In Part 1 of this bog, I tried to place in context the recent change in Rule 506 that eliminates — for one class of Rule 506 offerings — the long-time prohibition against general advertising or general solicitation. Part 2 of this blog comments on some of the possible consequences this amendment, and introduces the complexities (which I will deal with in another blog in the new future) raised by amendments to Regulation D proposed by the SEC at the same time it adopted Rule 506 ( c ).
When the SEC adopted New Rule 506 [506 ( c )] this past summer, The Wall Street Journal published an article highlighting stock promoters excited about the change and promising to use — or exploit — it vigorously. Coulter Lewis aimed to raise money for his seven-employee popcorn company Quinn Popcorn LLC by advertising on Twitter and Facebook. Nathan Derrick, founder of SupplyHog, expected to grow his home supply business from $300,00 in annual sales and 15 employees to $10 million in sales and 100 employees within 12 months by using New Rule 506 to raise capital. Brad McNamara of Freight Farms (which converts shipping containers into produce gardens) planned to place big ads (40 X 9 foot) on the sides of the containers to solicit investors. Douglas Penman of Nuktoys Inc. was considering splashing ads on tee shirts worn by window washers: at 45 stories above ground, they would become moving billboards to the affluent executives on the other side of the windows. Craig Sher of Stearclear LLC, a designated driver service for intoxicated individuals, was thinking of buying investor advertisements at the bars and restaurants where his customers gather. And Bryan Pate of ElliptiGO Inc., maker of exercise equipment, wanted to raise millions through Facebook and his 20,000 circulation newsletter.
In short, all of these entrepreneurs were shouting "Hurrah!" at the coming of New Rule 506: no more one-on-one meetings with potential investors, no more paying attorneys large fees to steer their companies through the difficult and dangerous waters of private placement, and no more humiliating days spent begging for introductions to the high net worth individual networks of investment advisors and brokers.
Four months later, a quick Google search for all of those companies reveals that several of them appear quite successful based on the information presented on the company websites, FB pages and Twitter accounts. Some are harder to find.
But that same search doesn't readily show any online gateway for New Rule 506 investors: no investor advertisement pages, no posted letters encouraging inquiries from potential investors, no pages or links captioned "Accredited Investors Welcome Here!"
Their initial ardor seems to have cooled. Why?
AccreditedInvestorLeads.com, may have put a finger on two of the problems with Rule 506 ( c ) [which were referenced in Part 1 of this blog]:
"However, many are now calling the move by the SEC, and indeed Congress itself, nothing more than a Trojan horse. One of the best ways the SEC has achieved this is by failing to, anywhere, define what exactly a general solicitation is. Another, implemented by the specific demand of Congress in passing the JOBS act, is that all investors need to be accredited. These two requirements when combined together create a one way ticket to a very sticky place, one that most investors want to avoid and certainly all start-ups would like to stay as far away from as possible. The place where investors have to turn over sensitive documents to verify their investment status, and where startups are unable to seek investment without taking 'due precautions' to verify that the investors they are soliciting are indeed accredited. When viewed as part of the general solicitation rule, this includes things like social media where a simple tweet about the company’s offerings could result in hopping on the train to a verification nightmare. There can be, and is, little doubt that investor are not about to turn over bank account statements, W2’s, credit reports, or brokerage statements to the companies they want to invest in. The more the hassle, the less likely it is that an investor will, in fact, invest. And with the doing away of a simple 'agree by signature' the complications continue to grow. Companies are now required to conduct a level of due diligence to ensure that their investors are, in fact, accredited, taking away from the time and effort needed to grow a small company that is seeking investment in the first place. Or companies can simply avoid general solicitation and go on with business as usual…. It would be remiss to say that there are not some success stories out there. Angel list [sic], a popular online platform, announces on its home page that it has helped thousands of investors to take advantage of Rule 506 (c), and successfully raise funds. While their verification process or that of their entrepreneurs could fall under scrutiny, it is for now a working model."
An editorial in The Wall Street Journal a few months ago expressed, in different words, the same concept regarding the new accredited investor verification condition: that by creating the "safe harbor within the safe harbor" [to quote from Part 1 of this blog] concept with a "nonexclusive" list of verification tests that will be deemed sufficient to meet the verification duty under New Rule 506, but which many potential investors are likely to consider uncomfortably intrusive, the SEC may have created the appearance of a more freely accessible market for unregistered securities offerings while actually raising the wall for private offerings under Rule 506.
A more hopeful article appeared about a month ago in The Wall Street Journal. The article presented the story of Estimote, which garnered $250,000 in funding in only three days; its founder had needed six months to gather less than 10% of that sum just four years ago for a different startup. The real success behind a good Rule 506 ( c ) offering lay in executing it through an AngelList syndication (the platform identified above by AccreditedInvestorLeads). AngelList, as the name implies, approaches the process from the investors' perspective, by forming syndicates of accredited investors who each specifies how much money he is willing to contribute toward private investments to be selected by a syndicate leader (sounds just like private equity funds). The leader gets a carried interest of 10% to 20% (like PE funds). Only difference? He has to give up 5% to AngelList for supplying the platform (or exchange or marketplace, whichever term you like) by which he is able to identify and organize his investment syndicate. Investors do NOT pay a management fee to the syndicator (unlike PE funds). Minimum investments? Sometimes as low as $2,500.
The reason this works — besides AngelList's history in the area of matching angel investors with startups — lies in the vetting by AngelList not only of all potential investors as "accredited investors" but also vetting that potential syndicators are "super" accredited investors with successful track records in fundraising.
At the time the article appeared, AngelList carried 85 syndicates. Startup companies are tapping the syndicates sometimes for more than one round of financing, and in doing so, are eschewing traditional venture capital funds as well as PE and VC funds. The competitive environment is shaking up the VC and PE worlds. Some VC firms are establishing their own syndication platforms in an attempt to regain the business they are losing — or fear they will lose — to AngelLinks and its progeny.
And just this week, in the "Small Business" section of The Wall Street Journal, a more informed picture began to emerge. Small companies eager (like the ones profiled earlier) to use New Rule 506 are being advised by their attorneys to go slowly. The first (and solid) reason is the one explained above: the problem of verifying the accredited investor status of purchasers. And the second reason (also mentioned above) is the problem of knowing what kind of statement or communication comprises "general solicitation" in a Facebook, Twitter, no-privacy Internet world. But here is another one, and I will write about this in a future blog soon: the amendments to Regulation D PROPOSED, not adopted, by the SEC in July, to combat the anticipated rise in securities fraud as a result of the changes effected or to be effected by the JOBS Act (including but not limited to the elimination of the prohibition against general solicitation). Those proposals would include a number of new conditions for using New Rule 506, including but not limited to:
- requiring issuers to file their Form D at least 15 days PRIOR to beginning a general solicitation, as well as subsequent filings when sales are made; and
- submitting written general solicitation materials to the SEC not later than the date of first use, and attaching specific disclaimers to fundraising materials and communications.
It appears that some attorneys are confused and believe these proposed amendments are actually in effect now. Better informed attorneys know better, but they also know that (1) the SEC could adopt these proposed changes — and others — within months, requiring a whole new round of learning by clients, (2) the SEC could — but might not — provide transitional relief for offerings that commence prior to adoption of those amendments but are still underway when the amendments take effect, and (3) there is a risk that offerings commenced and continued under transitional grace after adoption of those amendments, or commenced and even closed before adoption of those amendments, might be integrated with offerings started after the amendments are adopted, tripping up issuers. The puzzle seems to be one that confronts tax lawyers: when the agency that both adopts and enforces the regulations flashes a signal, in the form of proposed rules, of the way it thinks the law ought to operate, then it can be imprudent to disregard its warning of what is to come.
Nevertheless AngelList continues to push forward with its platform for utilizing New Rule 506. According to the same article, its "public fundraising" website section opened when New Rule 506 became effective and already boasts 3,000 issuers who have raised a total of $8.6 million.
So New Rule 506 IS operational, even if it isn't gaining velocity as quickly as it could.