While the business pages of newspapers and websites are largely dominated by Apple, Facebook, Google, and major media conglomerates, in reality most businesses are small or midsize and will never see the first page (or any page) of the Wall Street Journal or be mentioned on CNBC. These small businesses have capital needs the same as any other business, yet the capital-raising options for such companies are limited. This article will examine various issues relating to capital raises for small companies.
Though initial public offerings (IPOs) receive a great deal of attention, only a tiny percentage of companies are able to successfully navigate to the IPO stage. Moreover, there are several reasons a company may not even want to go public. First, a public company is required to comply with extensive disclosure requirements in proxy statements, 10-Ks, 10-Qs, and 8-Ks, which can be onerous for a company at the early or middle stages of its capital-raising life cycle. Second, public companies are required to disclose information that may not have been made public before and could be sensitive from a competitive standpoint. (Although the SEC allows certain information to be eligible for confidential treatment, the scope of the exclusion from public disclosure may not be sufficient to avoid sensitive matters seeing daylight.) Third, after the IPO a newly public company may face pressure from its public shareholders to meet earnings projections and to constantly increase earnings, which leads to a “short-termism” that may not always be conducive to a company’s long-term strategy.
Traditionally, if a company needed capital – whether to expand its business, to hire personnel, to open a new location, or for any other reason – the company would borrow money from a bank. However, banks may not be willing to provide financing to companies that do not have an established earnings history or sufficient assets to collateralize a loan.
In sum, the typical smaller company may not be sufficiently established for a typical bank loan, and may not have sufficient revenues or earnings to justify an IPO.
Private Placement of Securities
So where does this leave the small business? For most companies, the ideal (or perhaps only) funding mechanism is via a private offering of securities, i.e., ownership shares. Since the Securities Act of 1933 requires that all securities be either registered or offered pursuant to an exemption, small-cap companies seeking to issue securities without registration must find an appropriate exemption.
The most common registration exemption is provided through Regulation D under the 1933 act. Regulation D contains three separate exemptions: Rules 504, 505, and 506. The exemption a small business will choose depends on the amount of capital it wishes to raise, whether it wishes to avoid state registration, and whether it can raise from accredited investors, which is defined in Rule 501 of Regulation D, but in general refers to individuals with a net worth of at least $1 million, not including the value of their primary residence, or have had income of at least $200,000 each year for the past two years (or $300,000 together with their spouse, if married) and have the expectation to make the same amount in the upcoming year. Note that securities sold pursuant to Regulation D are restricted and thus cannot be sold on the open market for a period of time. Investors can use the “safe harbor” granted by Rule 144 to resell the shares after one to two years, depending on how much information on the company is publicly available.
Rule 504 was created for companies to raise up to $1 million in any 12-month period. The company issuing the securities (the issuer) may sell the securities to an unlimited number of accredited or nonaccredited investors. Rule 504 offerings are infrequent because they are subject to state securities law (blue sky laws), meaning issuers have to comply with the varying registration requirements of each state in which investors are located: an unduly burdensome process for many small-cap companies. The Rule 504 exemption prohibits general solicitation, which means the company cannot inform anyone of the offer with whom it does not already have a preexisting substantive relationship.
Likewise, Rule 505 offerings are also rarely used. Rule 505 limits the amount of capital that can be raised to $5 million in a 12-month period. Issuers may sell securities to an unlimited number of accredited investors and up to 35 nonaccredited investors. Once again, general solicitation is prohibited and issuers must comply with blue sky laws.
By a wide margin, Rule 506(b) is the most commonly used Regulation D exemption for seed and series funding rounds. The Rule 506 exemption can be used to raise any amount. A Rule 506 exempt offering is not required to be registered at the state level, and states cannot impose additional requirements on issuers, beyond submitting a notice filing and paying filing fees. Historically, any company utilizing Rule 506 could not engage in general solicitation. The SEC rules pursuant to the JOBS Act divided the Rule 506 registration exemption into two separate exemptions, 506(b) and 506(c). Under Rule 506(b), general solicitation continues to be prohibited, and issuers may offer securities to an unlimited number of accredited investors and up to 35 nonaccredited investors. A company must “reasonably believe” an investor is an accredited investor for an investor to be considered as such. The SEC has not imposed any special requirements on the verification process.
The new Rule 506(c) does allow general solicitation, but a company must take “reasonable steps” to ensure all investors are accredited investors. (The number of investors is unlimited.) There is no 35-person, or even one person, nonaccredited investor leeway. The SEC does not define the “reasonable steps” that must be taken, but SEC staff has indicated even reviewing tax returns may not be not sufficient without an affirmation on the part of the investor that he or she meets the accredited investor thresholds. Companies considering using Rule 506(c) must consider whether the benefits of attracting investors though general solicitation outweigh the need to use reasonable steps to verify all investors are accredited.
On March 25, 2015, the SEC, pursuant to Title IV of the JOBS Act, issued final rules revising the Regulation A securities offering registration exemption. The new “Regulation A+” provides two tiers of offerings: Tier 1, which allows offerings up to $20 million in a 12-month period, with not more than $6 million consisting of offers by current holders who are affiliates of the issuer; and Tier 2, which allows offerings up to $50 million in a 12-month period, with not more than $15 million in offers by affiliates. Regulation A+ is a 1933 Act Section 3(b) exemption and is considered an exempt public offering, as opposed to an exemption from registration.
Regulation A+ should be attractive to companies looking to raise a significant amount of capital but not growing fast enough to excite angel investors and venture capitalists. For further information regarding Regulation A+, see “Will Regulation A+ Find Its Niche? Some Opportunities to Explore” by Bonnie Roe in this issue.
Role of Counsel
Oftentimes a small-cap company will be new to the capital-raising process, and will need to rely on its outside counsel to shepherd it through the process. In these situations, the company’s counsel will have three primary tasks: (i) advising the company on approaching investors, (ii) negotiating with investors and documenting the transaction, and (iii) overseeing due diligence and disclosure. Each of these tasks is examined in greater detail below.
1) Potential Investors
Potential investors in a small-cap company include “friends & family,” angel investors, high net-worth individuals (who do not often invest in early-stage companies and thus would not be considered angel investors), syndicates of angels or venture capital funds and corporate venture capital units. Given the danger that can result from a securities law violation, including the right of rescission (enabling investors to sell their securities back to the company at the price they paid for it, usually at a very inopportune time for the company), and having to disclose any violations in future filings, company’s counsel should be intimately involved in the company’s efforts to attract investors.
In an offering exempt under Rule 506(b), the company’s counsel must advise the company against taking actions that could be construed as general solicitation. The SEC has not laid out definitive guidance for what is or is not considered general solicitation, other than the listing of several items in Rule 502 of Regulation D that are obviously general solicitation, such as advertisements in newspapers, magazines, radio, and television. However, the SEC has recognized a “pre-existing substantive relationship” between a company and a potential investor indicates a company did not use general solicitation.
Without general solicitation, how does a company find investors? Companies often find investors through the personal contacts of management, the board, or existing investors. Occasionally service providers such as attorneys or accountants may offer leads to investors. There are private placement broker-dealers (who likely have their own list of contacts), but their fees may prove too costly for the amount of capital being raised. Counsel should ask its client how it found investors in the past, and how it plans to find investors in the future.
The company’s counsel should anticipate advising as to questions such as whether it is considered a general solicitation to approach a venture capital fund that is known to be active in the company’s industry, a certain angel investor, or even friends of friends of the founders. A company must be careful in how it reaches out to those outside its immediate circle of preexisting contacts. The company counsel’s will likely want to review prior SEC enforcement actions relating to general solicitation. Finally, counsel should advise the company that whatever it does, and no matter what a certain person may be promising, it should never use an unregistered broker-dealer to offer or sell its securities. Depending on the nature of their activities, the SEC may take the position that compensated finders are required to be registered as broker-dealers. Reliance on an unregistered broker-dealer can lead to a sale being voided, as well as having to make uncomfortable subsequent disclosures. Diligence on the part of company counsel in advising clients regarding the appropriate manner of reaching out to potential investors may save the client from significant regulatory problems in effecting an offering.
2) Negotiating with Investors and Documenting the Transaction
Most of the work in a small-cap offering involves structuring the deal. An offering will take the form of debt or equity, a hybrid security such as a convertible promissory note or convertible preferred stock, and sometimes warrants or other rights.
In early-stage financings, the company’s counsel will draft the offering documents, but in later stage financings, the investor’s counsel will likely handle the lion’s share of the drafting. The company’s counsel not only prepares and reviews documents, but, as applicable, also advises the company as to what is standard in the market, which terms are worth fighting over and which should be considered inevitable. The company’s counsel should review all agreements with investors and investment banks, such as engagement letters (between the company and the investment bank), subscription agreements, and investor rights agreements. Corporate organizational documents, as well as documentation concerning employment arrangements and related party matters, will likely need to be reviewed and revised as well.
Angel investors in seed-round financings may invest using a convertible promissory note, which can be prepared relatively quickly and may delay having to determine the valuation of a company (normally a difficult task) until later rounds of financings. Convertible promissory notes are debt instruments that permit or require the holder to convert the note to equity, often upon a later financing round. There are alternatives to convertible promissory notes, such as the simple agreement for future equity (SAFE), which effectively removes the debt portion of a convertible note, but these have not yet gained wide acceptance (to the chagrin of many a company founder).
Venture capital firms typically want their investments in a company in the form of convertible preferred stock that allows for a preference in a liquidity event but also allows the firm to convert the preferred stock into common stock. The company’s counsel should thoroughly analyze all rights the company is granting to third parties as a result of a financing, and should be particularly careful about keeping the company from offering preferred stock too early.
Venture capital firms often require certain economic rights and control rights from its portfolio companies. Economic terms include valuation, antidilution rights, vesting rights, employee option pools, and pay-to-play provisions. Valuation is perhaps the most critical economic term, and the company’s counsel should determine (as the client might not know or appreciate) how much of the value of the company is being sold in a particular financing, especially with preferred stock, which could very well have coupons with a higher rate than the company’s rate of growth (not a good combination). The liquidation preference, widely regarded as the next most critical economic term after valuation, determines what multiple of the initial investment an investor will get back upon the occurrence of a liquidation event. An investor’s shares may also be “participating,” whereby the investor receives, in addition to the liquidation preference, a pro rata percentage of the remaining purchase price (i.e., the purchase price less the investor’s liquidation preference), based on the relative number of the company’s shares that the investor holds.
Control provisions include protective provisions, board composition and observer rights, drag-along rights and conversion rights. There will likely also be certain covenants and pro rata rights, the former of which the company may not have in place today, but must have in place post-closing. Covenants often include fire and casualty insurance, director and officer insurance, and the adoption of a compensation committee, to name a few.
Companies seeking an eventual exit should be mindful that the more complex the structure of its securities, and the more complicated its capitalization table, the less attractive the company will be to potential acquirers.
3) Due Diligence and Disclosure
In situations in which there is no private placement agent in a Rule 506(c) transaction, a veteran angel or professional investor will often drive the due diligence and disclosure process. In these cases, the company’s counsel will need to make sure the investor has an opportunity to examine company financials and other records and is afforded reasonable access to management (normally not an issue). Information should not be provided to investors selectively: all investors should have the same rights to disclosure. Most importantly, the company’s counsel must seek to ensure nothing sent to or made available to investors is false or misleading. Particularly demanding due diligence undertakings may be followed by a subscription purchase agreement that includes a full set of representations, warranties and schedules, similar to a merger and acquisition agreement.
There are no specific disclosures required for accredited investors in a Rule 506(c) offering, but the offering is still subject to the antifraud provisions of the securities laws, which provide that the disclosures not contain any material misstatements or omissions. Rule 506(b) offerings that include nonaccredited investors, as well as Regulation A+ offerings, require certain specified disclosures, which may depend on the amount being raised in the offering.
Even when specific disclosure is not required, seasoned accredited investors generally expect to receive a private placement memorandum (PPM) with information about the company, the management team, the use of the anticipated offering proceeds, and risk factors. Use of a PPM also provides the issuer some assurance that all investors have received basic information regarding the issuer and the offering. Regardless of whether a PPM is used, certain disclosures should be made to all investors (whether accredited or unaccredited), including the following:
- Risk factors;
- Forward-looking information disclosure(s);
- Use of proceeds;
- Disclosure of significant issues, such as IP, litigation, tax, regulatory matters, relationships with management, dependence on third parties, etc.;
- State blue sky legends (where required);
- Offering procedures and description of any brokerage fee(s);
- Terms of shareholder agreements, etc., particularly where not obvious; and
- Restrictions on transfer.
In a Rule 506(b) offering, if a company will be offering securities to nonaccredited investors, then all nonaccredited investors must be provided with extensive information regarding the company. If a company provides information specifically to accredited investors, it must do so to the nonaccredited investors as well. Any company seeking to raise capital through a securities offering should engage an experienced securities attorney to review or prepare a PPM and advise it of the appropriate process for conducting the offering.
Finally, counsel should advise the company in regard to “bad actors.” A “bad actor” is any person who has been convicted of a crime relating to the sale of securities, or has received SEC disciplinary or cease-and-desist orders or had other “disqualifying events” within the applicable look-back period. A company will not be able to carry out a Rule 506 offering if any company or broker personnel are deemed a bad actor. Note that even if the bad actor leaves his or her position, the person could still be considered a past promoter and render the company ineligible for a Rule 506 offering.
Small businesses should map out their long-term capital-raising plans, which admittedly can be hard to do when a company is struggling to keep up with the daily demands of the business. However, a company with a long-term capital-raising plan in place will likely avoid some of the financing alternatives that may be acceptable in the short term, but will limit a company’s options later. Without a long-term plan in place, a company may get capital from less than desirable sources that require harsher and harsher terms, until the company finds itself in a “death spiral of financing.” To avoid such consequences, a company should determine its long-term goals and, with the advice of counsel, plan for how it will achieve them.