On December 4, 2015 President Obama signed into law the FAST Act, which is mainly about transportation funding. Included within the FAST Act is a section, the Reforming Access for Investments in Startup Enterprises (“RAISE”) Act, which codifies a previously unwritten means through which startup employees, ex-employees, early investors, and other shareholders have been legally allowed to sell their shares.
The passing of the RAISE Act is a major step towards the development of orderly and deep secondary markets for private shares, as it will create more transparency around the process and its legality, and it will lend legitimacy to these markets. How this develops will impact all stakeholders—sellers of the shares, investors, the companies who issue the securities being bought and sold, and the service providers (full disclosure, I am a co-founder of EquityZen, a platform that conducts secondary transactions in pre-IPO shares).
Background
A quick—I promise—background on the securities laws and how they apply to sales of startup shares by employees, ex-employees, and early investors. Generally, the securities laws require registration of securities to be offered or sold, unless an exemption applies. The sale of startup shares by an employee, to, say, pay off school debt, is a sale of securities that must comply with the securities laws. The relevant exemption here is what is colloquially known among securities lawyers (admittedly, I am one of them) as the “4(a)(1-½)” exemption, which applies to resales of privately held shares.
Developed through interpretive guidance from the Securities and Exchange Commission (“SEC”) and from case law, the “4(a)(1-½)” exemption provides that a resale of privately held shares is exempt from registration requirements if the resale is to a limited number of purchasers and completed without public advertising or general solicitation, the seller provides the purchaser with certain information regarding the issuer (the company whose stock is being sold), although the seller may be limited in what she can provide, the purchaser is sufficiently sophisticated to evaluate the risks of investment and to bear economic loss resulting from the investment, and the purchaser is acquiring the shares for investment and not for resale.
RAISE Act
The RAISE Act codifies the “4(a)(1-½)” exemption by writing it into the securities laws as an explicit exemption. In order for a resale of private shares to qualify for the RAISE Act exemption, among other things the purchaser is an Accredited Investor, there is no general advertising or general solicitation of the transaction, and the seller is not a “bad actor” as specified in SEC rules.
Additionally, the new RAISE Act exemption would require that the purchaser is provided with certain information, including basic information about the issuer, the securities being sold, as well as the issuer’s balance sheet and similar financial statements for the last two years (in accordance with GAAP).
Additionally, if the seller is a control person with respect to the issuer (I note that “control person” is not defined but one can think of this as senior management, a director, or material shareholder), the affiliation must be disclosed (to address possible conflicts of interest).
Analysis
As one can see, the RAISE Act exemption generally corresponds with what the “4(a)(1-½)” exemption has required. Notably, there is not a limit on offers or the number of purchasers, a signal of legislative intent to foster the development of robust private secondary markets.
The RAISE Act also specifies disclosure requirements for these transactions. This is a welcome step towards standardization and transparency in admittedly bespoke and opaque markets.
However, it should be acknowledged that the disclosure requirements are not easy asks of the companies. A founding principle of EquityZen is that the company whose shares are being sold is a key stakeholder in the process, whose interests should be accounted for. A balance needs to be struck between a private issuer’s interest in guarding sensitive information and the investor’s interest in having sufficient information to make an investment decision.
It’s important to note that the new RAISE Act exemption is an explicit safe harbor from registration, but it is not the exclusive means for establishing an exemption from the registration requirements of the securities laws.
If the disclosure requirements prove too cumbersome for issuers, alternative means of exemption can be sought. Further, in order for this exemption to see adoption by the markets, it will be crucial to clear up whether and to what extent the issuer bears any liability for the required disclosures. Liability of issuers for material misstatements or material omissions in the required disclosure would have a chilling effect on adoption and would undermine the purpose of this legislation.
Outside of large institutional transactions ($5 million and up), issuers generally prefer to be at “arms-length” for secondary transactions between shareholders and third party purchasers. Liability for disclosure would move the needle from “arms-length” to retrenchment. At a minimum, the scope of the risk should be made clear, and ideally, if these markets are to mature, the scope of liability would be limited in some sensible fashion. After all, the purchasers under this exemption are folks deemed to be sophisticated by the SEC, needing less investor protection than the average Jane.
The uncertainties highlighted above are among the various ambiguities in the legislation. It’s possible that the SEC may seek to clarify and implement Congress’s law through its own rulemaking, which would shed light on some of the unknowns.
The rulemaking process will also offer up an opportunity for interested parties to comment and help refine how the exemption is carried out in practice.
The RAISE Act is a step in the right direction for the evolution of secondary markets. However, the SEC should clear up ambiguities and ensure that all stakeholders are taken into account in providing guidance on its implementation.