disclosed to the public at least 21 days before the issuer’s pre-IPO road show; and
- Avoid annual stockholder approval of executive compensation in a “say-on-pay” vote.
The wide-ranging changes contained in the JOBS Act will undoubtedly make capital raising easier in some ways for many types of issuers. What remains to be determined are questions of degree – how much easier? For whom, really? And what of the seemingly fair criticisms that the unscrupulous will use the relaxed rules as an opportunity for fraud and abuse? Which will be the JOBS Act’s dominant legacy – increased economic activity, or a failed experiment? Betting on the former, we look forward to the first JOBS Act crowdfunding-made millionaires, the EGCs who make it to the IPO, and the first iteration of advertised Rule 506 offerings.
Our appreciation to Abbey Stemler who contributed to this article.