The securities regulatory regime in the United States is one based on the principle of disclosure, disclosure, and more disclosure; only those who can fend for themselves may invest without the benefits of statutorily prescribed disclosure. Therefore in the United States, there are only three ways to offer and sell securities from a federal perspective:
(1) through the registration of such securities through a disclosure heavy S-1 or equivalent form (what is generally referred to as an “IPO” or a public market offering),
(2) through an exemption to that registration by following various rules or safe-harbors (“private market transactions” such as Reg A/A+, Reg. D, Reg. S, and Reg. CF) or
(3) in violation of federal law.
The legitimate private markets utilizing these exemptions from registration have grown significantly in recent years and are now more than double the size of the public markets: in 2018, issuers raised roughly $2.9 trillion of capital through exempt offerings, compared to only $1.4 trillion through public offerings.
This has been a clear trend for many years and the Securities and Exchange Commission (SEC) has taken notice.
In June, the SEC released a 200+ page concept release (the Harmonization Concept Release) providing a comprehensive overview of private markets. Never before has the SEC made such an open and far-reaching request for thought leadership with respect to exempt/unregistered security offerings. Yet only 31 comment letters have been provided with the September 24th, 2019 deadline approaching. (In the interest of full disclosure, one of these letters was submitted by the Associating of Online Investing Platforms (the AOIP), an organization Republic is a founding member of).
Disclosure, Disclosure and More Disclosure
The SEC used the Harmonization Concept Release as a method to review all existing methods for selling, and many of the methods for re-selling, securities privately (i.e., not sold through an IPO or equivalent). Specifically, the SEC is seeking comments on ways to make it easier for issuers of securities (especially smaller issuers) to raise capital in the private markets.
As the operator of the Republic crowdfunding portal since Reg CF’s inception, Republic is acutely aware of certain rules promulgated by the SEC which have reduced regulation crowdfunding’s efficacy at achieving the goals of allowing startups and small businesses to accept investments from the “crowd and expanding opportunities for the crowd to participate in these opportunities.”.
A bit of background, changes to the securities laws over the years have made it significantly easier for companies to remain private longer and raise capital through the private markets, however, the various rules and exemptions companies can utilize the raise capital through these private markets are misaligned and can cause a great deal of confusion.
Reg D 506c, Reg A+ and Reg CF
Traditionally, crowdfunding was a method of capital formation either done without offering a security (see Kickstarter), which made participants have no stake in the offering company or done solely intrastate (for example, NextSeed’s Texas intra-state portal). The National Securities Markets Improvement Act of 1996 made it more attractive for companies to issue private securities under Rule 506 by preempting state securities registration requirements and the the Jumpstart Our Business Startups Act of 2012 (JOBS Act) created additional new exempt offerings that preempted state securities laws that allows issuers to use general solicitation to raise privately as long as they only accept accredited investors (Rule 506(c)) and created a new exempt offering for “crowdfunding” offerings (Reg. CF) as well as expanded Reg A+.
All three of these general solicitation registration exemptions are forms of crowdfunding. The following are three observations of issues this current regime has left in place that particularly stymie regulation crowdfunding (Reg. CF) as it related to Reg A+ and Rule 506(c).
Offering Limits
Reg. CF suffers from an arbitrary offering cap.
Specifically the $1,070,000 cap on the amount an issuer may raise under this exemption in any 12-month period severely limits regulation crowdfunding’s value by
(i) denying issuers the ability to raise sufficient capital under one offering exemption,
(ii) blocking interested participants from investing due an oversubscribed offering’s limitations and
(iii) dissuading companies from utilizing the exemption due to point (i).
In the past three years the average seed round for a startup has ballooned to over $2,500,000, while the Republic funding portal (and other portals) have hosted numerous offerings that have hit the statutory funding cap with excess demand from other retail investors, many of these issuers had to spend additional time and expense soliciting investments through 506(c) or Regulation S (after or in conjunction with their regulation crowdfunding offering) to fill their necessary funding goals, as regulation crowdfunding was an incomplete offering method.
As the SEC found in the Regulation Crowdfunding’s three-year lookback report:
“ . . .many issuers choose not to rely on the crowdfunding exemption because the limit is too low. . . some issuers choose to raise funds needed in excess of the offering limit through a separate offering, which they consider to be a less optimal experience for investors and a more costly and potentially riskier approach for issuers. . . ”
Further, the SEC found that the majority of issuers who utilized Regulation Crowdfunding undertook a Regulation D exempt offering before, during and after their offerings, adding cost and additional regulatory burdens for the issuer.
The SEC found in the lookback report:
“ . . .many issuers choose not to rely on the crowdfunding exemption because the limit is too low. . . some issuers choose to raise funds needed in excess of the offering limit through a separate offering, which they consider to be a less optimal experience for investors and a more costly and potentially riskier approach for issuers. . . ”
These follow on and concurrent offerings were not “open” to the public, nor did they benefit from the same levels of disclosure as a Regulation Crowdfunding offering. Additionally, therefore the SEC should consider, and commenters should advocate for, raising the offering cap.
Investment Limits
Under Rule 506 (both (b) and (c)), participants can invest an unlimited amount, just like they can in the public markets. If participants are accredited, there are no requirements for any disclosure to be made to them.
However, under Reg CF, these same investors are severely limited in how much these accredited investors can invest into issuers who are making robust disclosure filings under Reg CF.
The SEC should consider removing these limits as there is no practical purpose to them. Accredited investors who wish to invest in an issuer that are limited by Reg CF’s investment limits will do so under Rule 506(c), only adding cost and complexity to the capital formation process.
The SEC should also look to the language of 4(a)(6) of the Securities Act to determine whether the rulemaking process incorrectly broadened the investment limits rules as authorized by Congress.
Testing the Waters
The SEC asked:
“In light of the fact that some exemptions impose limited or no restrictions at the time of the offer, should we revise our exemptions across the board to focus consistently on investor protections at the time of sale rather than at the time of offer? If our exemptions focused on investor protections at the time of sale rather than at the time of offer, should offers be deregulated altogether? . . .”
While traditionally, the offer and sale are considered to happen in tandem, they can be properly divided into distinct activities.
For example, under Reg A+ issuers may test the waters for interest in an offering—without restriction as to the types of investors solicited—before filing an offering statement (Form 1-A). Presumably, the SEC believed that issuers could be trusted to not complete any sale before the offering was qualified, the same situation can be used in extended to Regulation Crowdfunding to help early-stage companies determine whether to extend the expenses of preparing for a compliant, public, securities offering.
The SEC found, in its three-year lookback review of Reg CF, that the average offering costs $22,479 to conduct before paying commissions to portals and escrow agents, while average human capital expended in preparing and conducting the offering exceeded 241 hours.
Given the high cost of capital, both in dollars and hours, an issuer who cannot satisfy their capital needs through such offering, may find doing so unattractive when they could spend the same money traveling to meet friends, family, and institutional investors to secure greater capital at a reduced opportunity cost.
As Regulation Crowdfunding offerings cannot be conducted anywhere except for a properly registered and regulating funding portal (or broker-dealer acting as a funding portal) investors will face no risk as the sale of the securities cannot take place until a valid Form C is filed with the SEC, a funding portal publishes the offering, and the offering remains open for 21 days while meeting its target offering amount.
These onerous requirements will prevent any improper sale of securities until all of the requirements are met, with the oversight of a licensed intermediary, something not required to be used during a Reg A+.
These are but a few of the items commenters can address when writing to the commission. There are many more suggestions that could improve Reg. S, Rule 701 and other offering types and we hope other industry participants focusing on these areas address them appropriately.
Comments on the SEC Concept Release Regarding Regulatory Harmonization are available here. You may also submit your own comments here.
Maxwell R. Rich is the Deputy General Counsel of Republic, a full-stack investment platform operating a regulation crowdfunding portal (where he holds the Chief Compliance Officer role), a broker-dealer, an exempt investment adviser and advisory & technology services businesses. Republic was founded in 2016 to democratize investing, focusing on underserved founders, emerging technologies such as blockchain and legal innovation.