It’s crunch time for the new JOBS Act rules permitting general solicitation in startup fundraising. New rules went into effect on September 23, 2013 changing the landscape of Rule 506 pursuant to Regulation D and the Securities Act of 1933. This is important in the tech ecosystem because much of the financing received by tech startups is raised under this rule.
It’s crunch time because the rules released in September have several effects, some intended and others unintended. The intended effects:
- Companies can now engage in “general solicitation” in raising capital; in other words they can tell a lot more people they are raising money and broaden the investor target list
- While general solicitation is now permitted, the companies that take advantage of it must meet new requirements
The unintended effects:
- Companies making use of general solicitation need to be far more certain that the investors they deal with are “accredited investors” as defined by law and not “bad actors” as defined by law
- Such companies may be required to obtain detailed financial information from investors, thus rendering the newly created method of fundraising unworkable
- Companies may face extreme challenges in verifying that participants in their financings are not “bad actors”
- Entities like accelerators may not be able to hold their traditional Pitch Days without violating the new rules
SEC statutes and rules are intended to protect investors from unethical practices or insufficient disclosure by companies that issue securities. Nobody has a problem with that. It is much easier to define how this works in the public markets than it is in the private markets where startups raise money. This difference in fund raising practices (and the SEC’s understanding of them) may be behind some of the problems with the new rules allowing general solicitation.
It’s an obvious gain to allow startup companies to publicize their desire to raise capital to more people via broader means. The catch is that in order to cast a wider net, the companies take on more responsibility for proving that the investors who provide capital are accredited investors. It’s not totally clear how much proof is necessary to meet the burden for proving accredited status of investors. In such situations, company counsel will opt for safety.
Safety would be assured if the company raising money required financial information from investors. Such financial information could include bank account statements or brokerage statements from personal accounts. I mentioned this as a plausible way to assure accredited investor status to a very successful entrepreneur/investor in a conversation last month. He laughed out loud. Twice. His reaction was that he would never provide such information and could not believe that other angel investors would do it.
The new rules have also had an effect on the way tech company accelerators do business. Most of these entities conclude their sessions with what was formerly called a “Pitch Day”. This is no longer prudent because doing so can subject the participating companies to the requirement of verifying the accredited Investor status of attendees or even the fact that none of the attendees are “bad actors” who have committed acts that would disqualify them as investors.
Such requirements are likely to force companies raising capital to rely on the existing “quiet raise” provisions of the SEC’s Rule 506. This means that nothing would change. In sum, the rules which are meant to help companies could actually make it very difficult for startups to raise money via general solicitation. The time is now to provide comments to the SEC; the extended comment period closes on November 4! The comments were running almost 98% against the proposed rules the last time I checked. We need to keep the comments coming from experienced founders, accelerator operators and other interested parties. To comment go here.