The Securities and Exchange Commission has eased several rules surrounding exempt offerings, turning them into even more effective tools for companies seeking capital from the sale of securities without the regulatory burdens and legal costs associated with a traditional stock offering.
Proposed in March and approved in early November, the changes include a major expansion of Regulation A and of crowdfunding and could prove particularly useful to businesses— especially emerging, small and midsized players—struggling to raise funds amid the economic disruption caused by the COVID-19 pandemic.
Given the present market volatility and the difficulty they may find in accessing credit or attracting new venture investment, companies may see alternative sources of fundraising like online Regulation CF (crowdfunding) or Regulation A as a useful method for accessing substantial capital without listing on a major exchange.
The changes increase the annual offering limits for Regulation A and crowdfunding issuers, improve the ability of issuers to communicate with potential investors, and provide more rational rules to qualify for exemptions when pursuing multiple issues. Limits for crowdfunding would increase from $1 million to $5 million, and Regulation A’s Tier II cap would move from $50 million to $75 million.
CONTINUING IMPROVEMENTS
Congress and the Obama administration amended securities laws in 2012 to allow a greater number of companies to raise capital without the burden of cost-prohibitive registration requirements. The amendments increased the number of exempt offerings, providing a framework for crowdfunding and dramatically enhancing exemptions under Regulation A.
Commonly referred to as Regulation A+, the changes were intended to help smaller and midsized companies attract investment without forcing them to bear the cost of a full public offering. Smaller investors, too, have a greater opportunity to take advantage of investments in such securities. Reg A exemptions are offered in two tiers: Tier 1 is for offerings up to $20 million in a 12-month period; Tier 2 is currently for offerings of up to $50 million in a 12-month period. Under the present rules, secondary sales under Tier 2 are also allowed up to $15 million.
There are strategies with Reg A that allow issuers multiple chances to offer securities in a single year. The present rules also relax some of the prohibitions on “testing the waters” communications that allow an issuer to determine if there’s a market for its securities. Non-accredited investors can take part in offerings up to certain limits. And Tier II issuers are given protection from virtually all state-level registration requirements, having to provide only notice filings to the states.
In the years since the law was first enacted, Congress and the SEC have attempted to improve Reg A. Initially, for instance, companies subject to the reporting requirements of the Securities and Exchange Act (i.e., publicly traded companies) weren’t allowed to use Reg A. In 2018, the law was amended to allow reporting companies to take advantage of Reg A and to have satisfied its reporting requirements under Tier II of Reg A if they had already met their Exchange Act obligations.
NEW CAPS
Reg A offerings had been accelerating, particularly in the year prior to the COVID outbreak. From 2015 through 2019, issuers reported raising approximately $2.4 billion in 382 qualified offerings, according to SEC figures. Of the total raised, 43 percent—or $1.04 billion—came in 2019. The vast majority of the capital has been raised under Tier 2, including 96 percent of the money raised in 2019.
Though growing, Reg A offerings still represent a small percentage of the roughly $3 trillion in new capital raised through exempt offering methods in 2019. Moving the Tier 2 cap from $50 million to $75 million per year should allow for a significantly larger pool of companies to participate and may attract larger and more experienced investors to the fold. In addition, the cap on secondary offerings under Tier 2 is increased from $15 million to $22 million.
Similarly, advocates have long argued that the $1.07 million cap currently in place stymies the growth of Regulation CF as an effective approach for raising capital. A $5 million cap could, in the words of the SEC, “improve investor access…and issuers’ ability to raise capital.” Private placements under Regulation D’s Rule 504—another underutilized capital-raising vehicle—also would increase from $5 million to $10 million.
To help spur Reg CF, as well, the SEC is easing restrictions on investors. Accredited investors would no longer be subject to investment limits. And nonaccredited investors would be limited to 10 percent of their annual income or net worth, whichever is greater. Under the current rules, investors are capped at the lower figure. Crowdfunding investors would also be allowed to use special purposes vehicles to aggregate their investments in the new framework.
IMPROVING INTEGRATION
Along with changes in the caps, the new rules also streamline the Securities Act integration framework for both registered and exempt offerings. Integration refers to a process used by the SEC to prevent companies from inappropriately dividing one offering into multiple offerings in an attempt to improperly gain exemptions from registration requirements. In general, an issuer whose offerings were found to be integrated would lose their exemptions and be required to fully register.
Over the years, as the number of exemptions has increased, however, companies legitimately making multiple exempt offerings have run afoul of integration rules. A few years ago, the SEC began to ease its stance to encourage Regulation A and CF offerings, and the new rules enshrine a series of integration “safe harbors” to help make clear when and how regulators will consider multiple offerings as a single event for the purposes of compliance.
Specifically, the safe harbors limit integration based on issues like the timing of the offering in relation to other offerings, the nature of communications with prospective investors, and whether the offering is related to an employee benefit plan or in compliance with the rules on foreign offerings.
In essence, harmonizing the rules across offerings will help companies remain eligible for exemptions even if they simultaneously raise money through public offerings and private investments.
EXPANDED COMMUNICATIONS
Unlike Regulation A, many exempted offerings do not allow issuers to engage in oral or written testing-the-waters communications with potential investors. (Reg A issuers may solicit interest, provided they meet certain requirements.) That, too, has changed under the new rules. Before they determine which exempt offering method they will use, an issuer would be able to solicit interest from potential investors. In doing so, the SEC believes the issuer will be able to select the exemption that best fits their specific needs.
For Reg CF issuers, general solicitations of interest will now be allowed. Previously, such solicitations were limited to qualified investment brokers and accredited investors. However, general solicitations would still be off limits in other types of offerings.
That said, the SEC will allow issuers to take part in “demo days,” where they present to a gathering of investors, usually venture capitalists or other start-up-oriented investment professionals. The events must obey a few guidelines: Issuers should not refer to any specific securities offerings, and the sponsors should not be paid or charge fees for holding the event. If they participate in a demo day, issuers are still eligible to participate in a Regulation D offering under Rule 506(b). (Private placements under Rule 506(b) – at nearly $1.5 trillion raised in 2019 alone — are the most common type of exempt offering.)
Aside from the communications provisions, the revised rules also: simplify existing bad actor provisions under Regulation A, crowdfunding, and Regulation D; allow an accredited investor to provide proof of its status in a written representation to an investor; and harmonize several other provisions across exempt offerings.
OPPORTUNITIES FOR COMPANIES AND INVESTORS
Having an alternative to registered offerings and the limited number of exemptions that existed before Regulation A has been a game changer for some companies. They have been able to tap into funding streams that would not have been possible a decade ago and are able to reach beyond the accredited investors they might find in a private placement under Reg D.
For investors, a Reg A offering can provide a consistent yield, something they may be hard-pressed to find amid the recent extreme volatility of the traded markets. Investors are able to enter new areas, like real estate, without having to commit a major chunk of their net worth at the outset. And they may be able to do this without moving beyond a select group of professionally managed portfolios, ones that have a higher level of transparency because of the report requirements associated with Reg A.
Consider Red Oak Capital, a client of our firm. Over the course of two-and-a-half years, the company has capitalized a family of bond funds via Reg A offerings that back commercial real estate acquisitions and redevelopment projects across the country. Typically, a minimum investment of $10,000 is required, and approximately 4,000 investors have taken part in the offerings. As a result, the company is on track to raise more than $250 million. And the rewards have extended beyond money. With its offerings, Red Oak has created an organic network of investors who, via word of mouth to friends and family, have helped market the company and its investment opportunities.
Real estate is but one example of an area where Reg A has been used effectively. A wide spectrum of companies has been able to deploy Reg A offerings to communities of investors who are highly motivated to invest in an issuer and participate in its success. For instance, companies in the entertainment production space are developing family-oriented and faith-based content with the help of a large groups of investors who share their vision and want to promote their messages.
A SUCCESSFUL STRATEGY
To successfully take advantage of the powerful exemptions offered through Reg A and other offerings, careful planning and commitment is required. Here are a few issues to consider:
- Does your business have a track record? Many potential issuers have come to us looking to fund a business that is not yet off the ground. This simply doesn’t work — particularly with securities broker-dealers and financial advisors, who will be critical to enhancing the success of any offering, even if you employing social media and other online tools to promote an offering. These professionals do not put their clients’ money in dreams. They will want to see an established business that is in the “growth stage” of development. This can take the form of cash flow or, in the case of some tech start-ups, a history of successful development of your technology.
- How will you promote your offering? Many voices are competing for the dollars you want for your business. Thus, a well-considered strategy for effectively placing your offering is a must. Consider your value proposition: Do you tailor your strategy to a particular geography or demographic? How will you engage in large-scale marketing? How will you deploy social media? An investment banker can help develop this kind of strategy and tailor messaging to reach investors.
- Are you ready for the regulatory and governance requirements? If you conduct an offering, a lot of people will be trusting you with their hard-earned dollars. Don’t take this lightly! You’ll need to meet SEC’s reporting and audit requirements. Moreover, you’ll need professional governance and investor relations and a clear understanding of the fiduciary obligations a business undertakes when it brings on investors.
CONCLUSION
At a moment when most companies are facing deep uncertainty, the SEC’s new rules may enable nimble and creative business leaders to seek out funds – while reducing the red tape that comes with offering securities to a larger pool of investors. The changes should make exempt investment offerings like crowdfunding and Regulation A easier to navigate and more practical for a wider swath of entrepreneurs and investors.
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Originally published on Law.com on December 16th, 2020.