Traditionally, when raising capital, an overwhelming majority of businesses have used Rule 506 of Regulation D, also often known as the “private placement exemption” as their exemption from securities registration requirements. In recent years, Congress, the SEC, and state regulators have enacted a number of alternative exemptions designed to make capital formation easier for growing businesses, such as equity crowdfunding and “mini-IPOs,” as well as made refinements to existing exemptions, such as Rule 147 (intrastate offerings) and Rule 504. In this post, I’ll provide an overview of these newer options.
Rule 506(c) (aka “Accredited Investor Crowdfunding”)
Since the passage of the Securities Act in 1933, issuers of securities were prohibited from generally soliciting investment from the public for private offerings. However, under pressure to ease the regulatory burden of raising capital for small businesses, President Obama signed the Jumpstart Our Small Businesses Act (“JOBS Act”) into law on April 5, 2012, which removed the ban on general solicitation activities for issuers qualifying under a new exemption called “Rule 506(c).” Unlike in Rule 506(b), which technically allows up to 35 non-accredited purchasers (but in practice doesn’t), the statute limits 506(c) offerings to accredited investors only, and the issuer must go further by taking “reasonable steps” to verify the accredited investor status of each purchaser. This means that an issuer cannot simply rely on an investor questionnaire to determine accredited investor status like it could in a Rule 506(b) offering. Generally, in a Rule 506(c) offering, accredited investor status will be verified by the issuer or a trusted advisor of the investor (e.g. CPA or attorney) who reviews the investor’s tax return, bank account, or other similar information and confirms the investor meets the net worth or income requirements. Although Rule 506(c) includes the same features of a Rule 506(b) offering, including the state securities law preemption, notice filings, and an unlimited offering amount, these offerings still represent a small portion of the private capital market. This is likely due to the burden of needing to verify investors’ net worth or income and market uncertainty about what methods are permissible for such verification. In addition, accredited investors who meet the net worth standard because of their ownership of difficult to value assets, such as privately-owned companies, may find it difficult to prove that they are accredited investors
Crowdfunding is a term used to describe a new method of raising money involving online contributions from a large number of people. Crowdfunding was popularized in the U.S. by websites like Kickstarter and Indiegogo who launched in 2008 and 2009. Bands use crowdfunding to get the word out or to pre-sell a new album while others use crowdfunding to raise funds for someone who has fallen ill or had a personal tragedy. Before the passage of the JOBS Act in 2012, advocates for small businesses began asking the federal government and state regulators to amend their securities laws to allow small businesses to use this new fundraising method to raise capital for its ventures.
Title III of the JOBS Act introduced the equity crowdfunding provisions, which allow issuers using online “funding platforms” to raise up to $1,070,000 in a 12-month period. Title III has some attractive advantages, including state law preemption and the ability to sell to non-accredited investors, but the SEC has implemented regulations that increase the costs of this type of offering relative to the size of the offering. The SEC requires issuers to disclose a significant amount of information up front, provide ongoing reports annually, and submit financial statements, which must be audited if the offering is large enough. The funding platforms that the issuers must use to solicit investments are required to register with the SEC and become a member of a national securities association (e.g. FINRA). Finally, although investors are not required to be accredited, the amount each investor can invest is limited based on the annual income and net worth of the investor.
Regulation A+ (a “Mini-IPO”)
Another underutilized Securities Act exemption was Regulation A, which was designed to allow smaller companies to raise capital without having to go through a formal initial public offering. The JOBS Act directed the SEC to adopt rules allowing for exempt offerings of up to $50 million per year, and the new rules adopted by the SEC (called “Regulation A+”) became effective on June 19, 2015. Regulation A+ establishes two tiers of rules: “Tier 1” applies to a capital raise of less than $20 million in a 12-month period, and “Tier 2” applies to offerings less than $50 million. Although issuers do not have to register with the SEC, issuers must first file and get the SEC to sign off on the issuer’s “offering statement” before it can sell securities pursuant to the exemption. The offering statement requires the issuer to disclose information about the issuer, the offering, previous unregistered offerings, the issuer’s eligibility to make the offering, and the jurisdiction in which the offering will be sold. Issuers may solicit prospective investor interest, also called “testing the waters,” before their offering statement is qualified but may not obtain commitments to purchase prior to SEC qualification. Tier 2 offerings are subject to the ongoing SEC reporting obligations, but unlike Tier 1, Tier 2 offerings preempt state securities laws. Therefore, like Rule 506 issuers, those operating under Tier 2 of Regulation A+ need not worry about registering with state securities authorities or complying with additional state requirements but will need to make a notice filing with many states. Read more: Frequently Asked Questions about Regulation A+
The New Rule 147 and 147A (Federal Intrastate Exemption)
The Securities Act permits issuers to raise an unlimited amount of money from investors in a single state through Section 3(a)(11)’s intrastate offering exemption. In 1974, the SEC adopted Rule 147 providing a safe harbor to ensure compliance with the intrastate exemption. Rule 147 has been underutilized historically, and the SEC recently sought to revitalize the intrastate exemption by amending Rule 147 and creating a new Rule 147A to solve three primary problems. First, under the old Rule 147, intrastate solicitation was permitted, but a single out of state “offer” could destroy the entire exemption for the offering. Next, the issuer was required to be incorporated and do business in the same state where the offering took place, which ignores the valid business reasons companies incorporate in other states like Delaware. Finally, the issuer was required to meet multiple tests to be deemed “doing business” in a certain state. The SEC amended Rule 147 to modernize the “doing business” test by allowing a company to be considered “doing business” in a state if it met one of the following conditions: where a majority of its employees were located, where it derived at least 80% of its revenue, or where 80% of its assets were located. To fix the first two problems, the SEC had to create a new intrastate offering exemption called Rule 147A, which requires companies to do business and have its principal place of business in the state where the offering is sold, not offered and sold. This recognizes the reality that in the internet age, it is very difficult to prohibit all out of state residents from accessing or viewing the terms of the proposed offering. Unlike Rule 506, however, intrastate offerings must still comply with any additional restrictions in the applicable state’s securities laws.
After the SEC’s delayed implementation of Title III of the JOBS Act relating to equity crowdfunding (described above), many states passed their own intrastate crowdfunding exemptions. For example, Tennessee’s “Invest Tennessee Exemption” allows issuers to raise up to $1 million dollars in a 12-month period from Tennessee investors if it complies with the federal intrastate exemption under Section 3(a)(11). Tennessee issuers under this exemption must provide notice to the TN Securities Division and may not accept more than $10,000 from any non-accredited investor.
Not surprisingly, intrastate crowdfunding has been most successful for projects with a local focus while high-growth startups that want to raise larger rounds of capital down the road have been hesitant to take on lots of small investors at an early stage. One issue that intrastate exemptions, including the Invest Tennessee Exemption, have is that some of them have not been updated to use the new Rule 147 or 147A, so the problems remediated by the recent changes to Rule 147 would still be present for an issuer attempting to raise funds pursuant to one of these intrastate crowdfunding exemptions.
An amendment to “Rule 504 of Regulation D” was recently enacted, which could make it more useful to certain small businesses. Like Rule 506, issuers qualifying under Rule 504 are exempt from SEC registration and are only required to provide the Form D notice filing. Whereas Rule 504 offerings were previously capped at $1 million, since the amendment became effective on January 20, 2017, companies can now raise up to $5 million under Rule 504. These offerings can also be offered to non-accredited investors; however, the securities offered under Rule 504 are not covered securities (i.e. state registration requirements are not preempted as they are in Rule 506), so the issuer will be required to comply with each state’s securities laws where the offering takes place. Despite this drawback, many states exempt offerings with a small number of investors, so some companies who are looking to raise less than $5 million from a handful of investors will benefit from this amendment. Further, the SEC has called on states to create a more unified, cost-effective registration process, and if states comply, we may see significant growth in Rule 504 offerings as the cost of blue sky compliance decreases.
In recent years, Congress and the SEC have been hard at work changing and modernizing the fundraising options available to small businesses while maintaining their goal of protecting investors and minimizing fraud. Traditionally, small businesses looking to raise money were limited to their pre-existing, accredited investor contacts, which prevented many from getting the capital that they needed, but with the passage of the JOBS Act, well-advised small business owners should reconsider whether there are new options that fit their needs better than the traditional private placement.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.