Entrepreneurship is a path to freedom, wealth and prosperity—not just for the entrepreneur, but for society in general. Successful entrepreneurship requires, first and foremost, the entrepreneur who has the ability to navigate the company to success. Second, it requires capital and the ability to move capital.
The second factor is the bottleneck that often prohibits promising entrepreneurs from moving forward. Access to capital can be hard to find for many entrepreneurs but the added channel is keeping in compliance with all of the regulation around equity investment.
The Securities Act of 1933 states that any security, which is essentially any commercial interest in a company (stock, LLC membership interest, investment contract, etc), must be registered with the Securities Exchange Commission (SEC) OR it must be exempt from registration. Public registration of a security or “going public” is a very burdensome process for companies that are more well established. The cost of registration is usually prohibitive for most small private companies.
However, the law allows for certain exemptions from the registration requirement and this article is mostly concerned with the three main exemptions—Regulation D, Regulation A+ and Regulation CF. Each of these registrations has its own set of pros and cons. The biggest challenge for smaller private companies is whether the exemption allows for raising capital from accredited or unaccredited investors.
Accredited investors are those who meet one of the following criteria:
- Any bank (as defined by the statute)
- Any private business development company (as defined by statute)
- Any nonprofit organization with total assets in excess of $5,000,000
- Any director, executive officer or general partner of the issuer
- Any natural person whose individual net worth exceeds $1,000,000
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income in excess of $300,000
- Any trust with total assets in excess of $5,000,000
- Any entity in which ALL equity owners are accredited investors
For most smaller private companies or funds, the reliance is on smaller investors who may or may not be accredited investors. A further challenge presented by the regulations is whether a federal filing is sufficient or whether the issuer needs to file under the state securities laws of each state in which it has investors. This can become very costly and burdensome depending on how many states in which filing is required.
Regulation D
The most commonly used exemption remains Regulation D, which itself has two parts. Under Rule 504, an issuer—the company raising capital—can raise up to $5,000,000 in any 12-month period. The securities are restricted to accredited investors only if general solicitation is being used to market the offering. However, in addition to filing with the SEC, the issuer will have to also comply with all applicable state laws.
Under Rule 506, an issuer may raise an unlimited amount of capital. If the issuer is using general solicitation to market the securities, then only accredited investors may invest. However, the issuer is allowed up to 35 unaccredited investors if general solicitation is not used. The major advantage to Rule 506 is that the federal filing with the SEC preempts state laws.
Regulation A+
In 2016, the SEC finally implemented the JOBS Act, a bill which had gone into effect in 2012. Regulation A+ is a colloquial term used to refer to the new and improved Regulation A after the implementation of the JOBS Act.
Regulation A+ also has two tiers, each with their own sets of pros and cons. Under Tier 1, the issuer may raise up to $20,000,000 with no limits as to how many unaccredited investors. In fact, Regulation A+ allows the issuer to “test the waters” and solicit the offering with the general public before any filing with the SEC. Tier 1 still requires the issuer to complete all state filings that are required based on investors. The issuer does not have to present any audited financials and there are no ongoing reporting requirements other than an exit report after completion of the offering.
Under Tier 2, the issuer may raise up to $50,000,000 also with no limits on how many unaccredited investors. Similar to Tier 1, the issuer may “test the waters” and market the offering prior to any filings. A major advantage of Tier 2 is that it preempts state securities registration requirements. With a Tier 2 offering, the issuer may also seek to have the offering listed on publicly traded exchanges. Tier 2 filings must present audited financials and have ongoing reporting requirements including annual and semiannual reports.
Regulation CF (Crowdfunding)
Another great addition under the JOBS Act was the inclusion of an exemption for crowdfunding. Prior to Regulation CF, crowdfunding was becoming more and more popularized by sites like Kickstarter.com. However, since such sites met none of the existing exemptions, Kickstarter implemented a model of rewards and donations. “Issuers” could raise capital for a project and rather than investors, individuals funding the project would receive some kind of reward (for example, a production credit on a movie, or an advanced version of the product, etc.).
Regulation CF was passed and it allowed the necessary leeway for equity crowdfunding—or crowdfunding where the funders could actually receive equity in the company. Regulation CF allows an issuer to raise $1,007,000 in any 12-month period. This amount will continue to increase along with rates of inflation. The issuer must list the company on an approved crowdfunding portal. Naturally, there is no limit on unaccredited investors and Regulation CF also preempts state securities registration requirements. Finally, the documents required by the SEC are far less stringent than those required under Regulation A and D.
Issuers under Regulation A+ and D can still list on crowdfunding portals, however, they would have to ensure that they continue to meet all the requirements for filing with appropriate states and maintaining that all investors are accredited investors.
Crowdfunding portals have naturally grown significantly since the establishment of Regulation CF as it allows even more small companies to raise smaller amounts of capital with much less of a legal and accounting burden. However, as with all other exemptions, a competent securities attorney is still extremely necessary.