Also on November 3, the House passed HR 2940 – known as the “Access to Capital for Job Creators Act.”  HR 2940 would eliminate the ban on “general solicitation” under certain private securities offerings conducted under Regulation D.  Like the crowdfunding bill, this bill enjoyed broad bipartisan support in the House.  A description of HR 2940 can be found in a previous post.

-Wythe Michael 

Elimination of General Solicitation Ban

Under current SEC rules, companies seeking to raise capital are generally prohibited from seeking investors by means of a “general solicitation.”  This means that the company cannot approach potential investors unless a principal of the company or an agent of the company has a substantive, pre-existing relationship with that investor.  Accordingly, even if the company knows that the investor is, for example, listed on the Forbes 400 list of the world’s wealthiest individuals, the company cannot approach the investor about investing in the offering unless there is a pre-existing relationship.

HR 2940 directs the SEC to eliminate the ban on general solicitation and advertising with respect to offerings conducted under Rule 506 of Regulation D.  This is the exemption that is most typically used by companies conducting private offerings.  The only limitation in the bill is that all investors in such an offering must be “accredited investors.”  (Information on recent changes to the “accredited investor” definition can be found here)

We believe that this bill could be a game changer with respect to private offerings and could significantly boost the ability of early stage companies to obtain needed capital.

Crowdfunding Exemption

HR 2930 would establish an exemption under the federal securities laws for sales of certain “crowdfunded” securities.  The term “crowdfund” typically refers to the raising of funds in small amounts from a large group of contributors.  In its original incarnation, the bill would have allowed up to $5 million to be raised under this exemption.  Unfortunately, the bill has been watered down substantially.  Below are the basic requirements to satisfy the exemption under the current version of the bill:

• The aggregate annual amount raised cannot exceed $1 million ($2 million if the issuer provides investors with audited financial statements).
• The total amount invested by each investor cannot exceed $10,ooo per year (or 10% of the investors income, if less).
• The securities cannot be resold within the first year after issuance (except to the issuer or an accredited investor).
• Certain “bad actors” will be disqualified from utilizing the exemption.  The SEC is directed to issue rules implementing the disqualification standards.
• Importantly, the bill pre-empts state law.  This means that issuers would not be required to obtain an exemption under state blue sky laws for an offering conducted under this exemption.  This is critical since each state has different blue sky laws and most state laws do not contain an exemption similar to this bill.  It is unlikely that any issuer would utilize the crowdfunding exemption if the issuer was required to comply with 50 different state laws.

In addition to the general requirements listed above, the bill contains two separate sets of similar requirements that must be satisfied.  One set of requirements applies if the issuer is using an “intermediary.”  The second set of requirements applies if the issuer is not using an intermediary.  The requirements applicable to an issuer who is not using an intermediary are summarized below:

• The issuer must provide certain warnings to the investor.  It appears that these warnings are similar to the language we already include in subscription agreements.
• The issuer must provide the SEC with certain basic information and must also provide the SEC with ”investor level access” to the issuer’s web site.
• The issuer must obtain answers to certain questions from each investor.
• The issuer must disclose a target offering amount and withhold offering proceeds until the aggregate capital raised from investors other than the issuer is no less than 60 percent of the target offering amount.  This appears to be similar to escrow accounts commonly used in private offerings.
• The issuer must provide the SEC with a basic notice of the offering.  Curiously, the bill does not mention Form D - a previously established method for providing electronic notice of an offering to the SEC.
• The issuer must outsource cash management functions to a broker-dealer or an insured bank.  Again, it would appear that the typical bank escrow would satisfy this requirement.
• The issuer must maintain such books and records as the SEC deems appropriate (hopefully this won’t result in a requirement to obtain audited financials).
• The issuer must provide a method on the issuer’s web site to enable investors and the issuer to communicate.

As with the bill eliminating the ban on general solicitation, this bill would significantly increase the ability of small companies to access capital in an efficient and inexpensive manner.  We will continue to update you on developments in this area.

-Wythe Michael 

Lifting the Ban on General Solicitation

Recently, the Subcommittee on Capital Markets and Government Sponsored Enterprises of the House of Representatives approved a bill that would remove the restrictions on “general solicitation” in private securities offerings.  The bill, titled The Access to Capital for Job Creators Act (HR 2940), has been referred to the House Financial Services Committee for consideration.

Under current SEC rules, companies seeking to raise capital are generally prohibited from seeking investors by means of a “general solicitation.”  This means that the company cannot approach potential investors unless a principal of the company or an agent of the company has a substantive, pre-existing relationship with that investor.  Accordingly, even if the company knows that the investor is, for example, listed on the Forbes 400 list of the world’s wealthiest individuals, the company cannot approach the investor about investing in the offering unless there is a pre-existing relationship.

The bill directs the SEC to eliminate the ban on general solicitation and advertising with respect to offerings conducted under Rule 506 of Regulation D.  This is the exemption that is most typically used by companies conducting private offerings.  If the bill were to pass and become law, it would eliminate one of the biggest impediments to raising capital in private offerings.  In addition, since investors would still be required to be “accredited,” we believe the bill would not significantly impact investor protection.

A New Exemption for Crowdfunding

A second bill, titled The Entrepreneur Access to Capital Act (HR 2930) would establish an exemption under the federal securities laws for sales of certain “crowdfunded” securities.  The term “crowdfund” typically refers to the raising of funds in small amounts from a large group of contributors.

This bill would amend the Securities Act of 1933 to allow companies to raise up to $5 million from sales of securities if ”individual investments in the securities are limited to an aggregate annual amount equal to the lesser of (i) $10,000; and (ii) 10 percent of the investor’s annual income.”  Importantly, the bill provides that investors who purchase securities under the crowdfunding exemption would not be counted toward the 500 owner cap (above which requires public reporting).  Finally, the bill contains a provision pre-empting any state law to the contrary – an extremely important feature given the large differences in laws from state to state.

Both bills would go a long way toward improving the ability of small businesses to raise capital and create new jobs.  Although the Obama administration has expressed some support for a crowdfunding bill (without offering any details), both bills face an uncertain future – especially in the Senate.

-Wythe Michael 

A recent article in Inc. Magazine titled Divvying Up the Business is a great reminder of the value of ownership agreements and the need to address these issues as early as possible in the life of the business.  The article reminded me of a situation involving a friend of mine a number of years ago.  My friend was a minority owner of a very successful business.  Unfortunately, there was no ownership agreement requiring the sale of stock upon the death of an owner.  When the majority owner died unexpectedly, his wife - who had never been involved in the business - decided that she would take over her husband’s role as President and majority owner.  With the wife having no experience operating the business, the business began to lose employees and customers.  Within a year, the business failed.

This outcome could have been prevented with a good ownership agreement.  A properly drafted agreement would have required the company (or the other owners) to purchase all of the shares owned by the majority owner upon his death.  This would have enabled his wife to receive the fair value of the shares in cash (preserving the value of the company for her) and would have enabled the minority owners to continue operating the business.          

 Given the benefits of these agreements – and the relatively low cost of addressing these issues early in the life of a business – we strongly encourage all businesses with multiple owners to establish a mutually agreeable ownership agreement as soon as possible.

  -Wythe Michael

Despite the conclusions in the Wall Street Journal article, Chairman Shapiro’s letter, while somewhat responsive to certain questions from Congressman Issa, doesn’t appear to break much new ground.  It contains the typical Washington response of “we are looking into it.”  In fact, Chairman Shapiro’s letter concludes with the following statement:    

I recently instructed the staff to review the impact of our regulations on capital formation
for small businesses, specifically focusing on issues such as:

• the restrictions on communications in initial public offerings;
• whether the general solicitation ban should be revisited in light of current technologies,
capital-raising trends and our mandates to protect investors and facilitate capital
formation;
• the number of shareholders that trigger public reporting, including questions surrounding
the use of [special purpose vehicles] that hold securities of a private company for groups of investors; and
• the regulatory questions posed by new capital raising strategies.

Given all of the matters currently on the SEC’s plate, it seems unlikely that any of these issues will be tackled in the near future.  This is a shame because private companies seeking capital would certainly benefit from liberalized rules regarding general solicitation.  Private companies also would benefit from an increase in the maximum number of shareholders (currently 500) and amount of assets (currently $10,000,000) that triggers the requirement to register as a SEC reporting company.  Hopefully the SEC will address these issues shortly – but we aren’t holding our breath. 

-Wythe Michael

The SEC release contains a proposed change in the net worth standard for individuals qualifying as accredited investors.  The new net worth standard for individual accredited investors would read as follows: 

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.

 For companies seeking equity financing through private securities offerings, the main things to note are as follows:

• In determining whether a natural person has a sufficient net worth, the total net worth of the investor should be reduced by the net value of the investor’s primary residence.  For example, if the estimated value of the residence is $800,000 and the residence is secured by a $600,000 mortgage, the investor’s net worth would be reduced by $200,000.
• However, if the value of the investor’s primary residence is “underwater” (the amount of secured debt exceeds the estimated value), a portion of the indebtedness will reduce the amount of the investor’s net worth.  For example, if the estimated value of the residence is $600,000 but the residence is secured by a $800,000 mortgage, no deduction from net worth would occur for the value of the residence (since there is no equity value) and the $200,000 in mortgage indebtedness should already have been deducted in the net worth calculation.  
• Disclosure documents, including private placement memorandums, subscription agreements, investment representation letters, etc. should be changed to reflect the reduction of the investor’s primary residence from the calculation of net worth.   

The ABA has submitted a comment letter to the SEC regarding the proposed rule.  The ABA letter offers suggested language for the net worth standard which is different from the SEC’s proposed language.  In my opinion, the ABA’s proposed language is much easier to understand and implement.  In addition, the ABA made an important request regarding the impact of the new standard on individuals who are currently investors in private companies and funds.  Such investors often have the opportunity (and sometimes are required) to make “follow-on” investments after the initial investment.  Accordingly, the ABA recommended that the SEC provide transitional relief for investors who previously qualified as accredited investors before the enactment of Dodd-Frank so that such investors may continue to qualify for purposes of subsequent “follow-on” investments.

It is unclear when the SEC will issue a final rule regarding the net worth standard.  However, we will continue to follow this topic until a final rule is implemented.

-Wythe Michael

We’d also like to congratulate our client Elevation Branding for creating the banner below poking fun at ESPN analyst Dick Vitale.  The sign is currently hanging at Richmond International Airport.  Click here for a story about the banner and Elevation’s role in creating it.

Let’s Go V-C-U!

One alternative could be SBA loans.  Although SBA loans have often been criticized as expensive and difficult to close, new SBA loan rules enacted by Congress have made SBA loans more attractive.  The new SBA provisions, signed into law in late September, temporarily allow for a waiver of the SBA guaranty fee.  As an example, the fee waiver could save a borrower up to $31,500 in guaranty fees on a $1 million loan.  This waiver will last until the end of the year – unless the $505 million of appropriated funds runs out first.

Other changes increase the potential size of business loans and owner occupied real estate loans to $5 million.  Combined with changes in size standards (discussed below), this makes SBA loans an option for larger businesses.  In addition, for a two year period, owner occupied real estate can be refinanced with a SBA 504 loan (again, up to $5 million).  With many commercial real estate loans coming due over the next few years, this program could help reduce the number of commercial properties that go into foreclosure because they can’t be refinanced by traditional or conduit financing.

Finally, the size standards for businesses have been changed.  Businesses that have a tangible net worth of no more than $15 million and a two-year average net income of $5 million after federal income tax are now eligible to participate in SBA loans.

Although SBA loans remain complex and difficult to close, the changes discussed above should make SBA loans more attractive to businesses seeking financing.

The biggest change implemented by Dodd-Frank involves the definition of “accredited investor.”  Under Regulation D, an accredited investor is defined as a natural person whose individual net worth, or joint net worth with that person’s spouse exceeds $1,000,000.  For purposes of calculating an investor’s net worth, “net worth” is defined as the difference between an investor’s total assets and total liabilities.  

Prior to the enactment of the Dodd-Frank Act, an investor could include the value of the investor’s principal residence in determining the investor’s net worth.  However, pursuant to provisions contained in the Dodd-Frank Act, an investor may not include the value of the investor’s personal residence in determining the investor’s net worth.  Interestingly, the SEC issued guidance after the effective date of the Dodd-Frank Act confirming that an investor need not subtract the mortgage indebtedness associated with the investor’s principal residence in determining net worth (except to the extent that the indebtedness exceeds the value of the residence).  Although the change to the net worth definition will reduce the number of potential accredited investors, it should not have a significantly adverse impact on capital raising  – except perhaps in early stage businesses which often seek capital from less wealthy sources such as “friends and family”.

In other areas, Dodd-Frank mandates that the SEC adopt new regulations impacting Regulation D offerings.  For example, Dodd-Frank requires the SEC to adopt new regulations prohibiting certain persons deemed “bad-actors” from utilizing Regulation D.  The new rules are expected to disqualify those convicted of felonies and those who have previously violated certain security laws.  However, the scope of this prohibition will be fleshed out in regulations which, according to the most recent SEC calendar for Dodd-Frank implementation, could be issued in the November-December 2010 time frame.

Dodd-Frank also suggests that the SEC review the accredited investor standards for natural persons.  Although there is no time limit on such a review, the SEC’s most recently published calendar of activity for Dodd-Frank implementation indicates that it will propose rules to revise the accredited investor standard in November-December, 2010.  Any significant upward changes to to the accredited investor standards could have a major negative impact on capital raising activities. 

Stay tuned for updates. 

-Wythe Michael          

Other points made in the article:

• Investors expect companies to reach profitability with the Series A round alone.  This means that capital efficiency is key.
• Traditionally, VC investors have been interested in companies only if they believe the company has the potential of realizing a 10x return on their investment.  Today, 5x returns are considered extraordinary.  However, investors are less patient and want a quicker exit.
• Most venture backed private companies are exiting at a sale price of between $20 million to $70 million (citing Dow Jones Venture Source) with most exits consisting of an acquisition by a larger company.

Venture capital firms that invest seed capital in early stage companies (also called “super angels”) include First Round Capital, Baseline Ventures, Floodgate, Felicis Ventures and Golden Seeds (which focuses on women owned companies).  We would like to hear of other super angel firms from our readers.

While the above information confirms that early stage angel and VC investors still exist, companies need to actively position themselves to attract angel investors and the super angel funds.  This includes planning for the efficient use of capital, detailing and planning a quick path to profitability and developing a viable short-term exit strategy.

-Wythe Michael