By Georgia Quinn
The passage of the JOBS Act of 2012 started a chain reaction that unlocked three new avenues of private capital formation and revolutionized US securities law. To assist with the numeric and alphabet soup of regulations, this article will describe the basics of each of these three new avenues of capital raising and highlight some of the pros and cons for companies looking to raise money.
Titles and Regulations
The JOBS Act has seven titles or chapters. We are going to focus on Titles II, III and IV, which address capital raising for private or pre-IPO companies. Title II deals with raising money from accredited investors and allows for what is called a general solicitation. The SEC regulations that contain the details of Title II are called Regulation D. Title III deals with retail investor crowdfunding, and the SEC regulations that set forth the specifics of this section were recently finalized and are called Regulation CF. Title IV addresses larger quasi public capital raises, and the SEC regulations that detail these types of offerings are called Regulation A.
Title II allows a private company to conduct a “general solicitation” or advertise to the general public that it is raising money and seeking investors. Until Title II and for over 80 years, companies were not allowed to publicize that they were raising money and had to communicate through special channels such as broker dealers and accredited investor networks. This both created a constraint to the flow of capital to small and startup businesses, who might not be privy to such networks, and similarly prevented the majority of US citizens from participating in the private capital markets. With the change in the law, companies can now advertise far and wide that they are seeking capital, using new mediums such as the internet, but can only actually sell securities to (allow investment from) accredited investors. With respect to individuals, accredited investors are defined by the SEC as a person who has $200,000 or more in income for the past two years (or $300,000 including their spouse) with a reasonable expectation of meeting that threshold in the current year or has $1 million of net worth, not including his or her primary residence. Accredited investors, as defined, make up roughly 7% of the US population. Thus, the vast majority of citizens are still not allowed to participate in Title II offerings. Regardless when you consider that prior to Title II only 3% of all accredited investors actually invested in private companies, you see the potential flood of capital that could be unleashed.
Some important things to keep in mind when considering whether to raise money for your business pursuant to Title II and Regulation D are that there are no limits on the amount of money that you can raise for you company or from each investor. You will have to take “reasonable steps” to ensure that each investor you accept money from is indeed accredited. The SEC has provided certain safe harbor actions that if taken, will be deemed to be reasonable. Those actions are the review of tax returns for the past two years showing the requisite amount of income, the review of a bank statement or brokerage statement showing assets that when netted against outstanding debt from a third party credit report exceed $1 million, or a letter from the investor’s attorney, accountant or broker confirming they qualify as accredited. A company may take other steps to ensure that investors are accredited, but these will suffice according to the SEC. There are also several third party service providers that will perform accreditation checks. In addition, Title II raises do not have specific disclosure requirement or require the pre-filing of any documentation with the SEC. A company only has to file a Form D, which is a one page notice, with the SEC within 15 days of the first closing of its offering.
Of the three options, Title II is by far the least burdensome and is well suited for companies that have accredited investor networks or access to accredited investors or who can use a general solicitation to reach accredited investors. I always counsel my clients that if you can conduct a Title II offering successfully, that is the way you should go, but for companies who cannot reach or interest accredited investors or who fundamentally want to access retail investors, there are other options.
One such option is Title III, also known as Regulation CF, which was finalized on October 30, 2015 and will be effective on May 16, 2016. Title III allows a company to raise up to $1 million on a rolling 12-month basis from retail investors or ordinary citizens regardless of their income or net worth, subject to certain investment limits. Individuals with annual income of less than $100,000 or net worth of less than $1 million, can only invest the greater of $2,000 or 5% of their annual income or net worth, whichever is lower, on an annual basis in Title III deals. If they have both annual income above $100,000 and net worth greater than $1 million they can invest 10% of their annual income or net worth, whichever is lower, up to $100,000, on an annual basis in Title III deals.
There are a lot more requirements to use Title III, such as the completion and filing of a Form C with the SEC. This disclosure document requires the preparation of financial statements, which must be reviewed by an auditor if the company is raising over $100,000. Importantly, the Form C does not have to be reviewed or declared effective by the SEC. Simply by filing and waiting 21 days a company may begin soliciting and accepting investments. The company will also have ongoing reporting requirements with the SEC. In addition, the company must use an online intermediary to conduct the offering. The intermediary is responsible for the information flow between investors and the company and performs functions similar to what Indiegogo and Kickstarter perform for the rewards crowdfunding space. The intermediary will either hold investor funds or engage an escrow agent to hold the funds until the target amount of money the company is attempting to raise is reached. If the amount is not reached within the deadline set by the company, the money will be returned to investors. If the target is reached, the funds will be released to the company to be used as disclosed in the Form C.
Title III has a lot of requirements and will work best for companies needing to raise relatively smaller amounts of money, who want to tap into their customer base or other unaccredited investor networks to raise funds.
Title IV, also known as Regulation A, similarly allows companies to raise money from retail or unaccredited investors, subject to investment limitations. Importantly, Title IV allows companies to raise up to $50 million in a rolling 12-month period. Individual investments for Tier 2 deals, as described below, are capped at 10% of an investors’ annual income or net worth. In order to raise money using Title IV, a company must file a disclosure document called a Form 1-A with the SEC, which must include financial statements, and depending on the amount of money being raised will need to be audited by a public accounting firm. The Form 1-A is similar to, though less comprehensive than, the registration statement that must be filed when conducting an IPO, and thus Title IV deals are sometimes referred to as “baby IPOs.” Once the Form 1-A is filed, the SEC will conduct a review process and must formally qualify the offering, after which the company can solicit and accept investor funds. Prior to filing and approval of the Form 1-A, a company may “test the waters” which means they can solicit indications of interest from potential investors (but not funds) to determine the likelihood of the success of their offering before expending time and energy on the qualification process. The company must provide all materials used in a testing the waters campaign to the SEC.
Title IV is divided into two tiers. Tier 1 allows a company to raise up to $20 million and does not require audited financial statements to be provided. Tier 2 allows a company to raise up to $50 million and requires audited financial statements. Tier 1 offering must be approved by each state in which the company offers its securities, while Tier 2 offerings are exempt from state registration. Tier 2 has ongoing reporting requirements with the SEC, while Tier 1 does not. Tier 2 offerings may also be conducted on an open or continual basis, meaning they can have multiple closings and can continue to accept funds over a prolonged period of time.
Title IV works best for a more advanced company that is looking to raise a significant amount of money from retail investors. Although there is a lot more time and expense involved with Title IV, it is a great stepping stone to becoming a public company as it allows a company to take some of the steps required to be a full blown reporting company, such as audited financial statements and annual reporting, but not all of the more cumbersome requirements such as quarterly reporting and internal controls. Unlike Titles II and III, Title IV securities are immediately freely tradeable, and may provide investors with liquidity.
In addition to the requirements listed above, all three titles prohibit certain “bad actors” from participating in the offerings. Bad actors have a legal definition but basically include individuals who have been involved in financial fraud or sanctioned by the SEC or FINRA. Also as with all securities offerings, these deals will be subject to state and federal anti-fraud provisions.
The table below sets forth some of the pros and cons of each type of offering, to help companies begin to determine which financing alternative is right for them.
Georgia P. Quinn is the CEO and co-founder of iDisclose, an adaptive web-based application that enables entrepreneurs to prepare customized institutional grade private placement documents for a fraction of the time and cost. As the original visionary and lead developer of the application, Georgia’s extensive legal career in working on over $1 billion in corporate transactions, provides her with the practical expertise and firsthand experience to help business owners successfully achieve and secure capital.
Heralded by Thomson-Reuters as a Top Female Attorney in New York City, she also currently serves as of counsel at the leading crowdfunding firm in the industry, Ellenoff, Grossman & Schole, where she specializes in JOBS Act regulations. Georgia was recently named a Rising Star in the New York Times “Super Lawyers” section. Prior to founding iDisclose, Georgia was an associate at Weil, Gotshal & Manges, one of the top ten law firms in the world, and Seyfarth Shaw, a leader in legal technology. Over her eight-year tenure serving global firms, she represented public and private companies and investment banks in a wide range of capital markets transactions by directing hundreds of offerings, SEC filings and disclosure documents. Through her career-long, integral involvement in the capital formation process, Georgia has not only gained a mastery of securities law, but a deep understanding of the legal problems that currently plague corporate finance.
As an award-winning attorney in the alternative finance space, Georgia is a globally recognized thought leader on crowdfunding and marketplace lending matters. Deemed as one of the top influencers in the private placement industry, she has been a highly sought after speaker for a myriad of conferences and has advised multiple, federal authorities, including the Securities and Exchange Commission (SEC), the American Bar Association (ABA) and the Small Business Administration, as well as Congressional staff-members and top, international FinTech executives. She is also a senior contributor and trusted source for such industry publications as Crowdfund Insider and Debtwire.
Georgia received her Juris Doctorate from Columbia Law School and her Bachelor’s from NYU.
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