Financing Transactions/Securities Offerings

The SEC’s SPAC Proposal and Projections

The SEC has issued its long-expected proposed rules regarding SPACs. Here are the proposing rule release and the shorter press release. The SEC has always been skeptical of SPACs, and the rules are generally designed to impose new disclosure requirements on SPACs that make the rules more aligned with those applicable to traditional IPOs. One of the reasons SPACs had their moment in the sun recently is that they are easier to complete than IPOs, so the rules, if enacted, could have the effect of severely dampening the market for SPACs, even if they do nothing to directly restrict them from being done. In fact, the general expectation that rules like these were coming down the pike has, anecdotally, been a factor in the SPAC market slowing down recently.

One of the key areas in the proposed rules relates to projections. Under current rules, companies merging with a SPAC can include projections about the company’s future expected results and can benefit from a safe harbor protecting it from litigation if the projections don’t come to pass, as long as the projections are accompanied by a disclaimer and the companies don’t have actual knowledge that they won’t come true. In contrast, companies going public the traditional way don’t have the benefit of this safe harbor. The proposed rules would eliminate the safe harbor in the SPAC context, which would have the practical effect of precluding most projections from being presented.

There are exceptions, but companies doing traditional IPOs are generally more mature than those seeking to go public via SPAC, which are often pre-revenue (or at least pre-profit). This doesn’t mean the companies are inherently dodgy; rather, there are hurdles to meet, like further research and development, regulatory approvals, etc., before they can actually realize a profit. In a way, it makes sense that these early-stage companies would want to include projections to give potential investors a picture of how an investment could perform, since the historical financial statements don’t provide much useful information about where the company is going. However, trying to project future financial results for companies before they are fully doing the thing that they’re hoping to do is an inherently imprecise undertaking.

Suppose a company projects that its revenues will increase twenty-fold over the next five years, which could be a completely legitimate, good-faith estimate in particular contexts (though laughably unrealistic in others). If this company actually ends up achieving a fifteen-fold increase, most early investors would be happy with that result and wouldn’t feel aggrieved, but the projection would have been off by hundreds of percentage points.

I’m not a regular investor in early-stage companies, just an advisor and observer, but from my perch I can see that there is high demand for projections – investors want to see them to inform their go/no-go decisions and companies want to make them to attract investment with blowout return scenarios. But making a decision based on whether the projected numbers reach an exact threshold you have in mind seems misguided, whether it’s the company or the investor making the projection. The whole point of equity investing versus debt is that you have theoretically unlimited gains, paired with a higher risk of losses. If you’re going to be in the business of investing in early-stage companies, the general strategy is to diversify: do whatever due diligence you can, but accept that success is inherently uncertain and hope that by spreading the investments to a wide number of ventures, the outsized gains from the hits will more than offset the failures. Trying to artificially impose precision on this by distinguishing between a projection of 10X or 50X or whatever doesn’t seem to be to be a productive use of an MBA.

The Advantages of Rule 506(c)

There is something weirdly contradictory about Rule 506(c) under Regulation D, which has been available for less than 10 years. Regulation D was adopted years before that as a safe harbor for private offerings under Section 4(a)(2) of the Securities Act. In other words, for companies who didn’t want to undergo the costly and involved process of registering their offering publicly, they could do a simpler offering that’s not marketed widely. That process is reflected in what is now Rule 506(b). However, Rule 506(c), even though it’s within the rule that’s supposed to be for private offerings, expressly permits “general solicitation or general advertising” – so, public marketing of the offering.

There are two conditions for the use of Rule 506(c) that aren’t requirements for Rule 506(b):

            1.  Every single participant in the offering must be an accredited investor (up to 35 non-accredited investors can be included under Rule 506(b)); and

            2.  The accredited investor status of each investor must be verified, e.g., through examination of tax returns or brokerage statements, to confirm income or net worth, so, the company cannot just rely on a written representation by the investor.

In practice, condition No. 1 doesn’t matter that much because most Rule 506(b) offerings are made exclusively to accredited investors in any event. Including even one of the 35 non-accredited investors permitted under Rule 506(b) triggers a requirement to provide full business and financial disclosure to all investors that makes it impossible to have a “documentation-lite” approach that makes Regulation D offerings attractive for many companies. So, the real catch when determining whether to rely on Rule 506(c) is the need to comply with condition No. 2, accredited investor verification.

The verification process is still a roadblock even for many prospective investors who easily qualify as accredited. Most companies raising capital don’t want to be involved with directly reviewing the private financial information of their investors and so will outsource the process to a third-party verification service. I’ve found with my clients that a significant number of prospective investors get stuck during the verification process. Surely, in some cases it’s because they weren’t in fact accredited, meaning the rule is serving its proper function, but in others, whether because of privacy concerns, laziness or some other factor, the investor never gets around to giving the verification service what it requires.

However, these practical issues with verification mainly apply to individual investors. For more institutional investors like venture funds, there is no real impediment to their compliance, whether it involves a certification from an accountant or attorney or providing direct evidence of assets to a verification service. On one hand, you might wonder why general solicitation and advertising is even necessary in the context of an institutional-type round, since there is a long-standing practice of conducting these offerings in a traditional, Rule 506(b) setting. But using Rule 506(c) in these offerings frees the company from some of the usual constraints on how it communicates during the offering period. For example, it can mention the offering in press releases and social media posts even before the offering is done.

As always, all company communications are subject to the anti-fraud rules of the securities laws, so there’s never an “anything goes” rule for communications. But relying on Rule 506(c) can allow companies more freedom in how they operate during offerings, with only a slight additional burden imposed by the verification process in larger offerings.

The BuzzFeed Option Exercise Dustup

The New Yorker magazine, not my usual source of prompts for blog posts on corporate and securities law, posted a piece on the recent hiccup with stock option exercises by the newly public media company BuzzFeed. BuzzFeed went public by merging with a SPAC. Longtime employees that were hoping to cash in on their stock options were unable to do so right after the merger, at which point the company’s stock price sharply declined, making the options less valuable. The employees are aggrieved at the missed opportunity to exercise options and sell shares at the higher price.

Continental Stock Transfer & Trust Company is featured prominently in the piece. Continental is BuzzFeed’s transfer agent, a category of service provider unknown to most people outside the corporate finance world. As the back-office company responsible for keeping track of who owns which of BuzzFeed’s shares, Continental’s job, among others, is to process the exercise of BuzzFeed’s options and issuance of shares to the employees. (I’ve worked with Continental for years with my public company clients but have no personal connection to the BuzzFeed controversy.)

Assessing the Costs of SPACs

The casual reader of the business pages has seen over the past year or so many articles about SPACs, the financial structure du jour, which have actually been around for a while. (I worked on some in the ‘00s.) The acronym stands for Special (or Specified) Purpose Acquisition Company. For those of my readers that are not corporate finance professionals, the way to conceptualize a SPAC is that it’s a private equity fund that is publicly traded. In other words, investors put funds in a newly created entity via an initial public offering (IPO). The entity has no operations other than a plan to acquire an operating company with the IPO funds within the next couple of years, with a management team that is tasked with doing the acquiring. From the perspective of the operating company being acquired, it’s a way to go public, by merging with the already-public SPAC, as an alternative to a traditional IPO. (In a traditional IPO, there is no merger; rather, a bunch of new shares in the private company are sold to the public, and poof, it’s a public company.)

The investment community has been abuzz recently about an academic paper, summarized here, that found the costs of going public via SPAC merger to be much higher on average than doing so via a traditional IPO. For my non-finance professionals out there, the most concise way I can put it is that the typical SPAC structure is designed to favor the initial sponsors and initial investors, over investors who buy shares in the open market after the SPAC’s IPO and the target company shareholders. This is because of two concepts present in most SPACs but not in most other contexts: the promote and warrants.

A promote is a form of compensation for the management team that forms the SPAC, brings it public and finds an acquisition target. Generally, this sponsor team gets, for nominal cost, 20% of the post-IPO shares of the company. Ultimately, these shares dilute the ownership of the SPAC investors and of the target company’s shareholders, post-merger, in a way that doesn’t occur in a traditional IPO.

Additionally, in most SPACs, the IPO is done as a sale of units, comprised of regular shares and warrants to purchase additional shares. The warrants (which are like stock options for those unfamiliar with the term) have an exercise price somewhat higher than the IPO price. The warrants are essentially a free add-on for the SPAC IPO investor. They can elect to have the company redeem their shares in advance of the merger and get their invested money back, but they still can keep the warrant and cash in if the stock pops. The additional shares that are issued when warrants are exercised constitute dilution to other holders, again in a way that wouldn’t occur in a traditional IPO. At least as compared to the promote, a warrant exercise for cash would bring funds into the company, but if the warrant is in the money (i.e., the market price exceeds the exercise price), then the shares are being purchased at a discount, which is not the kind of dilution that existing holders want to see.

Ultimately, there are some advantages for private companies in going public by SPAC merger over a traditional IPO. For example, whether an IPO can be completed can depend on general market conditions at the time of pricing of the IPO that are completely outside the company’s control. A SPAC merger may be the right choice for certain companies. But they need to be sure they are taking into account and fully understand the SPAC structure before choosing this option over other alternatives, like a traditional IPO, an acquisition by another operating company or private equity fund, or simply staying put as a private company.

The SEC Streamlines Accredited Investor Verification Under Rule 506(c)

The SEC’s recent final rule release regarding exempt offerings covered various topics, including the subject of my previous post, on the expanded offering limits for Regulation CF crowdfunding and Regulation A offerings. In the release, the SEC also provided some welcome relief in the accredited investor verification process for Rule 506(c) offerings.

The SEC Broadens the Crowdfunding and Regulation A Exemptions

The SEC issued a 388-page final rule release, entitled Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets. (The clunky wording seems like it was done to accommodate a catchy acronym, but “FCFAEIOBIATCIPM” doesn’t really flow.) The release details rule changes in a variety of areas relating to private offerings, but I will focus for this post on the expansion of the crowdfunding (Regulation CF) and Regulation A offering exemptions, and cover other topics in future posts. Here are the SEC’s press release and fact sheet about all the new rule changes.

The SEC’s Proposed Expansion of Accredited Investors

When to use a Private Placement Memorandum | Andrew Abramowitz, PLLCThe SEC has issued a proposal to expand the definition of “accredited investor” as used for the Regulation D safe harbor for private offerings. This press release/fact sheet summarizes the changes. There are a number of technical updates to reflect developments in how business is now conducted, e.g., LLCs with sufficient assets would qualify in the same manner as corporations now do. However, the change that would likely have the most impact, at least in my practice, is the inclusion as accredited investors of natural persons with appropriate professional certification, such as holders of a Series 7 securities license, even if they don’t qualify under the existing standards for natural persons for income or net worth. I’m not aware of any significant opposition to this concept and assume it will be enacted by the SEC after public comment.

However, any time the topic of the accredited investor definition is raised serves as a trigger for me to raise the issue of investment limits in private offerings. Crowdfunding offerings under Regulation CF, enacted in recent years and still used far less than Regulation D, impose investment limits on investors that are based on a percentage of the investor’s income or net worth. Accordingly, the structure precludes a total financial wipeout of the individual investor as a result of a failed investment. …

The SEC’s Concept Release on Exempt Offerings and Investment Limits

Share Buybacks as a Political Issue | Andrew Abramowitz, PLLCThe SEC recently issued a long “concept release” on harmonization of securities offering exemptions. Whenever I hear about one of these, my first thought is that it’s somehow like a concept album from a ‘70s prog rock outfit (and therefore to be avoided), but in reality, the point of concept releases is to solicit input from the securities law community on a broad topic without immediately proposing changes. In this case, it’s about the complex web of exempt offering types that have evolved over the years and whether and how to harmonize them.

Pushing Back Against the SEC on Finders Rules

Legal Referrals | A. Abramowitz | NYC

As I’ve blogged about in the past, the SEC in recent years has taken a relatively strict position against payments to “finders” who are not registered broker-dealers, as compensation for introducing investors to companies. The SEC’s focus has primarily been on “transaction-based compensation,” i.e., payment to the finder that is contingent on investment by the introduced investor, which according to the SEC is a hallmark of broker-like activity that requires registration.

At-the-Market (ATM) Offerings

At-the-Market (ATM) Offerings | Andrew Abramowitz, PLLCBloomberg Law’s Corporate Transactions Blog recently posted an item entitled “At the Market Offerings are Again Wildly Popular.” (I should note that I am in favor of trying to spice up securities law articles by using words like “wildly,” though if we’re being honest, there is nothing remotely wild described in that article, or this one either.) ATM offerings are a way for already-public companies to raise further capital by selling newly issued shares. They are particularly popular among life sciences companies, which often need to continually raise capital for research and regulatory clearance efforts before having significant revenue with which to fund those activities.