What, exactly, are the new general solicitation rules? And what, in simple terms, do they mean?
Everyone is saying the same thing since new SEC crowdfunding rules came into effect on September 23, 2013: “can someone please explain this in simple terms?” I believe I ought to be able to – being an angel with a background in securities law ought to have some silver lining… But keep in mind that in doing so, I am deliberately going to omit minor elements of these rules for the sake of clarity and simplicity. And in case it is not abundantly clear, this blog post is not legal advice – it is educational background information. Get yourself a lawyer if you are planning an offering – this is complicated stuff.
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: (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.
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 turn out not to be. Unfortunately, in practice, with general solicitation guidelines so broad, it is going to be far 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, the SEC feels companies 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 so invasive and draconian that angel investors the world over became apoplectic at the thought of 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 and other reasons, and (ii) represent a level of per-investor effort that companies could ill-afford to undertake.
As if this weren’t bad enough, the SEC’s new rules have also put a spotlight on exactly what general solicitation is in this new modern internet enabled start-up world of ours. 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, are pretty clearly 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.
We don’t know where things will end up when the dust settles, 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 may 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 rase more without going to some other more traditional and labor-intenstive 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 a lot 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.) For more details on the ACA position, see their white paper here and their JOBS Act resources center here.)
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, 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 finally, although I am loathe to contemplate it, if needed, 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 Gonna Be OK
So in the end, while change is hard, and anxiety is the knee-jerk reaction, 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.
I only wish I could say the same about crowdfunding, which I think has the potential to be a lot messier. For some thoughts on that, see Thoughts on Crowdfunding, Chris Dixon: Startup Crowdfunding, Fred Wilson: Leading vs Following.
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If you enjoyed this post, you might enjoy: Fred Wilson: Leading vs Following, Chris Dixon: Some thoughts on startup crowdfunding, Funding Startups (Video), Swimming Against the Tide (Angel Investing), Nailing The One Minute Pitch, Start-Up Marketing Series, Customer Crowdfunding: Not So Fast Entrepreneurs (Again!), Constructing a Pitch, Pick Your Angel Investors Wisely (David Hornik), Why Angels Chase Electrons, Boards vs. Advisory Boards, Interview: State of the VC & Angel Market and How to Raise Money, Delusional Economics, That Vision Thing, The Power of An Advisory Board, Loch Ness, Unicorns & The First-Mover Advantage, Does This Slide Deck Make Me Look Fat?, The Long Road to Instant Success, Top Angel Investors in New England, Launchpad Overview – Angel Video Interview Series, Customer Crowdfunding: Not So Fast, Entrepreneurs, Angel Video Interview Series, Thoughts on Crowdfunding, The Crowdfunding Interview (Frank Peters Show), Getting Off The Ground; Early Formation Economics, Pitch Clinic at MassChallenge (Video), Top 20 Dos & Don’ts with Angel Groups & Early Stage Financing, What I Look For In An Entrepreneur, The Overture, Open Forum with Angel, Seed and VC Investors (Video), 20 Bootstrapping Ideas.
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