Regulation A+: Not for Start-Ups or Early-Stage Companies

Proposed rule amendments for small businesses and additional exemptions under Section 3(b) of the Securities Act

On December 18, 2013, the Securities and Exchange Commission released their long-awaited proposed rules on Regulation A+. The amendments to Regulation A were proposed pursuant to Title IV of the Jumpstart Our Business Startups Act of 2012. The proposed rules are intended to increase access to the capital markets for lower middle-market firms since Reg. A has been sparingly used; there were only 19 qualified Reg. A offerings between 2009 and 2012. While pre-revenue firms, start-ups and those in the early stages will not likely choose to proceed under Regulation A+, it should be of interest to financial advisors and law firms serving lower middle market firms that are in need of growth capital.

On December 18, 2013, the Securities and Exchange Commission (SEC) released proposed rule amendments to Regulation A; the comment period just ended. The proposed rule changes are intended to implement Section 401 of the Jumpstart Our Business Startups (JOBS) Act. Section 401 of the JOBS Act added Section 3(b)(2) to the Securities Act. Specifically, this section directs the SEC to adopt rules exempting offerings of up to $50 million of securities annually from the registration requirements of the Securities Act. The proposed rules would amend Rules 251-263 under Regulation A. In addition, the rule would revise Form 1-A and create four new forms: Form 1-K (annual updates), Form 1-SA (semiannual updates), Form 1-U (current reporting), and Form 1-Z (exit reporting).

The proposed rule amendments are lengthy; 387 pages in length, which includes the proposed new forms. Although the proposed rule is intended to assist “small businesses,” despite the reference to small business, this rule is not intended for true start-up companies –high-tech, pharma, or medical device companies that have either do not have an established product pipeline or a recurring revenue stream and a positive cash flow. The reporting requirements and costs are too prohibitive for most of start-ups and small businesses. These latter companies will need to think hard about Reg. D and the new crowdfunding option and, if the latter option is chosen, how that may impact future capital raising efforts.

Despite that Reg. A has been on the books for years, as noted above, this exemption has rarely been used by companies seeking to raise capital. Reg. A+ is possibly a proverbial “game changer” that could benefit lower middle market professionals, financial advisors and law firms, serving the segment.

In this changing landscape, let’s consider the various federal and state exemptions from securities registration; these include Regulation D, Reg. A, and now, the crowdfunding exemption under Title III of the JOBS Act. Section 3(b) of the Securities Act gave the SEC authority to exempt certain securities from registration, and, pursuant to that provision, the SEC adopted Reg. A to help small companies raise limited amounts of capital without going through the full registration requirement. Accordingly, a Reg. A offering is often called a “mini-registration” because the issuer needs to provide only certain documents, such as Form 1-A, financial statements, and an offering circular. Title IV of the JOBS Act was intended to increase the appeal of Reg. A for issuers by adding a new exemption that securities professionals refer to as Reg. A+. As noted earlier, Reg. A+ raises the maximum amount that may be offered from $5 million to $50 million.

Reg. A+ offerings are not limited to equity securities; debt and convertible securities are contemplated under Reg. A+. Reg. A+ securities can be advertised or promoted through general solicitation and advertisement. This latter fact expands the pool of potential investors available to the issuer. Furthermore, there are no holding periods or similar restrictions on re-sales of Reg. A+ securities. Reg. A+ also permits “testing the waters,” which enables the issuer to solicit interest prior to the offering by filing an offering statement. In a change from previous law, securities offered through Reg. A+ must meet disclosure requirements, which include filing audited financial statements on an annual basis. As evident from the above, Reg. A+ is not intended for start-ups or firms that have a limited revenue stream. Whether it displaces Rue 506 of Regulation D—which allows for general solicitation and advertisement, as long as all ultimate purchasers are accredited investors—remains to be seen. Reg. D also widens the investor audience.

As evident from the above, the revisions are intended to ease access to capital. So, who has used the pre-JOBS Act exemptions? On October 23, 2013, the SEC, in part, observed that:

The alternative to raising capital via registered offerings is for startups and small businesses to offer and sell securities by relying on an existing exemption from registration under the federal securities laws.  For example, they could rely on current exemptions from registration under the Securities Act, such as Section 3(a)(11), Section 4(a)(2), Regulation D and Regulation A.   While we do not have complete data on offerings relying on an exemption under Section 3(a)(11) or Section 4(a)(2), certain data available from Regulation D and Regulation A filings allow us to gauge how frequently issuers use these exemptions when raising capital.  Based on Regulation D filings by non-fund issuers from 2009 to 2012, there are a substantial number of issuers who choose to raise capital by relying on Rule 506 even though their offering size would qualify for an exemption under Rule 504 or Rule 505.   With the recent amendment to Rule 506 of Regulation D that permits an issuer to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, subject to certain conditions, we expect to see an even higher percentage of issuers relying on that rule.  As shown in the table below reporting the number of Regulation D and Regulation A offerings by non-fund issuers, from 2009 to 2012, relatively few issuers rely on Regulation A. 

Note that data shown above comes from Form D and Form 1-A filings from 2009 to 2012. The SEC noted that the dataconsidered only new offerings and that it exclude offerings with amount sold reported as $0 on Form D. Further, the SEC used the maximum amount indicated in Form 1-A to determine offering size for Regulation A offerings.

The above clearly indicates that the recent data showed that Rule 506 has been the choice of issuers seeking an exemption. The SEC also observed (which helps explain the urgency to implement federal securities law changes):

Each of these exemptions, however, includes restrictions that may limit its suitability for startups and small businesses.  The table below not included in this article) lists the main requirements of these exemptions. For example, the exemption under Securities Act Section 3(a)(11) is limited to intrastate offerings, and an issuer seeking to offer and sell securities pursuant to Regulation A may be required to register in all 50 states if it intends to offer and sell the securities in all 50 states using the Internet.  An issuer relying on Regulation A also would need to file with the Commission an offering document, which, coupled with the potential review of such document by the staff, has been cited as a reason why Regulation A is not widely use.   Issuers of securities pursuant to Securities Act Section 4(a)(2) and Rules 504, 505 and 506(b) under Regulation D generally may not engage in general solicitation and general advertising to reach potential investors, which also could place a significant limitation on offerings by startups and small businesses.  Although an issuer may avoid the restriction on general solicitation and general advertising by using the services of a financial intermediary, those services may be costly.  While Rule 506 under Regulation D preempts the applicability of state laws regarding the offer and sale of securities and new Rule 506(c) permits general solicitation and general advertising, an issuer seeking to rely on Rule 506(c) would be limited to selling securities only to accredited investor. 

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It is unclear what types of investors would participate in offerings made in reliance on Section 4(a)(6), but based on the profile of investors in the current domestic reward-based and donation-based crowdfunding market, we believe that many investors affected by the proposed rules would likely be individual retail investors who currently do not have broad access to investment opportunities in early-stage ventures, either because they do not have the necessary accreditation or sophistication to invest in most private offerings or because they do not have sufficient funds to participate as angel investors.  Offerings made in reliance on Section 4(a)(6) might provide retail investors with additional investment opportunities, although the extent to which they invest in such offerings would likely depend on their view of the potential return on investment as well as the risk for fraud. 

It is unclear what types of investors would participate in offerings made in reliance on Section 4(a)(6), but based on the profile of investors in the current domestic reward-based and donation-based crowdfunding market, we believe that many investors affected by the proposed rules would likely be individual retail investors who currently do not have broad access to investment opportunities in early-stage ventures, either because they do not have the necessary accreditation or sophistication to invest in most private offerings or because they do not have sufficient funds to participate as angel investors.  Offerings made in reliance on Section 4(a)(6) might provide retail investors with additional investment opportunities, although the extent to which they invest in such offerings would likely depend on their view of the potential return on investment as well as the risk for fraud. 

In contrast, larger, more sophisticated or well-funded investors may be less likely to invest in offerings made in reliance on Section 4(a)(6). The relatively low investment limits set by the statute for crowdfunding investors might make these offerings less attractive for professional investors, including VCs and angel investors.  While an offering made in reliance on Section 4(a)(6) could bring an issuer to the attention of these investors, it is possible that professional investors would prefer, instead, to invest in a Rule 506 offering, which is not subject to the investment limitations applicable to offerings made in reliance on Section 4(a)(6).

The latter point is speculative and helps us differentiate Reg. A+ from crowdfunding and who the issuers will likely target and to a lesser extent, why. The proposed Reg. A+ rule also envisions creating two tiers of exemptions to broaden the appeal of Reg. A+. See here. The proposed rules would amend Reg. A by creating a Tier I and Tier II exempt offering. See p. 192, ¶123 of the proposed reg. Those are:

• Tier I: Consisting of offerings up to $5,000,000 in a 12-month period, including up to $1,500,00 for reselling of shares by security-holders.
• Tier II: Consisting of offerings up to $50,000,000 in a 12-month period, including up to $15,000,000 for the account of selling security-holders.

As proposed, an issuer could elect to proceed under either tier; however, offerings under Tier II would be subject to additional requirements, such as providing ongoing disclosure/reporting (filing the likes of new Form 1-K (annual report), From 1-SA (semiannual updates), and Form 1-U (current reports); these are simplified versions of Forms 10-K, 10-Q and 8-K.) One advantage to those electing Tier II is that the issuer would not be subject to Sarbanes-Oxley’s 404(b) attestation requirement, insider trading rules, or SEC proxy rules. See pp. 158, 232, 234-35 of the proposed reg.

Another proposal under Reg. A+ involves the creation of “venture exchanges”, ¶106, or secondary trading markets for securities issued in connection with Tier II offerings. The workings of any such exchange are unknown.

So how does this proposed rule impact start-ups and smaller firms? Again, this depends. I do not currently think that most start-ups and early-revenue firms will use Reg. A+ despite the proposed tier system and potential venture exchanges. The costs for a start-up or firm with minimal cash flow to use the Reg. A+ exemption seems prohibitive. On the other hand, Reg. A+ should appeal to lower U.S. and Canadian middle-market firms. As for the start-ups and firms with a limited revenue stream, they will more likely consider the crowdfunding option—hopefully, with the advice of counsel…recognizing the benefits and limitations of the same—and…,who knows, perhaps they may find a slightly more receptive family office, seed investor, angel, or venture capital fund willing to take a closer look.

A detailed review of the proposed rules is not within the scope of this article. One can access the proposed rules by clicking here. Bear in mind that the comment period has ended and prepare yourself to explain the various funding options and requirements to your client base.
 

Roberto Castro, Esq., MST, MBA, CVA, CMEA, CPVA, is a managing member of Central Washington Appraisal, Economic & Forensics, LLC, www.cwa-appraisal.com, a machinery and equipment, business valuation, litigation support services firm in Central Washington. In addition, he is a business broker with Murphy Business & Financial, LLC, serving Central Washington State, www.murphybusiness.com/centralwashington, and Managing Member of the Law Office of Roberto Castro, PLLC, which serves the Douglas, Chelan, Grant, Okanogan, Kittitas and Yakima counties and is focused on succession and exit planning. All three entities were established in 2014 by Mr. Castro, who returned to Washington State. Previously, he worked and resided in Utah, where he managed Wasatch Business Valuation & Litigation Support Services, LLC, www.wasatchbusval.com. Mr. Castro can be reached at either RCastro@cwa-appraisal.com, R.Castro@murphybusiness.com or RobertoC1@NACVA.com.