The JOBS Act is designed to help growing companies get the capital they need by removing barriers, giving them more options, and eliminating or deferring costly legal and accounting hurdles. In approving the legislation, Congress and the President recognized the power of the innovation economy to create jobs and invent new products and services that improve our quality of life.
Historically, more than ninety percent of new job creation occurred after companies went public. In recent years, however, a variety of regulatory, market, and other changes have led to a dramatic decline in the number of new offerings and the total number of U.S. listed companies. Smaller initial public offerings have virtually disappeared, and the average amount of time it takes for a company to get to an IPO has grown significantly. This means less job creation, more M&A exits, and a harder row to hoe for entrepreneurs.
The JOBS Act helps alleviate some of these challenges. It lets startups raise capital from a broader array of investors. It relaxes regulatory requirements that eat up time and money but aren't as essential for protecting investors. It gives companies more control over when to go public, lets them keep business information confidential while they decide, and enhances their ability to communicate with potential investors. In sum, it provides greater flexibility for entrepreneurs to make the best strategic decisions on how to grow.
The Act lays the groundwork for the most significant changes to securities laws in several years. Its full impact, however, will be clear only when the regulatory process has played out, the new rules have been put into practice by the financial community, and investors have responded.
But, for now, here's a thumbnail sketch of what the Act says and what's to come.
New Avenues to Raise Money: Crowd-funding and Regulation "A+"
The Wisdom of the Crowd: Crowd-funding
Steve Case calls crowd-funding "the democratization of access to investment." For startups just out of the gate, it could expand the group of prospective backers from a small circle of wealthy investors to anyone accessible by text, email or a social network. While VCs and angel investors will likely remain the mainstays for many high growth startups, crowd-funding has the potential to create a new, broader source of capital for early stage entrepreneurs.
Even before the JOBS Act, entrepreneurs had begun to turn to crowd-sourcing sites to "bootstrap" their way through product development and testing. Earlier this year, Pebble Watch reportedly raised $10 million in a matter of a few weeks. The company took pre-orders for its product and issued no securities — an important difference, since historically it's been illegal to use crowd-funding to sell securities, as opposed to products and services.
The JOBS Act changes that. Under the JOBS Act, a private company will be able to raise capital through either a registered broker or a registered "funding portal" (something that still needs to be defined by the SEC). There are limits, however, both for the company and for potential investors.
A company can raise up to $1 million over a 12-month period. Importantly, this money can come from any investor — even those who do not meet the wealth thresholds that historically have defined who may legally invest in venture capital funds and private placements.
To protect investors, however, the JOBS Act caps the amount they can put at risk. An investor with a net worth or annual income of less than $100,000 can invest annually up to $2,000 or 5 percent of their annual income/net worth, whichever is greater. Investors with a net worth or income above $100,000 can invest annually up to $100,000 or 10 percent of their annual income/net worth, whichever is less.
There is a one-year holding period for investments, subject to a few exceptions. Companies will need to file with the SEC and provide ongoing reports and information to investors. The specifics will vary based on the offering size, but will include a variety of business and financial information and, for larger offerings, audited financial statements. Importantly, these filing requirements are likely to be much less onerous than the requirements that apply to public companies.
While crowd-funding has created a lot of buzz, the SEC must still write regulations to implement it … which creates a lot of uncertainty. For small capital raises, how the SEC strikes the balance between open capital markets and investor protection — and how much information they require companies to provide — likely will have a big impact on whether crowd-funding takes off. There's also a question of timing. Crowd-funding can't begin until the SEC adopts rules. That's not expected to happen until the end of the year at the earliest, and it's very possible regulations will take a lot longer since the SEC is still dealing with the enormous workload created by the Dodd-Frank financial reform bill as well as the other aspects of the JOBS Act.
There is a great deal of debate over whether crowd-funding will augment other sources of capital for high growth companies or whether it will be used primarily by companies who don't expect to turn to professional investors down the line. People are only beginning to discuss core questions, such as how crowd-funded companies (and any professional investors that come in over time) will manage a diverse shareholder base, how a crowd-funded company can manage dilution to original shareholders if it brings in professional investors at a later stage, and whether crowd-funding can work for companies in "stealth mode".
If you're a crowd-funding advocate, we encourage you to get involved. The SEC's rulemaking process will be open to public comment, and we expect investor protection concerns will be top of mind for them. In order to increase the chances of ending up with crowd-funding rules that are most beneficial and workable, advocates will need to make the case to the SEC for crowd-funding's benefits, explain how certain regulatory burdens can make crowd-funding infeasible, and help the SEC understand the positive experiences people have had to date with marketplace and crowd-sourcing sites.
During the Great Depression, Regulation A was enacted with the goal of helping the economy by providing small businesses with a more streamlined way to access public capital markets. But it is now almost never used, for two reasons. One, it only allows offerings of up to $5 million. And two, in many cases issuers still have to contend with state-by-state regulation.
The JOBS Act is designed to breathe new life into the concept by creating a new exemption for offerings of up to $50 million annually. Commonly referred to as Reg "A+," it builds upon the existing Reg A, providing a new path to raise capital through public or private offerings to a broad base of potential investors. If it's successful, it could re-invigorate small cap IPOs by a creating a simpler, more cost effective "mini" registration process that accommodates smaller offerings and leaves a greater share of proceeds in the hands of the company.
Unlike private placements, Reg A+ offerings are open to all investors — not just "accredited investors." There are no resale restrictions, so there is the ability to create a secondary market for shares. In addition, Reg A+ can be used alongside other private offering exemptions, allowing a company to tap into different pools of capital through a series of offerings.
Those going down the Reg A+ path will have to provide an offering circular, audited financial statements, and other disclosures (to be decided by the SEC). They will be liable for misstatements and omissions, but will not have to deal with state-by-state regulations if the securities are sold on a national securities exchange or to "qualified purchasers" (if the SEC elects to define such a class of investors). They can advertise the offering broadly, and can engage in conversations to "test the waters" with potential investors before incurring the full expense of preparing and distributing offering documents.
As with crowd-funding, none of this will be "real" until the SEC issues rules…and there is no deadline by which the SEC must act.
More Flexibility, Expanded Reach for Private Placements
Many companies and virtually all venture capital funds rely on "private placements" to raise capital. These are typically governed by two provisions of the securities laws – Rule 144A and Rule 506 of Reg D.
In general, only "accredited investors" and "qualified institutional buyers" are allowed to purchase securities in a private placement. Before the JOBS Act was passed, entities not only had to make sure they didn't sell to an ineligible buyer — they also had to make sure they didn't advertise the offering to ineligible purchasers.
This restriction always required a certain amount of care, but it became increasingly stifling as modes of communication proliferated. The JOBS Act updates the rules governing private placements to reflect the modern realities of how we communicate. It puts the focus on who the securities are actually sold to, rather than who sees the solicitations and advertisements or hears about the fact that the company or fund is fundraising.
At a minimum, this change will make life easier for funds and companies going through a private placement. At best, it could more dramatically affect the fundraising environment by allowing investors to be aware of more opportunities and letting companies and funds create greater demand for their offerings.
The new rules on advertising and solicitations will be effective only when the SEC writes new rules, which the JOBS Act requires by July 4, 2012. As noted above, however, it's likely the SEC may miss this deadline.
To IPO or Not? It's Your Choice
While some companies want to go public, others want to stay private or aren't yet ready to take the IPO leap. But historically, they've had a problem. Until the JOBS Act was passed, companies with more than 500 shareholders had to register with the SEC and file public periodic financial reports — essentially becoming subject to many of the burdens of being a public company.
The problem has grown more acute in recent years, as the time and scale it takes for companies to go public has increased. Larger companies mean more employees — and if those employees receive shares or options as part of their pay, that pushes a company toward the "500 shareholder" limit. In addition, when it takes the better part of a decade to reach the scale needed for an IPO, employees and early investors may want to sell shares on a secondary exchange to get interim liquidity – further pushing companies toward the shareholder limit.
The JOBS Act alleviates this problem, giving companies greater control over whether and when to go public. Going forward, a company will need to register with the SEC only if a class of shares is held by 2,000 or more people — up from 500 — or if the number of "unaccredited investors" goes over 500. Equally or more importantly, companies don't have to count employees who received equity under an employee plan or shareholders who bought through a crowd-funding site in those numbers. (Both before and after the JOBS Act, companies that exceed these shareholder thresholds must register only if they have more than $10 million in assets.)
This provision is already effective, although the SEC will need to adopt rules to address a few details.
The IPO Roadmap Just Got Smoother
The IPO "on-ramp" is one of the cornerstone provisions of the JOBS Act. It was designed to help reverse the sharp decline in the number of small cap IPOs and the dramatic rise in the number of high growth companies that "exit" through a merger or acquisition, rather than grow through an IPO.
The legislation creates a new category called an "emerging growth company," or EGC. It makes it easier for EGCs to go public by phasing in some regulatory requirements and increases their probability of success by altering the rules that govern the IPO process.
To qualify as an EGC, a company must have had less than $1 billion in annual gross revenues in its most recently completed fiscal year. A company will remain an EGC for five years or until it exceeds the $1 billion annual revenues threshold, issues $1 billion in non-convertible debt in a three year period, or becomes a "large accelerated filer" under the SEC's rules. (Large accelerated filers are basically companies with more than $700 million in equity held by non-affiliates.)
An EGC gets several benefits — some that make it easier to go public, and others that make it easier to be public.
One, EGCs can submit their preliminary IPO documents to the SEC confidentially. This means the company can get ready for its IPO — and decide whether it wants to proceed with the IPO — before it has to disclose sensitive business information to its competitors and the public. (The company does need to make the filings public at least 21 days before starting its road show.)
Two, EGCs have up to five years to come into compliance with an array of financial and corporate governance disclosures and public company reporting requirements. For example, at the time of the IPO the company only has to file two years of audited financial statements and selected financial data, instead of three years of audited financial statements and five years of selected financial data. This means they have to spend a lot less time and money getting historical financials ready to file, and can spend more of their resources running and growing their business. EGCs also don't need to pay their auditors to attest to their SOX internal controls over financial reporting (though they do need to have those controls and their CEO and CFO need to certify the controls work). EGCs can make a more limited set of executive compensation disclosures, and they don't have to hold shareholder "say on pay" votes. Post IPO, they also have longer to come into compliance with new and revised accounting standards.
Three, both pre- and post-IPO, the JOBS Act expands the communication opportunities for EGCs, their underwriters, and potential investors. EGCs and their underwriters can "test the waters" with potential accredited investors, which can help them assess investors' interest and decide how to price and size the deal. Analysts covering an EGC can publish reports before, during, and after the offering, and investment bankers will be able to arrange communications between analysts and investors – both of which should encourage coverage and improve investor confidence.
As noted at the outset of this paper, the decline in the number of IPOs was caused by many forces, and it's too early to tell how much the IPO on-ramp will re-invigorate IPOs. It's also too early to say how investors and investment banks will respond to the new rules. But the JOBS Act and its IPO on-ramp at least have initiated a shift away from heavier regulation — and fewer small cap IPOs — which should help growth companies, their investors, their employees and the broader economy thrive.
Many of the JOBS Act provisions require new SEC rules — which means the job's not yet done. We live in an environment characterized by increased skepticism of private markets and a strong aversion to risk. Regulators have a lot on their plate, and some of the JOBS Act provisions are novel and will test the SEC's willingness to embrace change. As a result, we won't know for a while whether the JOBS Act will achieve its full promise for high growth startups. But there are two things we do know. One, there will be surprises ahead. And two, those who care about the outcome should make their voices heard by submitting comments to the SEC.
- If you’re a high growth startup and would like to get information and insights on emerging policy issues affecting startups, click here to request an invitation to join SVB’s on-line Startup Policy Forum.
- If you have questions regarding the JOBS Act, Gibson, Dunn & Crutcher's lawyers are available to assist you. Please contact the Gibson Dunn lawyer with whom you work, or email Greg Davidson.
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