This is a discussion of the provisions of the new amendments to Regulation A (so-called “Regulation A+”) recently announced by the SEC in Release No. 33-9741. These rules will take effect 60 days after publication in the Federal Register.
This is not a guide on how to comply nor a legal summary of the Rule. These will be covered later. This is a discussion of factors important to company management and is based on our experiences with small, fast growing companies looking for financing.
Of Importance to Companies
We believe the following factors are material to a company's decision to use the new Rule:
Audited Financial Statements
In my experience, companies are primarily interested in two things when considering raising money by selling stock. First, how long will it take? The speed of business makes this important. If you can get funds faster than your competition, you are that much ahead of the game. The speed with which you can access new funds will in large part dictate how fast you can grow. Second, what will it cost out of pocket until we get the money?
If you have not been getting audited financial statements as part of your historical operations, then it will take time to get the audit done. Accountants in my experience are almost always late. They can run into unforeseen issues that are lurking in the company's books or they can just be late. Once an accountant is engaged, you are stuck with them for better or for worse. An unethical accountant can drag out the work and keep hitting you up for more money knowing that if you had to hire a new accountant, more time would be added to your fund raising process. Fortunately these are rare.
With Reg A+, if you want to raise a small amount of money, you have a choice. You can offer without an audit and hope that investors who do not know your company will trust you. Or you can wait and pay to get the audit.
In any event, if you go for the audit, you do not need a full PCAOB audit. You may have an accountant who is familiar with your work and can do a relatively fast audit. I would suggest you compare the cost of a non-PCAOB audit with a PCAOB audit to see if you might prefer the PCAOB audit which could be useful later on.
State filing has been one of the reasons the old Reg A was not much used. If you wanted to do an offering in many states, your Blue Sky fees were huge. Even in one state, the state regulator could hold you up for what seemed like forever. You would almost inevitably be subject to merit review rules which imposed severe if not impossible limitations on new, speculative companies.
Many years ago I had one state regulator tell me off the record that his state would never approve a Reg A offering despite the fact that the rules in that state would permit one. Presumably they intended to delay approval with endless review until the issuer gave up.
Under Tier 1, you can have one state designated as the lead state for coordinated state review. However, you may still be stifled by stringent merit review if you want to sell in a merit review state. Merit review can be a very difficult hurdle for a small startup that is incurring red ink because it is spending money to grow.
Under Tier 2, you are exempt from state filing review. However, you have to face the delay and expense of getting an audit.
For a new company that has exhausted investments from friends and family, advertising is vital. The company has to either get an underwriter who will do a small deal, and there are very few of those, or have an effective promotional campaign.
These campaigns cost money up front and are much more likely to succeed if the company is in a hot industry.
If the issuer is limited to using a tombstone ad, rather than a more expansive presentation, sales will be hampered. While Tier 2 seems to have no limits on the presentation itself, in Tier 1, most state rules may limit advertising to a tombstone ad.
The test the waters feature may be useful in seeing if an offering is viable without committing to the whole cost. However, a huge marketing effort is often needed to place stock in a new company that is unknown and has a limited history, the type of company we might think of as a crowdfunding company. Be aware that a limited amount spent on testing the waters is not likely to be anywhere near the amount needed to show a response large enough to create much confidence in the marketability of the issue.
As the SEC reports, approximately 12.4 million U.S. households are qualified as accredited investors, based on either the income standard or the net worth standard. Most of these investors have not invested in the types of deals contemplated under the new Regulation A.
Speed of Processing
The SEC was kind enough to provide a very enlightening discussion of the existing ways to raise up to $50 million.
One of the most exceptional revelations is that the average offering under the old Reg A took 300 days to qualify with the SEC. We doubt that many companies would use any avenue to raise money if they knew it would take 300 days just to start selling, after the delay involved in preparing the filing.
If we optimistically allow three months to prepare the filing, and three months to place the deal, we are suddenly up to 480 days elapsed, over a year, between the decision to make the offering and having the money in the bank. For a fast growing company, this is impractical. The SEC statistics revealed that Reg D, Rule 506 was much more popular than Reg A.
If it takes 300 days to qualify, you would have been much better off filing a full S-1.In calendar years 2012 to 2014, only 26 Regulation A offerings, excluding amendments, were qualified by the SEC. Compare this to the 11,228 Regulation D offerings in 2014 that would have been potentially eligible to be conducted under amended Regulation A. Of those, 10,671 offerings relied on Rule 506, 376 on Rule 504, and 181 on Rule 505.
Consider the time to completion for a Reg D, Rule 506 offering. Using the same three months to prepare the offering and the same three months to sell, gives us less than half the time of an old Reg A offering, assuming only accredited investors subscribe so there is no state Blue Sky review.
If the time to qualify with the SEC does not accelerate, you will see more companies opting for private placements, including Rule 506c which allows advertising to accredited investors. After a successful 506 offering, the company can then go public at its leisure.
Resales by Affiliates
One of the sensible provisions of some state securities laws is to limit fast resales of insiders by various rules, including escrow of insider stock. This forces the insiders to develop the company in order to see capital gains.
If anything, Reg A+, which allows 30% of the stock sold to be sales by existing holders could give the insiders a chance to dump. Under the new rule, affiliate resales are permitted even if the issuer has no net income from continuing operations. As we know, many successful startup companies, companies that have been acquired at huge prices, have never had net income.
Allowing insiders to sell is very beneficial if the insiders have been making a large financial sacrifice to build their company, as is quite common. For example, the founders may be of an age where they want to send their children to college. This allows the key executives to get back into decent financial condition. However, investors may be less enthusiastic about an offering if they see large sales by insiders in the offering.
Secondary trading is important to those who want to sell their investment, be they investors or insiders.
The Reg A company can trade on OTC Markets Pink Sheets, giving it limited visibility and costing $4,200 per year with a $500 setup fee.
To move up on OTCMarkets to OTCQB status, the company would have to pay to OTCMarkets $2,500 application fee and $10,000 per year.
These are not very attractive options. Pink Sheet stocks are shunned by serious investors and costs are important to small companies.
The SEC believes that “Tier 1 offerings will be conducted by issuers that are unlikely to seek the creation of a secondary trading market in their securities.” Thus, the new Reg A may be used by companies that do not want a secondary market, but are seeking simply to take in money in lieu of classic venture capital investment. These companies may have failed to get venture capital, or they may not be willing to accept the terms offered by venture capitalists.
The SEC's final rules for Regulation A amend Exchange Act Rule 15c2-11(a) so that an issuer’s ongoing reports filed under Tier 2 will satisfy the specified information about an issuer and its security that a market maker must review before publishing a quotation for a security (or submitting a quotation for publication) in a quotation medium.
There are advantages in forgoing venture capital money and instead seeking private investors. Venture capitalists may drive a harder bargain than private investors. The company insiders will not have to give up a large degree of control. The company can advertise widely in a Tier 2 deal.
However, all investors look to have an exit strategy which a company will have to provide with an immediate secondary market, registration rights, or some other method.
It would be impossible to overestimate the importance to small, growing companies\ of Rule 144, which allows the resale by investors of securities purchased outside of a public offering. Having such an exit strategy encourages investors to write checks.
Under the new rule, Tier 2 ongoing reports do not satisfy the current information requirements of Rule 144 for the entirety of an issuer’s year. The SEC did not believe that the frequency of the required Tier 2 ongoing reporting merits a broad determination that such reports will constitute “adequate public information” or “reasonably current information” on a year-round basis. Only quarterly reporting can do this.
Semiannual reporting is required under the final rules for Tier 2 offerings. This will result in issuers only having “reasonably current information” and “adequate current public information” for the portions of the year during which the financial statements of such issuers continue to satisfy the respective rules. The company may voluntarily submit on Form 1-U quarterly financial statements or other information necessary to satisfy Rule 144.
Issuers wishing to register a class of Regulation A securities under the Exchange Act may do so by filing a Form 8-A in conjunction with the qualification of a Form 1-A. Only issuers that follow Part I of Form S-1 or the Form S-11 disclosure model in the offering circular will be permitted to use Form 8-A.
Application to a Developing Company
Some believe the new Rule is a great boon to companies needed crowdfunding. We assume that a company like this is one with a hot new technology, one that might grow rapidly with proper funding. Typically such companies are making losses to get developed. The founders are often taking limited salaries and have invested most of their own capital. The company is seeking outside investors because it has exhausted friends and family. The company may or may not have angel money. It may not have successfully gotten venture capital or it may find that VC terms are too rich or the founders may not want to give up control. Often the company does not have large cash reserves. Being publicly traded will help the company attract money as it will allow investors to have an exit strategy.
Let us look at how the new Reg A might impact such a company. In terms of time, if the offering is processed rapidly, the new rule may help. In terms of time and money the company has a key decision to make in getting an audit or not. Personally, I believe that an audit will increase the marketability of the deal because it will increase investor confidence. Further, a company without an audit can only trade in the Pink Sheets. Pink Sheet stocks are shunned by many investors. However, the company must be careful in its selection of an auditor as time and money can be lost here.
As always with small companies, a huge marketing effort is needed to overcome the fact that the company is unknown and overcome the prejudice against small companies. The new Rule may be of some help here if the company is Tier 2, another reason to go for an audit.
Small issuers have to look to the time and expense of getting an audit and weigh that against the costs and limits of state rules in Tier 1. The issues presented are time, up front expense, restrictions on advertising, and merit review. As an audit will create more trust, it may be desirable for marketing reasons. The audit will move the company into Tier 2 which may allow the company more options for advertising. In Tier 2, the company may also escape state merit review. The company should also look to how it wants to approach having a secondary market for its securities.
Overall, any rule which increases the options of small, growing companies is a good rule. Much will depend on how it is implemented and the speed of processing filings.