The Jumpstart Our Business Startups Act (the JOBS Act), enacted in April this year, makes a variety of significant changes to securities laws, some of which relate to early-stage entrepreneurs, startup companies and venture capitalists concerned about fund raising with respect to their portfolio companies.
In this article, I address provisions of the JOBS Act most applicable to startup companies and venture capitalists that fund them. In this piece, I will not be covering other changes in the Act such as broker/dealer regulations, “Reg A+”, or the changes to research reporting and analyst rules.
The JOBS Act contains various changes to the requirements for a company listing its shares in its initial public offering, referred to as the IPO “on-ramp” provisions. These changes should assist emerging companies as they consider an IPO as a strategy to raise funds for growth while creating liquidity for their venture capital and other investors. The key IPO on-ramp provisions, which went into effect immediately in April, are identified below.
Reduced initial and ongoing disclosure requirements of “emerging growth companies” for up to five years following an initial public offering
To qualify as an “emerging growth company” (“EGC”), an issuer must:
- Have less than US$1 billion in annual revenue;
- Have been publicly traded for less than five years;
- Have a public float of less than US$700 million; and
- Not have issued US$1 billion in debt in the prior three-year period.
If a company qualifies as an EGC, which most IPO candidates will, the changes to the disclosure requirements under the JOBS Act may result in savings for such companies as they go public. In particular, the rules now:
- Require only two years (instead of three) of audited financial statements in the EGC’s IPO filings with the SEC;
- Exclude EGCs from the requirement under the Sarbanes-Oxley Act to obtain an auditor attestation report regarding financial reporting internal controls;
- Exclude EGCs from the “say-on-pay,” “say-on-frequency” and “say-on-parachutes” advisory votes on executive compensation required under the Dodd-Frank Act; and
- Exclude EGCs from the Dodd-Frank Act requirement to provide disclosures comparing executive pay to performance and to median employee compensation.
IPO registration statements filed with the SEC may be kept confidential until shortly before the offering to the public commences
Under the JOBS Act, an EGC may file its IPO registration statement confidentially with the SEC for review as long as the registration statement (and amendments) are publicly filed no later than 21 days before the start of the company’s IPO road show. As a result, an EGC may file to go public with the SEC, resolve various SEC comments to its offering documents, and prepare for its initial public offering without publicly disclosing any competitive information until 3 weeks before beginning its roadshow with potential investors. This change provides a company the option of foregoing the IPO process and withdrawing its proposed SEC registration statement without having first disclosed sensitive financial or competitive information to its competitors, customers or the public.
Testing the Waters
In addition to the confidential filing process, the JOBS Act allows an EGC to communicate with certain potential investors such as Qualified Institutional Investors or “QIBs” (large institutional investors) before or after filing its registration statement in order to “test the waters” to determine whether there is interest in the contemplated IPO.
Private Company Changes
The JOBS Act also includes a number of provisions that may be useful to private companies interested in fundraising.
Relaxation of prohibition on general solicitation in private offerings to accredited investors
Under current rules, to qualify for an exemption from registration, sales of stock by private companies must not involve a “public offering”. This “no public offering” aspect been interpreted to prohibit general solicitation of investors (such as advertising). Such general solicitation and advertising are expressly prohibited under the safe harbor provisions of Rule 506 of Regulation D, which is the exemption often utilized by private emerging growth companies in sales of unregistered securities to investors. (Note: this change is not yet effective and is currently subject to rulemaking by the SEC. Such rulemaking is currently anticipated to occur in the second half of 2012.)
Once SEC rule-making on this issue is complete (as required by the JOBS Act), general solicitation of investors will be permitted under Rule 506, so long as all actual sales are to “accredited investors” as defined in Rule 501 of Regulation D of the federal securities laws (typically wealthy individuals or investment funds, see http://www.sec.gov/answers/accred.htm).
Increased number of “holders of record” permitted before triggering public company reporting requirements
Effective immediately, the JOBS Act increased from 500 to 2,000 (or 500 persons who are not accredited investors) the maximum number of holders of record a private company may have before it is required to register its securities with the SEC (pursuant to Section 12(g) of the Securities Exchange Act and Rule 12g-1 thereunder). The JOBS Act also revised the definition of “held of record” to exclude holders who received such securities under an employee compensation plan in transactions exempt from Securities Act registration as well as those who purchased securities in exempt “crowdfunding” transactions, discussed below.
While venture capitalists are unlikely to participate in crowdfunding transactions, some entrepreneurs may be interested in using it as a means of raising ‘seed’ funding. Crowdfunding typically means raising money from a large number of investors, with each investing only a small amount. Subject to SEC rulemaking, the JOBS Act creates an exemption from the registration requirements of the Securities Act for crowdfunding transactions where:
- the aggregate amount of the offering is less than US$1 million in any 12-month period;
- the aggregate amount sold to any one investor does not exceed certain limits; and
- the issuer uses the services of an intermediary that is either a broker or a “funding portal”, in each case registered with the SEC.
Note: the crowdfunding exemption will not be effective until SEC rulemaking is complete and this is not expected before the end of 2012.
Income/Net Worth Tests for Investors in Crowdfunding Issuances
For an investor whose annual income or net worth is less than US$100,000, the limit is the greater of US$2,000 or 5 percent of the annual income or net worth of such investor, as applicable. For an investor whose annual income or net worth is equal to or greater than US$100,000, the limit is 10 percent of the annual income or net worth of such investor up to a maximum of US$100,000.
Funding Portal Requirement
Under the JOBS Act, crowdfunding transactions must be conducted through a registered broker or through a “funding portal,” which is a new category of financial intermediary subject to SEC registration. In addition to the requirement to register with the SEC, the funding portal will be subject to the SEC’s examination, enforcement, and rulemaking authority. It must also become a member of a national securities association that is registered under Section 15A of the Exchange Act (FINRA is the sole entity meeting this Section 15A registration requirement at this time).
Under the JOBS Act, a funding portal may not:
- offer investment advice or recommendations;
- solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal;
- compensate employees, agents, or others persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;
- hold, manage, possess, or otherwise handle investor funds or securities; or
- engage in such other activities as the SEC, by rule, determines appropriate.
The restrictions on business activities set forth above may limit the number of entities seeking registration as authorized funding portals. For some thoughts on the challenges posed by crowdfunding, see this earlier post.