Last week the SEC adopted “amendments to Rule 506 of Regulation D under the Securities Act of 1933 to implement Section 201(a) of the Jumpstart Our Business Startups (JOBS) Act. The amendment to Rule 506 permits an issuer to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. The amendment to Rule 506 also includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons. [The SEC also will revise Form D] to require issuers to indicate whether they are relying on the provision that permits general solicitation or general advertising in a Rule 506 offering.”
For a number of reasons, we believe that ending the ban on general solicitation will dramatically change how private companies raise money from investors, particularly at the early stages.
What is general solicitation? For eighty years, it has been unlawful for a private company to seek investors through general solicitation or general advertising. As a result, companies were prohibited from using mail, magazines, newspapers, television or radio, phones or even seminars where attendees have been invited by such means to solicit potential investors. In recent years, the SEC has also confirmed that other uses of publicly available media (such as unrestricted websites, social media, etc.) constituted “general solicitation” and “general advertising.”
Removing the ban will allow private companies to solicit investors by these general means, provided that such issuers otherwise comply with the requirements for a valid Rule 506 offering (including, without limitation, the requirements that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors – these requirements are discussed in more detail in the SEC fact sheet referenced above and in the final SEC rules adopting the Rule 506 amendments).
What were the effects of the ban on general solicitation? Due to the historical ban on general solicitation, the established framework for private company fundraising has been a largely “underground” marketplace made up of private meetings, small group pitches, emails and “demo days.” Some of these methodologies may, in practice, arguably skirt general solicitation (especially demo days and mass emails) but, in any event, private companies have traditionally raised money through off-line and “back-room” avenues based on their personal relationships and established startup networks.
By banning general solicitation, one can argue that historical securities laws actually hindered one of the more important aspects of an investment decision – namely, the ability for potential investors to obtain adequate information. Specifically, by making the marketplace closed and less transparent, investors have had limited information about the companies in which they are considering investing and the possible alternative investment opportunities among comparable private companies.
In addition, because issuers were unable to solicit investors across multiple channels, companies have historically had limited ability to reach a wide audience, and the cost to do so was high. As every entrepreneur knows, it takes a tremendous amount of time and effort to find and pitch the right investors for your company.
Thus, many argue that the ban on general solicitation makes the private fundraising process more inefficient and costly, and may cause undesirable outcomes (e.g. good companies going underfunded while other companies receive higher valuations and funding amounts than they would otherwise receive in a more transparent market). For some other reading on the effects of the ban on general solicitation, read this, this, this and this.
Why does this matter? Removing the ban on general solicitation helps eliminate one of the biggest hurdles to private companies seeking capital from investors across multiple channels. Private companies will be able to reach a larger number of investors through many different methods (investment platform campaigns, social media campaigns, email marketing, etc.) so long as they comply with the Rule 506 requirements (including the accredited investor verification requirements). The associated costs of raising capital (which include travel, legal expenses and, most importantly, time) will be significantly reduced.
For many entrepreneurs, especially first-time entrepreneurs, a major roadblock to raising capital is the lack of information about where to go to pitch investors (this problem prompted us to write this blog post). Removing the ban on general solicitation may make it easier for entrepreneurs to find platforms and get connected with fundraising opportunities, simply because they will now be more visible online and elsewhere.
Also, removing the ban will increase the level of information in the marketplace for private companies seeking capital. Investors of all kinds (provided that they are accredited) will have a better picture of what types of companies are seeking capital and under what terms. Online investment platforms like Angelist, CircleUp, Fundable, Secondmarket and others will make it easier for investors to peruse and filter investment opportunities and gain access to critical information necessary to make investment decisions. Without the ban on general solicitation, we anticipate that investment platforms will expand rapidly as more and more investors seek investment opportunities in private companies online, and as private companies seek capital online.
Why this may not matter… On the other hand, the method that a private company utilizes to solicit investors may not make any difference as to whether that specific company raises funds or how much or under what terms. Each company seeking to raise capital still must have all of the necessary elements of a successful investment opportunity. In this respect, ending the ban on general solicitation only addresses one (albeit important) aspect of matching investor with issuer.
Moreover, private companies must determine whether the benefits of advertising and general solicitations outweigh the costs of taking reasonable steps to verify that each investor is accredited and complying with the additional requirements that have been proposed by the SEC to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting issuers to advertise and engage in general solicitations under new Rule 506. As a brief summary, these proposed requirements include:
- 15 day advance notice (via a Form D filing) of the use of general solicitation in a private offering, and filing an updated Form D within 30 days after completing an offering;
- Additional information about the issuer and the offering (e.g. issuer’s website, types of investors, use of proceeds, types of general solicitation used, methods used to verify accredited investor status);
- Disqualification of issuers who fail to file Form D;
- Additional legends and disclosures in written general solicitation materials; and
- Submission of written general solicitation materials to the SEC.
Finally, as Erin Griffith points out in her recent post on PandoDaily, “[w]ithin large [tech] startup ecosystems, there are established systems and networks in place for raising capital.” This weighs against the likelihood that the capital markets for startup tech companies, at least, will be significantly impacted by the end of the ban on general solicitation. However, it is not a foregone conclusion that large tech startup ecosystems like Silicon Valley are necessarily the only places where a technology startup could or should be located or raise money. Indeed, if the idea of the JOBS Act is to spur innovation, entrepreneurship and jobs all throughout the country, then ending the ban on general solicitation may advance this goal by unlocking potential fundraising opportunities for startups of all kinds (tech and non-tech) in places without robust startup communities.
While it is true that removing the ban on general solicitation may not make much of a difference on a company–by-company basis, increasing the level of available information in the marketplace and reducing the costs of raising capital will change the landscape for private company fundraising in general, and is anticipated to make the market more efficient, transparent, and robust. This is true for tech startups and non-tech startups alike, especially those outside of highly concentrated tech locations like Silicon Valley.
Will this worsen the Series A Crunch? In the past year or so, we’ve seen that tech startups are suffering a major deficit in capital at the second round stage (the so-called “Series A Crunch”). While there are many reasons for the Series A Crunch, the most obvious explanation is a rapid increase in the number of technology startups getting funded at the earliest stages (seed, friends and family and angel), and the inability (or unwillingness) of larger, institutional investors (like VCs) to fund most of those companies in future rounds. Ending the ban on general solicitation may result in even more private companies raising money at the earliest stages, possibly deepening and broadening the Series A Crunch problem.
Will this increase fraud? Time will tell. However, it isn’t exactly clear how the ban on general solicitation reduced the risk of fraud in the first place. In fact, by making the market for private investments “go underground” with limited information and absent public scrutiny, arguably it may have been easier for fraudulent investment schemes to exist in the shadows. In that respect, there may be fewer instances of fraud under a general solicitation paradigm since it may increase the level of public (and prosecutorial) awareness of fraudulent investment schemes and therefore enhance the efforts of regulatory and law enforcement bodies. On the other hand, an increase in the number and types of investment channels may also expose more accredited investors to the risk of fraud by means through which they were previously unable to invest.
Bottom-line. If you’re an early-stage company seeking to raise funds, the end of the ban on general solicitation may make it easier and cheaper for you to do so. If you’re an investor, the end of the ban on general solicitation may make it easier and cheaper for you to gain critical information about investment opportunities. The collateral effects resulting from the end of the ban are yet to be determined, but it is clear that there will be exciting and marked changes to the marketplace for investments in private companies.
- SEC Lifts Ban Against General Solicitation, Allowing Startups To Advertise That They’re Fundraising (techcrunch.com)
- SEC: Startups can now advertise they are fundraising; crowdfunding has to wait (venturebeat.com)
- Angels: New SEC rules ‘could kill most angel investment’ in U.S. (bizjournals.com)
- For VCs, SEC Ruling Should Make Fundraising a Bit Easier (pehub.com)