Fiona Brophy, Partner, Perkins Coie
There was much fanfare around the passing of the JOBS Act, especially around the relaxation of the securities laws with respect to the use of “general solicitations.” Notwithstanding the excitement in the blogosphere, the revised rules also come with some hidden costs that CEOs should be aware of and that make using a “general solicitation” in fundraising less attractive.
First, what is a “general solicitation”? General solicitations refer to the public advertisement of a fundraising through mass communication. Raising money through any of the following means likely involves a general solicitation:
- a mass newsletter or email,
- a company (or personal or third party) website open to the public,
- a public speaking engagement, including industry conferences, trade shows or similar forums,
- a posting on social media with public access (such as Facebook, LinkedIn, etc.)
- displaying videos on television or the internet.
Generally, any method you use to communicate to a large audience of people, including unaccredited investors, that your Company is raising funds and the terms of such fundraising will likely be deemed to be a general solicitation.
Since September 23, 2013, CEOs, and the companies they run, who are seeking to raise money are allowed to engage in general solicitations, subject to certain new restrictions. Most importantly, new Rule 506(c) allows companies to use general solicitations subject to the following conditions:
- your company may only sell equity securities to accredited investors,
- your company must now go through a more robust process to verify that your purchasers actually are accredited investors (more on this below),
- your company must file a Form D with the SEC, and check a box to confirm whether you raised money under 506(b) (the old rule) or 506(c) (a general solicitation).
While this all sounds pretty streamlined, there are some hidden costs to conducting a “general solicitation.”
More Onerous Verification Requirements
One of the primary hidden costs of conducting a general solicitation arises from some new requirements regarding the verification process your company must undertake to ensure the purchasers of your securities are, in fact, “accredited investors.” Previously, accredited investor status was typically verified by self-certification (e.g. having the purchaser execute an accredited investor questionnaire, checking the boxes that stated he, she or it was accredited and signing the document). Now, under new Rule 506(c), a company conducting a general solicitation must take “reasonable steps” to verify that all investors in the offering are accredited. Based on the SEC guidance to date, your company will now need to undertake a much more cumbersome and fairly invasive process to confirm the accredited status of its purchasers. In fact, the SEC guidance on Rule 506(c) expressly states that “self-certification” is not sufficient to prove accredited investor status. Rather, your company (or a third party verification service) will need to review evidence of your investor’s net worth, which evidence might be comprised of tax returns, Form W-2s, bank statements and/or credit reports. Imagine the embarrassment of having to ask each of your investors to supply their personal bank statements or W-2s! Investors could easily be turned off by this level of scrutiny and, in some cases, might forego making the investment if they are required to hand over personal financial information as a condition for investing. The regulations do allow for third-party verification of accredited investor status, including by an attorney, accountant or other third party, and there are some third party service providers already popping up to provide these services, but the transaction costs and additional time necessary to conduct such investigation may be significant.
Failure to Meet Filing Requirements Can Be Fatal
Unlike the prior Rule 506 offerings, offerings under Rule 506(c) are exclusive—meaning that if the exemption is not available to your company because of a procedural defect, including failure to file the Form D on time, there is no fallback position under any other federal securities law exemption. Before these changes, offerings made under the old Rule 506 could fall back and rely on Section 4(2) of the Securities Act if there was a technical defect in the application of the Rule 506 exemption (old Rule 506 was a safe harbor under the Section 4(2) exemption). However, because Section 4(2) is not available to exempt a general solicitation, there is no such safety net for these new types of Rule 506(c) offerings. If your company fails to comply with all the requirements of Rule 506(c), there would be no federal exemption available to cover the offering and your company will have engaged in an unregistered public offering of securities—and be exposed to the full panoply of liability for this type of securities law violation, including liability for the company’s control persons.
Potential for Additional Requirements
The SEC has made proposals to further amend Rule 506 to, among other things, require the Form D filing for an offering involving a general solicitation to be made 15 days before the actual offering. If this proposal is enacted, it will be cumbersome to comply with – and effectively slow down your fundraising process. Additionally, the SEC has proposed that all general solicitation materials be submitted to the SEC—which would impose yet more regulatory burdens on your company.
What Does This Mean For Today’s CEOs?
You’ll want to think very carefully before publicly promoting your fundraising and should seek advice from legal counsel as to the pros and cons of doing a “general solicitation.” You may ultimately decide that the benefits outweigh the costs, but it’s always better to be aware of those costs (and plan for them) before embarking on the process.
About the Author
Fiona Brophy is a partner in Perkins Coie’s Palo Alto office and a member of the Emerging Companies & Venture Capital practice. Fiona focuses her practice on providing a broad range of services to emerging companies and venture capital funds in the technology area, primarily in consumer e-commerce, interactive entertainment, digital media, information technology, Internet and social media, cloud services and life sciences.