On March 8, 2012, the U.S. House of Representatives passed the “Jumpstart Our Business Startups Act” (H.R. 3606) with very strong bipartisan support. Competing, but more restrictive, legislation is pending in the U.S. Senate. The JOBS Act contains a number of important provisions intended to benefit startup companies and emerging growth companies, including loosening the current prohibition on general solicitation of investors and allowing crowdfunding by investors subject to a number of protective requirements.
Access to Capital – General Solicitation
In a major departure from existing limitations under federal securities law, the current prohibition on general solicitation or general advertising in connection with the offer or sale of securities under Rule 506 of Regulation D under the U.S. Securities Act of 1933 would not apply to an offering if all purchasers of the securities are “accredited investors.” See Raising Capital for Your Business for a description of the requirements for an accredited investor. As a result, startup companies and established businesses would be free to solicit potential investors via internet websites and other means, including a company’s own website and other promotional materials, as long as the company accepts actual investments only from accredited investors. A company would be required to take reasonable steps to verify that purchasers of securities are accredited investors. All solicitations would remain subject to the anti-fraud provisions of federal and state securities law which require accuracy and completeness of information provided in connection with a purchase or sale of securities.
Entrepreneur Access to Capital – Crowdfunding Exemption
In another major innovation, startup companies would be able to raise up to $1,000,000 (or $2,000,000 if the company provides audited financial statements) in any 12-month period without regard to an investor’s financial qualifications, provided that the amount purchased by each investor does not exceed the lesser of $10,000 and 10% of the investor’s annual income. In order to use the proposed new crowdfunding exemption, the company issuing securities would have to:
- warn investors, including on the company’s website, of the speculative nature generally applicable to investments in startups, emerging businesses and small issuers, including risks of illiquidity (inability to resell or transfer securities)
- warn investors that they may not transfer the securities for 1 year following purchase, except for transfers to an accredited investor or to the company
- take reasonable measures to reduce the risk of fraud in connection with the transaction
- provide the Securities and Exchange Commission (SEC) with the company’s physical address, website address and the names of the principals and employees of the company, and keep this information up-to-date
- provide the SEC with continuous investor-level access to the company’s website
- require each potential investor to answer questions demonstrating: an understanding of the level of risk generally applicable to investments in startups, emerging businesses and small companies; an understanding of the risk of illiquidity; and other areas determined by the SEC
- state a target offering amount and ensure that cash proceeds are held by a third-party custodian (such as a registered broker-dealer or insured depository institution) until the company receives at least 60% of the target offering amount
- provide notice to the SEC no later than the first day securities are offered to potential investors, including the stated purpose and intended use of proceeds of the offering, the target offering amount and the deadline to reach the target offering amount
- outsource cash-management functions to a qualified third-party custodian, such as a registered broker-dealer or an insured depository institution
- maintain books and records as required by the SEC
- make available on the company’s website a method of communication that permits the company and investors to communicate with one another
- not offer investment advice to potential investors
- provide notice to the SEC upon completion of the offering, including the aggregate offering amount and number of purchasers
- disclose to potential investors on the company’s website that the company has an interest in the issuance of the securities
A company also would be able to satisfy these requirements through the use of a qualified intermediary who would comply with each of the above requirements and in addition would be required to carry out a background check on the principals of the company. It is likely that a significant number of qualified intermediaries would offer their services to the startup universe. Importantly, an intermediary would not be required to register as a broker-dealer in order to qualify under the proposed legislation.
Initial Public Offerings by Emerging Growth Companies
Emerging growth companies would be defined as companies with total annual gross revenues of less than $1,000,000,000. The Jumpstart Our Business Startups Act would reduce compliance requirements for emerging growth companies for up to 5 years after an initial public offering (IPO), including waiver or reduction of requirements for:
- Shareholder approval of executive compensation
- Shareholder approval of golden parachute compensation
- Certain executive compensation disclosure
- Number of years of audited financial statements presented when going public
- Internal controls audit under Section 404(b) of the Sarbanes-Oxley Act of 2002
- Restrictions on communications with securities analysts and investors
The Jumpstart Our Business Startups Act would also permit an emerging growth company, before an IPO, to confidentially submit to the SEC a draft registration statement for confidential nonpublic review by the SEC before public filing. Current law generally requires immediate public availability of all registration statements submitted to the SEC.
Private Company Flexibility and Growth
The threshold for mandatory SEC registration by private companies (comparable in scope and cost to voluntary registration in connection with an IPO) would be increased from $1,000,000 total assets and 500 holders of equity securities under current law to $10,000,000 total assets and either 2,000 holders of equity securities or 500 holders who are not accredited investors, excluding holders who received securities pursuant to an employee compensation plan.
Next Steps
In order to become law, the Jumpstart Our Business Startups Act must be passed by the U.S. Senate and signed by the President. The SEC would then have 90 – 180 days to propose detailed regulations to implement the legislation. Until such time as final legislation is passed by the House and Senate and approved by the President, and new SEC regulations become effective, companies must continue to adhere to existing law in connection with the sale of securities. If enacted, however, the legislation would greatly expand the ability of startups and other businesses to seek capital from investors in the United States.