Hanson Law Gazette - April 11, 2012

The Hanson Law Gazette

April 11, 2012

The Brave New World of Small Scale Corporate Fundraising: The JOBS Act

Part 1: Lowering Costs and Complications for Stock Subscriptions and Offerings under the JOBS Act

With much fanfare, and no small amount of both enthusiasm and trepidation in different parts of the business community, the federal Jumpstart Our Business Startup Act (JOBS) has been signed into law.  Will it live up to its name and give a noticeable boost to America’s still-lagging economy?  Will it unleash a torrent of corporate shenanigans resulting in a spate of mini-securities lawsuits?

In order to plumb the depths of the potential liabilities that await businesses, professional advisers, and their insurers in the new world of JOBS Act investment solicitations, it is necessary to consider just how different the process of soliciting capital will be going forward from the reality in place before the passage of the Act.  The stated purpose of JOBS is to create new jobs by loosening the collective grip of regulators on the capital-raising efforts of the nation’s modestly sized businesses.  But will lessened government control and oversight in the earliest stages of the fundraising process lead to more misunderstandings, more fraud, and more claims against businesses, directors and officers, lawyers, and accountants?

Prior to the enactment of the JOBS Act, business owners and entrepreneurs seeking to capitalize either a new venture or the expansion of an existing business could not readily seek money from a broad range of potential investors.  In order to avoid the complications and substantial expense involved in preparing a public offering under the federal Securities Act of 1933, they would have to limit their offerings to certain states, certain accredited investors, or both.  These offerings, called private placements, are generally expensive to formulate and slow to launch.  As the record of litigation relating to private placements demonstrates, this has traditionally been a legal landscape filled with landmines for the unwary.

With the JOBS Act in place, small companies will see substantial benefits when seeking to attract capital.  Nominally, JOBS only addresses “crowdfunding,” enabling issuers to “crowd” together many small investments.  However, the benefits of the Act are broader because the crowdfunding provisions preempt state law.  Without preemption, a lowly small business could have to register in every state where anyone hears about their offering.  That typically would prove to be a prohibitively expensive, prohibitively time-consuming process.  As a result, prior to the passage of the JOBS Act, this added expense would effectively restrict the target zone for small offerings to one or a few states.  That, in turn, leaves many small businesses reliant on funding derived from friends and family, from cash earned on existing operations, and on bank loans – all sources that have diminished in availability in the last four years.  The dearth of capital available from these traditional sources has arguably led to a real investment-capital crisis for smaller businesses in the United States.

From a public policy standpoint, this is a particular worry since the bulk of new jobs in the United States have traditionally been available through smaller businesses rather than large, national, and international enterprises.  To counteract this trend toward restricted availability of capital for smaller businesses, the JOBS Act provides an avenue for business people to seek investors cheaply and efficiently across state borders.  To accomplish this, the Acts’ “crowdfunding” provisions preempt most state law.  Thus, if a business comes within the provisions of the JOBS Act solicitation restrictions, it can offer securities to investors in many states simultaneously and with but a single offering circular.

Here are the basics of the crowdfunding provisions contained in the JOBS Act:

  • Overall limits: Businesses can raise up to $1 million per year, from either a traditional broker or a “funding portal” (websites like kickstarter.com).
  • Unaccredited Investors: JOBS allows businesses to take investment from anyone, including those of modest means, up to $2,000 per person.  If a person’s net worth or annual income is over $50,000, that person can invest more.  The maximum investment per person can be as high as $100,000 (only for people with an annual income or net worth over $1 million).  This amount is no coincidence, since it is once a person’s net worth is $1 million that he becomes an accredited investor, qualifying for the private placements described in Regulation D (especially 506).
  • Big crowds: One of the many mines awaiting a small business with crowdfunding is the possibility that they will inadvertently become a public company by having too many shareholders.  The JOBS Act helps by extending the number from any 500 shareholders to 500 unaccredited shareholders (or any 2,000 shareholders, if that occurs first).  Once the company has this number of shareholders and has $10 million or more in assets, it may rise to another level of regulatory pitfalls.
  • Small crowds: Because there is no lower limit on the number of investors, it appears possible to use the JOBS Act as a method of more easily making an investment similar to a private placement.  This can work with investors that do not have enough assets to be accredited or when both accredited and unaccredited investors purchase securities in a single offering (but can still fit within the parameters of this exemption).
  • Graduated disclosure: Whenever raising money by selling securities, a small business should disclose all material information relating to the business.  Legally, this is to protect the offering business from later claims by an unhappy investor crying “Fraud!” when the business does not do as well as was hoped at the time of the investment.  That is always a practical and legal necessity; however, JOBS relaxes many of the other requirements usually associated with stock offerings:
    • If raising less than $100,000, it will suffice to provide an income-tax return for the last year and financial statements that the CEO swears are true – plus providing some more innocuous information to the SEC like a description of the business and the offering terms.
    • If raising up to $500,000, financial statements must be reviewed by an independent accountant – but they need not be audited.
    • If raising up to $1 million, financial statements must be fully audited.  Importantly, this is still a great deal less burdensome than the accounting requirements associated with larger offerings such as those under Regulation A or those constituting a full initial public offering (“IPO”).
  • Upcoming ability to solicit accredited investors: Separate from the crowdfunding provisions, in the realm of private placements to accredited investors, “general solicitation” is currently prohibited by the SEC.  However, JOBS instructs the SEC that it must change that regulation.  The SEC will have some wiggle room in how it writes this rule, including in specifying just what steps businesses must take to verify that purchasers of the securities are accredited investors.  Still, unless the SEC chooses to obstruct the implementation of the JOBS Act by dragging its feet with regard to rules revisions or by leaving in place restrictive rules that conflict with the apparent overall intent of the JOBS Act, the path to wider advertisement for wealthy investors should open fairly quickly.  The Act requires the SEC’s rule modification effort to be completed by July 2012.  This modification should help businesses slightly in their attempts to find investors, though we expect that most businesses will find it necessary to utilize traditional networking services and brokers to find angel funds, venture capitalists, and other accredited investors.
  • Still a minefield: JOBS leaves intact an expansive minefield of legal traps for the unwary.  There are many additional requirements ranging from prohibitions against certain advertising activities, to filing certain reports with the SEC, to ensuring that all investors are provided with sufficient information that makes sense in light of the unique risks associated with the offering business.  Though JOBS clears a path through much of the forest of state regulation, it leaves intact state and federal antifraud laws.  Securities regulation still provides hefty fines and other sanctions against those that violate its (sometimes archaic and difficult to decipher) requirements.

At the same time that the new JOBS Act smooths the way for small businesses to raise money from the public, larger businesses will also enjoy access to new investment capital paths that are relatively free from the crippling regulation that previously may have stifled their desire to go public.  While prior regulation will still be in place for very large businesses, JOBS raises the threshold at which those regulations take hold.  Changes in this area include:

  • JOBS creates the category of “Emerging Growth Company.”  Such an Emerging Growth Company can avoid certain SEC regulations and fees longer – particularly those mandated under the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  A company is an Emerging Growth Company for as long as five years after its IPO, though the company loses its exemption if it exceeds $1 billion in annual gross revenue.  Many commentators have argued that the added record keeping and reporting requirements of Sarbanes-Oxley and Dodd-Frank are prohibitively stringent (and expensive to satisfy) with regard to such smaller companies, even if they are arguably more sensible when applied to companies with $1 billion or more of annual revenue.  However, as even the smallest of public companies will be subject to Sarbanes-Oxley and Dodd-Frank after five years of operation under the current provisions of the JOBS Act, it is difficult to say whether this provision will entice many more companies to go public.
  • For somewhat smaller companies, the JOBS Acts increases the desirability of Regulation A (“Reg. A”).  Most importantly, Reg. A will now preempt state law regulations (along with crowdfunding, as discussed above).  Moreover, the Act increases the limitations of Reg. A tenfold – from $5 million to $50 million – and labels these securities “non-restricted” and thus able to be sold within a year of the offering.  Though the precise contours of this exemption will be unclear until the implementing regulations are completed by the SEC in the coming several months, this development will provide another zone in which growing companies can enjoy decreased regulation.  This legal reform is sorely needed, as now Reg. A will have a true place in the landscape rather than being effectively obsolete in light of Regulation D, Rule 506.

For entrepreneurs looking to become the next Amazon or Google, JOBS with its crowdfunding provision is a ray of sunshine in the world of harsh venture capital competition, particularly for those outside of New York City or Silicon Valley.  “Capital is not adequately deployed across the nation, and this will be another tool that will help provide capital to underserved regions,” said Steve Case, AOL co-founder and Startup American chairman.  “Overall, that will be a good thing for innovation and for job creation.”  Companies such as Giddy, a snack company, may be unable to obtain venture capital through normal channels because many potential investors may require substantial revenue is booked before they are willing to provide capital support.  Giddy had not hit a high enough revenue mark to satisfy traditional venture capital investors even though its products were being sold in 250 Targets, 30 Whole Foods and other retailers around the country.  Under the new law, such companies will be able to seek investment for expansion and growth from never-before-available sources.

As an additional benefit, legislators are expected to offer competing proposals to further tax cuts and benefits to growing companies.  House Majority Leader Eric Cantor and his fellow House Republicans plan to vote next month on a measure that would grant 20 percent tax cuts to growing companies.  In addition, a Democratic proposal now is pending in the United States Senate that calls for $26 billion in tax credits for smaller companies that either employ new workers or increase the overall size of their payroll.  If both of these proposals become law, coupled with the new funding opportunities associated with the JOBS Act, the prospects for small businesses in the United States would seem to be noticeably brighter in the year ahead.

The JOBS Act has significantly changed the landscape of securities offerings.  Crowdfunding may begin to legitimately compete with angel investment groups and smaller venture capitalists.  Looking forward, will a burst of direct investment activity in small businesses bring with it a burst of litigation against offering firms, directors and officers, lawyers, accountants and crowdfunding facilitators?  In Part 2 of this article we explore the likely impact that the JOBS Act will have both on those involved in the new crowdfunding revolution and the companies that advise, serve and insure them.

If you would like to discuss how JOBS might help your business, affect your liabilities or impact your exposures, please feel free to contact the knowledgeable attorneys at Hanson Law Group.