Posted: December 01, 2012
Changes to federal law open new avenues for business owners seeking capital
Legal Insight Special Section
By David Babiarz and Trevor Crow
Provisions of the Jumpstart Our Business Startups (JOBS) Act adopted by the U.S. Congress in 2012 create new opportunities for business owners seeking to raise capital to start or grow their businesses. Business owners who do not qualify for traditional bank financing have historically been very limited in the means by which they can contact investors to raise money. However, certain provisions of the JOBS Act, together with rules recently proposed by the Federal agency charged with overseeing capital formation, make that process easier. Business owners need to be aware of these provisions to take advantage of what might be a historic window of opportunity for job creation.
When a company seeks to raise money to start or expand its business, there are two broad categories of financing available – debt or equity. Debt financing typically takes the form of a bank loan, while equity financing involves the sale of a portion of the company to investors. Equity investments generally come from friends, family and more rarely from professional investors such as angels, venture capitalists, investment banks and private equity firms. When raising equity and some forms of debt, companies must be mindful of securities laws, which regulate such activities.
At the core of the securities laws is the prohibition against the offer and sale of securities unless the transaction is registered or unless the offering qualifies for an exemption. Registration is an expensive and time-consuming process generally reserved for larger companies, but which give rise to the company’s stock trading on a stock exchange. Exemptions, on the other hand, allow a company to raise money without such time and expense. A private offering is an exemption that allows a company to raise money without many of the expensive elements of a public offering such as filing a registration statement with the Securities and Exchange Commission (SEC) and navigating many additional rules applicable to being a public company and making a public offering.
When conducting a private offering, companies frequently rely upon the rules under Regulation D adopted by the SEC, including Rule 506. Rule 506 is attractive to companies because they do not have to register with the SEC, it pre-empts state securities laws, and there is no ceiling on the amount that can be raised. Billions of dollars are raised every year by U.S. companies using Rule 506.
Prior to the JOBS Act, Rule 506 prohibited companies from offering securities through the use of general solicitation or advertising that was distributed to broad audiences such as through television, Internet, and other similar forms of communication. The SEC traditionally thought of these general solicitations as being at odds with the concept of a private offering. Thus, companies seeking capital were limited to contacting existing investors, friends or business associates with which they had a pre-existing relationship or working with investment banks that had preexisting relationships with sophisticated investors.
The JOBS Act Provisions allowing General Solicitation for Private Offerings
The JOBS Act provides a revolutionary change to the way private securities offerings may be executed by companies in the U.S. These changes were designed to make it easier for companies to access capital, potentially growing the business and creating more jobs.
To implement the Congressionally mandated change under the JOBS Act, the SEC recently proposed an amendment to Rule 506, adding a new section that permits the use of general solicitation to offer securities to an unlimited number of investors for an unlimited amount of money so long as all the purchasers of securities are high net worth investors known as "accredited investors." Further, the companies must take reasonable steps to verify that the investors who purchase securities are accredited.
While the proposed amendment adds a new twist to Rule 506, the SEC is preserving, under existing sections of Rule 506, the ability to conduct traditional Rule 506 offerings without the use of general solicitation, which some commentators have referred to as the "quiet" Rule 506 offering. The quiet Rule 506 offering prohibits general solicitation but allows companies to sell securities to up to 35 non-accredited investors in addition to accredited investors. Sales to non-accredited investors must be accompanied by more rigorous disclosure.
The companies that stand to benefit most from the amendment to Rule 506 will be the companies that do not have relationships with professional investors such as venture capitalists or investment banks, but have a business that is attractive to a larger audience of high net worth investors. In addition, the changes to Rule 506 may be especially beneficial to companies seeking capital prior to an initial public offering (IPO).
The companies that seek to take advantage of these new provisions of Rule 506 must still be mindful not to violate the anti-fraud rules that apply to sales of securities. The main purpose of the U.S. securities laws is to prevent fraud. For this reason, the anti-fraud provisions under the federal securities laws apply to all issuers of securities, whether the issuance must be registered or it is exempt. In general, the anti-fraud provisions prohibit the use of material misstatements or omissions of fact in connection with the purchase or sale of a security.
Before companies hire someone to spin a sign on the 16th Street Mall to trumpet their next private offering, they should take caution in respect to the following:
• As of the date of this publication, the SEC’s rule which would permit general solicitation is subject to final approval. Thus, until the rule becomes effective, companies cannot use general solicitations under Rule 506. Further, because the rule is tentative at this time, the SEC could still make changes to increase investor protections.
• Prior to the JOBS Act, it was customary for companies to rely on "representations" from the investors certifying their qualification as accredited investors. However, the JOBS Act and the SEC’s proposed rule suggest that some additional effort may be required to verify accredited investor status. It will be important for companies relying on the new rule to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor.
• In practice, companies, attorneys, and broker-dealers will have to develop systems for verifying a potential investor’s status as an accredited investor when conducting a Rule 506 offering that employs general solicitation.
• All issuers of securities should be mindful of the generally applicable anti-fraud provisions under the securities laws as well as under the common law. The anti-fraud provisions apply to all sales of securities, whether registered or exempt. Companies seeking to raise money under the new JOBS Act provisions should therefore seek advice regarding steps to take to avoid running afoul of these anti-fraud provisions.
• Persons engaged in purchasing or selling securities raise issues regarding the federal and state laws requiring registration as a "broker-dealer." There are several exemptions from registration available under federal and state law, a discussion of which is outside the scope of this article. However, companies raising money should seek counsel regarding compliance with the broker-dealer rules.
Other Provisions of the JOBS Act Affecting Capital Formation
While this article focuses on the JOBS Act provisions concerning private offerings, two other provisions of the JOBS Act that are designed to increase access to capital are worth mentioning. The first is known as the IPO "on-ramp," which delays several complex and expensive disclosure requirements for smaller public companies. The theory behind these rules is that decreased disclosure requirements will incentivize smaller companies to access the public markets through an IPO.
Second are the Crowdfunding provisions of the JOBS Act. Crowdfunding refers to the act of raising funds from many relatively small investments by a large group of people. The JOBS Act creates an exemption from the public company registration requirements for these offerings, but limits the amount that can be raised in any 12-month period to $1,000,000 and limits the amount that each investor can contribute. Significant rulemaking by the SEC is required before the Crowdfunding provisions become effective, which likely will not occur until 2013.
While the Crowdfunding provisions of the JOBS Act have monopolized most of the headlines, the amendments to Rule 506 offerings may have a greater impact on capital formation because of the unlimited amount of money that can be raised and the absence of potentially onerous regulatory requirements associated with Crowdfunding.
This article is intended as a summary to aid the reader’s understanding of the future of Rule 506 offerings should the final rules be adopted in substantially similar form as the proposed rules. However, business owners must wait until the final rules become effective and be cautious about navigating these new rules when raising money.
The impetus behind the JOBS Act is to make it easier for companies to raise capital. Business owners who are aware of these provisions will be better-positioned to take advantage of what might be a historic window of opportunity to raise money and create jobs.
David Babiarz is the President and a Director in Dufford & Brown P.C.’s corporate and securities practice group. Mr. Babiarz has extensive experience in securities, including private and public offerings, compliance reporting, proxy solicitation, and "going private" transactions. Mr. Babiarz can be reached at 303-837-6325 or firstname.lastname@example.org
Trevor Crow is an Associate in the corporate and securities practice group at Dufford & Brown P.C. Mr. Crow’s practice focuses on public company securities compliance, mergers and acquisitions, entity formation, and start-up company financing. Mr. Crow can be reached at 303-837-6358 or email@example.com.