[authors: Jacob D. Babcock, Christopher C. Cain, Terry D. Nelson, Mark T. Plichta, Kevin M. Shuler]
On April 5, 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. The JOBS Act seeks to reduce securities law burdens on start-ups and small businesses to make capital more accessible. In a statement preceding the signing ceremony, President Obama stated, “America’s high-growth entrepreneurs and small businesses play a vital role in creating jobs and growing the economy. I’m pleased Congress took bipartisan action to pass this bill. These proposals will help entrepreneurs raise the capital they need to put Americans back to work and create an economy that’s built to last.”
Both political parties supported the JOBS Act as a way to ease the burden on smaller companies looking to obtain capital from public and private sources. The JOBS Act seeks to facilitate growth in IPOs through a special IPO process and scalable disclosure requirements for smaller companies, while other provisions streamline current regulations pertaining to exempt offerings. Not all JOBS Act changes take effect immediately, as the SEC must implement certain regulations. When fully implemented, the provisions should provide companies with greater flexibility in seeking capital from investors.
Among its provisions, the JOBS Act creates a new “emerging growth company” designation under the Securities Act of 1933 (Securities Act), which is defined as a company with total annual gross revenues of less than $1 billion in its most recently completed fiscal year. A company will retain this designation until the earlier of (1) the last day of the first fiscal year in which its total annual gross revenues exceed $1 billion, (2) the date on which it is deemed to be a “large accelerated filer” under Securities Exchange Act of 1934 (Exchange Act) regulations (based on the company having an unaffiliated public float in excess of $700 million as of the end of its most recent second fiscal quarter), (3) the date on which it has issued $1 billion or more of non-convertible debt during the prior three years, or (4) the last day of the fiscal year following the fifth anniversary of the IPO.
The JOBS Act creates a new IPO process for emerging growth companies. In particular, an emerging growth company may now submit its IPO registration statements and amendments to the SEC on a confidential basis, so long the registration statement and amendments are all filed publicly at least 21 days before commencing a road show.
The JOBS Act also loosens requirements on pre-registration statement communications for emerging growth companies. Prior to the JOBS Act, any communication by a company or its agents with potential investors was not permitted once the IPO process had commenced until the initial registration statement was filed. However, the JOBS Act provides that emerging growth companies (and agents acting on their behalf) may now engage in oral and written communications with qualified institutional buyers (QIBs) and accredited investors, both before and after the filing of a registration statement, to determine their interest in the IPO and subsequent securities offerings.
In addition to streamlining the IPO process for emerging growth companies, the JOBS Act also creates a phase-in period for certain disclosure requirements for such companies. Specifically, the JOBS Act:
Exempts such companies from the auditor attestation requirements under Section 404(b) of the Sarbanes-Oxley Act and the shareholder advisory votes on executive compensation, or “say on pay,” and golden parachutes required by the Dodd-Frank Act
Allows such companies to have only two years of audited financial statements in their IPO registration statements and the related MD&A discussion
Exempts such companies from compliance with any Public Company Accounting Oversight Board (PCAOB) rules pertaining to audit firm rotation
Provides that emerging growth companies are entitled to adopt any new or revised U.S. GAAP accounting standards on the same timeframe as private companies (even though most such principles state that they will apply first to public companies and then later to private companies)
The JOBS ACT also makes Regulation A offerings easier for companies as it increases the current offering limit of $5 million to $50 million. Furthermore, it excludes Regulation A offerings from state securities law registration requirements, provided that the securities sold in the Regulation A offering are either (1) offered or sold on a national securities exchange, or (2) sold exclusively to “qualified purchasers” (to be defined by the SEC pursuant to its rulemaking authority).
In addition to streamlining certain mandated public company disclosure obligations and redefining certain Regulation A exemption limits, the JOBS Act facilitates certain private offerings by removing restrictions that had prevented the growth of the “crowdfunding” investment model. Crowdfunding is a term used to describe a network of people who pool their money, usually via the Internet, to collectively support the financing needs of another person or organization. The JOBS Act amends Section 4 of the Securities Act to add a new exemption from securities registration subject to the conditions that:
The aggregate amount sold to all investors by the company, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, is not more than $1 million
The aggregate amount sold to any investor by the company, including any amount sold in reliance on the crowdfunding exemption during the 12-month period proceeding the date of the transaction, does not exceed: (1) the greater of $2,000 or five percent of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; or (2) 10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000
The transaction is conducted through a registered broker-dealer or funding portal that complies with the requirements of the exemption
The company complies with the disclosure requirements of the exemption
If a company seeks to raise more than $500,000 under the crowdfunding exemption, the company will be required to provide investors with publicly audited financial statements. The crowdfunding exemption is not available to foreign private companies, public companies, or investment companies. Securities acquired in a crowdfunding transaction may not be resold for one year, except to the issuing company, to an accredited investor or in a registered offering. There also is a preemption of the state securities law registration provisions, except for the home state of the company and any state in which 50 percent or more of the company’s shareholders reside.
The JOBS Act also removes the current regulations under Rule 506 of Regulation D under the Securities Act that had prohibited the use of general solicitation or advertisements, including social media, in the private placement of a company’s securities. As a result, companies may now utilize general solicitation or advertising in their private placement efforts and expand the universe of potential investors, provided that all of the purchasers in the private placement are accredited investors. However, the SEC has 90 days from the enactment of the JOBS Act to revise the regulations to accommodate these changes for a Rule 506 “accredited investors”-only offering. Under the circumstances, it would be prudent to wait for the SEC regulatory changes before preceding with such an offering and taking advantage of the aforementioned changes under the JOBS Act.
Finally, the JOBS Act increases the maximum number of shareholders of record that a private company or private bank or bank holding company may have before it is required to register as a public company pursuant to the Exchange Act, from 500 to 2,000 shareholders (provided that, for non-bank or non-bank holding companies, fewer than 500 of such shareholders are non-accredited investors), allowing companies greater flexibility to raise private capital from a larger pool of investors without having to register as a public company. Similarly, the law permits public banks or bank holding companies to terminate their Exchange Act reporting requirements if they have fewer than 1,200 shareholders of record (rather than 300 shareholders of record as required prior to the passage of the JOBS Act). For purposes of the shareholder count, the JOBS Act would not include those shareholders who received their securities pursuant to an employee compensation plan in transactions that are exempt from registration under the Securities Act (thus enabling private companies with active participation by their employees in an equity incentive plan to avoid a “forced registration”). As more companies have decided to stay “private” longer and defer IPOs, the prior shareholder threshold, which had been adopted in the 1960s, constrained the capital-raising efforts by some private companies with a large shareholder base to avoid tripping the 500-shareholder limit.
Considerations for Start-Ups
Generally, it appears that the JOBS Act is a positive development for small businesses and start-ups trying to raise capital as it makes the process less cumbersome, increases access to investors, and, for some companies, reduces regulatory burdens. However, antifraud provisions still apply to offerings and sales of securities, even if exempt from registration requirements, so companies must still be mindful of appropriate disclosures.
In addition, there can be drawbacks to targeting a large pool of smaller investors. For example, small shareholders have rights to inspect the company’s books and records, rights to bring a derivative claim on behalf of the company, and, often, some protections against oppression by the controlling stakeholders, all of which may add additional layers of complexity for the management team. Further, the costs incurred in connection with a large shareholder base can be significant, including execution of subscription documents, shareholder agreements, and similar documentation and implementation of transfer restrictions. Finally, venture capital investors and other sophisticated investors may be discouraged from investing in companies with larger shareholder bases in an effort to avoid the administrative headaches, costs, and potentially greater litigation risk that some believe are caused by large shareholder bases.