The changing SEC rules on fundraising and what they mean for startups
For as long as we have all been alive, startups have not been able to "generally advertise" or “generally solicit” their securities offerings. This has made fundraising more difficult for startups than it ought to be. This is about to change.
On September 23rd, new SEC rules will go into effect to allow startups to generally solicit and generally advertise their offerings. This is a positive and dramatic change that has been met with cheers. As you might expect, however, there are some drawbacks and potential gotchas.
Here I offer a general primer on the SEC rule changes and how they could affect startups. It's complicated and not a little bit arcane at times, but if you or your startup plans to take advantage you need to truly understand how it will work.
The first thing you need to know if you plan to generally solicit is you will have to take additional steps to verify the accredited investor status of your investors and maintain records to prove this. It means reviewing Forms W-2 or other financial records. Investors may balk and back out of your deal when you ask to see their Forms W-2 or financial statements. It’s a risk -- a potential reason to not generally solicit, even though you are legally entitled to.
You should also know that if you generally solicit you can't accept money from non-accredited investors. This isn’t a big deal, because most offerings are all accredited investors anyway. “Accredited” means, generally, an individual with at least $200,000 in income for the last two years, with the expectation of the same in the current year, or $300,000 with spouse; or $1 million net worth excluding primary residence.
And you should be aware there could be various state law complications associated with general solicitation – some states might impose additional requirements. (Of course, you should always consult an attorney before doing any general solicitation.)
If the only drawbacks of generally soliciting or generally advertising your offering were those listed above, companies could generally solicit or generally advertise their offerings without losing much sleep. But there are more.
On the same day the SEC adopted the final rules on general solicitation, it issued for public comment proposed rules that would make generally soliciting/generally advertising your offering much, much more difficult and problematic.
These proposed rules would require:
- Advance Forms D to be filed at least 15 days before any general solicitation was made
- Specific, lengthy legends on all written general solicitation materials
- Submission of written general solicitation materials with the SEC before their use
- Most problematically, if you miss a deadline and don’t cure within 30 days (and you can only cure once an offering), a one-year penalty box. (Meaning, you couldn’t use Regulation D again for the whole year starting after the end of the offering in which you blew a filing deadline.)
When you read the actual law of general solicitation, you discover that this “body” of law, this cadaver of law, if you want to call it that, is anything but a model of clarity. To give you a sense of how bad it is, I want to guide you through some of the SEC guidance. After we finish our tour, I think you will agree that we need the SEC to revisit its guidance and make it more helpful, understandable, and accessible. And I want your help in asking the SEC to do this.
Let’s take a dive into the law of general solicitation as we know it. Prepare yourself. The water gets murky here.
The first thing you should know is that right now the SEC rules don't define what the terms “general advertising” and “general solicitation” actually mean. As the SEC said in its final rules on general solicitation, “the terms ‘general solicitation’ and ‘general advertising’ are not defined in Regulation D.”
If you want guidance on what constitutes general solicitation, you must dig in several places:
- The SEC Rules
- SEC Staff Interpretations
- SEC No Action letters
- SEC enforcement actions/decisions
- Court decisions
If you look up the current rules on general solicitation, here is what you will find:
neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:
(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. Huh? Does the advertisement have to actually offer the securities? In this context, what does "offer" mean? What if an advertisement merely makes vague references? What if it makes no mention of the securities at all? What about pre-existing relationships? Where does that concept fit? Does it or should it fit in at all? What if a seminar is limited to “accredited investors” only? Does that help?
SEC Rules and Its Interpretation of the Law
The SEC staff has issued interpretations that break down the above language. Back in 1983, it said:
First, is the communication in question a general solicitation or general advertisement? Second, if it is, is it being used by the issuer or by someone on the issuer’s behalf to offer or sell the securities? If either question can be answered in the negative, then the issuer will not be in violation of 502(c).Then the SEC went on to say:
Questions under Rule 502(c) typically present issues of fact and circumstances that the staff is not in a position to resolve.Now you know why lawyers can charge $500 an hour, but I digress. More to the point, startups founders deserve better than to live in a world where the SEC refuses to define key terms and then claims that on such a key issue it can’t provide concrete answers.
We need guidance we can rely upon. We need what is referred to in the dusty old English law books as “The Rule of Law.” Meaning, we need a simple, well-written rule that someone without a background in the law can read and understand and apply.
This rule needs to be so simple and easy to understand that if we asked 100 founders to apply the rule to the same fact pattern we'd receive almost unanimously the same answer. The law as written right now is one big gotcha scheme.
Since 1983 the SEC has issued additional pieces of guidance that are downright unhelpful and even hostile.
For example, in 2009, the SEC answered this question -- if a solicitation is limited to accredited investors, is that okay? The SEC said no!
The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering, not the nature of the offerees. [Jan. 26, 2009]Then the SEC has this to say when asked if the prohibition on general solicitation and general advertising in connection with the offer and sale of securities barred product advertising. The SEC said it might!
Rule 502(c) does not bar product advertising, although such advertising is not permitted under the rule when it involves the solicitation of an offer to buy a security. Whether or not particular product advertising constitutes a solicitation in contravention of Rule 502(c) depends on the facts and circumstances. [Jan. 26, 2009]In 2000, the SEC issued guidance on the use of electronic media. The SEC advised:
One method of ensuring that a general solicitation is not involved is to establish the existence of a pre-existing, substantive relationship.This is a great thought, but how does this work with Demo Days and business plan competitions? Perhaps the concept of a pre-existing, substantive relationship could be OK if it were just one way to assure that you hadn’t generally solicited. We need other ways, too.
We need the SEC to revisit its interpretations. They were written in a time when general solicitation was not allowed; it was a No No. Given that backdrop, it is no wonder the existing SEC guidance is hostile.
In the JOBS Act Congress directed the SEC to allow general solicitation in offerings in which all investors were accredited and in which the issuer took reasonable steps to verify the accredited investor status of the investor. So, Congress blessed general solicitation. It is no longer forboten.
When putting the Jobs Act together, Congress in fact mulled over the specific issue the SEC seems especially concerned about: How do we make sure non-accredited investors don’t get caught up in generally solicited offerings and ripped off? And you know what Congress decided? To add the additional verification requirements. Congress found a simple solution. Now we need the SEC to follow suit.
If you really don’t want to find helpful information on what does or doesn’t constitute general solicitation, read enforcement opinions. The trouble with enforcement decisions is that they arise in the context of malfeasance.
For example, this case, in which a guy runs an ad essentially saying, "Come learn about hedge funds."
The SEC says the guy broke rules these because his purpose was to find investors. If this is the law, a lot of current practices are going to be in trouble.
But this can't be the law, can it?
What the Startup Community Can Do
You can help. Write the SEC a comment letter on the proposed rules, asking that the SEC write clear rules on what does and doesn’t constitute general solicitation.
Request that it sanctify current practices surrounding Demo Days, business plan competitions and pitch competitions.
Ask that it make clear that there is no absolute requirement of a substantive, pre-existing relationship in order for there not to be general solicitation or general advertising.
Instead, ask the SEC to adopt a model that more closely hues to what Congress shot for in the JOBS Act. If a room is pre-screened for accredited investors, that ought to work. It ought to be clear that there is no general solicitation if only pre-screened accredited investors are in attendance at a pitch, regardless of whether the event is publicly announced or not.
We all deserve to have the SEC tell us what does and doesn’t constitute general solicitation, especially with so much riding on this under the proposed rules. (I am referring to the one-year death penalty box). No startup or founder should have to operate in the dark with this sword hanging over his head.
You can submit your comments here.
- Please don’t issue these rules at all. Congress didn’t ask you to issue these rules. In fact, rules that Congress did ask you to issue you still haven’t gotten around to (crowdfunding rules, for example).
- The 15-day Advance Form D filing requirement is unnecessary and a bad idea.
- The one-year death penalty box is a terrible idea.
- The filing of the Form D should not be due until after money is raised.
- The SEC ought to consider lengthening the time period to file the Form D to 30 or even 60 days after accepting funds.
- Clarify the way demo days can be run, the way business plan competitions can work, and the way current fundraising platforms that keep information behind walled gardens for accredited investors only, do not constitute general solicitation. No founder, startup or demo day organizer or accelerator should have to guess on this key question under the law.