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What the New Regulation A Rules Really Mean to Your Company
Introduction
This
is a discussion of the provisions of the new amendments to Regulation
A (so-called “Regulation A+”) recently announced by the SEC in Release No. 33-9741. These rules will take effect 60 days after
publication in the Federal Register.
This is not a guide on how to comply nor a legal summary of the Rule.
These will be covered later. This is a discussion of factors
important to company management and is based on our experiences with
small, fast growing companies looking for financing.
Of
Importance to Companies
We
believe the following factors are material to a company's decision to
use the new Rule:
Audited
Financial Statements
In
my experience, companies are primarily interested in two things when
considering raising money by selling stock. First, how long will it
take? The speed of business makes this important. If you can get
funds faster than your competition, you are that much ahead of the
game. The speed with which you can access new funds will in large
part dictate how fast you can grow. Second, what will it cost out of
pocket until we get the money?
If
you have not been getting audited financial statements as part of
your historical operations, then it will take time to get the audit
done. Accountants in my experience are almost always late. They can
run into unforeseen issues that are lurking in the company's books or
they can just be late. Once an accountant is engaged, you are stuck
with them for better or for worse. An unethical accountant can drag
out the work and keep hitting you up for more money knowing that if
you had to hire a new accountant, more time would be added to your
fund raising process. Fortunately these are rare.
With
Reg A+, if you want to raise a small amount of money, you have a
choice. You can offer without an audit and hope that investors who do
not know your company will trust you. Or you can wait and pay to get
the audit.
In
any event, if you go for the audit, you do not need a full PCAOB
audit. You may have an accountant who is familiar with your work and
can do a relatively fast audit. I would suggest you compare the cost
of a non-PCAOB audit with a PCAOB audit to see if you might prefer
the PCAOB audit which could be useful later on.
State
filing
State
filing has been one of the reasons the old Reg A was not much used.
If you wanted to do an offering in many states, your Blue Sky fees
were huge. Even in one state, the state regulator could hold you up
for what seemed like forever. You would almost inevitably be subject
to merit review rules which imposed severe if not impossible
limitations on new, speculative companies.
Many
years ago I had one state regulator tell me off the record that his
state would never approve a Reg A offering despite the fact that the
rules in that state would permit one. Presumably they intended to
delay approval with endless review until the issuer gave up.
Under
Tier 1, you can have one state designated as the lead state for
coordinated state review. However, you may still be stifled by
stringent merit review if you want to sell in a merit review state.
Merit review can be a very difficult hurdle for a small startup that
is incurring red ink because it is spending money to grow.
Under
Tier 2, you are exempt from state filing review. However, you have to
face the delay and expense of getting an audit.
Advertising
For
a new company that has exhausted investments from friends and family,
advertising is vital. The company has to either get an underwriter
who will do a small deal, and there are very few of those, or have an
effective promotional campaign.
These
campaigns cost money up front and are much more likely to succeed if
the company is in a hot industry.
If
the issuer is limited to using a tombstone ad, rather than a more
expansive presentation, sales will be hampered. While Tier 2 seems to
have no limits on the presentation itself, in Tier 1, most state
rules may limit advertising to a tombstone ad.
The
test the waters feature may be useful in seeing if an offering is
viable without committing to the whole cost. However, a huge
marketing effort is often needed to place stock in a new company that
is unknown and has a limited history, the type of company we might
think of as a crowdfunding company. Be aware that a limited amount
spent on testing the waters is not likely to be anywhere near the
amount needed to show a response large enough to create much
confidence in the marketability of the issue.
As
the SEC reports, approximately 12.4 million U.S. households are
qualified as accredited investors, based on either the income
standard or the net worth standard. Most of these investors have not
invested in the types of deals contemplated under the new Regulation
A.
Speed
of Processing
The
SEC was kind enough to provide a very enlightening discussion of the
existing ways to raise up to $50 million.
One
of the most exceptional revelations is that the average offering
under the old Reg A took 300 days to qualify with the SEC. We doubt
that many companies would use any avenue to raise money if they knew
it would take 300 days just to start selling, after the delay
involved in preparing the filing.
If
we optimistically allow three months to prepare the filing, and three
months to place the deal, we are suddenly up to 480 days elapsed,
over a year, between the decision to make the offering and having the
money in the bank. For a fast growing company, this is impractical.
The SEC statistics revealed that Reg D, Rule 506 was much more
popular than Reg A.
If
it takes 300 days to qualify, you would have been much better off
filing a full S-1. In
calendar years 2012 to 2014, only 26 Regulation A offerings,
excluding amendments, were qualified by the SEC. Compare this to the
11,228 Regulation D offerings in 2014 that would have been
potentially eligible to be conducted under amended Regulation A. Of
those, 10,671 offerings relied on Rule 506, 376 on Rule 504, and 181
on Rule 505.
Consider
the time to completion for a Reg D, Rule 506 offering. Using the same
three months to prepare the offering and the same three months to
sell, gives us less than half the time of an old Reg A offering,
assuming only accredited investors subscribe so there is no state
Blue Sky review.
If
the time to qualify with the SEC does not accelerate, you will see
more companies opting for private placements, including Rule 506c
which allows advertising to accredited investors. After a successful
506 offering, the company can then go public at its leisure.
Resales
by Affiliates
One
of the sensible provisions of some state securities laws is to limit
fast resales of insiders by various rules, including escrow of
insider stock. This forces the insiders to develop the company in
order to see capital gains.
If
anything, Reg A+, which allows 30% of the stock sold to be sales by
existing holders could give the insiders a chance to dump. Under
the new rule, affiliate resales are permitted even if the issuer has
no net income from continuing operations. As we know, many successful
startup companies, companies that have been acquired at huge prices,
have never had net income.
Allowing
insiders to sell is very beneficial if the insiders have been making
a large financial sacrifice to build their company, as is quite
common. For example, the founders may be of an age where they want to
send their children to college. This allows the key executives to get
back into decent financial condition. However, investors may be less
enthusiastic about an offering if they see large sales by insiders in
the offering.
Secondary
Market
Secondary
trading is important to those who want to sell their investment, be
they investors or insiders.
The
Reg A company can trade on OTC Markets Pink Sheets, giving it limited
visibility and costing $4,200 per year with a $500 setup fee.
To
move up on OTCMarkets to OTCQB status, the company would have to pay
to OTCMarkets $2,500 application fee and $10,000 per year.
These
are not very attractive options. Pink Sheet stocks are shunned by
serious investors and costs are important to small companies.
The
SEC believes that “Tier 1 offerings will be conducted by issuers
that are unlikely to seek the creation of a secondary trading market
in their securities.” Thus, the
new Reg A may be used by companies that do not want a secondary
market, but are seeking simply to take in money in lieu of classic
venture capital investment. These companies may have failed to get
venture capital, or they may not be willing to accept the terms
offered by venture capitalists.
The
SEC's final rules for Regulation A amend Exchange Act Rule 15c2-11(a)
so that an issuer’s ongoing reports filed under Tier 2 will satisfy
the specified information about an issuer and its security that a
market maker must review before publishing a quotation for a security
(or submitting a quotation for publication) in a quotation medium.
There
are advantages in forgoing venture capital money and instead seeking
private investors. Venture capitalists may drive a harder bargain
than private investors. The company insiders will not have to give up
a large degree of control. The company can advertise widely in a Tier
2 deal.
However,
all investors look to have an exit strategy which a company will have
to provide with an immediate secondary market, registration rights,
or some other method.
Rule
144
It
would be impossible to overestimate the importance to small, growing
companies\ of Rule 144, which allows the resale by investors of
securities purchased outside of a public offering. Having such an
exit strategy encourages investors to write checks.
Under
the new rule, Tier 2 ongoing reports do not satisfy the current
information requirements of Rule 144 for the entirety of an issuer’s
year. The SEC did not believe that the frequency of the required Tier
2 ongoing reporting merits a broad determination that such reports
will constitute “adequate public information” or “reasonably
current information” on a year-round basis. Only
quarterly reporting can do this.
Semiannual
reporting is required under the final rules for Tier 2 offerings.
This will result in issuers only having “reasonably current
information” and “adequate current public information” for the
portions of the year during which the financial statements of such
issuers continue to satisfy the respective rules. The company may
voluntarily submit on Form 1-U quarterly financial statements or
other information necessary to satisfy Rule 144.
Issuers
wishing to register a class of Regulation A securities under the
Exchange Act may do so by filing a Form 8-A in conjunction with the
qualification of a Form 1-A. Only issuers that follow Part I of Form
S-1 or the Form S-11 disclosure model in the offering circular will
be permitted to use Form 8-A.
Application
to a Developing Company
Some
believe the new Rule is a great boon to companies needed
crowdfunding. We assume that a company like this is one with a hot
new technology, one that might grow rapidly with proper funding.
Typically such companies are making losses to get developed. The
founders are often taking limited salaries and have invested most of
their own capital. The company is seeking outside investors because
it has exhausted friends and family. The company may or may not have
angel money. It may not have successfully gotten venture capital or
it may find that VC terms are too rich or the founders may not want
to give up control. Often the company does not have large cash
reserves. Being publicly traded will help the company attract money
as it will allow investors to have an exit strategy.
Let
us look at how the new Reg A might impact such a company. In terms of
time, if the offering is processed rapidly, the new rule may help. In
terms of time and money the company has a key decision to make in
getting an audit or not. Personally, I believe that an audit will
increase the marketability of the deal because it will increase
investor confidence. Further, a company without an audit can only
trade in the Pink Sheets. Pink Sheet stocks are shunned by many
investors. However, the company must be careful in its selection of
an auditor as time and money can be lost here.
As
always with small companies, a huge marketing effort is needed to
overcome the fact that the company is unknown and overcome the
prejudice against small companies. The new Rule may be of some help
here if the company is Tier 2, another reason to go for an audit.
Summary
Small
issuers have to look to the time and expense of getting an audit and
weigh that against the costs and limits of state rules in Tier 1. The
issues presented are time, up front expense, restrictions on
advertising, and merit review. As an audit will create more trust,
it may be desirable for marketing reasons. The audit will move the
company into Tier 2 which may allow the company more options for
advertising. In Tier 2, the company may also escape state merit
review. The company should also look to how it wants to approach
having a secondary market for its securities.
Overall,
any rule which increases the options of small, growing companies is a
good rule. Much will depend on how it is implemented and the speed of
processing filings.
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