SEC Modernizing Private Securities Offerings
Starting in August 2020 with the long-awaited expansion of the long-standing definition of “Accredited Investor”, the US Securities and Exchange Commission (the “SEC”) has been incrementally making rule changes to expand the scope of those who can participate in certain investment opportunities while maintaining investor protections from the prior existing rules.
On November 2, 2020, the SEC went further to simplify and improve the exempt or unregistered offering framework. While these changes are comprehensive and multi-faceted, at a high level, to practitioners, these changes are a very much welcomed and are a long time coming. For those raising capital, some of these changes as to the form of conducting an exempt offering may seem less significant, but the rules related to expanded eligibility of who can invest and how they can “test the waters” are a positive operational change.
From our point of view, the most important changes for those raising capital are the following:
The new rule permits an issuer to use generic solicitation of interest materials to “test-the-waters” for an exempt offering of securities prior to determining which exemption it will rely upon for the sale of the securities. This is an important legal change because, the fact of the matter on the ground is that this already is, de facto, a common practice by those raising money anyway. The SEC has slowly expanded the “test-the-waters” accommodation over the years so that it can be used by more and more capital raising participants.
Related to the first bullet above, certain “demo day” communications will now not be deemed general solicitation or general advertising. This is an important revision because, again, it is already commonly done in practice, but feared by lawyers. For years, there has been a question as to whether a start-up company’s demo day presentation may disqualify it from relying on private placement exemptions available to them. Although each company presentation at a demo day event typically focuses on the start-up company’s business, almost invariably, the presentation includes at least some aspect of the company’s capital raising plans. The legal concern regarding such a practice is that these statements may inadvertently fall within the broad definition of a “securities offering”, as it has historically been interpreted by the SEC and, therefore, subject the company to future regulatory and due diligence scrutiny. This change is a nice understanding of modern capital raising practices regarding such communications and eliminating a common concern for securities practitioners.
Currently, there are three registered offering exemptions that cap the total amount that can be raised. These three amounts are increased under the revised regulations as follows: (i) the Regulation A Tier 2 primary offerings limit is increased from $50 million to $75 million and the secondary sales limit is increased from $15 million to $22.5 million; (ii) the Regulation Crowdfunding (CF) limit is increased from $1.07 million to $5 million; and (iii) the Regulation D Rule 504 limit is increased from $5 million to $10 million. These three offerings are all underutilized, for a variety of reasons, one of which has been commonly believed to be that the caps are too low, and the associated costs are too high to comply with each offering’s specific required. Regulation Crowdfunding, notably, often goes unused because most companies raising money in this category cannot raise enough money to make it worthwhile and raising money from a crowd comes with its own set of administrative difficulties as well as lack of attractiveness for further large-scale fund investors due to the sheer number of existing shareholders. With the offering limit increases, perhaps more companies will try to utilize these offerings (although increasing the limits are not the only barriers to using these specific offering exemptions that should be reformed, in our view).
Under the amendments to the definition of an accredited investor, a “knowledgeable employee”, as defined in Rule 3c5(a)(4) under the Investment Company Act of 1940, of an entity that would be required to register as an investment company under the Investment Company Act but for the exclusions provided by Section 3(c)(1) or 3(c)(7) thereof, generally known as “private funds”, will qualify as an accredited investor with respect to securities offerings of such fund. Under Rule 3c5(a)(4), a “knowledgeable employee” includes an executive officer, director, trustee, general partner, advisory board member, or similar, of the private fund or an affiliated management person, or an employee of the fund or “an affiliated management person” who participates in investment activities as part of his or her regular functions or duties. Functionally, what this does is it will allow these small private funds to accept investments from knowledgeable employees without jeopardizing their status as accredited investors under Rule 501(a)(8) and their ability to participate in certain offerings under Rule 506 in which they would not otherwise be eligible to participate.
Consistent with existing SEC staff guidance, limited liability companies with total assets exceeding $5 million, not formed for the specific purpose of acquiring the securities offered, will be deemed to meet the accredited investor definition, thereby expanding this provision from the current list which only includes corporations, business trusts, and partnerships.
The amendments adopted by the SEC should serve to lower the barrier for smaller companies to engage with investors in the private markets and to raise capital from a wider pool of investors. These amendments will also simplify future exempt offerings by eliminating certain potential pitfalls and causes for unnecessary uncertainty. The new amendments, while not seemingly groundbreaking, demonstrate that the SEC is open to continually adapting to the times to facilitate better functioning private markets and the growth of small and medium-sized businesses.
* * *
If you are a business that has questions about securities laws and how the laws impact your business, contact the Founders Legal team.
- SEC Modernizing Private Securities Offerings - November 9, 2020
- The Benefits of the GDPR Two Years In - April 8, 2020
- Part Two: Managing Equity Incentive Plans in a Volatile Market - April 7, 2020