Last year the SEC changed its general solicitation rules? What, in simple terms, do they mean?
Ever since the new SEC crowdfunding rules came into effect on September 23, 2013 angels have been asking: "can someone please explain this in simple terms?" Turns out it is not that complicated.
Quick History Lesson
For the last 80 or so years, the basic rule on selling stock has been that no issuer is permitted to sell stock to the public without either (i) a registration statement full of mandated disclosures (e.g. the long Form S-1 associated with most IPOs), or (ii) a special exemption from that registration statement requirement.
The most popular exemption from the registration statement requirement for the last 30 years has been Rule 506 under Regulation D. Rule 506 allows certain private companies to raise unlimited capital without a registration statement PROVIDED the offer is private and only goes to qualified investors. Specifically the SEC required that: (i) they only sold to "Accredited Investors" (with a narrow exception) and (ii) they did not use "General Solicitation" in connection with the offering. Accredited Investors are investors the SEC deems sophisticated and able to bear losses because they are rich. General Solicitation is not defined by the SEC, but, based in part on Rule 502(c) and various no action letters over the years, it is generally agreed to be pretty much any form of public discussion or public advertising of the terms of the offering. As long as it was a private sale to accredited folks, an issuer did not need to file a registration statement.
What Has Changed
On the surface, very little. In 2012, Congress passed the JOBS Act which required the SEC to lift the ban on general solicitation and bring their rules into the modern Internet era. The SEC has dragged its feet on this, and rightly so, because Congress' mandate was more political pandering than well-thought out plan. But in September of 2013, the SEC finally rolled out its rule and lifted the ban on general solicitation.
What Hasn't Changed
The SEC went to some lengths to preserve the existing practices. The original process of making private offerings to accredited investors was retained - the exact rule was preserved and given the new name, Rule 506(b). And the new rule was added as new section, Rule 506(c). So in theory, current angel practices should be allowed to continue without interruption, and all is well. And as it turns out, since the rules have passed the vast majority of US angel deals have continued to be done under the old rule 506(b). Since you can only include accredited investors in your offering, there isn’t any benefit to general solicitation, so companies are, for the most part, not broadly soliciting their deals. (Keep in mind that most of the so-called equity crowdfunding sites are limited to accredited investors, so listing on one of those sites is not general solicitation.)
Where is the Problem?
If, in theory, everything can stay the same, where is the problem? Cue one of my favorite observations, which is that while in theory, theory and practice are the same, in practice, they are not. Unfortunately, in practice, with general solicitation guidelines so broad, it is too easy to fall accidentally out of the old 506(b) process and into the brave new world of 506(c).
And the problem with 506(c) is that if a company has used general solicitation, they can no longer take an investors' word for it that they are accredited. For the last 30 years, accredited investors have been checking a simple self-certification box in their deal paperwork, and it has been viewed as reasonable for companies to rely on investor self-certification in ensuring it complies with Reg D Rule 506.
Now that the SEC is allowing companies to use general solicitation and advertise to the world that they are raising money and potentially bringing in non-accredited investors, the SEC feels companies using general solicitation should take "reasonable steps" to verify that investors are accredited. What are "reasonable steps?" This, the SEC refused to say, beyond saying the old self-certification was no longer good enough. They said it is a "principles-based" rule, and that companies, investors and lawyers should, in effect, figure it out for themselves.
At the urging of early commenters, the SEC did provide some safe harbors, but these were pretty invasive and draconian - angel investors have had an extremely negative reaction to them. The safe harbors included such things as looking at tax filings, bank statements, having investment advisors or lawyers certify, looking at credit reports, and so on. Things that (i) investors are extremely unwilling to submit to for data privacy, identity theft, and other reasons, and (ii) represent a level of per-investor effort that companies could ill-afford to undertake.
As if this weren't concern enough, the SEC's new rules have also had the effect of putting a spotlight on exactly what general solicitation is in this new modern internet enabled start-up world we live in. This spotlight is expected by many to result in greater scrutiny of company and investor behavior. Unfortunately, a lot of loose practices which have sort of quietly existed in the shadows are now being thrust into the light. Demo days and pitch contests, for example, can easily be argued to be general solicitation if they include any reference to open rounds, money raising, investors, etc. and they have an audience that includes unaccredited investors, members of the press, etc. Similarly, blogs, websites, tweets, video interviews and other examples of the normal start-up chatter we are all used to may also qualify. The Angel Capital Association has been very vocal in lobbying Congress to pass legislation which will carve demo days and pitch contests out of the definition of general solicitation, and proposed legislation exists, but has not been passed.
We don't know where things will end up with the passage of time, nor how much of an enforcement priority this will be for the SEC. But the implications are clear: even if you think you are still doing a normal quiet offering under the old (b) rules, the new sensibilities around general solicitation could cause you to fall inadvertently into 506(c) territory.
Once your offering falls into (c) territory, you now have to take steps to ensure that all the investors are accredited (and that no one involved in the offering is a "bad actor" - a separate set of hoops I am omitting from this discussion, but compliance with which is quite burdensome and troublesome to investors and companies alike.)
In addition, there are some new proposed rules which would, among other things, require 15 day advance submission to the SEC of any general solicitation materials along with extensive information on a new Form D, and legends on the materials themselves (which legends, many wags have noted, are longer than 140 characters. If your legend is longer than the permitted length of a tweet, it is going to be hard to use twitter to talk about your company. The horror.) Perhaps even more worrying is that the SEC would require breaches to be cured within 30 days, and would only allow one such breach in the lifetime of each company. After that, the company is barred from using Rule 506 to raise money, and presumably can be more harshly sanctioned for further breaches. Given that many breaches would be accidental, most view these proposed rules as unworkably harsh. And investors fear the spectre of having their early money get stranded in a dead in the water company that cannot easily raise more without going to some other more traditional and labor-intensive offering under another area of Section 4(2). Fortunately, the SEC has reopened the comment period for these proposed rules; you can still sound off here.
So taken altogether, these new rules initially appeared to most to be a disaster for early stage investing, and everyone has understandably been very upset.
The Way Forward
In my view, however, while we still have things to figure out, there are some reasons to be hopeful that with time and repetition, we will eventually find a workable new status quo. One that balances the important and legitimate need to protect against fraud with the equally important need to fund innovation, create jobs and keep our economy competitive on the global stage.
Why are you Optimistic?
Part of the basis for my optimism is that the SEC's "principles based approach" allows for some common sense to be applied. In essence, what it says is that more likely it is that someone is accredited, the less you have to do to verify (and vise versa). This means that companies dealing with professional angels may not have to go too far out of their way. For example, the Angel Capital Association has outlined a very reasonable approach. The ACA has spoken extensively with the SEC and received some comfort that companies dealing with and Established Angel Group ("EAG") may rely on that fact, in combination with the traditional written certification, as their reasonable steps. The ACA's logic is that an EAG is a private, invitation-only group where new members must be vetted by existing members, must certify that they are accredited, and are doing these deals repeatedly and of their own accord. Further, the groups make no recommendation as to the investments, and no one gets any transaction-based brokerage fees or compensation in connection with offerings. (Such brokers being a major source of fraud and an enforcement priority for the SEC.) The ACA has launched a formal program by means of which angels in established groups can become certified.
Why Else?
Another part of the basis for my optimism is that it is relatively easy to separate general discussion about a company from discussion about an offering. Today they seem inextricably intertwined, but once we have a sense of some guardrails, if necessary because legislation does not carve them out, it will be relatively easy to remove offering information from demo days and pitch contests and reserve that information for a separate reception to which only accredited investors are invited by non-general solicitation. It will require some deliberate effort and rejiggering, but in relatively short order it will become the new habitual norm.
And?
And finally, although I am loathe to contemplate it, if needed, I expect a whole industry will spring up to provide verification of investor accreditation if needed. I hope this is not necessary, and I hope that reliance on such third parties does not become the norm, but if it has to, it will happen. Consider that not long ago there was a huge fuss over how mandatory Rule 409A valuations were going to be the end of the world, and seemingly overnight, an army of firms has popped up to provide these valuations in a timely and somewhat cost effective fashion. And more importantly, companies have found less formal, but equally valid ways to conduct these valuations.
Net/Net, It's Going to Be OK
So in the end, while change is hard, and anxiety is the knee-jerk reaction, based on the first year of operating under the new rules, I feel pretty confident that this will work itself out. And angel investing will continue to fund innovation, create jobs and keep our economy competitive on the global stage
