SEC amendments promise help for early stage companies

March 2021 | EXPERT BRIEFING | FINANCE & INVESTMENT

financierworldwide.com

Capital is the lifeblood of business enterprises. After the resources of founders and friends and family are exhausted, few alternatives exist for most early stage and emerging growth companies.

Compounding this capital conundrum is the difficulty of accessing the capital markets posed by the requirement of US federal securities laws that offers and sales of securities be registered under the Securities Act – unless an exemption from registration is available.

Because registration under the Securities Act can be a complex and costly undertaking, most offers and sales of securities are made pursuant to an exemption from the registration requirements.

Exemptions from registration are based on statute and rules, as well as interpretive guidance provided by the Securities and Exchange Commission (SEC). The Jumpstart Our Business Startups (JOBS) Act added new exemptions, including regulation crowdfunding, and amended the terms of others, particularly focused on early stage companies.

These recent changes further complicated a patchwork structure of exemptions, which include sometimes inconsistent provisions, and which can be confusing and costly to navigate, defeating their purposes.

In November 2020, the SEC adopted revisions to the exemption framework to make the framework more consistent and address gaps and complexities with the goal of promoting capital formation and expanding investment opportunities, while maintaining appropriate investor protections. These amendments do the following: (i) establish an integration framework which enhances and clarifies the circumstances where an issuer may move from one exemption to another; (ii) establish new opportunities for companies to “test the waters” and engage in “demo days” prior to undertaking a securities offering; (iii) increase the offering limits for crowdfunded offerings, Regulation A offerings and Rule 504 offerings; and (iv) harmonise certain disclosure and eligibility requirements for exemptions and the “bad actor” disqualification provisions.

In August 2020, the SEC adopted amendments to the definition of “accredited investor (AI)”, a classification critical to many of the exemptions from registration under the Securities Act.

Collectively, these changes provide new opportunities for early stage companies to raise capital.

The definition of an AI can be critical because accredited investors are deemed to have financial sophistication sufficient to invest in securities without many of the protections afforded non-accredited investors. Prior to the recent amendments, the accredited investor definition focused primarily on wealth and institutional status as a proxy for financial sophistication.

The amendments expand the universe of accredited investors by adding qualified natural persons who are deemed to be able to assess the risks and merits of investment opportunities based on their professional qualifications or role. Qualifying persons include individuals who hold professional certifications, designations or credentials determined by SEC order, initially to include individuals holding Series 7, Series 82 and Series 65 licences. The amendments add “knowledgeable employees” of a private fund as accredited investors.

In addition, the amendments confirm SEC guidance that sovereigns, Indian tribes and municipalities qualify as accredited investors, and clarify the treatment of LLCs consistent with the treatment of other entities.

In the harmonisation amendments, the SEC adopted a revised Rule 152 which provides a clearer and more consistent general integration framework and four specific safe harbours. This rule replaces prior integration rules and guidance, permitting companies to more easily move from one exemption to another, while continuing to protect against abuses where an issuer could artificially divide a single offering into multiple offerings which would not qualify for an exemption from registration for the combined offering.

If safe harbours do not apply, offers and sales will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or the requirements of the exemption on which the offering relies.

Where companies rely on an exemption that prohibits general solicitation, the company must have a reasonable belief, based on the facts and circumstances, that the company (or other person acting on the company’s behalf) either did not solicit the purchaser through the use of general solicitation or has established a substantive relationship with the purchaser prior to the commencement of the exempt offering prohibiting general solicitation.

The new rule codifies and expands the SEC’s guidance for when a company can conduct simultaneous registered and private offerings, including circumstances where a company can conduct simultaneous private offerings under Rule 506, which permit and prohibit general solicitation. The new rule also requires that, when the solicitation materials for one offering includes information about the material terms of a concurrent offering, each offering must comply with all the requirements and restrictions of each offering.

The rule provides four non-exclusive integration safe harbours as follows: (i) any offering made more than 30 days before the commencement of any other offering, or more than 30 days after the termination or completion of any other offering, provided that where an exempt offering permitting general solicitation follows an offering prohibiting general solicitation

the company has a reasonable belief that each purchaser in the exempt offering prohibiting general solicitation was not solicited through the use of general solicitation or established a substantive relationship prior to the commencement of the exempt offering prohibiting general solicitation; (ii) offers and sales complying with Rule 701 or Regulation S; (iii) offerings for which a Securities Act registration statement has been filed if made subsequent to (x) a terminated or completed offering for which general solicitation is not permitted, (y) a terminated or completed offering for which general solicitation is permitted that was made only to qualified institutional buyers and institutional accredited investors or (z) an offering for which general solicitation is permitted if such offering is terminated or completed more than 30 days prior to the commencement of the registered offering; and (iv) offers and sales made in reliance on an exemption for which general solicitation is permitted if made subsequent to any terminated or completed offering.

For offerings relying on the 30-day safe harbour and using the exemption provided by Rule 506(b), the number of non-accredited investors is limited to not more than 35 within a 90-day period to prevent unregistered sales to a significant number of non-accredited investors in a 12-month period.

The amendments also exclude ‘demo days’ and where a company ‘tests the waters’ from the definition of a general solicitation. ‘Demo days’ are events organised by a group or entity, such as a university, angel investors, an accelerator or an incubator, that invites issuers to present their businesses to potential investors in anticipation of an offer and sale of securities.

The exemption for ‘demo days’ requires that more than one issuer participate in the event and prohibits the sponsor from: (i) making investment recommendations or providing investment advice to attendees of the event; (ii) engaging in any investment negotiations; (iii) charging attendees any fees, other than reasonable administrative fees; (iv) receiving any compensation for making introductions or for investment negotiations between the parties; and (v) receiving any compensation that would require it to register as a broker or dealer under the Exchange Act or as an investment adviser under the Investment Advisers Act, and limits advertising for the event.

In addition, where the event is held online, participation must be limited to members or others associated with the sponsor organisation, individuals which the sponsor reasonably believes are accredited investors or individuals who have been invited based on industry or investment-related experience.

Under the amendments, an issuer or its agent may use generic solicitation materials to ‘test the waters’ to determine if there is any interest in a contemplated exempt offer of securities. Such solicitation is an offer subject to the antifraud provisions of the Securities Act. However, no money or other consideration may be solicited or accepted, nor may any prospective investor make any commitment until the company determines the exemption on which it will rely and commences the offering in compliance with such exemption.

The generic testing-the-waters materials must include disclosures notifying potential investors that: (i) the company is considering an exempt offering of securities but has not determined the exemption it will use; (ii) no money or other consideration is being solicited and if given will not be accepted; (iii) no offer to buy can be accepted; and (iv) an indication of interest involves no obligation or commitment of any kind.

The SEC’s amendments make the financial disclosure requirements for investors who are not accredited investors in a Regulation D, offering the same as those required by Regulation A and treat confidential information included in the disclosure in a manner consistent with the disclosure in offerings registered under the Securities Act.

The amendments increase the offering limits under Tier 2 of Regulation A from $50m to $75m, Tier 2 of Regulation A for secondary sales from $15m to $22,5m, regulation crowdfunding from $1,07m to $5m, and Rule 504 from $5m to $10m. The amendments also remove individual investment limits for accredited investors and changed the calculation of the limit for other investors to an amount based on the greater of their annual income or net worth.

Importantly, the amendments add an exemption to the Investment Company Act for certain special purpose vehicles (SPVs) that function as a conduit for individual natural persons to invest in crowdfunding issuers, subject to certain conditions. The conditions require the SPV to act solely as a conduit for directly acquiring, holding and disposing of securities of a single issuer and limit the scope of the activities in which the SPV can engage and the compensation it can receive.

The amendments also make harmonising changes for the bad actor disqualification provisions of the exemptions, adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.

Robert C. Brighton, Jr is a shareholder at Becker. He can be contacted on +1 (954) 985 4178 or by email: rbrighton@beckerlawyers.com.

Robert C. Brighton, Jr

Becker