President Obama Signs the JOBS ActPrint PDF
On April 5, 2012, President Obama signed the Jumpstart Our Business Startups (“JOBS”) Act into law. The JOBS Act represents the latest significant change to United States securities laws, and one that may have a greater impact on how entrepreneurs and small businesses raise capital than any piece of legislation since the Securities Act of 1933 (the “Securities Act”).
The JOBS Act intends to encourage entrepreneurship by easing regulatory burdens on raising capital across the lifecycle of an enterprise, including:
- Seed Capital: The JOBS Act permits companies in need of seed capital ($1 million or less) for the first time to obtain small sums of capital from a broad pool of investors in a practice referred to as “crowdfunding.”
- Pre-Initial Public Offering: The JOBS Act makes it easier for private companies to stay private by increasing the number of shareholders a private company may have and easing the restrictions on general advertising in offerings to qualified investors.
- Post-Initial Public Offering: The JOBS Act provides an “on-ramp” for emerging growth companies to seek capital in the public markets by reducing onerous reporting and auditing requirements that in the last decade have become an impediment to going public.
COMPANIES SEEKING SEED CAPITAL: CROWDFUNDING
Under the JOBS Act, a new category of exemption from the registration requirements under the Securities Act is created for “crowdfunding.” “Crowdfunding” is the term for receiving small sums of investment capital from ordinary investors, and it is often used by entrepreneurs and small businesses if they cannot obtain or do not desire financing from angel, venture capital, private equity or banking sources.
Prior to the JOBS Act, United States securities laws permitted emerging companies to raise capital primarily from wealthy, knowledgeable investors, known as “accredited investors,” including angel investors, venture capital and private equity funds, unless the company registered its capital raise with appropriate state and federal authorities. The time and cost of completing the registration process could be more costly than the sum of capital being raised (especially for seed investments) and therefore most companies had little choice but to finance their growth solely from accredited investors, if at all.
Title III of the JOBS Act exempts from registration any securities sold by a private company raising up to $1 million within any given 12-month period, provided that:
(i) the amount purchased by an investor in the transaction does not exceed the maximum investment amount;
(ii) the transaction is conducted through a broker or “funding portal;” and
(iii) the private company provides certain descriptive information to the funding portal and Securities and Exchange Commission (“SEC”).
Maximum Investment Amount: Prior to the JOBS Act, a private company was permitted to offer and sell its securities to a non-accredited investor under limited circumstances based on a public policy of protecting unsophisticated investors from investing (and losing) all of their savings. Without undermining the public policy of protecting unsophisticated investors, the JOBS Act eases the restrictions on entrepreneurs and small businesses. Under the JOBS Act, the maximum dollar amount of investment interests any private company may sell to an individual investor is:
- The greater of $2,000 or 5% of the individual investor’s annual income or net worth within any 12-month period (if either the individual investor’s annual income or net worth is less than $100,000); and
- 10% of the individual investor’s annual income or net worth, not to exceed a maximum amount of $100,000 (if either the individual investor’s annual income or net worth is equal to or greater than $100,000).
Broker or Funding Portal: To obtain the benefit of the “crowdfunding” exemption, private companies must conduct offerings through an SEC-registered intermediary, such as a broker or “funding portal.”
A funding portal, which is defined under the JOBS Act, is an operator of one or more web sites or portals used to facilitate small transactions for the accounts of others as contemplated by the crowdfunding provisions of the JOBS Act.
The intermediary must register with the SEC and a self-regulatory organization and meet certain obligations. Among other things, the intermediary is required to ensure investors understand the risks and can afford to lose the investment. Intermediaries must also conduct a background check on the private company's officers, directors and large shareholders (i.e., holders of more than 20% of the outstanding equity). The funding portal cannot give investors advice or recommendations, solicit purchases or sales of the securities offered on its website or handle investor funds or securities.
Issuer Information: Companies taking advantage of the crowdfunding exemption from registration must still provide certain descriptive information necessary for individual investors to make an informed investment decision. This information includes:
- A description of the issuer’s business and anticipated business plan;
- A description of the issuer’s financial condition together with (i) income tax returns filed by the issuer for the most recently completed year if the issuer has targeted to raise $100,000 or less within the preceding 12-month period, (ii) financial statements reviewed by an independent public accountant if the issuer has targeted to raise between $100,000 and $500,000 within the preceding 12-month period, and (iii) audited financial statements if the issuer has targeted to raise more than $500,000 within the preceding 12-month period;
- A description of the transaction, including the target offering amount, the deadline to reach the target amount, the price of the securities, the use of proceeds and the risks to purchasers;
- A description of the ownership and capital structure of the issuer, including the differences between various classes of securities, a description of how the exercise of rights of the principal shareholders could negatively impact the purchasers, the name and ownership level of each existing shareholder with more than 20% of any class of securities, the valuation methodology and the risks to purchasers relating to minority ownership in the issuer; and
- File with the SEC and provide to investors at least annually reports of the issuer’s results of operations and financial statements (the JOBS Act does not require that these annual reports be audited but the SEC may require audited annual reports if it determines it appropriate).
Additional Considerations: Securities purchased in a crowdfunding offering will not be as liquid as shares purchased or sold in the public market. The JOBS Act imposes a statutory restriction on transfers (in addition to any company specific restrictions on transfer) that prohibits an individual investor from selling securities purchased in a crowdfunding offering for at least one year, unless the securities are sold to the issuer, an accredited investor or as part of an offering registered with the SEC. This transfer restriction is essentially the same as the restriction applicable to securities purchased in a private placement.
A private company and its directors and officers are exposed to civil liability in connection with securities offered in a crowdfunding offering. An investor may sue to recover an investment (plus interest) if the issuer makes any material misstatements in, or material omissions from, an offering document or oral communication involved in the offer or sale of securities.
Compliance with other laws: Securities offered in a crowdfunding offering are regarded as “covered securities” and thereby are not required to be registered under state security laws (commonly referred to as “Blue Sky Laws”). It remains to be seen whether SEC rules will require an issuer to file a notice (similar to the current Form D) upon the sale of securities via crowdfunding.
Generally, a company is subject to certain additional reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”) when the company has more than a specified number of shareholders (discussed below). The JOBS Act specifically excludes from this shareholder threshold any shareholder who purchased securities in a crowdfunding offering.
PRE-IPO COMPANIES: STAYING PRIVATE LONGER
The JOBS Act makes it easier for private companies to stay private by increasing the number of shareholders a private company may have and easing the restrictions on general advertising in offerings to qualified investors.
Private Offering Exemptions
The JOBS Act intends to facilitate private offerings by easing restrictions on companies soliciting accredited investors and by easing restrictions on qualified institutional buyers (“QIBs”) seeking to resell their holdings.
Private offerings made to accredited investors are exempt from registration under the safe harbor provisions of Rule 506 of Regulation D under the Securities Act (“Rule 506”). Prior to the JOBS Act, Rule 506 allowed a company to offer an unlimited amount of securities to accredited investors and not more than 35 non-accredited investors, provided the offer is not by any form of general solicitation or general advertising. The SEC has interpreted the terms “general solicitation” and “general advertisement” broadly to include any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio.
Securities purchased in a private offering can be resold under Rule 144A of the Securities Act (“Rule 144A”), which allows a person (other than an issuer or dealer) to offer or sell securities without being deemed an underwriter, provided the securities are sold only to a QIB or someone the seller reasonably believes to be a QIB.
The prohibition on general solicitation and general advertising increases the costs for and burdens on (i) companies seeking capital to solicit potential investors; and (ii) investors seeking liquidity to resell the securities purchased through a private offering.
To encourage liquidity of securities purchased through private offerings, Title II of the JOBS Act instructs the SEC to revise Rule 506 to permit general solicitation and general advertising in connection with such private offerings provided that all purchasers of securities pursuant to the Rule 506 exemption are accredited investors (an issuer will be required to take reasonable steps to ensure that all purchasers are accredited investors). Title II also instructs the SEC to revise Rule 144A to permit general solicitation and general advertising, provided that sales of securities pursuant to the rule are only made to persons reasonably believed to be QIBs.
Small Public Offerings
Regulation A of the Securities Act (“Regulation A” and also known as the small issuer exemption) exempts from registration any offering of up to $5 million per year, provided not more than $1.5 million is offered to the public by selling security holders. Securities issued under Regulation A may be sold publicly and are not considered restricted securities (unlike securities sold through a private offering). Regulation A’s relatively small cap of $5 million is often a major reason why many companies are unable to take advantage of this exemption.
Title IV of the JOBS Act requires the SEC to amend Regulation A (or create a new exemption from registration similar to Regulation A) to (i) raise the cap in the exemption for small public issuances of unrestricted debt, equity or convertible securities to $50 million (from $5 million) in any given 12-month period and (ii) require any Regulation A issuer to file audited financial statements with the SEC.
A private company and its directors and officers are exposed to civil liability in connection with securities offered via Regulation A. An investor may sue to recover an investment (plus interest) if the private company makes any material misstatements in, or material omissions from, an offering document or oral communication involved in the offer or sale of securities.
Shareholders of Record
Prior to the adoption of the JOBS Act, if a company was not listed on a stock exchange, Section 12(g) of the Exchange Act and its related rules required a company with more than $10 million in assets to register any class of its equity securities held of record by 500 or more persons. For private companies, “shareholders of record” generally means all shareholders of the company, including employees holding shares granted under an employee compensation plan. Some companies approaching the Section 12(g) shareholder threshold are compelled to go public, even if such action may not be in the strategic interest of the company due to then-current market conditions or other business considerations.
The JOBS Act increase the number of shareholders of record a company may have prior to being required to register its equity securities. The holder of record threshold (i) has been raised to 2,000 person or 500 persons who are non-accredited investors and (ii) excludes shareholders who received their shares under an employee compensation plan and shareholders who purchased their shares in a crowdfunding offering.
EMERGING GROWTH COMPANY: IPO ON-RAMP
The JOBS Act further reduces many of the burdensome reporting and auditing requirements previously placed on emerging growth companies that raised money through public capital markets. Title I, commonly referred to as the “IPO On-Ramp,” establishes a new category of issuer called an “Emerging Growth Company” under the Securities Act and Securities Exchange Act of 1934.
An Emerging Growth Company is defined as an issuer with less than $1 billion of total gross revenue during its most recently completed fiscal year. An issuer will continue to be deemed an Emerging Growth Company until the earlier of:
(i) The last day of the fiscal year during which it had total annual revenue of at least $1 billion;
(ii) The last day of the fiscal year following the 5th anniversary of the issuer’s IPO;
(iii) The date on which it has, during the previous 3 year period, issued more than $1 billion in non-convertible debt; or
(iv) The date on which the issuer is deemed a “large accelerated filer” under the Exchange Act (i.e., the issuer has an aggregate worldwide market value of $700 million or more as of the last business day of the issuer’s most recently completed second fiscal quarter).
An Emerging Growth Company is exempt from, or subject to reduced, regulatory requirements.
Reduced Financial and Compensation Information in SEC filings:
- An Emerging Growth Company is required to provide only 2 years of audited financial statements in its IPO registration statement (rather than the 3 years of audited financial statements and 5 years of selected financial data required before passage of the JOBS Act).
- An Emerging Growth Company may avail itself of the reduced executive compensation disclosure requirements available to smaller reporting companies.
- An Emerging Growth Company does not need to provide to its shareholders a separate, non-binding advisory vote on executive compensation (“Say on Pay”) until at most 3 years after the issuer is no longer an Emerging Growth Company (smaller reporting companies are only exempt from required Say on Pay vote until 2013).
Exemption for certain Internal Audit Controls and Accounting Standards
- A registered public accounting firm that prepares or issues an audit report for an Emerging Growth Company is not required to provide an attestation report on the company’s internal controls as generally required by the Sarbanes-Oxley Act of 2002.
- An Emerging Growth Company is not required to comply with any new or revised financial accounting standards until such standard applies to private companies.
- The current and future rules of the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report do not apply to the audit of an Emerging Growth Company, unless the SEC determines that the application of such rules is necessary or appropriate in the public interest.
Communications with Accredited Investors and Publishing of Research:
- An Emerging Growth Company (and its authorized representatives) is permitted to engage in oral and written communication, even during the quiet period between from the time a company files a registration statement with the SEC until SEC staff declare the registration statement effective, with potential investors that are QIBs or institutions that are accredited investors to determine whether such investors might have an interest in the contemplated securities offering.
- Brokers and dealers are permitted to publish and distribute research reports about an Emerging Growth Company that proposes to file an IPO registration statement or has filed or has an effective IPO registration statement.
- Brokers, dealers or members of a national securities association may publish or distribute research reports or make public appearances with respect to the securities of an Emerging Growth Company during the post-IPO quiet and lock-up periods.
- Expanded security analyst communications with potential investors and/or management of an Emerging Growth Company.
Confidential submissions of draft IPO registration statements
- An Emerging Growth Company is permitted to submit a draft IPO registration statement for confidential review by the staff of the SEC prior to publicly filing its IPO registration statement. Notwithstanding any confidential draft submissions, an Emerging Growth Company may not conduct any “road show” unless its IPO registration statement and all amendments have been publicly filed with the SEC at least 21 days prior to any road show.
An Emerging Growth Company may elect to comply with the heightened disclosure requirements that apply to a public company that is not an Emerging Growth Company. The JOBS Act states that if an Emerging Growth Company elects to comply with the non-Emerging Growth Company accounting standards, it must comply with all accounting standards and may not select some accounting standards to comply with and not others. The JOBS Act makes no similar requirement if an Emerging Growth Company elects to comply with the heightened executive compensation disclosure requirements.
The JOBS Act represents a major step by the federal government in facilitating entrepreneurship and business growth by easing the regulatory burdens on raising capital. During the summer and fall of 2012, the SEC will promulgate the rules to administer the JOBS Act and many of the details as to how crowdfunding will operate and how Emerging Growth Companies may actually avail themselves of the public markets. Legal observers, the investing community and business leaders will closely watch this process as it develops and Nutter will continue to provide updates and analysis.
This advisory was prepared by the Emerging Companies Group at Nutter McClennen & Fish LLP. For more information, please contact your Nutter attorney or any member of the Emerging Companies Group at 617-439-2000.
This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.