SEC Changes Rules to Improve Deal Flow for Private Companies and Investors
In a 3-2 vote held in November 2020, the SEC approved new rules and amendments to existing rules that are intended to harmonize, simplify and improve the private placement regime that start-ups and other issuers, small and large, rely on to raise private capital. The SEC recognized that the current system of private placement exemptions, which was built over many decades, was filled with gaps and uncertainties. The adopting release covered a wide range of topics to address these matters, including:
- Increases in the offering and investment limits permitted under Regulation Crowdfunding and Regulation A;
- Establishment/clarification of rules to allow issuers to participate in demo days in compliance with private placement exemptions;
- Expansion of permissible “testing the waters” inquiries, which allow issuers to gauge the interest of potential investors before incurring the expense of preparing and conducting an offering;
- Much-needed clarifications to the SEC’s integration doctrine; and
- Establishment of rules that permit the use of certain special purpose vehicles that function as conduits for investors to facilitate investing in Regulation Crowdfunding issuers.
Rather than discuss each of the changes recently approved by the SEC, this Client Alert will focus on certain key takeaways that we expect will have significant potential benefits to private companies and investors.
Offering Limits: Regulation Crowdfunding and Regulation A
Regulation A and Regulation Crowdfunding contain a variety of requirements and investor protections, including limits on the amount of securities that may be offered and sold and limits on how much an individual may invest. The SEC has estimated that approximately $2.7 trillion of new capital was raised through exempt offering channels in 2019, of which approximately $1.1 billion was raised under Regulation A and Regulation Crowdfunding combined.
Crowdfunding refers to a financing method in which capital is raised through soliciting investments from a large number of people. In October 2015, the SEC adopted Regulation Crowdfunding, which was intended to help provide capital to start-ups and small businesses by making relatively low dollar offerings of securities less costly. However, Regulation Crowdfunding did not have the impact on capital formation that the SEC had hoped.
The number of offerings and the total amount of funding under Regulation Crowdfunding have been anemic, with issuers raising $108 million from May 2016 through December 2018. Further, the typical crowdfunding offering was relatively small and raised only a modest amount of capital. In an effort to increase the use cases for Regulation Crowdfunding, the SEC adopted amendments to Regulation Crowdfunding as summarized below. The amendments will:
- Raise the 12-month period offering limit for an issuer under Regulation Crowdfunding from $1.07 million to $5 million;
- Remove the investment limits in Regulation Crowdfunding for high net worth individuals and entities that qualify as accredited investors (as defined by the SEC); and
- Allow investors who do not qualify as accredited investors to rely on the greater of their income or net worth in calculating their investment limit and remove the $107,000 cap on an individual’s crowdfunding investments during a 12-month period.
Regulation A is an exemption from registration that establishes two tiers of offerings for a 12-month period:
- Tier 1 – Offerings that do not exceed $20 million; and
- Tier 2 – Offerings that do not exceed $50 million.
The SEC is required to review the $50 million Tier 2 offering limit every two years. The SEC’s recently adopted amendments to Tier 2 of Regulation A will:
- Raise the maximum offering amount from $50 million to $75 million in a 12-month period; and
- Raise the maximum offering amount for secondary sales from $15 million to $22.5 million.
We think the changes to Regulation Crowdfunding and Regulation A are likely to increase the number and size of offerings by issuers under these rules and will result in a wider range of investment opportunities for investors.
Special Purpose Vehicles
Previously, Regulation Crowdfunding required investors purchasing securities in an offering to hold the securities in their own name, creating administrative complexities. We also believe this contributed to limiting the attractiveness of Regulation Crowdfunding because any offering resulted in an excessively large number of investors on an issuer's capitalization table.
In order to reduce the administrative complexities associated with a large and diffuse shareholder base, the SEC adopted certain amendments to allow investors who are natural persons to invest through a crowdfunding vehicle, which would constitute a single record holder in the company’s capitalization table. Further, among other things, the crowdfunding vehicle must:
- Function solely as a conduit for investors to invest directly in a business;
- Be organized and operated for the sole purpose of directly acquiring, holding, and disposing of securities issued by a single crowdfunding issuer;
- Issue only one class of securities in one or more offerings under Regulation Crowdfunding in which the crowdfunding vehicle and the crowdfunding issuer are deemed to be co-issuers under the Securities Act of 1933, as amended, and therefore must jointly file a Form C with the SEC under Regulation Crowdfunding;
- Maintain a one-to-one relationship between the number, denomination, type and rights of crowdfunding issuer securities it owns and the number, denomination, type and rights of its securities outstanding;
- Vote crowdfunding issuer securities and participate in tender or exchange offers only in accordance with investor instructions; and
- Promptly provide disclosure and other information it receives from the crowdfunding issuer to the investors in the crowdfunding vehicle.
This approach is intended to benefit both investors and issuers alike by allowing investors to achieve the same economic exposure and voting power as if they had invested directly in the underlying issuer, while allowing the crowdfunding issuer to maintain a simplified capitalization table and reducing the administrative complexities associated with a large shareholder base.
For years there has been a question as to whether a start-up company’s demo day presentation may disqualify it from relying on certain private placement exemptions available for the sale of stock or other securities. Demo day events feature groups of start-up companies making presentations to prospective investors and other attendees. Although each presentation typically focuses on the start-up company’s business, they often conclude with the company’s capital raising plans. In the past, when a founder had informed the audience that his company was currently raising funds, these statements could have potentially fallen within the broad definition of a "securities offering" as interpreted by the SEC.
In 2015, the SEC issued guidance that suggested that the offering of securities at a demo day may constitute a general solicitation unless the attendees are limited to an audience exclusively made up of persons (i) with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or (ii) who have been contacted through a personal network of experienced investors with sufficient financial experience and sophistication.
Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications could be part of a general solicitation.
New Rule 148 will make it easier for companies participating in a demo day to remain in compliance with the SEC’s private placement exemptions. Listed below are specific requirements under the Rule:
- The communications must be made in connection with a seminar or meeting involving more than one issuer that is hosted by (i) an angel investor group, incubator or accelerator, (ii) a college, university or other institution of higher education, (iii) a state or local government, including their agencies and other instrumentalities or (iv) a nonprofit organization;
- Any advertising for the event must not reference any specific offering of securities by an issuer;
- The sponsor of such event must not make investment recommendations or provide investment advice to attendees and must not engage in negotiations between the issuers and investors attending the event;
- To the extent the event sponsor charges a fee to attend the event, the attendance fee must not be more than a reasonable administrative fee for attendance; and
- The sponsor may not receive any compensation for introductions between attendees and issuers or for investment negotiations between the parties, and the sponsor would not be permitted to receive any compensation with respect to the event that would require the sponsor to register as a broker-dealer or as an investment adviser.
Under the new Rule, companies would be allowed to discuss their securities offerings, provided they only cover the following information:
- Notification that the issuer is in the process of offering or planning to offer securities;
- Description of the type and amount of securities being offered;
- Description of the intended use of the proceeds from the offering; and
- The unsubscribed amount in an ongoing offering.
The Rule also includes additional restrictions for events that allow attendees to participate virtually by requiring that online participants fall within at least one of the following categories: (i) they must be members of, or otherwise associated with, the event sponsor’s organization, (ii) the sponsor must reasonably believe such attendees are accredited investors or (iii) the attendees must be invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications of the event. These restrictions do not apply to individuals that attend the event in person.
The SEC also noted that if the organizer of the event limits the event attendees to individuals or groups of individuals with whom the issuer or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals, then the issuers could avoid the limitations of new Rule 148 because the communications at the event would not likely be considered general solicitations or general advertising.
The amendments and new rules discussed above are expected to become effective in late February or early March. The recent changes adopted by the SEC to the exempt offering framework are significant and detailed. This Client Alert provides a brief overview of only certain noted provisions. If you would like further information, please contact the lawyer at Sullivan & Worcester LLP with whom you regularly consult, or the lawyers listed above.