We have all heard of the importance of small and startup companies to the recovery of our economy, and so did Congress. With job growth in mind, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law April of last year to help small and startup businesses prosper. The JOBS Act primarily focuses on making investment capital more accessible for startup companies, which is sorely needed in South Carolina. Although the newest addition to the JOBS Act aims to help startups, they may actually hinder them and make existing methods for raising capital more difficult.
The JOBS Act provides multiple methods to achieve its objective of accessing investments, some of which are subject to rules and regulations being written and adopted by the Securities and Exchange Commission (SEC). Two of the most anticipated by startups are the ability to use crowdfunding and the ability to use general solicitation and advertising in private offerings. Both have seemed teasingly close for the past year, but have been waiting on the SEC to adopt the associated rules.
While crowdfunding has not previously been an option for raising capital, private offerings are a key source of startup funding. In 2012 over $900 billion of investment was raised by over 50,000 issuers through private offerings, with the offerings having a median size of $1.5 million. Though private offerings are not limited to use by small companies, these statistics suggest that many offerings are being made by small companies and emphasize the importance of these offerings to startup growth. Imagine the boosts to startups if funding can be more easily raised.
While we continue to wait on rules for crowdfunding, on July 10, 2013, the SEC finally adopted the rules removing the prohibition on general solicitation and advertising in private offerings. This brought forth a flood of eager startups wanting to take advantage of this new opportunity to find investors through online promotions, advertising and social media as well as traditional approaches.
However, as the 18th century English poet Samuel Coleridge noted, “Good and bad men are less than they seem.” The same can be said for these rules. While the adoption of these rules has opened a new path for raising investment, this path comes with new potholes that the startup businesses must navigate.
First, the companies are subject to increased filing obligations with the SEC. Companies have always had to file an informational form that provides basic information on the company, the nature of the offer, and the exemption that the company is relying upon in the offering. With offerings that use general solicitation, the filing requirement is being expanded to include both pre- and post-offering filings, increased information in filings and filings of all of the offering and solicitation materials. These additional requirements are likely to add significantly to the cost of an offering.
Second, the companies are faced with new, stricter requirements on validating investors. Any company using general solicitation can only accept investment from accredited investors, which are generally highnet- worth individuals or companies with a strong financial position. Additionally, companies cannot rely upon the investor to certify to its financial position; the company must verify that the investor meets the accredited investor status. The SEC has suggested that this be done by having the investor submit tax returns or bank and mortgage account statements or have the investor’s status certificated by a third party, such as the investor’s accountant, attorney or financial planner.
This requirement is the one most likely to chill potential investors. It is unlikely investors will be willing to provide detailed financial data. Therefore, this will lead to a reliance on certifications from third parties to validate investors’ financial qualifications. While advisors may offer this service, it will likely add time to the process and be costly, as these advisors must spend time analyzing the financial data and assume risk and potential liability with the certification.
While the new path may be less than it seemed, there are still old familiar paths. Right? Maybe not.
The existing rules remain in place for private offerings and continue to be available to startups. However, the line that defines the behavior that the SEC considers general solicitation can be grey and thick. Furthermore, with the new rules, additional penalties have been adopted that prohibit the use of the private offering exemption for up to a year if a company fails to file the proper forms. So, startups need to be more conservative in their behavior to clearly stay within the current rule, which will make this old path less productive. Or more likely, prudence will dictate that the new path is the safest path, making it more likely to be taken, even with its potholes.
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Terrell Mills is an attorney with Wyche P.A. and heads its entrepreneur services group. Additionally, he is a member of UCAN and a supporter of its startup community.
