133 posts categorized "JOBS Act"

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.

SEC official to angel community: go ahead, develop your own verification methods!

Keith Higgins, the relatively new Director of the Division of Corporation Finance, delivered a speech at the closing session of the 2014 Angel Capital Association Summit - and was it a doozy!

A huge issue for angel investors is the "reasonable steps to verify" accredited status that is part of new Rule 506(c), which permits issuers to engage in "general solicitation." The issue was a focus of at least two breakout sessions at the Summit, including one Thursday moderated by ACA policy chair Mike Eckert that I participated in with the gifted lawyers Peter Rosenblum and Rob Rosenblum (not related), and an excellent breakfast briefing Friday from K&L Gates lawyers Gary Kocher and Kevin Gruben.

1842308438_83cb923365_oThe reason for such attention is the anxiety caused by the non-exclusive verification "safe harbors" set out in Rule 506(c). These verification methods contemplate that, going forward, an issuer is going to have to demand personal financial information from investors, or engage third party verification services to do so. To many readers of the new rule, including a majority of securities lawyers, the safe harbors - in spite of the "non-exclusive" label - feel destined to prove de facto requirement.

But Higgins said that needn't be the case.

In his speech (the full text of which you can access on the SEC's website), Higgins emphasized that if any verification standard might be core under Rule 506(c), it is the flexible, "principles-based" approach laid out in the inital release proposing the new rule:

"These [applications of the principles-based method] are all part of a deliberate effort by the Commission to provide issuers with an alternative to the clear but highly prescriptive list of verification methods included in the rule. In fact, it is ironic that this list of verification methods is being viewed by some as the primary way to verify a purchaser’s accredited investor status when, in fact, the Commission originally proposed the principles-based approach as the way issuers would comply with the rule’s verification requirement and added the list of specific verification methods only in response to address the concerns of commenters who wanted more certainty."

As Gary Kocher explained plainly in his breakfast briefing earlier in the day, lawyers are a conservative bunch, and naturally are going to navigate to the safe harbors. But, Gary stated he believed that the staff meant what they said in the rule and in the release, that the principles-based approach was viable. I think Higgins' speech completely validates Gary's view.

All of this portends well for verification methods based on the Angel Capital Association's Established Angel Group guidance, which would not require the turning over of sensitive financial information to issuers or their vendors.

As for seeking express SEC staff blessing of particular applications of the principles-based method of verification? Higgins seemed to say that was both not likely to be forthcoming anytime soon, and also beside the point:

"On that note, we have had recent inquiries asking whether the staff would provide guidance – presumably on a case-by-case basis – confirming that a specified principles-based verification method constitutes 'reasonable steps' for purposes of the rule’s requirement.  The notion of the staff reviewing and approving specific verification methods seems somewhat contrary to the very purpose of a principles-based rule and I am not yet convinced of the need for this type of staff involvement. Rather, this is an area where issuers and other market participants have the flexibility to think about innovative approaches for complying with the verification requirement of the rule and use the methods that best suit their needs. While the staff may not be in a position at this point to provide guidance on what constitutes 'reasonable steps' under particular circumstances, I also believe the staff will not be quick to second guess decisions that issuers and their advisers make in good faith that appear to be reasonable under the circumstances."

I should note that the angels I spoke to at the Summit, and the questions they posed in the breakout sessions, were more precisely focused on the definition of general solicitation and the activities at pitch events and the like that might push a company from 506(b) territory into 506(c) territory. But let's step back a second and look at the problem from just a story or two higher: to the extent that verification under 506(c) becomes more manageable, then the general solicitation issue becomes somewhat less of an existential distinction. (There may yet be reasons to avoid publicly soliciting investors - but that is another topic.)

Success for principles-based verification approaches will not be self-executing. Angels and their entrepreneurs will have to insist on them, and will have to make sure they have enough rigor to acquire respect. In the right circumstances, lawyers for a given deal might, just might, go along.

Drawing: "Principles Mound" by Paul Downey / Flickr.

What exactly is crowdfunding?

This morning I took part in a panel at the Thompson Reuters 2014 Online Financial Services Symposium.

Moderated by Suzanne Barlyn of Thomson Reuters, the topic was "disruptive alternatives," including crowdfunding and peer-to-peer lending.

Bjkz7mTIQAEPKAkThe audience is made up of financial services professionals who manage online trading and other retail financial services on a massive scale. As I blog this, a panel is getting into the nitty-gritty of trade execution. A later panel will talk about user interface design and new ways to engage both self-directed and managed investors (and how the categories are blurring).

So I hope that lends context. The panel I took part in was to discuss new classes of investing that might be around the bend for the mainstream online financial services industry.

6a01156e3d83cb970c01a3fcde8425970b-580wiSomething big that I learned in the course of the morning is that peer-to-peer lending is something not far off into the future, like Title III non-accredited crowdfunding, but a phenomenon already here and even embraced by policy makers at the Federal Reserve. Ron Suber (pictured) of Prosper, a San Francisco based marketplace matching consumer borrowers with lenders, captured everyone's imagination with his vision of disintermediating banks in the consumer credit space. He calls it an investable asset class, and emphasized the pains taken to qualify would-be borrowers (eighty percent of applicants are turned down, he said).

Closer to the world with which I am more familiar - equity financing provided by accredited investors to startups - Michael Raneri of Venovate, another San Francisco-based company, described a sweet spot for online activity that is post-seed stage (later than AngelList or FundersClub), but still very much emerging growth. His company is part broker, part part portal, part VC fund (or maybe fully all three). He does not appear to like the term "crowdfunding," however, for the connotations it brings of Title III.

BjlGgPNIUAAnRkwTim Baker, Global Head of Content Strategy at Thomson Reuters, reminded all that angel and venture financing is relatively small - only about $25 billion a year. He cited historical precedents which suggest to him that, if crowdfunding on the equity side is going to take off, it will take 5 years or so to catch on.

If Tim is right, I imagine that, in that span of time, people will get comfortable with the idea that some kind of clearinghouse will standardize accreditation. When that happens, the 506(b)/506(c) distinction - so very existentially critical in this moment of transition - won't be as big a deal. 

So debt crowdfunding at a retail level is here already. And accredited crowdfunding (Tito Singh of Thomson Reuters terms it "elite crowdfunding") is finding its footings and will likely impact angel investing as we know it. What about equity crowdfunding for everyone?

I know there are people in the nascent non-accredited crowdfunding industry, who see non-accredited crowdfunding of startups as a asset class. That is a mistake. In fact, part of why I like the state crowdfunding alternatives (alternatives to JOBS Act Title III) is that they seem to take more of the approach that people want to back small companies for reasons that are as compelling or more compelling than the prospect of financial return.

Picture credits: first two, Lauren Young of Thomson Reuters (from her tweet stream); third is picture I took from the dais of Suzanne Barlyn before she took the podium.

The costs of Title III crowdfunding

Kiran Lingam has a deflating post up at the SeedInvest blog this morning.

Kiran and his firm are modeling what costs look like, for pursuing an offering claiming an exemption under the JOBS Act Title III investment crowdfunding rules (caution: these rules are not in effect; they have just been proposed, and I presume Kiran's model is based on the proposed rules).

197742056_c761e25f10_zIt's not pretty.

"A successful $99,999 crowdfunding raise with no audited financials," Kiran writes, "will result in negative CASH FLOW to the company of about $38,000."

So that suggests the sweet spot for Title III fundraising will have to be higher, right? But little comfort there, Kiran says. "A successful $1M raise will actually only net $750,000 in capital, he writes. "This is an astronomical cost of capital."

My suggestion to investment crowdfunding advocates: turn attention away from the prospective federal exemption, and toward analysis of those state crowdfunding exemptions already on the books. Would, say, Wisconsin's investment crowdfunding exemption impose fewer costs?

Thanks to Joe Wallin for the heads up on Kiran's post.

Photo: Mark Jones / Flickr.

Ruth Simon and Angus Loten WSJ articles this week about use of 506(c)

Ruth Simon and Angus Loten of the WSJ have a couple of really interesting articles this week, by way of tracking just how people are using the new accredited crowdfunding rule:

5917135851_7ce6399d13_zBy "accredited crowdfunding rule," I mean of course Rule 506(c), the new rule that lets issuers engage in general solicitation and general advertising, as long as all purchasers are accredited, the issuer takes reasonable steps to ensure each purchaser is accredited, and the issuer otherwise satisfies the applicable requirements of Reg D.

This is a BIG regulatory change. Recall how everyone always used to say, don't talk to reporters about your offering! Don't tweet it, don't blog about it! That's the old rule, which remains in place, renumbered now as Rule 506(b).

Well, the upshot of the Simon/Loten WSJ pieces, is, arguably, the maxims that follow from the old rule are still, as a practical matter, still in place. Don't talk to reporters about your offering! Don't tweet it, don't blog about it!

That's because the conditions of the new rule are not trivial. And also because of uncertainty about proposed rules that would make compliance with 506(c) even harder.

The Simon/Loten articles do, however, speak to examples of folks who are using 506(c). And he pieces relay some WSJ data/analysis on how much money has been raised under 506(c) so far.

"Among companies that have filed with the SEC, those that disclosed their fundraising goals say they intend to raise more than $25 billion, according to The Wall Street Journal's analysis. Since the new measure was implemented, firms that claimed the exemption and have since netted their first investor have raised a total of $1 billion, the analysis shows."

Thanks to Catherine Mott for pointing me to the Simon/Loten articles.

Image: Poster Boy / Flickr.

Early data on use of 506(c) (accredited crowdfunding)

Recent remarks by Keith Higgins, newly appointed Director of the SEC's Division of Corporate Finance, give us some early data on how issuers are making use of new Rule 506(c).

You'll recall that 506(c) is the rule that implements the lifting of the ban on general solicitation in offerings that otherwise meet the applicable Reg D requirements, and also limit purchasers to accredited investors who are subjected to a heightened verification standard. "Implements" refers to the Congressional mandate to do so, under the JOBS Act. (It's interesting to me that Higgins at least once in his written remarks refers to the Congressional mandate as "requiring the Commission to modify the prohibition against general solicitation," emphasis added.)


In a footnote to his written remarks, footnote 18 on page 10, Higgins relays the following information from the SEC's Division of Economic Risk Analysis (DERA):

"Based on the information reported in the initial Form D filings reviewed by DERA, as of October 18, 2013, there have been 170 new offerings made in reliance on the new Rule 506 exemption that became effective on September 23, 2013, with approximately $911 million in total amount sold in these offerings. In addition, 44 offerings that commenced in 2013, but before the effective date of the new Rule 506 exemption, were subsequently converted to offerings relying on the new exemption. Since the new rules became effective, the average offering size for Rule 506(c) offerings was $6.1 million, as compared to $22.8 million for Rule 506(b) offerings; the median offering size for Rule 506(c) offerings was $1.3 million, as compared to $1.8 million for Rule 506(b) offerings.

What does this suggest? Well, that issuers (be they startups or hedgefunds, we can't really tell from this data) are using 506(c); and that generally solicited offerings may be targeting smaller amounts than traditional 506 deals.

You may be thinking, the modest number of filings - some 200 - seems too small. After all, weren't thousands of startups going "public" with their "private" offerings on AngelList within hours of 506(c) becoming effective on September 23?

Ah, but recall that the filing deadline is 15 days from first sale. So there should be a healthy lag, at least as long as the current filing requirements remain in place (recall that proposed rules are out, imposing pre-filing requirements for 506(c) deals and lots of other not-so-fun changes for both 506(c) and 506(b)).

Thanks to articles by Broc Romanek and Sarah Lynch for identifying Higgins' testimony.

Working Summary of the Proposed Crowdfunding Rules by Kevin Laws

So here is an early holiday present: AngelList COO Kevin Laws's working, in-process summary of the Title III crowdfunding rules proposed yesterday by the SEC.

Capture113Keep in mind that these rules were first posted some 24 hours ago. Kevin is the last person to think the summary he prepared yesterday will prove definitive. But I personally think his effort is amazing, condensing things at just the right level.

Rather than cut and past Kevin's working summary into the body of this post, the link above is to a Google doc that Kevin is updating as he receives feedback.

Kevin's summary will prove hugely useful to crowdfunding advocates, players in the nascent non-accredited crowdfunding industry, and others just interested in the startup financing ecosystem and trying to figure out how viable this new alternative may prove to be.

Please do also feel free to add comments in the comment thread to this post.

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