The SEC issued Final Rules last week that effectively eliminate the ban on the use of general solicitation and general advertising in connection with certain securities offerings performed under Rule 506 of Regulation D. This is a major shift that will allow issuers to use general solicitation and advertising to promote certain private securities offerings. Rule 506 is widely used by many startup and early stage companies to provide a safe harbor from registration under the 1933 Act. The elimination of this ban should have very positive effects for startup and early stage companies. Hopefully it will facilitate capital raising for these companies and thus begin to allow some of the long-awaited positive impacts that we all expected from the JOBS Act. These Final Rules will become effective in mid-September of this year.
These Final Rules provide amendments to Rule 506 and Rule 144A under the 1933 Act. I will focus on the Rule 506 amendments since they are most relevant to startup and early stage company financing situations. These Rule 506 amendments allow an issuer to engage in general solicitation and advertising in connection with the offering and sale of securities under Rule 506 provided that all purchasers of the securities are accredited investors under the Rule 501 standards and that the issuer takes “reasonable steps” to verify each investor’s accredited investor status. The Rule 506 amendments provide a non-exclusive list of methods that issuers can use to verify the accredited investor status of natural persons. These amendments also amend Form D to require issuers to tell the SEC whether they are relying on the provision that permits general solicitation and advertising in a Rule 506 offering. The Final Rules also contain some very interesting economic and statistical data on Rule 506 offerings and participation by accredited investors.
In a related development, the SEC issued a Final Rule on July 10, 2013 that amended Rule 506 to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering. This action implements Section 926 of the Dodd Frank Act. We will discuss these items in a future post.
The elimination of this ban implements the provisions of Section 201(a) of the JOBS Act. While this ban has been in place for a number of years, many observers feel that it is overly restrictive in view of the highly enhanced communications and high volume of information that are now available to investors. President Obama signed the JOBS Act into law on April 5, 2012, but this SEC action is one of the first major practical benefits resulting from the JOBS Act.
I also believe that this ban has significantly restricted startups and early stage companies from raising much-needed expansion and growth capital. Under the current system, a private company or its advisors had to be extremely cautious when seeking capital. Although there are a significant number of accredited investors across the United States who could be potential investors for startup and early stage situations, these companies could not reach out in any general way to solicit these investors for possible interest. This has resulted in a closed system of relationships that by their nature substantially restrict the number of potential investors that a company can approach. Rather than seek potential interest generally from accredited investors, companies were forced to only deal with a small percentage of potential investors who were introduced to them by their advisors or who they met by other means. This system has not worked well for startup and early stage companies which need capital.
The lifting of this ban on general solicitation and advertising should have some quick positive effects on capital raising by startups and early stage companies. Probably the most immediate positive effect will be the access to a significantly larger number of potential investors that the companies do not have access to under the current system. According to WeFunder, a crowdfunding website, there are approximately 8 million accredited investors in the United States, and only 3% of them are active investors in startup and early stage investments. The ability of these companies to get their message out to a larger pool of potential investors should lead to a substantial number of additional funding opportunities. I also believe that sophisticated and high net worth potential investors are actively searching for alternative investments. This elimination of the ban on general solicitation and advertising could introduce theses potential investors to a large number of startup and early stage companies that need financing.
The ability of issuers to use general solicitation and advertising did not meet with universal approval. Some commentators fear that this will lead to unscrupulous promoters selling the securities of weak or suspect companies. Alex Mittal, CEO of FoundersClub, expresses these concerns in his blog post where he warns readers to be ready for “a wave of less than credible issuers… pushing all sorts of private offerings.” This is a very legitimate concern given the long history of issuer and promoter abuses in the small company securities offering space, but I believe that the benefits of using general solicitation and advertising far outweigh these concerns. I also believe that these concerns can be mitigated and adequately managed using our current Federal and state regulatory resources. The “bad actors” prohibition in Rule 506 offerings that I mention above should also help to reduce some of these problems. To counter some of the concerns of investor advocates, the SEC also issued Proposed Rules for the amendment of Regulation D, Form D and Rule 156 under the 1933 Act to add investor protections in Regulation D offerings.
TechCrunch expresses an unexpected concern – that the allowance of general solicitation and advertising will actually create more companies (since it will be easier to raise investment capital) and that this will dilute technical and management talent by spreading it out among these additional companies. It is difficult for me to see how the creation and financing of more companies will be detrimental.
The SEC’s elimination of the ban on general solicitation and advertising is a huge positive step that should quickly benefit startup and early stage companies that have been desperate for investment capital. I applaud the SEC for issuing these Final Rules, and I encourage them to keep enacting the various provisions of the JOBS Act as quickly as possible.