In its recently proposed Regulation Crowdfunding (“Reg CF”), the Securities and Exchange Commission (“SEC”) released interesting statistics on the types of unregistered offerings that have been popular with smaller issuers over the past few years. Since the crowdfunding proposals won’t become effective till mid-summer at the earliest, companies interested in initiating offerings and going public in the next few months should take note.
Many startups begin by raising capital from family and friends to obtain seed shareholders for their going public transactions. Funds may be raised through donations, loans, or the sale of stock.
Traditionally, business owners have looked to banks for personal and commercial loans, business credit cards and lines of credit, but since the economic crisis of 2008, bank lending to startups has fallen sharply.
In 2012, fewer than one third of small businesses reported a business bank loan. While large business loans have been on the rise since 2010, small business loans continue to decline in 2013. The Small Business Association seems a logical place to turn, but currently it administers less than two percent of all small business loans.
Young companies may hope to attract venture capitalists or angel investors, but in most cases those hopes are unrealistic.
In the end, startups usually choose to launch offerings making use of exemptions from registration under the federal securities laws in their going public transactions. The shares sold in these exempt offerings are then registered with the SEC on Form S-1.
Two obvious possibilities are Regulation D and Regulation A. They are available to all OTC issuers both before and after going public transactions.
The SEC points out that Regulation A is “not widely used,” in part because issuers must file an offering document with the SEC that may be reviewed by staff who will request amendments, and because it provides no safe harbor from state securities regulations, which means that issuers may be required to register in every state in which they intend to offer and sell their securities. (A new coordinated review program proposed by the North American Securities Administrators Association should make the latter easier in the near future.). For now, many issuers find the Regulation A process as cumbersome as filing a registration statement with the SEC.
Given the SEC’s recognition that Regulation A offerings are unpopular, it is somewhat surprising that the Commission has designed requirements for issuers using Reg CF that closely resemble those for Reg A.
Regulation D is by far the preferred choice for companies seeking to sell equity in unregistered offerings. There are three types of offerings, each with its own restrictions and requirements. Regulation D provides the most commonly used securities exemptions.
Rule 504 permits the issuer to raise no more than $1 million within a 12 month period. A Form D must be filed with the SEC not later than 15 days after the first sale. The stock sold in Rule 504 offerings is restricted. Compliance with state blue sky laws is required.
Rule 505 permits the issuer to raise up to $5 million within a 12 month period. Participants may be any number of accredited investors and 35 non-accredited investors.
Rule 506(b) allows the issuer to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non-accredited investors. Filing a Form D is encouraged, but not required. Securities sold are exempt from state blue sky laws as “covered securities.”
Rule 506(c) is new, mandated by the JOBS Act. The benefits and requirements are the same as for Rule 506(b), with three differences: general solicitation and advertisement are allowed, only accredited investors may participate, and the filing of a Form D is mandatory.
The SEC notes that although Rule 504 is designed for companies wishing to raise less than $1 million, those companies rarely use it, preferring instead to use Rule 506. Rule 506 is more than ten times more popular than all exemptions from registration, as a table furnished by the SEC clearly illustrates.
What all this tells us is that at some point nearly all young companies will make use of Regulation D, and will probably choose a Rule 506 offering during the going public process. Given that between 2009 and 2012 only 16 companies chose to venture a Regulation A offering, it may be wondered how many will be interested in Regulation Crowdfunding, which, as designed by the SEC, will be very similar to Reg A.
Issuers interested in raising money for their small business should carefully consider the options available to them. It is important to remember that not all offerings are successful, so costs should be taken into account as well as the conditions of the offering. A qualified securities attorney can advise on the advantages and disadvantages of all types of exempt offerings.
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