54 posts categorized "Seed Financings"

Want to Avoid "General Solicitation?" Focus on Relationships!

The following is adapted from remarks prepared for the Angel Capital Association's 2015 Angel Insights Exchange, held in New Orleans the week of November 9. I am the volunteer chair of an advisory council to the ACA, but the views I express below are personal to me, and not a reflection of ACA views or policy; nor are they a reflection of views of my law firm.

As we all know, Dodd-Frank (2010) and the JOBS Act (2012) brought big changes to the rules that govern what’s okay and what’s not okay in the world of federal exemptions from securities registration requirements.

Couple-by-Paul-Kline-Creative-CommonsOne of the biggest reforms – permitting startups and other private companies to advertise a securities offering, provided that all purchasers are accredited investors – has caused the most consternation, at least in the early implementation. That’s largely because this particular reform – “lifting the ban on general solicitation” in Rule 506, the primary federal exemption on which almost all angel-backed companies rely – came with a catch. The catch is this: if you advertise or otherwise “generally solicit,” you will have a newly-invented1 and heightened burden to verify the accredited investor status of your purchasers.

This has caused many entrepreneurs and angels to shun Rule 506(c). Because the new rules made clear that the old rule (now called Rule 506(b)) remains available on a parallel track, you can still raise your money privately the old way; the heightened verification burden will not apply.2

But still there are gray areas: what about demo days; what about online platforms that restrict access so that only accredited investors can see deals; what about angels syndicating deals with other angels? In the early days of implementation of these reforms, people are worried – even more than they were before the JOBS Act, it seems3 – on whether they might trip accidently into conduct that could be deemed “general solicitation.”

Thankfully, we’ve had new guidance from the SEC this year pertinent to the quandary of “general solicitation” and what we might call the 506(b)/506(c) divide. 2015 has brought us:

  • No fewer than eleven (11) new questions-and-answers on general solicitation, to be added to the Division of Corporation Finance’s ongoing Compliance and Disclosure Interpretations; and
  • A new “No Action” letter, called “Citizen VC,” which tells an online platform how it might avoid slipping into Rule 506(c) territory.

The theme of the new SEC guidance is this: a “pre-existing, substantive relationship” can be a terrific antidote to the virus4 of “general solicitation.”

Now, the concept of the pre-existing, substantive business relationship has been around for a long time. It’s been a way of demonstrating that a given deal is indeed private, and prior guidance from the SEC has long held that an issuer can extend the utility of the concept by including, not only persons the issuer knows, but also the relationships of a broker dealer participating in a given offering.

The new SEC guidance, however, now makes it expressly clear that it’s more than okay for an issuer to be introduced by an angel to other angels the issuer might be meeting for the first time, without tripping into “general solicitation.”5 Here’s an excerpt from the answer to Question 256.27:

[W]e acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members . . . may introduce [the] issuer to other members. Issuers . . . may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication.

Similarly, the new SEC guidance at Question 256.33 states that demo days can be “insulated” by the pre-existing, substantive relationships that a demo day organizer has with attendees:

Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network [of angels] as described in Question 256.27.

Finally, I want to highlight the Citizen VC No Action Letter, because it speaks to what an online angel investing platform might do, should it wish to remain under the ambit of Rule 506(b). Here’s how Dan DeWolfe, a member of the ACA Advisory Council and the attorney who wrote the no-action request on behalf of Citizen VC, summarized in a blog post (co-written with Samuel Asher Effron) his take on the import of this particular guidance:

In essence, the approach under the CVC Letter is to make the online private placement offering similar in policies and procedures to an offline private placement. The pre-existing relationship is not time based nor is it satisfied by answering a mere two questions. Rather, the establishment of a pre-existing relationship depends on the QUALITY of the relationship between the issuer and a potential investor. While the vast majority of online offerings will clearly fall within the new Rule 506(c), the CVC Letter does spell out a way to conduct a true private placement in a password protected web page that does not give rise to a general solicitation.

How can an online platform be sure it is not using general solicitation? That’s right, the answer is in line with the guidance theme for 2015: establish a substantive, pre-existing relationship with prospective investors. In the case of online platforms, establishing such a relationship must occur prior to, and not in the context of, a given offering by an issuer on the platform.

Photo credit: Paul Kline (Creative Commons)

<id="fn1">1. On the “newly invented” nature of the verification burden imposed by offerings that are generally solicited pursuant to new Rule 506(c): many securities lawyers might emphasize that Rule 506 has always, always required an issuer to have a reasonable basis on which to conclude that its purchasers were accredited. I myself predict that the distinctions between 506(b) and 506(c), on the point of verification, will inevitably blur over time. But it is certainly fair to say that current industry practices that pass muster as sufficient under 506(b) do not pass muster under 506(c).

<id="fn2">2. It’s fair, and probably important, to point out that the verification pitfall is connected with another aspect of Rule 506(c) that is scary to startup and emerging company lawyers, and should be to entrepreneurs and angels as well: if you’re relying on an exemption that expressly stipulates that you have engaged in general solicitation, then, unlike what would be typical in most Rule 506(b) offerings, you will not have other private offering exemptions to fall back on, should your Rule 506 exemption somehow fail. Claiming exemption under 506(c) is like walking a highwire without a net.

<id="fn2"><id="fn3">3. Anxiety about the meaning of “general solicitation” dates back to the rollout of Rule 506(c) two years ago. See this piece I wrote for the Wall Street Journal: http://blogs.wsj.com/accelerators/2013/09/27/weekend-read-the-trojan-horse-of-accredited-investor-verification/.

<id="fn4">4. Is my metaphor over the top, or is it really dangerous and unhealthy for a startup to conduct a Rule 506(c) offering? This is a question I would like to put back to all of you!

<id="fn5">5. Technically speaking, it does not appear as though the new guidance is saying that a given angel’s network extends the reach of the issuer’s pre-existing, substantive relationships, at least not in the same way that a broker-dealer’s relationships might. See Question 256.29. Rather, the long-standing practice of introductions via angel networks appears to be a similar but independent method of “neutralizing” general solicitation.

Cracking open the SAFE

I see Antone Johnson and Joe Wallin are tweeting about the "SAFE," or "simple agreement for future equity") being promoted by Y Combinator as a seed-financing alternative to convertible notes.

6901756969_dcb05eac80_zThe animating idea appears to be to take the pressure off a startup to close on a priced equity round before a slew of seed fin ancing convertible notes mature.

What does a purchaser of a SAFE get? A promise that future shares will be issued on triggering events that the SAFE agreement defines.

There are four varieties of the instrument indexed on the Y Combinator site. I've had a quick look at this one, a version that imposes a valuation cap and gives the SAFE purchaser a conversion discount. A few things stand out:

  • The size of the SAFE round is not scoped; I suppose this simply reflects a Y Combinator and perhaps Silicon Valley philosophy of open ended rounds, with notes (or SAFEs) being issued with different discounts at different times. (A byproduct of this approach is that you have to get each investor to individually agree to any change in terms; maybe this is not so bad here, as the investor really has no downside protection to give up.)
  • Unless I missed it, I don't think the SAFEs convert into convertible note rounds, if the company later determines to issue convertible notes before a conversion-triggering equity round. Nor is there a covenant restricting the company from issuing convertible notes without consent.
  • Investors do get the benefit of a few key company reps, but there is no capitalization rep, no rep as to founder reverse vesting, and no rep that everyone has signed an inventions agreement (though there is a rep that the company has the IP it needs).
  • There seems to be an appetite to put off corporate approvals to authorize offerings, make reservations of shares, and make appropriate Reg D filings; I think a sophisticated investor is not going to be comfortable with that (even assuming she is willing to get past the threshold problem of not having any priority over the common stock).

The above from a quick read just after seeing Joe's and Antone's tweets. LMK if you see anything I missed.

Photo: Dennis van Zuijlekom / Flickr.

Weekend Read: WSJ Accelerators Post on Pitch Events and General Solicitation

This weekend please read an article I wrote for The Accelerators blog of the Wall Street Journal, The Trojan Horse of Accredited-Investor Verification.

6960882500_cc7fccd4d4_oThe piece gets into how some angel groups, pitch event promoters, and demo day organizers are dealing with new Rule 506(c). Basically, the days of a de facto industry practice of ignoring the Rule 506 prohibition on general solicitation and general advertising are over.

Now that it is okay to generally solicit, it's also time to come to terms with what came part-and-parcel with such over permission: the need to take reasonable steps to verify the accredited status of all purchasers.

It's going to take some time for the ecosystem to sort things out.

Check out this Pando Daily post that Doug Cornelius quoted from in his weekly roundup post. Do you think the newly conservative steps demo days promoters are taking, as recounted by the Pando Daily reporter, Erin Griffith, cut the mustard?

Please do read the piece for the WSJ Accelerators!

Photo: D Services / Flickr.

Three longer reads for where we are after General Solicitation Day

We are now living in the second day after General Solicitation Day. All trying to take stock of what has happened, and how the landscape is different.

And there is no shortage of media coverage! (Here, from a news angle, is a good overview from the Wall Street Journal: General Solicitation Brings Startups Capital, Risks. I was interviewed for this article and love the quote they got from me: "The government is doubling down on the idea that accredited investors can fend for themselves.")

PhotoBut today I wanted to call out three different, longer-form pieces of writing, each published within the last week. Each, in a different way, lends a deeper perspective on where we in the startup financing ecosystem are now.

Each will be a reference piece in the weeks and months to come.

1. Paul Spinrad's take on where we are, how we got here, and how all the different pieces fit together.

Here is an article that Paul Spinrad published on a PBS website: Online Platforms Give the First Public Look at Private Equity. As I said on Twitter yesterday, Paul's is the best written, broadest article yet on general solicitation and the changes to private financing rules.

Among the delights of Paul's well written survey are: an explanation of how public offerings came to be squeezed into a private exemption framework; the balance or contrast of considerations when approaching policy for accredited and non-accredited crowdfunding; and how private equity platforms are rolling out new features to facilitate the new rule set.

On Monday in GeekWire, I tried, not very effectively, to point out some of the new features on some of the leading online platforms. Paul's take on the same topic is far more accomplished. And that topic is only one facet of his survey.

2. Trent Dykes', Megan Muir's and Kiran Lingam's whitepaper on do's and do not's at demo days and pitch events.

This one, Demo Days, Pitch Events and the New Reg D, is controversial. I've had an earful from several people already on how this whitepaper may get one or another thing wrong.

But I greatly admire the ambition and timeliness of it. The question that the rest of us hem and haw about – am I automatically generally soliciting if I show up at a demo day or pitch event? - they tackle.

Whether or not you agree with the protocols and checklists they lay out, Dykes, Muir and Lingam are calling out the right factors to consider and giving laypeople the means to educate themselves about general solicitation.

3. The Gunderson law firm's comment letter to the SEC on the proposed Reg D rules.

This is a letter published on the SEC's received comments page, signed by a Gunderson partner, Sean Caplice.

There are a ton of comment letters on the proposed rules, none too few from big law firms.

What's remarkable about the Gunderson letter is that it provides answers to all 101 "requests for comment" posed by the SEC in its proposing release.

Most commentators either cherry pick which of the SEC's questions they want to answer, or skip the agency's questions altogether and comment from the perspective of the commentators' own agenda or frames of reference. For tackling all 101 requests for comment, and for that reason alone, I think the Gunderson comment letter is a touchstone. (Kudos to Joe Wallin for pointing the letter out to me.)

The 506(c) Seed Financing Blues

I know I can't just take from any Joe
Investment in my fledgling startup co.

But come the 23rd this month, I hear,
It's dope to advertise with brazen cheer

My need for funds. The only legal catch:
My purchasers must be accreds. (Well, natch.)

But wait, a second catch I now recall.
Accred! I have to verify them all.

The legal bloggers tell me I must hire
Someone like them to get me through the mire

Of 506(c), final and proposed,
And all the Form D notice filing woes.

One might have thought that Congress, when it passed
An Act to make it easier to gas

Small businesses to drive more growth in jobs,
It would have fended off last-minute lobs

To compromise by complicating law.
Oh well - democracy's systemic flaw.

The 23rd, I'll take my chances on that day
And verify by asking NSA

What it can tell me 'bout my purchasers.
Yes, that's my plan. It could be worse. And yours?

The general solicitation quandary: can you shoehorn today's pitch events into yesterday's rules?

Lots and lots of questions about the new and final general solicitation rule, as well as proposed rules that would add additional conditions - beyond the accredited investor verification required by Congress - for exempt offerings that make use of general solicitation.

As we sort through the questions and ambiguities, however, one point couldn't be clearer: the old rule used for most startup and emerging company financings, old Rule 506 (hereinafter to be known as 506)b)), was expressly preserved.

9417926220_c54429ce2f_zTrue, if the proposed Reg D rules are finalized as proposed, new Form D filing requirements will impact Rule 506(b), as well as the new, final, general solicitation-friendly rule 506(c).

But 506(b) has no heightened verification requirement, and no pre-filing or information requirements have been proposed for 506(b) deals. It may well be that Form D filing obligations will soon have more teeth, regardless of whether you choose 506(b) or 506(c), but it's fair to say that the new Reg D rule set goes out of its way to preserve the old way of doing things, as long as you do not generally solicit or generally advertise, and as long as you otherwise comply with the conditions that have always been in place for Rule 506.

It didn't have to be thus and the SEC deserves credit and praise for thinking this through.

As drafted, Title II of the JOBS Act did not actually require that the old 506 be preserved. The notion had been in the air. A version of the JOBS Act that had been introduced in the Senate in March 2012, not the version that made it into law, expressly contemplated that the SEC might bifurcate 506 in the way that the agency ended up doing. And I and others advocated for such an approach in the run up to the SEC's August 2012 proposed rules to implement the lifting of the ban on general solicitation. But there was no Congressional imperative that the agency do so.

And because the Reg D rule set expressly preserves "the old way" of startup and emerging company financing - no general solicitiaton or general advertising - there is actually pretty darn good intuitive appeal to the apparently commonsense reaction, "just stay away from general solicitation."

I'll bet many companies will decide to stay inside the cozy, clubby confines of 506(b). But here's the problem with taking too much comfort from such a reassurance: industry practice today has been bending the old rule - prohibiting general solicitaiton and general advertising - to the point of breaking.

Joe Wallin puts it this way on his blog:

"What about startup weekends? What about business plan competitions? What about incubator demo or graduation days? Will the teams that compete in these events be deemed to have generally solicited an offering? Some of these events, if conducted as they’ve been run in the past, will clearly constitute general solicitation."

If you're going to content yourself (limit yourself? liberate yourself?) with the old way, if you're going to stay within the confines of 506(b), here's the longstanding verbiage from the Reg D rule set you need to get comfortable with:

". . . . neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following: (1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and (2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising . . . ."

Ask yourself: come September 23, will some offerings that formerly looked like 506(b) now look like 506(c)?

Photo: Entrepreneurs Club Berlin / Flickr.

Congress not yet fully awake to the problems with the SEC's proposed overhaul of Reg D

A letter to the SEC from two Republican congresspersons is getting a lot of attention.

The subject is SEC proposed Reg D rules at odds with Congressional intent under the JOBS Act. This is a point I and others previously made in the press so it is good to see some members of Congress waking up. (From TechCrunch: Let’s Have General Solicitation As Congress Intended It.)

8355141_067c162acc_oBut it's disappointing, frankly, that the letter is so strident and partisan. Yet again we have to hear over and over how late the SEC was in adopting 506(c). (Get over it already Rep. McHenry and look forward!)

And it's difficult to credibly speak for Congressional intent when you get core features of your own legislation wrong. Example: the letter speaks of the lifting of the ban on general solicitation "for those Rule 506 offerings that solely target accredited investors." That is exactly the opposite of the policy choice actually made in the legislation. The greatest significance of the lifting of the ban on general solicitation is that you need not target. You can broadcast if you like. The point is to only allow as purchasers those persons for whom you have taken reasonable steps to verify accredited status.

Really, the SEC's proposed re-trading of Title II of the JOBS Act should not be a partisan issue. I would think that moderate Democrats and the White House would be equally interested in seeing 506(c) work and in 506(b) being protected. After all, the JOBS Act was actively supported by the Obama administration, and championed by the President himself.

And I imagine the SEC could probably use the political cover as state regulators will never be at peace with the democratization of angel investing. I am speculating here, but the agency could be more worried about hedge fund advertising then what a little incubated three-person startup raising $200,000 might do. The right policy choice might be to say yes to information requirements for hedge funds, no for operating issuers.

The consensus, non-partisan agenda should include, not just general solicitation, but also the angel platform exemption that Rep. McHenry originally introduced as a floor amendment, with express support from then Rep. Barney Frank. Congressional intent for that provision could not have been clearer. And yet an SEC staff FAQ threatens to compromise its utility.

My call to New Democrats, White House policy staffers, independents worried about depriving startups of a useful federal exemption: get together and own, by consensus, what the JOBS Act was supposed to do for angel investing.

Photo: Diane Hamilton / Flickr.

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