On November 2, 2020, the SEC published a final rule called “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets.” I refer to this as the rule or rulemaking.
This rule is one of the most significant pieces of SEC rulemaking for private companies in the last twenty years. The reason is that it marks a shift at the SEC from an academic and theoretical approach to regulating capital raising to a more practical and realistic approach.
Before we dig into the specifics we need to review the background to the rulemaking to understand its impact.
How the SEC Views Securities Issuances
The SEC takes the position that every issuance of securities by a company is subject to the registration requirements of the SEC unless there is a valid exemption for the sale. Registration in this situation means filing a registration statement with the SEC covering the securities to be sold.
Why Private Companies Need Exemptions from Registration
Most private companies do not have the money or time to prepare and file a registration statement with the SEC as part of their fundraising efforts. Therefore, they need to find an exemption from registration to cover the securities issuance.
Finding the right exemption can be tricky because at the outset nobody knows how much money will be raised and from whom meaning accredited or unaccredited investors.
The following are five of the most significant changes contained in the rule.
Gauging Investor Interest
Prior to the rule, with a few narow exceptions, companies looking to raise capital were not allowed to gauge investor interest prior to starting the offering. This created a situation where everyone had to scramble to find the right exemption from registration once money was in the bank.
Even innocent mistakes created potential liability for companies because of the inflexible nature of the exemptions.
Now, under the rule companies can communicate with potential investors to see how much interest there is and what types of investors are interested without worrying about violating the registration requirements.
Companies seeking capital can use this rule if their communication to potential investors is limited to the following information:
- The company is considering an offering of securities exempt from registration under the Securities Act of 1933, but has not determined a specific exemption from registration that the company intends to rely on;
- No money or other consideration is being solicited, and if sent in response, will not be accepted;
- No offer to buy the securities can be accepted and no part of the purchase price can be received until the company determines the exemption under which the offering is intended to be conducted and, where applicable, the filing, disclosure, or qualification requirements of such exemption are met; and
- A person’s indication of interest involves no obligation or commitment of any kind.
The rule additionally provides that the communication may include a means for a person to indicate interest in a potential offering and a company may require such indication to include the person’s name, address, telephone number, and/or email address.
Increase in Regulation A Tier 2 Limits
Companies using Regulation A for their capital raising go through an abbreviated registration process with the SEC as opposed to a full blown registration process in the case of an IPO.
Regulation A has two tiers: Tier 1 and Tier 2. Tier 1 offerings are capped at $20 Million. Tier 2 offerings were capped at $50 Million.
The SEC is required by law to examine the Tier 2 cap every two years in order to determine whether or not it should be raised. The SEC has the authority to increase the annual offering limit if it determines that it would be appropriate to do so.
The SEC decided that it was appropriate to raise the limit so the cap for Tier 2 is now set at $75 Million.
This has the effect of allowing a mini-IPO with an accelerated review process for companies using Regulation A to raise capital.
Increase in Rule 504 Dollar Limits
Rule 504 was the least used of the exemptions in Regulation D representing less than 2% of capital raised over a seven year period, according to the SEC.
Its main advantage was and is that it does not contain any restrictions on the type of investor that can invest. That means a company does not have to worry about whether an investor is accredited or not. This makes capital raising much easier and faster.
Its main disadvantage was the fact that the dollar limit was so low. Up until 2016, the dollar limit for companies using Rule 504 to raise money was $1 Million. In 2016, the SEC increased the limit to $5 Million.
Now, the SEC has increased the cap to $10 Million, a 10x increase since 2016.
The SEC noted that they increased the dollar limits in order to make Rule 504 more attractive to companies raising capital.
I believe that by raising the limit to $10 Million the SEC succeeded in making Rule 504 more attractive to companies.
Increase in Crowdfunding Dollar Limits and Other Improvements
The SEC by law is obligated to adjust the offering limits in Regulation CF at least once every five years.
Based on stakeholder input and the SEC’s own analysis, the SEC decided to increase the offering limits from $1.07 Million to $5 Million.
In addition, the SEC decided to:
- Exempt accredited investors from any income or net worth test based limits below, and
- Allow non-accredited investors to use the greater of their income or net worth in calculating the cap on their investment
Individual unaccredited investors are limited in their investments to:
- The greater of $2,200 or five percent of the greater of the investor’s annual income or net worth, if either of an investor’s annual income or net worth is less than $107,000; or
- Ten percent of the greater of his or her annual income or net worth, if both annual income and net worth are equal to or more than $107,000
Demo Days Safe Harbor
Demo days have become a staple in the tech world of accelerators, incubators and the like.
The only problem was that under prior law the SEC believed that companies participating in demo days were engaging in a general solicitation. Absent an exemption, a general solicitation is only allowed if a registration statement has been filed and/or approved by the SEC.
Startups attending demo days did not have the money, time or inclination to file a registration statement with the SEC just to raise awareness and some capital from the investors in attendance. Therefore, just by attending demo days startups were sometimes violating the SEC’s general solicitation rules.
The rule proposes to fix this by: (i) limiting who can be a sponsor, (ii) providing a list of sponsor prohibited activities, and (iii) restricting the information that companies participating can provide about their fundraising.
The SEC set out a list of persons/entities that can sponsor a demo day to include:
- Accelerators
- Angel investor groups
- Incubators
- State and local governments
- Universities
Sponsors cannot engage in the following activities:
- Making investment recommendations or providing investment advice to attendees of the event;
- Engaging in any investment negotiations between the company and investors attending the event;
- Charging attendees of the event any fees, other than reasonable administrative fees;
- Receiving any compensation for making introductions between event attendees and companies, or for investment negotiations between the parties; or
- Receiving any compensation (e.g., a commission) with respect to the event that would require it to register as a broker or dealer under the Exchange Act, or as an investment adviser under the Advisers Act.
Companies attending demo days can provide the following information to investors without fear of SEC enforcement:
- Notification that the company is in the process of offering or planning to offer securities;
- The type and amount of securities being offered;
- The intended use of the proceeds of the offering; and
- The unsubscribed amount in an offering.
When is the Rule Effective?
The rule is effective March 15, 2021.
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