Editor’s note: Rory Eakin is the co-founder and COO of CircleUp.
We’re approaching the third anniversary of the Jumpstart Our Business Startups (JOBS) Act, an omnibus bill of far-reaching financial reforms that was signed into law by President Barack Obama on April 5, 2012. Containing seven titles, the legislation’s intent was, and is, to create cost-effective access to capital for companies of all sizes.
Title II and Title III, the Access to Capital for Job Creators and Crowdfunding Acts respectively, focused on early-stage companies, aiming to make the startup financing process more accessible and efficient.
Title II did so by creating a new securities exemption, Rule 506(c) of Regulation D, that allows for companies to publicly advertise their investment offerings, maintaining, however, that only accredited investors — high-net-worth individuals — can invest in such offerings. Some have called this “accredited crowdfunding.”
Title III was far more ambitious. It proposed to create and regulate an entirely new funding ecosystem that would allow anyone — not just accredited investors — to buy shares in private companies. In effect, creating a public market for privately held companies.
And, lest we forget, Title IV, the Small Company Capital Formation Act. The SEC released final rules on Title IV this past week to the surprise of many. Title IV updates Regulation A, an exemption that’s rarely been used in the past, in hopes of reducing compliance costs and making it more viable for entrepreneurs to use. In fewer than 90 days, these rules will be written into law.
While Title II, III and IV are similar in intent, their respective outcomes could not be more different. More than two years after a congressionally mandated deadline, Title III rules have yet to be written in law. And much uncertainty remains around just how viable Title IV will be. Meanwhile, Title II is alive and well. Some would even say thriving: The SEC wrote Title II rules into law in September 2013, making Rule 506(c) available, which has since been used by thousands of entrepreneurs to raise capital.
Title III is a beast of a proposal. It doesn’t just aim to bolt on a new provision or two to existing securities regulation as is the case with Title II; it aims to build out entirely new capital markets infrastructure.
Proposed rules create a new kind of financial intermediary, called “funding portals,” that aren’t subjected to the same requirements as FINRA-regulated broker-dealers, and include a vast web of provisions intended to protect retail investors who, for the first time in recent history, would be given the opportunity to invest in private companies. The new provisions include heightened levels of disclosure from companies, as well as income/net-worth caps on the maximum amount retail investors are permitted to invest.
So where does Title III stand? The SEC released proposed rules (all 585 pages) in October 2013. In December 2014 it publicly set a goal to promulgate final rules by October 2015. Assuming the SEC meets its goal, and accounting for the 60 days it will take for the rules to be written into the federal register and become law, it appears early 2016 is when crowdfunding will finally come to fruition.
But here’s the issue: Even when Title III crowdfunding is finally realized, it won’t work. In fact, I believe it will fail quite spectacularly. The problem? As the rules are currently written, the hoops that companies will have to jump through will be far too burdensome. In spirit, these regulations are intended to protect retail investors; in effect, they will make capital-raising more time-consuming and more expensive for entrepreneurs. In many instances, significantly so.
While there may be edge cases — where the benefit of having a large, distributed cap table outweighs the additional regulatory burdens and costs (film investments perhaps) — in my view, Title III will rarely be used.
Simply put, if Title III is more expensive and time consuming than alternative paths to funding, promising entrepreneurs will, and should, avoid it, except as an option of last resort. I would never recommend a friend crowdfund if it would take longer, cost more and require more paperwork than alternative sources of funding. This will create adverse selection, where the most promising companies avoid crowdfunding. The irony here: heightened regulations intended to protect retail investors may only hurt them.
This isn’t to say the issue isn’t important. It is. There is no way around it: our private capital markets are incredibly inefficient, exclusive and insular. Only the wealthiest have access to private equity, which is growing in importance as more and more value creation is realized in the private markets by companies electing to stay private longer.
What’s alarming is that, today, the 97 percent of Americans who are not accredited cannot get exposure to our nation’s most innovative companies until much of their value creation has already been realized by private investors. Facebook went public at $100+ billion. Contrast this with Apple or Microsoft, which IPOed in 1980 and 1986 respectively, each valued at less than $500 million. Retail investors had ample upside, and massive amounts of public wealth has since been created. For Main Street investors today, how much upside is there?
Where will this end up? No one knows for sure. But there are many thoughtful folks in the SEC and in Congress who are working through the challenges of implementing the current law, or perhaps revisiting it altogether. As an active participant in the market, I think the best course is a new law – a JOBS Act 2.0 – that addresses these challenges, especially in light of the experiences and learnings we’ve had with online private placements through Title II.
Title IV: ‘Reg A+’
To the surprise of many, the SEC released final rules under Title IV this past week. These rules, commonly referred to as Regulation A+, or Reg A+, amend Regulation A, and do allow for non-accredited investors to participate in private offerings. Subject to a number of provisions, of course.
The new Reg A+ rules create two tiers of offerings: Tier 1 allows issuers to raise up to $20 million in a 12-month period; Tier II, up to $50 million. You can think of it as a ‘micro-IPO’ of sorts.
Some believe these new rules have the potential to realize the original vision of Title III — creating a market for private offerings that both accredited and non-accredited investors can, on the same footing, participate in. With Reg A+, Title III may be obsolete, some speculate.
Having worked with hundreds of entrepreneurs on their fundraise, and being acutely aware of how even the smallest additional friction affects the fundraising process, I have my reservations.
In both Tier 1 and Tier 2 offerings issuers must submit, and have approved, an “offering circular” to the SEC. The SEC did include a provision that allows issuers to ‘test the waters’ — allowing them to validate investor demand prior to preparing a full-blown offering circular — but no matter how you cut it this process will be more expensive and time consuming than filing a Form D, which is the only requirement in Regulation D offerings.
Moreover, Tier I offerings (up to $20 million) are not exempt from blue sky filings, which require issuers to file documentation with each state it plans to raise capital in. So, if Company A raises capital from investors in California, New York and Illinois, it will be on the hook for filings with all three states.
While Tier II (up to $50 million) offerings are exempt from blue sky filings — no managing a web of state filings — Tier II, in my view, has its own “deal-stopping” provision for very small issuers: ongoing reporting requirements.
Tier II issuers are subject to these ongoing reporting requirements in perpetuity, either until they fail or IPO. Issuers must make semi-annual and annual filings with the SEC that include audited financial statements for the two most recent years, along with narrative disclosures. Effectively, this is asking a private company to carry much of the same regulatory burden as a public company if they want to raise under Reg A+ Tier II.
The ultimate question is this: If issuers can fundraise using Regulation D — no blue sky, audited financial, or ongoing reporting requirements — why will they raise under Reg A+? Similar to Title III, I only see Reg A+ working in edge cases, where there is massive and differentiated value to having a large and distributed cap table, which offsets the additional compliance costs.
On a positive note, Title II of the JOBS Act is working and evolving in exciting ways. A host of online funding platforms, across nearly every asset class, now support publicly advertised 506(c) offerings — from consumer companies (CircleUp) to tech (AngelList, SeedInvest) to real estate opportunities (Fundrise, RealtyShares, et al.). Rule 506(c) is great for entrepreneurs — enabling them to reach more potential investors, more efficiently than ever before.
In the past three months, more than 50 percent of the companies we’ve launched on our platform have chosen to raise using the 506(c) exemption. Vaute and FlyKly are just two examples: each are advertising their fundraises online to reach those who know their brand best, their customers.
506(c) is also great for investors; it gives them more choice and more data than ever before. Opening up information tears down geographic barriers. Whereas previously investors were often confined to investing in companies in their immediate geographies, they can now identify and engage companies across the country. Seamlessly.
To be sure, it’s early: Of all private capital raised under Regulation D in 2014, less than 5 percent of it was raised under Rule 506(c). But I have no doubt this number will grow.
And as our private markets continue to shift online, becoming more transparent and efficient, entrepreneurs will win as they enjoy better, faster, cheaper access to the capital they need to thrive.