This post by Robert Fisher, the CEO of Fisher Tanner Associates, originally appeared in VC Experts Daily Buzz. In it, Fisher talks about pitfalls to the implementation of 506(c) General Solicitation provisions under the JOBS Act and why we are not seeing an explosion in deals marketed under the 506(c) provision. Basically, the article looks to answer the question, ‘Why aren’t we seeing deals being marketed more broadly now that it is legal to do so?”
With speed approaching perilously close to that of light itself, recent deregulation has freed huge and heretofore inaccessible pools of private monies to fund new investment and unshackle innovation…
Just kidding – that didn’t happen. Would have been nice, eh? One could argue it wasn’t for lack of good legislative intention. As part of the JOBS act – Congress did indeed instruct the SEC to remove the ancient prohibition against General Solicitation and Advertising under Regulation D. The concept: make it easier for start-ups to cast a wide net when seeking investors. You may recall good ol’ Reg D which provides exemptions from SEC registration. The Reg D exemption relied on by most private investors – now called 506(b) continues the solicitation ban. The new exemption since last September – 506(c) – eliminates the ban but not without a new gotcha of its own.
What are the hidden ‘gotchas?’
Enhanced Investor Credentials Required
In the JOBS Act Congress specified that issuers need to take “reasonable steps to verify” accredited investor status for advertised deals because they were concerned that new types of advertising and general solicitation would attract investors who were not accredited (based on either income or net worth– see the SEC definition). This was undoubtedly based on myriad published cases of problems arising from self-certification. Kidding again – of course there aren’t any. The legislation also directed the SEC to set the detailed rules on reasonable verification, and these rules went into effect in September, 2013. Regardless of whether this reflects sage SEC wisdom, making the issuer responsible for certifying their investors are truly accredited is a surmountable issue, whether done by a fearless issuer or a trusted third party certifier. So given the ultimate solvability of this accreditation issue leads us back to our initial question: why are we not seeing more 506(c) (i.e., General Solicitation) deals?
A Shortage of Legal Pioneers
Our travels and meetings this year with some of the smartest securities lawyers around leads us to a credible hypothesis: no one wants to be first. Law firms we met uniformly indicate that although they believe the migration to 506(c) is inevitable, to date they have steered clients to the more traditional 506(b) exemption. Pioneers are the ones with arrows in their back and most lawyers are paid not to be too adventuresome especially when facing new regulations. But lest we get too complacent, there is reason to suspect we may not have the luxury of relying indefinitely on 506(b) going forward.
No Place to Hide
The term “General Solicitation” has never been clearly defined. Entrepreneurs may reasonably assume a pitch for investment made in a public forum qualifies. But what about Demo Days, Pitch Contests, Business Plan Competitions, or oblique references to capital need made on social media? Enforcement of violations of the ban by the SEC or by state regulators has been rare in the past. But the JOBS Act changes the playing field. Because there is now a legal way to publicly solicit private investment, tolerance for illegal solicitation may wane. Most of the securities lawyers we spoke to are concerned about clients inadvertently sliding into a solicitation violation and risking rescission of the funding transaction because they didn’t reasonably verify the accredited status of their investors when their original offerings closed. The entrepreneur also risks being flagged as a Bad Actor wherein the penalties can effectively block them from future start-up ventures. That first step is a doozy. (See VCE’s note below for additional concerns about proposed SEC rules.)
Two new bipartisan bills, supported by Angel Capital Association and introduced by several Congressmen and Senators including U.S. Senator Chris Murphy (D-Conn.) called the HALOS Act (Helping Angels Lead Our Startups) attempt to remedy this by clarifying the definition of “General Solicitation” and carving out common types of presentation and forum sponsors as pre-approved. The effort is commendable but it may ultimately prove akin to trying to paint bright lines in quicksand. If one learns of a company seeking funds at a presentation open to the public, does it matter who sponsored it? Also – the fluidity and diversity of today’s communications (think tweets, emails, web sites, social media, mobile communications, et al.) makes it almost impossible to determine the provenance of the investor’s knowledge of the investment opportunity.
Solicitation Envy – The Solution to the Impasse?
There actually is a carrot to accompany this stick. As the start-up CEO begins to see other companies raising money via email campaigns, web sites, social media, public pitches, etc. – he/she will not be content to rely on traditional pre-506(c) methods to get the word out. Once accepting the 506(c) approach, General Solicitation becomes an opportunity and not a threat. For that reason alone, most lawyers believe it just a matter-of-time till their clients insist that General Solicitation be part of their arsenal.
Angel Capital Association
ACA has a variety of resources and information for the press, whether you are looking for angel industry trends, the impact of angels and innovative startups of the US economy, ACA’s positions and feedback on public policy issues, and connections to interesting investors and their portfolio companies.
(A note from VC Experts: While this article refers to enacted rules, many in the start-up community are particularly concerned about proposed SEC rules on Regulation D and Form D, which if finalized would require issuing entrepreneurs to submit a Form D in advance of their general solicitation and require them to file all fundraising materials by the date of advertising, among other things. While the proposal includes a one-time ability to correct a filing, any other violation would mean the issuer would not be able to raise capital through Rule 506 for one year. It is unclear if and when these proposed rules might become final.)