The JOBS Act: Impact on Capital-Raising for Startup Companies
Startup Companies Update
Date: April 05, 2012
On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act). The JOBS Act will bring about a number of significant changes to the federal securities laws and is intended to drive job creation by facilitating capital-raising by startups and other emerging growth companies. The JOBS Act seeks to ease the restrictions that are placed on private offerings, permits qualified "crowdfunding" transactions and allows startups to avoid SEC registration as their shareholder bases grow. These changes will likely have a significant impact on how startups raise capital. A description of the provisions of the JOBS Act that we believe will be most applicable to startups - and our view of each of them - follows.
Qualified Crowdfunding Transactions Permitted
The JOBS Act requires the SEC to issue new rules within 270 days that will permit startups to raise capital through qualifying crowdfunding transactions. A crowdfunding transaction involves a large number of individual investors pooling small amounts, through an online portal or other intermediary, in support of a larger financing objective.
The exemption created by the JOBS Act permits an issuer to raise up to $1 million in a 12-month period, provided that the securities sold to an investor whose annual income or net worth is less than $100,000 may not exceed the greater of $2,000 or 5 percent of the investor's annual income or net worth. For investors whose annual income or net worth is greater than $100,000, the securities sold to an investor may not exceed 10 percent of the investor's annual income or net worth or an aggregate amount of $100,000.
A crowdfunding transaction must be conducted through a broker or "funding portal" that meets the qualifications to be established under new SEC rules. The broker/funding portal must register with the SEC and make available to the SEC and prospective investors any information provided by the issuer in connection with the offering. The JOBS Act also directs the SEC to determine the disclosures that the broker/funding portal must provide to investors (such as investment risks and investor education materials), establish measures the broker/funding portal must take to reduce the risk of fraud (such as background and regulatory checks on directors, officers and significant equity holders) and determine the efforts the broker/funding portal must take to ensure that no investor in any 12-month period exceeds the applicable investment limits in the aggregate for all investments made by the investor.
Issuers engaged in crowdfunding must also meet a number of disclosure and filing requirements. The issuer must deliver to the SEC, the broker/funding portal and each investor specified information about the issuer, its business and the offering. Issuers must also provide to the SEC, the broker/funding portal and investors financial statements that are dependent on the size of the offering. Issuers conducting offerings of less than $100,000 are required to deliver income tax returns for the most recently completed year and financial statements certified by the issuer's principal executive officer. Issuers raising between $100,000 and $500,000 are required to provide financial statements reviewed by an independent public accountant. Issuers raising more than $500,000 must provide audited financial statements. Issuers will also be required to make annual filings with the SEC regarding the issuer's results of operations and financial condition.
Offerings meeting the requirements of the crowdfunding exemption will be exempt from state blue sky laws, which is intended to reduce the regulatory burden in these transactions.
Whether the crowdfunding exemption will be useful for startups is open to debate. Use of the new rules will impose disclosure and filing requirements on issuers and brokers/funding portals, and the fees charged by these intermediaries may therefore not be modest. The financial statement requirements may impose undue costs for startups at their earliest stages of growth. Startups looking to raise significant amounts of capital may find crowdfunding insufficient; larger offerings will likely continue to require the personal attention to investors that is often necessary to attract large investments. Startups are also likely to be advised that venture capital funds and other institutional investors will disfavor cap tables that include large numbers of nonaccredited investors. Although we believe a crowdfunding market is likely to develop, we believe it will prove most useful for smaller startups and small unique offerings; we expect that larger startups with high growth potential will not find this capital-raising strategy to be the optimal course.
General Solicitation Restrictions Under Regulation D Lifted
The JOBS Act directs the SEC to revise Regulation D under the Securities Act of 1933 (Securities Act) within 90 days to eliminate the prohibitions on general solicitation and general advertising in connection with a private offering conducted under Rule 506, provided that all investors acquiring securities in the offering are accredited investors. Issuers will also be required to take reasonable steps to verify that each investor in the offering is accredited, using methods to be determined by the SEC.
Most offerings by startups are conducted under Rule 506. The existing general solicitation and general advertising prohibitions have limited startups to raising capital from their existing investors and potential investors with which they or their representatives or placement agents have preexisting relationships.
The removal of these restrictions will likely have a significant impact on the capital-raising methods used by startups and the placement agents who serve them. Startups will be permitted to approach a wider audience when seeking investors and inviting prospects to meetings and investor presentations. They will also be able to advertise or provide notices on the Internet or in newspapers or other publications. Placement agents and finders will have greater freedom to publicize their investment opportunities on their websites or in other publications, or even through cold calls to prominent investors or other targets.
Although the new rules will allow startups to cast a wider net when seeking investors, they will not likely change the personal nature of closing these types of investments. Early-stage investors are often courted over extended periods of time and require a fair amount of personal attention. These investors often want to be comfortable with a management team before investing and usually make an investment based on personal relationships. Broad-based advertising might change how startups find prospects but will not likely change the dynamics involved in getting a prospect to the closing table.
Regulation A Expanded
The JOBS Act requires the SEC to amend Regulation A under the Securities Act to increase the limit on the permitted offering amount from $5 million to $50 million during any 12-month period. Regulation A is intended to permit a nonreporting issuer to effect a public offering of securities without becoming subject to regular SEC reporting obligations. The Regulation A offering exemption has for many years only rarely been used, due to the low offering amount but also due to the disclosure obligations that it imposes on issuers in the form of an extensive offering statement.
In addition to raising the permissible offering amount, the JOBS Act mandates the SEC to adopt rules requiring issuers to file audited financial statements with the SEC on an annual basis and authorizes the SEC to require issuers to file with the SEC and distribute to prospective investors an offering statement containing specified disclosures. The SEC is also authorized to require issuers to file with the SEC and make available to investors periodic disclosures regarding the issuer's business and operations, financial condition, corporate governance principles and use of investor proceeds.
The JOBS Act does not exempt a Regulation A offering from state blue sky laws, unless the securities offered will be listed on a national securities exchange. Issuers will therefore be required to navigate the securities laws of each state in which they propose to make offers and sales.
It is not clear that the JOBS Act goes far enough to breathe new life into Regulation A, particularly for startups. Regulation A will continue to impose significant disclosure obligations on issuers and will now require periodic SEC filings as well. The JOBS Act also leaves these offerings subject to the separate requirements of state blue sky laws. These changes do not appear to us to eliminate the burdens that have limited the utility of Regulation A. Assuming the SEC does not deviate from the structure reflected in the JOBS Act, startups and other small issuers will likely continue to rely on the more flexible exemption available under Regulation D.
Public Company Threshold Increased
The JOBS Act seeks to provide greater capital-raising flexibility for startups by allowing them to delay becoming subject to SEC reporting obligations as their shareholder bases grow. The Securities Exchange Act of 1934 previously required a company with more than $10 million in assets to register its equity securities with the SEC when they are held of record by 500 or more persons. The JOBS Act raises this threshold to 2,000 record holders, so long as not more than 499 of the record holders are nonaccredited investors.
The JOBS Act also eliminates from the calculation of record holders employee-shareholders who received their shares in exempt transactions under employee compensation plans, in addition to investors who acquired their shares in qualified crowdfunding transactions.
Facebook, which has now filed its IPO with the SEC and may be the inspiration for these rules, was viewed as stretching the bounds of the 500 record holder threshold by issuing equity alternatives through a complex investment vehicle organized by Goldman Sachs. Facebook also has a large number of employee-shareholders, which created additional issues for the company in avoiding the 500 record holder threshold.
The added flexibility created by increasing the 500 record holder threshold to 2,000 will benefit startups whose shareholder bases have expanded rapidly through multiple capital-raising transactions and employee issuances. As startups innovate with crowdfunding and other transactions that grow their shareholder bases, they should be able to delay the administrative cost and burden associated with SEC reporting obligations until they are ready to pursue public capital.
The JOBS Act offers a number of important changes that should lead to innovation in the way startups are funded. As the new rules are adopted and the markets begin to adapt, startups should continue to carefully evaluate how they raise capital in light of their own circumstances and capital-raising aspirations.