The Jumpstart Our Business Startups Act (the “JOBS Act”), signed into law on April 5, aims to promote economic growth and job creation by lowering the barriers to raising capital, particularly for privately held businesses with under $1 billion in annual gross revenue. For these “emerging growth companies,” as the Securities and Exchange Commission (“SEC”) has dubbed them, the JOBS Act facilitates fundraising by:
- easing the prohibition on general solicitation and advertising when raising capital from “accredited investors” under Rule 506 of Regulation D;
- increasing the amount companies may raise in “mini-IPOs”;
- easing mandatory reporting triggers under the Securities Exchange Act ("Exchange Act");
- reducing some of the regulatory compliance burdens when going public; and
- permitting the offer and sale of securities through "crowdfunding" under certain circumstances.
These changes present new possibilities for growing businesses. They also present new challenges and pitfalls corporate counsel must help company management navigate. Among them is determining which of these new avenues to capital makes sense for the business and how each option may impact the company’s near-term capital raising plans.
Fundraising From Accredited Investors (Rule 506 Of Regulation D)
A 2011 study by the SEC  reveals that financing undertaken pursuant to Regulation D is now the dominant method by which companies raise money in the United States, both in terms of amount raised and (overwhelmingly) number of transactions, but also found that the vast majority of Regulation D financings are limited to less than $1 million raised from 30 or fewer investors. In a report to the SEC  on January 6, 2012, the SEC’s Advisory Committee on Small and Emerging Companies (the “Committee”) concluded that the restrictions on general solicitation and advertising imposed by Rule 502(c) of Regulation D “prevent many privately held small businesses and smaller public companies from gaining sufficient access to sources of capital and thereby materially limit their ability to raise capital through private offerings of securities.” The JOBS Act mandates two changes to alleviate the concern raised by the Committee.
First, the JOBS Act requires that the SEC revise Regulation D to remove the prohibition on general solicitation and advertising for financings conducted under Rule 506 if all purchasers in the financing are accredited investors.  This will allow companies to solicit investors with whom they have no preexisting relationship through their websites, Facebook, Twitter and other social media outlets, as well as conventional media, without fear of losing the exemption from registration provided by Rule 506. The JOBS Act requires that the SEC establish the methods by which a company must verify that purchasers are accredited investors. This may mean companies cannot simply rely on a signed statement from an investor as to his or her income or net worth, as is currently common practice.
Second, the JOBS Act provides that a person connecting issuers and potential investors will not be required to register with the SEC as a broker or dealer if (a) the offering is being made pursuant to Rule 506, (b) the person does not receive compensation in connection with the purchase or sale of the securities, and (c) the person never takes possession of customer funds or securities in connection with the financing transaction. This clarifies the ways in which an unregistered broker (i.e., a “finder”) may assist in fundraising without compromising the company’s private offering exemption.
These changes will facilitate access to capital by emerging growth companies, particularly those located in areas of the country where early-stage financing is scarcer, by making it easier for them to reach out to potential investors. It will also, however, require corporate counsel ensure adherence to these new rules. In particular, because use of general solicitation or advertising will preclude reliance on other federal and state private offering exemptions, corporate counsel will need to insist on strict adherence to the methods established by the SEC for determining if an investor is accredited.
The JOBS Act also makes it easier for emerging growth companies to raise capital by amending Section 3(b) of the Securities Act of 1933 (“Securities Act”) to exempt from registration any class of equity, debt or convertible debt securities sold in an offering where the aggregate offering amount does not exceed $50 million in any 12-month period, provided the issuer files audited financial statements each year following the offering and complies with any other rules to be developed by the SEC. This new exemption, referred to by some as “Regulation A+,” effectively expands the existing exemption under Regulation A, which currently allows a private company to raise up to $5 million from the public using more streamlined disclosure than in a typical IPO, and without registering the offering with the SEC or becoming an SEC reporting company. Regulation A is rarely used, however, because even complying with the streamlined disclosure requirements is generally not cost-effective for an offering limited to $5 million, particularly when companies have the option to raise an unlimited amount from accredited investors under Rule 506 without any mandated disclosure obligation and without being subject to state “Blue Sky” laws. By setting a much higher offering limit for Regulation A+, Congress made it a more cost-effective option for raising capital.
Regulation A+, like Regulation A, has a number of compelling features not available in a Regulation D private placement: (1) the offering may be publicly announced; (2) there is no need to qualify investors as accredited; (3) there is no holding period before investors can resell the securities; and (4) an issuer is permitted to “test the waters” before the offering. However, the increased fundraising cap in Regulation A+ does come with new requirements: (a) companies must file an offering statement containing disclosures required by the SEC and must file annual audited financial statements and other documents the SEC may require; (b) the Act expands the scope of “bad actors” who may not make use of the exemption; and (c) the Act extends the liability provisions of Section 12(a)(2) of the Securities Act to offerings under Regulation A+. In addition, offerings under Regulation A+ will be exempt from Blue Sky laws only if they are listed on a national securities exchange (such as Nasdaq or NYSE) or are sold only to “qualified purchasers” (a term to be defined by the SEC). The JOBS Act requires the comptroller general to submit a study within 90 days of the passage of the JOBS Act on the impact of Blue Sky laws on Regulation A offerings, which could influence the SEC’s rulemaking.
Although not so suitable for very early stage companies, Regulation A+ should be attractive to companies looking to raise tens of millions of dollars that are sufficiently “mature” to have or procure audited financial statements, but do not want the ongoing expense and vigilance required to be a full-fledged SEC reporting company. In advising management on raising capital under Regulation A+, corporate counsel will need to pay close attention to the applicability of Blue Sky laws because state regulations are not always uniform, and regulatory review can be unpredictable and prohibitively expensive unless the offering is limited to a handful of states. If, however, the SEC defines “qualified purchaser” in a way that is not too restrictive, and the rules for determining which investors satisfy the definition are not too onerous, Regulation A+ will be well worth considering.
A more subtle way in which the JOBS Act makes it easier for emerging growth companies to raise capital is by allowing them to put off becoming an SEC reporting company by easing the mandatory reporting trigger in Section 12(g) of the Exchange Act. Previously, a company was compelled to register a class of equity securities with the SEC and file periodic reports once it had at least $1 million in assets and shares “held of record” by at least 500 shareholders at the end of its fiscal year. In a report to the SEC  on March 9, 2012, the Committee expressed its concern that these thresholds compel some companies to either (a) register and begin reporting “at a time in their development that is not the most advantageous to the company or its shareholders” or (b) “manage their capital raising or employee compensation activities in ways that may not be in their or their security holders’ best interests.”
The JOBS Act seeks to eliminate the conundrum posed by the current rules by making several changes to Section 12(g). First, the JOBS Act increases the Section 12(g) thresholds to $10 million in assets and 2,000 shareholders, of which up to 500 may be non-accredited investors. Second, the JOBS Act limits Section 12(g) by excluding from the definition of “held of record” holders who acquired securities pursuant to employee compensation plans in transactions exempted from registration under Section 5 of the Securities Act. This would include shares issued under a standard equity incentive plan (a.k.a. an “option plan”) that meets the requirements of Rule 701 of the Securities Act. Finally, the JOBS Act excludes from the definition of “held of record” holders who acquired securities in a crowdfunded offering under the new Section 4(6) of the Securities Act (discussed below).
These changes will allow an emerging growth company to stay private longer and choose the opportune time to go public. Corporate counsel will want to apprise company management of the new thresholds and educate them on how companies must now calculate shareholders of record.
Emerging Growth Company IPOs
For emerging growth companies that do choose to raise capital in the public markets, the JOBS Act makes it easier by exempting them from a number of current and proposed regulations applicable to companies when they undertake an initial public offering and once they are public.
Under the JOBS Act:
- Emerging growth companies may prefile confidential registration statements in order to begin the SEC review process without publicly revealing sensitive commercial and financial information. A company must publicly file the original registration statement and all amendments at least 21 days before it begins a pre-IPO road show.
- The publication or distribution by a broker or dealer of research reports about an emerging growth company that is the subject of a proposed public offering will not be considered an offer to sell securities, even if the broker or dealer is participating in the offering.
- An emerging growth company may communicate with qualified institutional buyers and with accredited institutional investors to determine their interest in a contemplated IPO both prior to and following the filing of a registration statement.
- Emerging growth companies are required to present only two years of audited financial statements in order to register for an IPO, and in any other registration statement are not required to present selected financial data for any period prior to the earliest audited period presented in connection with the company’s IPO.
- Emerging growth companies are exempt from compliance with new or revised financial accounting standards until such standards apply to private companies.
Once public, emerging growth companies are also exempt from several ongoing obligations that apply to larger companies:
- Emerging growth companies are exempt from Section 103(a)(3) of the Sarbanes-Oxley Act of 2002 ("SOX"), including from any rules adopted by the Public Company Accounting Oversight Board ("PCAOB") mandating audit firm rotation, and from any future PCAOB rule unless the SEC determines that compliance with the rule is necessary in the public interest.
- Emerging growth companies are not required to comply with Section 404(b) of SOX, which requires a report by an outside auditor on management’s assessment of the company’s internal controls over financial reporting, although management must still establish and report on its assessment as to the effectiveness of its internal controls.
- Emerging growth companies are also exempt from Section 951 and Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 951 requires public companies to hold a nonbinding shareholder vote on executive compensation arrangements at least once every three years. Section 953(b) requires that public companies disclose the median compensation of all employees compared with that of the company’s CEO.
A company will continue to be classified as an emerging growth company until the earliest of: (a) the last day of the fiscal year in which the company’s total annual gross revenues are $1 billion or more; (b) the last day of the fiscal year following the fifth anniversary of the company’s initial public offering; (c) the date on which the company has, during the previous three-year period, issued more than $1 billion in nonconvertible debt; or (d) the date the company is deemed a “large accelerated filer” under Rule 12b-2 of the Exchange Act (requiring, among other things, that the company have a public float of $700 million or more). The $1 billion annual gross revenue threshold is to be adjusted for inflation every five years, and a company that went public or was in registration on or before December 8, 2011, is not eligible to be an emerging growth company.
By reducing the burdens of going public, allowing the filing of confidential registration statements and allowing some prefiling communications with potential purchasers, the JOBS Act makes it easier for emerging growth companies to access the public markets and allows them to do so when they believe the offering is most likely to succeed. Counsel to companies that may be considering a public offering in the foreseeable future should update management on the new flexibility created by the JOBS Act.
Finally, the biggest change to raising capital effected by the JOBS Act is the creation of a new exemption from registration for the offer and sale of securities through crowdfunding. Crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people. It has become popular over the past few years via websites, such as Kickstarter.com, through which companies offer thank-you gifts of various sorts in exchange for donations, but because of federal and state securities regulations, offering stock or other securities has been verboten. The JOBS Act creates a new section in the Securities Act, Section 4(6), that will allow companies to raise up to $1 million in any 12-month period by selling securities to anyone – not just those wealthy enough to qualify as “accredited investors” – without being compelled to provide copious information. Securities sold in a crowdfunded offering will also be “covered securities” exempt from state Blue Sky registration requirements, though states will still have authority to take enforcement action against companies for fraud or other unlawful conduct perpetrated through crowdfunding.
While the JOBS Act removes a number of hurdles to raising capital from nonaccredited investors, it also imposes requirements that will make crowdfunding more complicated and expensive than many realize. It will be difficult to accurately estimate the true costs of crowdfunding for several months because the SEC has 270 days to issue rules enabling crowdfunding (and will likely take longer), but there are at least four elements of crowdfunding under the JOBS Act that will likely impact its utility as a fundraising tool for emerging growth companies.
1. Intermediaries. To help quell fears of fraud, the JOBS Act requires that crowdfunded offerings be conducted through authorized third-party intermediaries. Becoming an authorized intermediary will not be easy (or cheap): an intermediary will not only be required to register with the SEC – either as a “broker” or as a “funding portal” (a new classification to be defined by the SEC) – it will also need to register with a self-regulatory organization approved by the SEC and be a member of a national securities association. Intermediaries must supervise offerings to ensure they are conducted properly and must also take additional steps to reduce the risk of fraud. The costs of becoming an authorized intermediary and of complying with the investor protection requirements of the Act will likely be significant, and will be passed along through fees charged to companies raising capital.
2. Financial Statements. The JOBS Act also attempts to deter fraud by requiring that companies provide to potential investors, and in some cases file with the SEC, specific information about their business, including a description of their financial condition. For offerings of $100,000 or less, the company is only required to file its most recent tax return, if any, and financial statements certified by the company’s CEO. For offerings of $100,000 to $500,000, the company must also have the financial statements reviewed by an independent public accountant. For offerings of $500,000 to $1 million, the financial statements must be audited. Companies will need to carefully consider how much they need to raise, and how much they believe they can raise, when setting the limit of their offering. For many companies, the need for audited financials will preclude them from trying to raise more than $500,000. Adopting a two-tier approach – initially setting a limit below $500,000 and, if successful, using the proceeds to pay to have the company’s financials reviewed or audited – may be the best solution.
3. Corporate Governance. In order to limit the financial risk to investors, the JOBS Act limits the amount of their investment. The maximum any person may invest in crowdfunded offerings during a 12-month period may not exceed: (a) the greater of $2,000 or 5 percent of the investor’s annual income or net worth, if either is below $100,000; or (b) 10 percent of the investor’s annual income or net worth, up to a maximum of $100,000, if either is $100,000 or more. As a result, even companies raising $100,000 through crowdfunding could end up with dozens, hundreds or even thousands of investors. This creates legal and logistical challenges that companies will need to manage. Companies will want to take steps to reduce the costs and risks of dealing with so many stockholders, such as selling crowdfunding investors stock with more limited rights than those of other stockholders – for instance, non-voting stock – and setting a minimum investment amount.
4. Future Investors. Perhaps the biggest wild card for companies considering crowdfunding is whether it may impact their ability to obtain additional capital in the future. A startup that expects it will need to raise several million dollars before it becomes successful will eventually have to seek angel or venture capital investors. These investors may view crowdfunding investors as a liability (for the reasons described above, among others), which could deter them from investing or make it more difficult for companies to raise capital on favorable terms. To allay some of these concerns, companies may want crowdfunding investors to explicitly subordinate some of their rights to those of future investors. Obtaining this consent will be nearly impossible unless it is done at the time of the crowdfunding, so companies will need to think carefully about their long-term fundraising strategy when setting terms for crowdfunding.
Companies interested in taking advantage of crowdfunding will need to proceed carefully. Corporate counsel will need to help management vet crowdfunding intermediaries and structure a crowfunded offering to take account of the direct and indirect costs. Over time, these costs will likely go down due to competition among intermediaries; standardization of accounting and legal work; and familiarity among angel and venture capital investors. In the near term, however, crowdfunding may be more expensive and time-consuming than it first appears.
The JOBS Act represents an acknowledgment by Congress that a one-size-fits-all approach to securities regulation creates too many impediments to capital formation. Though the details are still being worked out by the SEC, emerging growth companies will soon have more options in raising capital in public and private transactions from accredited and non-accredited investors. Corporate counsel will play an important role in helping management weigh the costs and benefits when deciding among these options, and will need to carefully oversee the fundraising transaction to ensure compliance with new rules.
 The study is available at http://www.sec.gov/info/smallbus/acsec/acsec103111_analysis-reg-d-offering.pdf.
 The prohibition is supposed to be lifted within 90 days of the passage of the JOBS Act.
Published June 25, 2012.