KCSA PUBLIC RELATIONS, INVESTOR RELATIONS BLOG
Posted by Paul Sagan on September 5th, 2013
Lifting the ban on advertising for private securities offerings was widely hailed, but it may come with a raft of new regulations that could make life difficult for both angel investors and the startup companies they fund.
On July 10 of this year, the SEC made a landmark ruling that essentially changed 80 years of securities law when it lifted the ban on general solicitation for private securities issuers raising capital under Regulation D, Rule 506.
Private securities offerings are an enormous source of funding for startup and early stage companies (some $900 billion raised in 2012, compared with roughly $40 billion for the IPO market that same year) and liberalizing the advertising rules is expected to grow investments in these companies dramatically – a key goal of the JOBS Act.
Complying with these rules may not be cumbersome for established companies or institutional investors with compliance, legal and communications teams, however this is not typically the case for startups with small staffs, or for angel investors – often the first source of funding for early stage companies.
Understanding this new communications and disclosure landscape is important for entrepreneurs and young companies who may face strict sanctions for non-compliance, including up to a one-year ban from accessing the capital markets – potentially a death sentence for many startups.
An immediate change, and one that is in place whether a company chooses to “advertise” its offering or not is “bad actor” due diligence. This is new for issuers under the Dodd-Frank Act and means that startup companies will have to actively undertake due diligence to find out if any of its investors or “other relevant persons (such as underwriters, placement agents and the directors, officers and significant shareholders of the issuer) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.” The SEC does not give specific guidance on how to go about this, but failing to do so could result in the loss of a company’s securities law exemption.
While this rule change is currently adopted, there are also a myriad of proposed new filing requirements and penalties that go into effect on September 23, 2013, with comments on the proposed rules due that same day.
Perhaps the most controversial requirement is that startup companies wanting to take advantage of Rule 506(c) fundraising will need to “take reasonable steps to verify that all investors are accredited investors.” This is a new change and puts the burden on startup companies to make sure that any potential investor is “accredited,” rather than relying on that investor to self-certify, as was the case in the past.
Complying with this could potentially require a startup company to ask for an investor’s “pay stubs for the two most recent years and current year;” or “reviewing copies of any IRS form that reports income,” (including Form W-2, Form 1099 or a copy of filed Form 1040)” as part of a compliance “safe harbor” for the SEC.
This has raised concerns among the angel capital community, many of whom feel this would result in angels refusing to participate out of fear of disclosing personal financial information. “With thousands fewer angels participating in this market, startups will have far less access to capital, the millions of jobs they create each year will disappear, and the economy will suffer,” said Marianne Hudson, executive director of ACA. “This is the exact opposite of Congress’ intent in its near-unanimous passage of the JOBS Act.”
Other potential hurdles for startup companies include a requirement to make a publicly available filing with the SEC 15 days in advance of any general solicitation or general advertising. This pre-clearance would seem to put a damper on the typical ebb and flow of discussions between an entrepreneur and a potential investor.
Another proposal states that startups, “submit to the Commission any written communication that constitutes a general solicitation or general advertising in any offering conducted in reliance on §230.506(c) no later than the date of first use.” Difficult to do in an age of Tweeting and social media.
Early stage companies will also need to be vigilant on their SEC Form D filings under the new proposed rules. Late filers can be subject to a one-year prohibition on Rule 506 eligibility on their next financing.
The proposed rules also raise a number of other questions: would participating in a demo day, business plan competition or pitching to an angel organization constitute a general solicitation and make an entrepreneur subject to the requirements above? Final rulemaking is set for September 23 and comments on these proposed rules are due the same day to the SEC. (to send comments via the SEC website, click here).
This new law is a dramatic and largely positive development for the entrepreneurial community in the U.S. It will mean, however, that startup companies need to coordinate closely with their legal and communications counsel at the very earliest stages of fundraising, to make sure they comply with the Commission rules and can take full advantage of the law’s new fundraising opportunities.