New Developments in Private Capital Raising › assets › htmldocuments › New...New Developments in Private Capital Raising By Kristen A. Young and Adi Osovsky November 18, 2014

New Developments in Private Capital Raising

By Kristen A. Young and Adi Osovsky November 18, 2014

Road Map The JOBS Act

› Lifting the Ban on General Solicitation and General Advertising › Equity Crowdfunding › Regulation A+

The Secondary Market

Themes › Promoting capital formation and providing investor protection › Public vs. private

11/18/2014 © Sullivan & Worcester 2

The Traditional Private Placement Securities may generally be sold in the United States only if the

sales are registered with the SEC or their sale qualifies for one of a number of exemptions to registration.

Rule 506 › No limit to the amount of capital it can be used to raise. › Offer and sell to an unlimited number of accredited investors, but only 35 non-

accredited investors. › But no general solicitation or general advertising.


Who are accredited investors? Individual with $200K in income in the last two years and expected

this year;

Individuals with $300K in joint income with spouse over same period;

Individual with $1 million net worth – positive net value of home excluded;

Trusts, corporations and other entities with $5 million in assets;

Entities where all of the owners are accredited investors;

Certain institutions, e.g., banks; and

Officers and directors of the issuer.

Just because you have an MBA, does not mean that you can invest in startups!


What is the purpose of the accredited investor standard at least according to the GAO? protect investors by allowing only those who can withstand

financial losses access to unregistered securities offerings; and

streamline capital formation for small businesses.

Stay tuned! The accredited investor definition is being reconsidered by the SEC. November 20, 2014 – SEC to host a meeting of the SEC Government-Business Forum on Small Business Capital Formation.

The meeting will include discussion of secondary market liquidity for securities of small businesses and the definition of accredited investor.


What is the definition of General Solicitation? Not specifically defined in Regulation D.

Examples of what constitutes general solicitation and general advertising, include: › advertisements or article published in newspapers and magazines, › communications broadcast over television or radio, and › seminars or meetings where invitation is by general solicitation or general

advertising.

Other forms media qualify › Including unrestricted websites and other social media


New Rule 506(c) Under new Rule 506(c), companies can offer securities through

means of general solicitation, provided: › Comply with Regulation D; › All purchasers of securities must be accredited investors; and › The company must take reasonable steps to verify that the purchasers of the

securities are accredited investors.


Can we still do traditional private placements? Companies may continue to rely on the existing private placement exemption under Rule 506(b), subject to the prohibition against general solicitation.

Open Question: For online accredited investor sites, venture forums, pitch competitions, and other quasi-public venues, it remains unclear whether they will be able to continue to rely on Rule 506(b) or whether the SEC will require companies featured in such media to comply with Rule 506(c). Stay tuned this could have broader implications!


What reasonable steps do I need to take?

Facts and circumstances test. Among the factors to be considered are: › Nature of the purchaser; › Amount and type of information; and › Nature of the offering

Higgins’ address to the Angel Capital Association (March 28, 2014):

“The other method, however, is the principles-based verification method in which the issuer would look at the particular facts and circumstances to determine the steps that would be reasonable to verify that someone is indeed an accredited investor. Although the verification method must be objectively reasonable, the principles-based method is intended to provide issuers with significant flexibility in deciding the steps needed to verify a person’s accredited investor status and to avoid a “one size fits all” approach.”


Is there a safe harbor? Tax returns;

Bank statements or brokerage statements AND a consumer credit report, dated within the past three months;

Written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant within the prior three months; or

For pre-existing investors who are natural persons: personal certification.


Is this crowdfunding?

Yes, but not by the crowd


Prohibition on Bad Actor Participation

As mandated by Dodd-Frank Act, the SEC adopted disqualification provisions from participating in Rule 506 offerings for certain “covered persons”: › the company and any predecessor of the company or affiliated company; › any director, executive officer, other officer participating in the offering, general

partner or managing member of the company; › any beneficial owner of 20% or more of the company’s outstanding voting equity

securities, calculated on the basis of voting power; › any investment manager to a company that is a pooled investment fund and any

director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;

› any promoter connected with the company in any capacity at the time of the sale;


Prohibition on Bad Actor Participation (continued)

› any person that has been or will be paid remuneration for solicitation of purchasers in connection with sales of securities in the offering (a compensated solicitor); and

› any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

A company may not rely on a Rule 506 exemption if a covered person has been involved in a disqualifying event, which includes bad acts related to the purchase or sale of any security.

New Development: The Bad Actor Questionnaire and Respresentations


Additional Proposed Rules Additional company and offering disclosure on Form D

Legends on written general solicitation materials

Submit written general solicitation materials to the SEC

Advance Form D filing › 15 days before an offering relying on Rule 506(c); › 15 days after the date of first sale for 506 offerings (as is currently required); › 30 days after the conclusion of an offering relying on Rule 506; and › file amendments to Form D at least annually (as is currently required).


Why does the SEC want us to file Form Ds in advance of offering securities? Evaluate the use of Rule 506(c);

See if a company is at least attempting to comply with 506(c) and may allow for advance confirmation that no bad actors are participating in offerings under Rule 506(c); and

Allow state securities regulators check compliance with 506(c) and look for “red flags”.


What happens if I don’t file a Form D?

Disqualification from reliance on Rule 506

Automatic disqualification from making use of a Rule 506 exemption in any new offering for one year if the company, or any predecessor or affiliate of the company, did not comply, within the past 5 years, with the Form D filing.

ONE TIME, 30 calendar day cure period


Crowdfunding Crowdfunding occurs when people pool their money and other resources together to support efforts initiated by other people or organizations. Such pooling of money and resources typically occurs via the internet for any variety of purposes, including funding political campaigns, disaster relief, small loans (micro credit), artists, and even startups. In the United States, crowdfunding has occurred largely on a donation basis or as a loan, where the lender can only expect to be repaid principal.


Elements Target amount of funds to be raised

For a specified goal

From a large number of people investing small amounts

Wisdom of the crowd

Often perks


Equity Based Crowdfunding – Can I do it yet? For the most part, not yet. SEC only proposed rules.

Triggers the federal securities laws because it involves the offer and sale of a security.

JOBS Act added new Section 4(a)(6) to the Securities Act – provides an exemption from the registration requirements for certain crowdfunding transactions.

Exempts from registration transactions involving the offer or sale of securities by an issuer, provided that: › Aggregate amount sold to all investors by the issuer during prior 12 months is

≤ $1,000,000 › Aggregate amount sold to any investor by an issuer, during prior 12 months does

not exceed: o greater of $2,000 or 5% of the annual income or net worth, if either the annual

income or the net worth of the investor is < $100,000 o 10% of the annual income or net worth, not to exceed a maximum aggregate amount

sold of $100,000, if either the annual income or net worth of the investor is ≥ $100,000


Equity Based Crowdfunding – Can I do it yet? (continued)

Conducted through a crowdfunding intermediary (broker or funding portal)

As proposed: › 1 intermediary › Online-only › Electronic-only (electronic delivery of documents) Foster development of formation of the crowd Crowd shares information


What do Crowdfunding Platforms Look Like?

Register with SEC as a broker or a funding portal and any applicable self-regulatory organization

Provide certain disclosures, including disclosures related to risks and other investor-education materials

Ensure that each investor: › reviews investor-education information › positively affirms that the investor understands risk of loss of investment, and

could bear such loss › takes an investor quiz

Reduce the risk of fraud


Crowdfunding Intermediary Requirements (continued) Make available to the SEC and to potential investors certain issuer

information

Confirm target offering amount reached

Ensure that investors do not exceed the investment limits

Protect the privacy of information

Not compensate promoters, finders or lead generators

Prohibit its directors, officers, or partners from having any financial interest in an issuer using its services

Issuers may not have a financial interest in an intermediary


Issuer Information Requirements, Reporting on Form C filed on EDGAR, delivered to Intermediary, accessible to Investors

Lots of Information Required to be Disclosed:

Description of issuer’s business and anticipated business plan

Description of issuer’s financial condition (as proposed, MD&A), including, for offerings with target offering amounts of (as proposed, for the two most recent fiscal years with discussion of changes): › $100,000 or less (a) any income tax returns filed by the issuer for the most

recently completed year; and (b) financial statements of the issuer, certified by the principal executive officer to be true and complete in all material respects

› More than $100,000, but not more than $500,000, financial statements reviewed by a public accountant independent of the issuer

› More than $500,000, audited financial statements


Issuer Information Requirements (continued) Intended use of proceeds

Target offering amount and deadline to reach target offering amount › Proposed: Set a maximum

Price to public of the securities or method for determining the price

Description of issuer’s ownership and capital structure

Compensating paid to promoters of the offering

Not less than annually, file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer.


Proposed Additional Disclosures How the exercise of the rights held by the principal shareholders

could affect rights of the purchasers of the securities;

How securities being offered are valued;

Risks related to minority ownership;

Risks related to corporate actions;

Restrictions on transfer;

Process to cancel an investment commitment or complete a transaction once the target is met;

Disclose that if investor does not reconfirm after material event, then investor’s commitment is cancelled;

CRD Number of intermediary;


Proposed Additional Disclosures (continued) Compensation paid to intermediary;

Legends;

Number of current employees;

Material risk factors;

Material terms of indebtedness;

Exempt offerings conducted in past three years;

Related-party transactions;

Progress updates on meeting target offering amounts (50%, 100%, final) within 5 days; and

Material changes to the terms or disclosure already made.


How long do I have to annually report to the SEC? Become a reporting company;

Acquisition of crowd funded securities;

Dissolution.


If I am Crowdfunding, Can I Otherwise Generally Solicit for those Securities? Advertising terms of offering is not permitted, but

Tombstone notices which direct investors to the funding portal are permitted.


Who can’t crowdfund? Companies not organized under and subject to the laws of a U.S.

state or territory, or the District of Columbia

Reporting companies under the Exchange Act

Investment companies

Proposed: › Issuers that failed to file with the SEC and provide to investors during the 2 prior

years annual reports › Issuers that have no specific business plan or a business plan to engage in a

merger or acquisition with an unidentified company.


Crowdfunded Securities - Other Important Items May not be transferred by the purchaser for a 1-year period

Will not result in the holders of such securities being counted toward the Exchange Act shareholder cap


Unaccredited Investor Crowdfunding Not through the JOBS Act

Intra- State Crowdfunding

506(b) deals (35 unaccredited investors)


Regulation A+: the Mini IPO (coming soon) JOBS Act required SEC to create a class of exempted securities for

offerings with aggregate offering amounts in a 12-month period up to $50 million

Securities may be offered and sold publicly

Securities will not be restricted securities

Issuer may “test the waters”

Issuer must file audited financial statements with the SEC annually, and comply with certain other disclosure requirements

Disqualification provisions for “bad actors”

SEC periodic disclosures

State blue sky laws


The Secondary Market for Private Company Shares

New liquidity

New investment opportunities

New risks


The Public Market Sphere: Costly Disclosure & High Liability Exposure

“Sunlight is the best disinfectant, electric light the best policeman” — Louis D. Brandeis

o The Securities Act of 1933: o Disclosure in a registration statement & a prospectus

o The Exchange Act of 1934: o Extensive disclosure in annual, quarterly & current reports, proxy statements

& other filings.

o Costs: Legal and accounting fees, management opportunity costs, the costs of losing the company’s confidentiality.

o Potential civil & criminal liability


The Private Market Sphere: lax Sophistication-Based Regulation

Section 4(2) of the Securities Act: Exemption for Private Offerings

Sophistication SEC v. Ralston Purina Co.

“fend for themselves”

Wealth Regulation D

“accredited investors”


“Accredited Investors” Various financial institutions;

Certain pension plans;

Organizations exceeding a certain size;

An issuer’s officers & directors

Natural persons: 1. Net worth: $1 million excluding the investor’s primary residence. 2. Annual income: $200,000 ($300,000 with spouse)

Wealth is a proxy to sophistication; Accredited investors don’t need protection (no mandatory disclosure; lower liability standard)


Resale of Securities Purchased in a Private Offering Section 4(1) of the Securities Act exempts “transactions by any

person other than an issuer, underwriter, or dealer” from the requirements of section 5.

Broad definition of an “underwriter”- includes “any person who has purchased from an issuer with a view to… the distribution.”

Rule 144 › safe harbor: A seller satisfying certain conditions is deemed not to be engaged in

a distribution. › Holding period (one year for securities of non-reporting issuers; it used to be

two year)


The Rise of the Secondary Market Contributors to the Proliferation of Secondary Market Transactions:

› The sharp decrease in IPOs › The increase in employee incentives › The 2008 amendments to Rule 144 & 145 of the Securities Act (resales) › The launch of electronic marketplaces (SecondMarket & SharesPost)


Launched in 2004 by Barry Silbert, a former investment banker

Average trade: $2 million

Minimum trade: as low as $1000

Buyers: only accredited investors


Founded in 2009 by Greg Brogger, a former entrepreneur & securities lawyer

Passive bulletin board broker dealer

Average trade: $200,000

Minimum trade: $25,000

Buyers: only accredit investors


Shares of High Profile, Mature Start-Up Companies


The Challenges Big firms that have recently gone public

› (Facebook, LinkedIn, Groupon, Zynga, Pandora)

Regulatory obstacles regarding resales › (Types of investors, holding period)

The holder of record threshold – Section 12(g) of the Exchange Act


The Promise of the Secondary Market: Increase Liquidity Venture Capitalists

Advantages Disadvantages

An early exit opportunity with respect to a highly risky investment

Reduces investors’ supervision & incentives to monitor

Cash + non-cash recycling Doesn’t create liquidity for every start-up company

Diversification of portfolio


Employees

Advantage Disadvantage

A way to finance the exercise of options

Doesn’t create liquidity for every start-up company


The Problem with Respect to Investor Protection A. The Erosion of the Sophistication Presumption: Entry of Non-

Accredited investors into the Private Market Sphere

B. The Limitations of Individual Accredited Investors 1. Lack of information 2. Doubtful Correlation between Wealth and Sophistication 3. Cognitive biases


The Problem with Respect to Investor Protection A. The Erosion of the Sophistication Presumption: Entry of Non-

Accredited investors into the Private Market Sphere

Mixed players (like a public market) but limited information and weaker weapon in the litigation arsenal

Buyers - presumably sophisticated

Sellers- many unsophisticated, cannot fend for “themselves”


The Problem with Respect to Investor Protection (continued) B. The Limitations of Individual Accredited Investors

1. Lack of Information

Arguments for more disclosure

Arguments against more disclosure

Crucial for an informed decision: “Just as a scientist cannot be without his specimens, so the shrewdest investor’s acuity will be blunted without specifications about the issuer”

–Dorn v. Petroleum Management Corp.

Individuals have less access to information

Investors perform due diligence


Arguments for more disclosure

Arguments against more disclosure

Limited incentives to disclose voluntarily

There are incentives to disclose voluntarily

The information asymmetry argument: the party who has information advantage may omit or misrepresent material information

“Less is more”- individuals don’t necessarily have the tools to analyze the information

Particularly problematic given the uncertainties & high risk in private start-up companies (failure and fraud)

Investors may ignore or misread the information in light of various biases

Reduces transaction costs Costs: compliance, dissemination, litigation, competitive disadvantage, opportunity costs

Promotes fairness & enhances investors’ confidence


The Problem with Respect to Investor Protection (continued) 2. Doubtful Correlation between Wealth and Sophistication

The criteria are both over-inclusive & under-inclusive

The criteria were set in 1982 and haven't been properly adjusted for inflation. The threshold should have been more than doubled.


The Problem with Respect to Investor Protection (continued) 3. Cognitive Biases

The standard neo-classical economic approach (Homo Economicus) v. the behavioral economic approach (real people)

Optimism & overconfidence

The familiarity bias › One Second Market participant explained that he was making investment “going

by gut…You’re saying ‘I like the product’. I think the company’s doing well. The news that I read on… technology blogs, it all looks good”.

Ego, envy, greed & the “exclusivity bias”

Sophisticated investors are not immune to biases

And biases have economic consequences


The Future of the Secondary Market To what extent does the Secondary Market include both accredited

& non-accredited investors?

Can investors in the Secondary Market benefit from more disclosures?

Are there better alternatives for the wealth-based criterion?

What is the justification for “sacrificing the rich”?

The application of behavioral economics


Note: Slides 32-47 are based on the article “The Curious Case of the Secondary Market with Respect to Investor Protection” by Adi Osovsky, January 1, 2014:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2364542

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2364542

Find More Information


sandw.com/startup-series

Questions?


Kristen A. Young

Kristen A. Young Counsel Sullivan & Worcester One Post Office Square Boston, MA 02109

TEL: 617.338.2427 [email protected]

Kristen A. Young, counsel to the Corporate Department of our Boston office, represents clients in a broad range of general corporate matters, including corporate formation, venture capital financing, mergers and acquisitions, securities law compliance, public and private offerings, and other commercial and financial transactions. Ms. Young has represented clients in diverse industries, including in the high-technology, semiconductor, telecommunications, retail, manufacturing and restaurant industries, as well as hedge funds and investors in a variety of matters. Bar Admissions Massachusetts, 2003 Education LL.M., University of California, Berkeley School of Law, 2011 J.D., with honors, and Tax Certificate, University of Connecticut School of Law,

2003 B.A., summa cum laude, Boston University, 2000


Adi Osovsky

Adi Osovsky

Associate Sullivan & Worcester One Post Office Square Boston, MA 02109

TEL: 617.338.2453 [email protected]

Adi Osovsky is an associate in the Corporate Department of our Boston office. Her practice focuses on corporate, commercial and securities law, and she specializes in assisting Israelis and Israeli firms conducting business in the United States. Ms. Osovsky advises clients in a variety of industries, from technology and life sciences to manufacturing and services, through all stages of development from formation through fund raising, growth, M&A and IPO. Prior to joining Sullivan & Worcester, Ms. Osovsky was an associate at a leading Israeli law firm, where she specialized in corporate law, litigation and class actions, and provided on-going legal advice on regulatory and corporate governance issues to various key players in the Israeli economy.

Bar Admissions Israel, 2006 Education S.J.D. Candidate, Harvard Law School, expected 2015 LL.M., Harvard Law School, 2011 LL.B., magna cum laude, Tel Aviv University, 2005


www.sandw.com

Offices

Boston One Post Office Square Boston, MA 02109 Tel: 617 338 2800 Fax: 617 338 2880

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New Developments in Private Capital Raising › assets › htmldocuments › New...New Developments in Private Capital Raising By Kristen A. Young and Adi Osovsky November 18, 2014