New SEC Rule Helps Entrepreneurs Raise Capital, Imposes Stricter Protections for Investors
Dialing for Dollars
The Internet is already a great source for finding everything from jobs to dates. Now entrepreneurs, startups and small businesses can use it as an easier means to raise money.
New rules created by the Securities and Exchange Commission as part of the 2012 JOBS (Jumpstart Our Business Startups) Act authorize open advertising to raise capital in private offerings through general public solicitation. It’s a model that initially gained popularity under Kickstarter.com and other community fundraising websites.
The new Rule 506(c) gives startups and small companies access to wider audiences through solicitation and advertising methods previously unavailable. Entrepreneurs can now venture into previously forbidden territory, including advertising on the Internet, in newspapers or magazines and on social media. In addition to reaching broader audiences, this process avoids many of the costs and challenges that come with the traditional registration process.
But at the same time that the SEC opened the gates, the agency also imposed stricter requirements to protect investors. That means companies need to understand the fine print and be sure to comply. A key cost of this new level of public access is the obligation of fundraisers to take “reasonable steps” to verify the status of “accredited investors,” rather than just accepting the representations of the investors, as had been previously allowed.
According to the SEC, an “accredited investor” includes a natural person who: earned income exceeding $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). It may also be an entity such as a bank, partnership, corporation, nonprofit or trust that meets certain criteria.
While the number of “accredited investors” permitted to invest in a publically advertised private placement is unlimited, the total number of allowable non-accredited investors continues to be 35.
The challenge is that the definition of “reasonable steps” to verify an “accredited investor” status is not clear under the new rule. Until this requirement gains clarity over time, lawyers and other practitioners will want issuers to document that companies did more than just take the investors’ word. It is generally understood that tax returns, certifications from tax accountants, bank account statements and other forms of independent confirmation about potential investors will suffice to meet the “reasonable steps” standard.
Another change imposed by the new rules: a “bad actor” disqualification. This means issuers and other market participants must verify that investors are not felons or otherwise considered “bad actors.” If an investor is a bad actor, then the issuer is disqualified from relying on the new SEC rules.
As part of the adoption of these new rules, the SEC also issued new companion rules containing stronger investor protections. These include requiring entrepreneurs who take advantage of the new general solicitation rules to: (1) provide additional information about their capital raising offerings; (2) provide more information about the investors who are participating in the offerings; and (3) require companies to file Form D with the SEC at least 15 calendar days before engaging in general solicitation and within 30 days of completing the offerings to update the information contained in the Form D and indicate that the offerings have ended.
For business owners, remaining compliant with these complex new rules will require advice from qualified securities lawyers and investment bankers who can help them raise capital safely. Among other things, they will also have to ensure that the business owners qualify for the traditional exemption or are in the “safe harbor” of the new rule. Although this process involves cost and time commitments, the new avenues for fund-raising are significantly less complex and expensive than traditional registered offerings. If handled properly, entrepreneurs should have a powerful new vehicle at their disposal to support the establishment, development and growth of their companies.
Fred F. Harris Jr. is chairman of the Corporate Securities group in the Greenberg Traurig Tallahassee office. Bruce C. Rosetto, is co-managing shareholder of the Greenberg Traurig Boca Raton office.