94 posts categorized "General Solicitation"

Looking for Mr. 506(c)

"On a relative basis, issuances claiming the new Rule 506(c) exemption have accounted for only 2.1% of the reported capital raised pursuant to Rule 506 since becoming effective in September 2014."

Download (1)So reads a key finding of a report, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014, by Scott Baugess, Rachita Gullapalli and Vladimir Ivanov, staff at the SEC's Divisio of Economic and Risk Analysis. They are speaking about the way Rule 506 under Reg D was reformed by rulemaking pursuant to the JOBS Act, to permit general solicitation while preserving a Rule 506 exemption that is preemptive of state law, as long as all purchasers are verified to be accredited investors.

Rule 506(c) should be a big deal, and we should be seeing more "public" private offerings, like the one from the brewpub chain McMenamins, which my colleague, Jordan Rood, wrote about here.

But we aren't, not yet.

So far, old Rule 506, now re-styled Rule 506(b), is the Donald Trump to Reg D's Jeb Bush. The authors of the SEC staff report have ideas why:

The novelty of the 506(c) provisions after decades on non-permissibility of general solicitation in Regulation D offerings may be one reason why Rule 506(b) continues to dominate the Regulation D market. In particular, issuers with pre-existing sources of financing and/or intermediation channels may not yet have a need for the new flexibility. Other issuers may become more comfortable with market practices as they develop over time, including among other things, certainty over what constitutes general solicitation. There may also be concerns about the added burden or appropriate levels of verification of the accredited investor status of all purchasers, for which efficient market solutions may develop over time.

And might there be a whiff of the taint of adverse selection that one would readily associate with Title III crowdfunded deals. The authors allow that this might be so:

It is possible that some sophisticated investors may perceive the election of the 506(c) exemption as a signal that issuers anticipate difficulties in raising sufficient capital and consequently consider it a less attractive offering, which could also dissuade issuers from utilizing the new exemption for their financing needs.

I yet think this will change. Just not any time tomorrow.

Image: scene from Looking for Mr. Goodbar.

NW Brewpub Chain McMenamins Uses Own Site to Openly Solicit Accredited Investors

Those of you that enjoy beer or securities laws (or both), may have recently seen news articles from various Puget Sound media outlets amorphously mentioning “crowdfunding” when reporting on the development and grand opening of the new McMenamins Anderson School entertainment complex in Bothell. In developing the Anderson School project, McMenamins applied its expertise in creating funky, yet accessible, recreation properties to transform an old, empty middle school building into a complex with a hotel, brewery, restaurants, bars, music and event space and a public swimming pool, in partnership with the City of Bothell.

CaptureThe project has a successful precedent in the McMenamins Kennedy School complex in Portland, and the early reviews on the Anderson School have been quite positive, so much so, that McMenamins recently announced that it would be moving forward with a similar project at the old Elks Lodge in Tacoma.

However, beyond applying its tried and true aesthetic to transform the Anderson School, McMenamins broke new financing ground by using the Rule 506(c) private offering exemption to generally solicit accredited investors via the internet. The company raised approximately $6.3 million (with $250K as the minimum investment) in four months to obtain the initial equity for kickstarting development in the property. This experiment worked so well, the Company intends to use it again in connection with financing the forthcoming Tacoma project.

For those curious about the completed Anderson School deal terms, the offering website is still up, and you can still access all the LLC unit offering documents here. Additionally, a similar site is now up for the Elks Lodge project with initial information about the project and investment terms, however, the offering documents appear to be forthcoming, and no securities appear to be offered yet. Though it does appear similar to the Anderson School project, in that investors will receive a preferred return of 8% flowing from the proceeds of the long-term lease of the property to a McMenamins entity, among other terms.

Conducting private offerings publicly over the internet may sound like a contradiction in terms, and until recently that was the case. However, as part of the federal JOBS Act of 2012, Congress instructed the Securities and Exchange Commission to implement rules allowing general solicitation in a private offering if securities are sold only to accredited investors. As a result, the SEC amended Rule 506 to create Rule 506(c), which allows for general solicitation in a private offering, so long as the issuer takes reasonable steps to verify that sales are made only to accredited investors.

This “verification” standard is a heightened requirement in comparison to the “old-fashioned” Rule 506(b) exemption, which only requires issuers to have a “reasonable belief” that investors are accredited, which may include self-certification by the investor. Although the SEC has provided a set of non-exclusive safe harbors for 506(c) verification, including by bank/brokerage statements, tax returns or statement by a third-party attorney or accountant, this requirement has had a chilling effect on the use of Rule 506(c), as the admission of even one unaccredited investor will disqualify the issuer from use of the exemption, and if any general solicitation has occurred, the issuer will be disqualified from relying on any other exemptions from registration, which could result in significant civil and administrative penalties. As such, using Rule 506(c) has been described as similar to walking on a tightrope without a net.

But back to McMenamins, who rather than worry about the lack of net, just followed the clear rules set forth by the SEC to make sure they didn’t lose their balance. In particular, even though all of the offering information was publicly available on the internet, each prospective investor had to fill out a questionnaire, and submit it to the company counsel with supporting documentation to meet the aforementioned verification steps. Only once the company had “verified” a prospective investor’s accredited status, would any subscription be accepted.

Although some investors may not wish to undergo such scrutiny, this did not seem to be an obstacle for McMenamins, a brand with significant brand and consumer cachet. The Tacoma News Tribune reported that the company raised the $6.3 million from 23 investors (in an offering up to $8 million, per the SEC filing and company offering documents), and now intends to raise up to $10 million for the Elks Lodge project (with a $150K minimum investment), with preliminary indications of interest already received from prior investors.

The use of Rule 506(c) by a company like McMenamins is instructive. By working with competent counsel to safely stay within the investor verification guidance set forth by the SEC, the company was able to broadly reach out to its natural constituency of fans as prospective investors. Simultaneously, it was also able to avail itself of the broad benefits of the Rule 506 exemption, including the ability to raise an unlimited amount of money from an unlimited number of accredited investors, blue sky preemption and “relaxed” disclosure standards, as sales were only made to accredited investors (that said, the company did provide fulsome disclosure materials to prospective investors).

Accredited “crowdfunding” as a concept is generally associated with technology startups and angel investors, but the success McMenamins has had demonstrates that Rule 506(c) is a viable and potentially attractive, offering alternative for companies across a range of industries that may be able to draw widely upon accredited investor interest, rather than being subject to the limited personal networks required by the “substantive, pre-existing relationship” standard of Rule 506(b).

In addition to monitoring the development of these projects, I intend to personally kick the tires at the Anderson School soon by enjoying a McMenamins Terminator Stout, and the always delicious Cajun tater tots.

Image: detail from McMenamins webpage.

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)

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).

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.

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/.

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!

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.

ACA Webinar on Accredited Investor Definition and Established Angel Group Certification

I've just listened to an archived recording of an excellent webinar presented by the Angel Capital Association last week (I had intended to listen in real time, but got pulled away): ACA Webinar on Accredited Investor Definition and Established Angel Group Certification.

Presented by ACA Executive Director Marianne Hudson and ACA Chair David Verrill, the hour long webcast covers how the accredited investor definition might change (and how that might impact the startup investing ecosystem) and what the Angel Capital Association is doing to facilitate the transition to the brave new world of general solicitation.

The chief initiative of the ACA is the "Established Angel Group" certification program, which is designed to help issuers implement the "principles based method" in satisfying the heightened accredited investor verification burden under new Reg D Rule 506(c) (which allows general solicitation). The Established Angel Group (or "EAG") certification program has potentially broader implications as well - for instance, if the accredited investor definition changes to put more weight on, or define an alternative path to accreditation based on, investor sophistication, the EAG could be important for purposes of both Rule 506(b) and Rule 506(c).

Inside baseball stuff, I know, but if you're interested in the history of how it came to be that only high net worth people were allowed to invest in startups, how that situation was seemingly democratized (somewhat) by the 2012 JOBS Act, and the rearguard action of state securities administrators and others to put a lid on the reforms, giving an hour of your time to this webinar will help fill you in.

Toning down the anxiety over accredited-investor verification

There are times to turn up the heat, and then there are times to cool things down.

I happen to be in the camp of those who found nothing wrong with Richard Sherman's in-the-moment taunting of Michael Crabtree. Stoke it up!


But there's too much anxiety over the aspect of new Rule 506(c) which requires issuers to take "reasonable steps" to verify the accredited status of their purchasers.

That anxiety caused the startup community to complain about the first iteration of 506(c) proposed by the SEC, which contained no safe harbors but just a flexible standard that would have been shaped over time by industry practice. That gift horse was looked in the mouth, and the SEC issued final rules that gave folks the safe harbors they asked for.

Result: more anxiety! People now worry about being straight-jacketed into the safe harbors!

So I'm glad leaders in the angel community are working to suck the anxiety out of the accreditation process, from the ACA's guidance last fall, to the new service from AngelList recently announced.

There are third-party services, too, handling accredited investor verification. But angel groups should be shaping industry practice, and it's good that they are stepping up to do so.

Mining Form D filings for quiet deals

Here's a good example of what I was getting on about in yesterday's post: a Mattermark tweet yesterday announcing, publicly, a planned fund that is claiming a 506(b) (quiet; no general solicitation and no general advertising allowed) exemption.

Mattermark is, I think, making a mission of indexing, tracking, rating startups, and anticipating when they will seek funding. In this case at least, the company is accessing the EDGAR database, open to anyone. The link the company supplies in the tweet takes you right to the EDGAR filing.

By the way, I wish more journalists would link to primary sources.

Outing startup financings

A key, legal rule for startups in the US seeking private financing changed in the fall: it is now okay to "generally solicit and generally advertise" that you are seeking funds.

The paradox of this rule is that it makes a lot of startup financing activity somewhat more private than it had been.

How's that?

The new rule set expressly preserved the old ban on "general advertising and general solicitation," while tacitly conceding that start up investors could self-police whether and how they met the accredited investor standard.

For those wishing to advertise their financing, the protocol of self policing accredited investor status was upended.

An immediate effect of the new rule set was that many startup founders took the measure of the price to be paid for generally soliciting, and re-committed to the old way of conducting financings. And, with all the attention to being paid to what constitutes "general solicitation and general advertising," this group of founders got quieter than they otherwise would've been: more careful not to discuss financing plans with reporters; screening pitch event opportunities more carefully; asking existing and prospective investors not to tweet about the deal.

Other founders launched boldly into the new world of private financing that is really public financing with a federal securities registration exemption. And a cottage industry of accredited investor verification shops is following to support them.

4477710440_c2dea67d2a_zAs the year begins, I'm noticing more and more "outing" of startup financings by third parties - companies, associations and individuals - possibly picking up the information slack caused by those choosing to go more conservative.

What happens if you are extra good about not advertising your offering, but somebody unknown to you tweets about it?

We can probably all agree that if the NSA knows about your Rule 506(b) (that's the version of the rule that continues to prohibit "general solicitation and general advertising"), you have not blown the exemption.

Similarly, when you file your Form D within 15 days of first sale, even though you're offering is ongoing, you haven't blown the exemption either. That's in spite of the fact that your filed Form D is easily accessed online by anyone.

But what duties might you have to shut down other channels of information, leaks of your financing plans?

Those wishing to "generally solicit or generally advertise" must take "reasonable steps" to verify the accredited status of their investors. If you opt for the other camp, the old rule where advertising is prohibited, will you end up having to swear your employees and investors to secrecy?

Photo: Thomas Hawk / Flickr.

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