17 posts categorized "March 2010"

The Problem of Brokered Private Placements

I have a Google alert set up for the phrase "Reg D," and today it linked to a post on the blog of an Atlanta law firm that appears to specialize in bringing fraud suits on behalf of investors. Here's an excerpt:

The Hammer is Coming Down on Private Placement (Reg D) Offering Scams

Private placement offerings (also known as Reg D offerings), such as Medical Capital Holdings Inc. and Provident Royalties LLC, have devastated unsuspecting investors. . . .

Public securities offerings must be generally be registered under the Securities Act of 1933. Registration protects investors, at least in theory, by requiring disclosures, including audited financial statements, and review of those disclosures by a gatekeeper, the U.S. Securities and Exchange Commission. . . . Regulation D provides certain exemptions from the registration requirement, thus removing that gatekeeper protection.

. . . Brokers and advisers have been known to falsify investors’ annual income and net worth so that the investors appear to be “accredited” and the deal appears to qualify for the Reg D exemption from registration and consequent lack of regulatory scrutiny.
The post describes behavior completely foreign to the Seattle tech startup community, and, I dare venture to say, foreign to all other tech startup communities in the US.

But the news says fraudulent brokers and investment advisers are out there. Fraudulent broker-dealer and adviser behavior is surely what is driving the North American Securities Administrators Association (NASAA) to seek changes to federal securities laws, including the proposals, however misguided, to change Reg D, which have had the startup community in an uproar over the past week.

As I said elsewhere on the web recently, I don't think state securities regulators want to crush free enterprise. They don't have the perspective of we who operate within accountable regional communities where almost all participants -- entrepreneurs, board members, investors, attorneys -- are far more effective gatekeepers than a regulator in a state or national capital could ever be. Instead, they have the perspective of public servants who deal with Madoffs and would-be Madoffs in industries and communities that do not appear able to self-police effectively. In the Fox Business News interview posted just above, NASAA President Denise Voigt Crawford states that 80% of her cases are ponzi schemes.

My point here is that the provisions in Senator Dodd's bill came from somewhere. Now, Section 412 and Section 926 of that bill remain destructive and poorly conceived, and would be a national travesty if allowed to become law as now drafted. But the optimum resolution may be a compromise that would allow NASAA member regulators more authority over brokered deals and deals in which advisers are paid commissions.

Brokered deals aren't startup financings. Brokered deals arguably never really met basic Reg D requirements in the first place.

The Anniversary of this Blog, and Some Rules

Today is the anniversary of my first post on Wac6.com.

I'm new at blogging and still learning. And I love it. In the hierarchy of self perception, my Twitter profile names me "father, lawyer and blogger." Being a father will always be my most important occupation, but I'm starting to think of myself as much as a blogger who practices law, as a lawyer who blogs.

I am thankful to all my feedburner subscribers. You individually know who you are, but you may not be aware that your numbers are growing!

Matt Heaton, Jon Washburn and Joe Wallin each inspired me to begin blogging. Early on and consistently, Bob Muraski encouraged me to not be shy about replying immediately to comments. Nathan Bowers brought sophistication far beyond my deserts to the design of the site. And Marcelo Calbucci and Seattle 2.0 provided the best encouragement of all: by syndicating many of my posts, they made me feel that I could find an audience.

To mark the occasion, I have developed three rules of blogging, aspirations cobbled from what I've learned over the past year.

1. Don't waste people's time: be brief; where you can't be brief, be succinct.

2. Push away from yourself and toward your thoughts (and reveal your mind in the world).

3. Don't be impressed with, turgid over, sycophantic in relation to: friends, clients, competitors, icons, other publishers.

The Renewed Attack on Reg D: An FAQ

What is Reg D? Reg D sets up a system of rules that all in the startup financing ecosystem -- entrepreneurs, angels, venture capitalists and lawyers -- know, rely on, and self-police. The process is amazingly efficient, protects investors, and supports innovation, economic growth and jobs. It is a success story, of which our nation should be proud. Reg D worked to help angels and venture capitalists support startups throughout the financial crisis and has not let us down.

What is the renewed attack on Reg D? The renewed attack on Reg D is contained at Section 926 and Section 412 of Sen. Christopher Dodd's "Restoring American Financial Stability Act of 2010." The renewed attack has three offensives: 

  • one, to stop startups and other private companies from closing on financings until the SEC or a state regulatory authority has reviewed a regulatory filing; 
  • two, to end federal preemption of state authority over smaller financings (exact size and scope to be determined by SEC rulemaking) exempt under Rule 506 of Reg D; and
  • three, to change the existing thresholds for "accredited investors" so that most existing angel investors can no longer participate in the private financing of startups and other private businesses.

I thought Sen. Dodd's bill was about ending federal preemption over Reg D offerings. What is this about a 120 day waiting period? Through Section 926 of his bill, Senator Dodd would end the ability of startup companies and other private issuers to raise funds in reliance on their own self-policing of Rule 506. Instead, startups and other issuers would have to wait or escrow funds potentially for 120 days or more, pending SEC and possible subsequent state regulatory review. It is true that there was no such review period under the prior version of Sen. Dodd's proposed legislation; the prior version left the notice filing system intact.

So now the SEC would review Reg D filings, and the states would come in only if the SEC failed to review the filings in 120 days? That is one way the states would have jurisdiction over Reg D offerings under Sen. Dodd's bill. Another feature of Section 926 of Sen. Dodd's bill, however, would permit the SEC to determine, by rulemaking, that some offerings are too small in size or scope for Reg D exemption, and should be returned to the regulatory authority of the various states.

Senator Dodd is retiring. Doesn’t that mean that his attack on Reg D is dead? No. Sen. Dodd's bill was approved by the Senate Banking Committee on March 22, 2010, and now goes to the full Senate for consideration.

Is there something wrong with the current startup financing system, that requires this reform? No. As noted in a recent letter from the Angel Capital Association to Senator Dodd, there is virtually no fraud among angel financings for startups. The system works, and there are good reasons that it should. If you claim the exemption fraudulently, then anyone can come after you, personally: the SEC; the relevant states whose resident investors are hurt (federal preemption never stopped the states from pursuing fraud); and the investors themselves.

Why is Reg D so important?  Reg D does not slow down capital formation, and speed is essential to startups. While you do indeed need to make a Reg D filing in connection with each offering, you can do so concurrent with or shortly after closing a first sale. States need to be notified, too, but can't impose "merit review" or otherwise slow down the capital raising process.

Is there a way to stop this? Yes. Individual senators may offer amendments to the bill. The Angel Capital Association and private individuals are working hard to contact senators to tell them of their concerns and to offer alternative changes to the law that would not devastate startup seed financings and angel investment in the United States.

Who would want to kill Reg D? For all intents and purposes, state "blue sky" registration and review of seed financings for startup tech companies ended in 1996, when the National Securities Markets Improvement Act preempted state authority over offerings meeting the criteria for federal exemption under Rule 506 of Regulation D. State securities administrators, speaking through an organization called NASAA, have long sought to repeal this federal preemption to restore their former authority.

How does imposing a 120 wait period help restore state authority that existed prior to 1996? It doesn't. This is supposition, but it may be that the 120 waiting period feature of Sen. Dodd's bill is one of those misbegotten attempts at compromise that pleases no one and fundamentally misunderstands the very purpose of a registration exemption. It is not clear that NASAA even wants this. Dow Jones Newswires reported that the president of the organization, Denise Crawford, acknowledges that a 120 day waiting period is too long.

Would there be another way to address abuses that state regulators are worried about? "Get rich quick" scam artists and ponzi scheme promoters have used Reg D to attempt to shield themselves from state jurisdiction, and this problem might be fairly addressed by legislation. However, rather than gut Reg D, which facilitates the safe and efficient formation of startup capital for tech and other entrepreneurs in this country and is not abused by the participants in this industry, the rules could be reformed to match the practice that works. For instance, SEC and state regulators could be further empowered to regulate offerings that may pay lip service to Rule 506 under Reg D, but don't actually meet existing Reg D requirements. If Reg D were clarified to underscore that an issuer must have a pre-existing business relationship with its investors, or to not allow federal preemption when broker dealers participate in a private seed financing, the current, successful and prevalent practice of the tech startup community would be preserved.

Why is the National Venture Capital Association ambivalent on this? Early this month, together with the ACA, the NVCA did write a letter to Sen. Dodd, protesting the attack on Reg D. Since then, the ACA and other angels, entrepreneurs, lawyers and individual venture capitalists have taken the lead. It may be that the NVCA will become more active on the issue as Sen. Dodd's bill is considered by the full Senate. Some believe that many venture capitalists still may think that the attack on Reg D is primarily an "angel issue," and will not impact venture capital firm financing rounds that materially (costs and delays for VC-led rounds would be more manageable). Furthermore, with most angels eliminated from the startup ecosystem, some perceive that VC firms will have more 'leverage" over entrepreneurs with regard to financing terms.

How can I help? 

  • Learn more about the issue, and find links to important news articles and blog posts on this issue, at the Save Reg D website.
  • Contact your senators and representatives in Congress and tell them of your concerns. However you may feel about financial regulatory reform in the United States, the provisions in Sen. Dodd's bill that attack startups, entrepreneurs and angel investors are not necessary.
  • If you like, sign the petition against the attack on Reg D (widget link below).
  • If you are an angel investors, see the resources on the ACA site and get involved, either through the organization, a regional angel group, or on your own.
  • If you are a member of the NVCA, lobby the leadership of that group and let them know the NVCA should follow the instinct it had earlier this month and work for entrepreneurs on this issue.

My Take on the Series Seed Financing Documents

I had the chance I was hoping for, during a plane ride Monday, to read the Series Seed Financing Documents. They are good! I am looking forward to trying them.

Comparing the set with two others published for seed financings, I think the Series Seed docs look better, present better and feel better built.

And the deal terms reflected in the templates are better thought out.

Ted Wang, the principal author and curator of the set, states as a first principle that the documents "are intended to be fair, favoring neither the investors nor the entrepreneurs." And it's pleasing to see this pulled off: the suite doesn't reflect a bias to correct market norms or perceived market biases that some of the other sets do.

If there is an agenda to the Series Seed set, it may be to provide that holy grail of a simplified and relatively inexpensive set of documents for initial financing, complete with normative and sufficient deal terms, while at the same time anticipating future rounds of VC financing that will necessarily be significantly more complex. Again to quote Ted Wang, this time from his post addressed to lawyers using the set, "The documents are intended to be modular so that in future rounds additional terms can simply be layered in." (Yokum Taku, however, in what VentureHacks called his "reference-quality" comparison of the Series Seed set with other sets of seed financing documents now out there, believes that in later rounds one will need to start over with a more robust set of forms.)

Not that the set is devoid of inspiration for walking the median strip along a two-way road.

Anticipating that investors may bridle at the trimmed back rights and the pared down protective covenants, the Series Seed Investors' Rights Agreement has a novel provision, Section 1.2, titled "Additional Rights," that provides in part:

"In the event that the Company issues securities in its next equity financing after the date hereof (the “Next Financing”) which have (a) rights, preferences or privileges that are more favorable than the terms of the Shares, such as price based anti-dilution protection or (b) provides all such future investors other contractual terms such as preemptive rights or registration rights, the Company shall provide substantially equivalent rights to the Investors with respect to the Shares (with appropriate adjustment for economic terms or other contractual rights, subject to such Investor’s execution of any documents, including, if applicable, investors’ rights, co-sale, voting and other agreements, executed by the investors purchasing securities in the Next Financing (such documents referred to herein as the “Next Financing Documents”). Any Major Investor will remain a Major Investor for all purposes in the Next Financing Documents to the extent such concept exists. The Company shall pay the reasonable fees and expenses, not to exceed $5,000 in the aggregate, of one counsel for the Investors in connection with the Investors’ review, execution and delivery of the Next Financing Documents."

Pulling that off for all potential concessions to future investors may be trickier, and may (probably fairly) presuppose a standardization in terms downstream that are more predictable than those for seed financings.

I mentioned an "agenda" above, but I don't think use of the forms need be limited to startups that know they will receive VC financing in subsequent rounds. Some IT/software or web companies may not need a VC round or may bootstrap from revenue or raise supplemental funds when needed from their initial investor base. The terms of these docs are still good, and provisions like the Section 1.2 of the Investors' Rights Agreement, quoted above, will yet give those investors comfort against the unknown.

Two "Must Reads" on the Threat to Startup Financing

It still seems like an invasion from outer space, but Senator Dodd's financial regulatory reform bill yet contains provisions designed to shut down startup financing in this country.

As I post this, the Senate Banking Commitee is meeting to consider it. Not the provisions hostile to entrepreneurship and angel investment, necessarily, but the bill as a whole.

Do Senators even know this stuff is in there? Well, thanks to good reporting in the WSJ online and BusinessWeek, they have no excuse not to.

These are "must reads:"

COMPLIANCE WATCH: Financial Reform Could Hurt Small Business

BusinessWeek: How Dodd's Reform Plan Hurts Startup Financing

Will the Last Startup Leaving Dodd's America Please Turn Off the Lights?

Senator Dodd's legislation has to change. It simply has to. Otherwise, we have to contemplate that startups will be possible only for those who (a) can bootstrap their way, all the way, with no outside investment, or (b) are very, very rich.

BusinessWeek has some data on how the angel community will be hit, and the numbers are not just sobering, they are devastating (see the article for better context):

  • By one measure, the number of accredited investors would drop 77%;
  • By another measure, the pool of active accredited investors (people who made a friends-and-family or angel investment in the previous three years) could drop from 528,000 to 756,000 (currently), to from 121,000 to 174,000 people.

Remember: "Most entrepreneurs get their first real investments from angels, not VCs." (The quote is from a post by Fred Wilson on his blog.)

Not that VCs will do any better by Sen. Dodd. As I noted yesterday on the Save Reg D site, the BusinessWeek article goes on to describe the negative downstream effects on venture capital financing.

The retiring Senator Dodd wants to leave a mark, all right. If someone doesn't take notice, step up and change that bill, Senator Dodd may well lay waste to startup land.

The Attack on Reg D: Some Fallback Positions

Most folks I know concerned about Senator Dodd's attack on Reg D think it is too early to propose a fallback position or compromise. I agree the best and first line of defense is this: make the case that the self-policing system of exemption and federal preemption under Rule 506 is working; that it is working well; and that it is necessary for entrepreneurship and innovation in America.

But I'm worried the train is leaving the station, and that only the NASAA's views are being heard by Sen. Dodd and the legislators and/or staffers behind the drafting of Sen. Dodd's atrocious proposals to gut angel financing.

At the moment, the only thing approaching a coherent narrative to make sense of the language in Sen. Dodd's bill (and there is no way to make legal or policy sense of the mish mash, as I tried to show yesterday, and as Dennis Brennan and Joe Stansell, in their comments to yesterday's post, did a better job of explaining) is the one put forward by NASAA, and it is this: unscrupulous broker-dealers and placement agents are bilking unsophisticated innocents of their savings, all the while shielding themselves from prospective merit review by filing under Rule 506 of Reg D.

So I think those of us who want to protect seed financings have to brainstorm alternative changes to Reg D that address the problems of which NASAA speaks.

There are other ways to change Reg D, alternative proposals, that would leave the essential system intact for startup technology companies, as well as for other entrepreneurial sectors of the economy that fuel innovation, growth and jobs.

Here are two I can think of:

  • Leave everything in Reg D as it is now, but mandate that the SEC refine Rule 506 to say that securites issued in reliance on that rule are not "covered," and thus states may intervene prior to sale, if and only if the issuer sells to non-accredited investors.
  • Leave everything in Reg D as it is now, but mandate that the SEC toughen up, by rule, the prohibition against "general solicitation" and/or the "existing business relationship" standard.

And as for the disastrous proposal that could more than double the thresholds for "accredited investor" status, here's one alternative: 

Let accredited investors who meet any of the current threshold tests "opt out" and declare themselves as "deemed non-accredited" and in need of state protection. Those who don't earn 6-figure salaries or don't have million dollar net worths are still automatically protected (it's slightly Orwellian, isn't it, to say "protected" where the context requires the word "excluded"), as they are today; and the millionaires who perceive themselves to be unsophisticated can avail themselves of state protection, too.

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