Financing Transactions/Securities Offerings

Going Public by Direct Listing

New York Stock ExchangeFelix Salmon argues, convincingly in my view, in favor of Spotify’s reported plan to go public by direct listing, not a traditional IPO. A little background, for those unfamiliar with the term: The usual way to go public is via an initial public offering of shares, where the company creates new shares in addition to the ones in existence, sells them to the public through an underwriter, and all old and new shares are thereafter publicly traded on an exchange. However, it’s not always the case that the company actually needs the new capital it ends up raising by selling new shares. Direct listing skips this step; instead, the company just flips a switch and becomes public. (Of course it’s more complicated than literally flipping a switch – you hire, well, me to help you through the process. But it’s certainly simpler than having to market and complete a new offering of stock as part of it.)

The Merits of Angel Investing

Angel Investors | Andrew Abramowitz, PLLCThe Financial Samurai personal finance blog posted an argument against angel investing, based in part on the writer’s own experience with a seemingly successful investment that really wasn’t so great, upon reflection. Toward the end of the post, the author says that if you do angel investing, you should devote no more than 5-10% of your funds towards it, and don’t expect anything good to come of it. But who is really advocating for devoting half or more of your nest egg to illiquid, speculative investments, even if you have a lot of financial leeway? There are legitimate reasons for wealthy individuals to want to participate in angel investing, like the satisfaction of helping a founder with a promising idea to realize a dream. As long as these investors aren’t blowing their whole fortune on it, what is the harm?

The Pitfalls of Being an OTC Public Company

Title III CrowdfundingThe SEC’s Division of Economic and Risk Analysis (DERA) recently issued a paper about over-the-counter stocks, i.e., stocks of publicly traded companies that are not listed on a national securities exchange like the New York Stock Exchange or Nasdaq. While the main subject of the paper is on the inadvisability of individual investors purchasing OTC stocks, my focus here, briefly addressed in the paper, is on whether the companies themselves should consider transactions that result in them having OTC stock. For example, companies that are not in a position to complete a traditional IPO may be able to go public via a backdoor method such as merger with a SPAC or a reverse merger.

For these companies, the usual plan is not to remain an OTC company forever, with thinly traded stock and low institutional ownership. Rather, the hope is that, with the capital usually raised concurrently with the transaction that made the company public, it can successfully execute its business plan such that it can meet the listing standards for admission on the NYSE or Nasdaq at a later date. However, this scenario rarely plays out in practice. Studies cited in the DERA paper find that, over a nine-year period, less than 9% of OTC companies became listed on an exchange, and even those that do have a poor average investment return.

Accordingly, any company planning to go public by alternative means has to consider the possibility of remaining in OTC status indefinitely. There are some advantages to being public. It may be easier to attract employees with equity compensation packages, since there is an easier path to eventually selling shares than would be the case with a private company. Also, public company stock can be used to acquire other companies (though a target company may be skeptical about receiving OTC stock). Finally, there are forms of financing like PIPEs that are available only to public companies (though the terms of those transactions are not necessarily any more company-favorable than investments that private companies can secure).

Recent Trends in Financing Startups

start-up-financingThe Wall Street Journal recently detailed trends in how startups are financing themselves. If you don’t have a Journal subscription, this article will likely be behind a paywall, but to sum it up, young businesses are using bank loans and home equity loans less than in the past, owing to continued cautiousness from lenders following the Great Recession. Instead, they are relying on their own savings and family loans and high interest personal credit card debt.

Bank loans to businesses still exist, but they typically require two years of business activity. This is of course no help to businesses that require a cash infusion to get started, though it can be helpful for more established businesses who want to expand their business or to smooth cash flow. Personal credit card debt is relatively easy to obtain, but the interest rates are high, and if your business fails, you’re in a far worse position than when you started.

For those who want to start a business but don’t want to potentially blow their personal savings on a venture or be stuck with high interest credit card debt, the lower risk alternative is to sell equity to outside investors. You are giving up some of your business’s upside, but receiving financing that does not immediately (or perhaps ever) need to be paid back may be worthwhile for some companies. The Journal article mentions crowdfunding as a means to obtain equity capital, and while this is a young and developing form of offering equity, it has the potential to be a common and viable method for startups to finance themselves. Even when crowdfunding does become more commonplace, it will likely still be hard for completely new businesses to receiving financing, unless the founders have already had demonstrated success with other ventures. However, there is always the possibility of friends and family equity financing to jumpstart ventures to get to the point where they can then seek financing from the crowd.

Finally, even though there are many challenges involved with fundraising for new businesses, the silver lining is that in many cases, the cost of starting a business is far less than in the past as a result of recent developments in technology and the rise of the gig economy. Taking my own business of launching a law firm, in the past, I would have had to rent expensive office space, hire an assistant and full-time attorneys, etc., all of which requires a significant initial outlay. Now, a lawyer can run a virtual firm and have work performed on a pay-as-you-go, project-by-project basis. Pretty much the only significant initial outlay is the cost of a website. Accordingly, despite the challenges in raising funds in the current environment, it’s as good a time as any to launch a business because, in many cases, less financing is required.

The Shark Tank Approach to Startup Investing

I always enjoy the reality show Shark Tank, where startups make appeals to a panel of well-known individual investors, seeking their venture investment. However, most of the negotiations are only focused on two deal points: how much will be invested, and what percentage of the company the investor will get. In my legal work, more often than not, these basic financial terms are already worked out by the time I get involved, and the heavy negotiation, particularly when the investor is a venture capital or private equity fund, is about special rights that the investor can obtain: board representation, veto rights over major (or minor) decisions, preferences upon sale or liquidation, anti-dilution rights, and many more.

At times, the rights sought by the investor can be pretty onerous. The investor will argue that they are necessary to induce the investor to make a risky investment. There is some validity to this reasoning, though I think it’s a bit overstated.

Startup InvestingWhat if, however, a fund investor decided instead to take a Shark Tank-type approach and negotiate only the amount invested and valuation with no special rights – just common stock, no board representation, no economic preferences. (By the way, I have no idea whether the sharks on the show negotiate these sorts of rights as part of their deals – it would be too boring to describe to a network TV audience – but I’m just using the show to illustrate a point.) The approach on the part of the investor is that if a due diligence investigation shows that this is a promising venture, just give the company the needed funds and let the founders do their thing, providing advice only as requested by the company. Of course, some ventures won’t work out, but in any event the idea (particularly with venture capital funds) is to spread funds around many investments and wait for a few to pay off big. The rationale for stepping back like this is to make yourself attractive to companies seeking capital, allowing you to be more selective in the companies you invest in, hopefully leading to greater ultimate success.

I’d be curious to hear if any readers have experience with funds that take this approach. In my experience, I’ve seen exactly one example.

Regulation A+ – An Improved Way for Smaller Companies to Go Public

The new Regulation A+ offerings, which are available for use starting on June 19, 2015, should not be thought of in the same category as Regulation D offerings. If a company’s primary goal is to raise as much money as possible with as little offering-related and ongoing securities compliance as possible, you still can’t beat Regulation D. Rather, Regulation A+ offerings will be useful to smaller companies who want some of the advantages of going public, without having to rely on imperfect solutions like reverse mergers or self-filing registrations.

Regulation A+Unlike small companies that go public through means like a reverse merger, companies relying on Regulation A+ are not subject to the high ongoing disclosure burdens of public companies. Tier 2 offerings under Regulation A+ (up to $50 million) impose limited ongoing disclosure requirements as compared to the burdens imposed on traditional public companies, and Tier 1 offerings (up to $20 million) don’t impose any ongoing requirements at all after initial clearance with the SEC and state blue sky regulators (the latter of which is preempted for Tier 2 offerings). Many small companies that go public via reverse mergers find it difficult to keep up with the compliance costs of being a public company; companies using Regulation A+ will not have the same issue.

Unlike Regulation D offerings, Regulation A+ permits a limited amount of securities to be sold by existing stockholders – up to $6 million in Tier 1 offerings, and up to $15 million in Tier 2 offerings. As a result, the company’s early investors and founders have an opportunity to cash out and realize a profit on their investment of money or time. Additionally, the shares purchased in a Regulation A+ offering are unrestricted, meaning there’s a potential for a secondary market to emerge in the company’s shares.   In most cases, there won’t be high trading volume comparable to large public companies, but this is already the case with small companies that go public via a reverse merger or otherwise.

Another factor that could cause a company to opt for a Regulation A+ offering is when the target investor base has several non-accredited investors. Under Regulation D, a Rule 506(b) offering permits no more than 35 non-accredited investors, and a Rule 506(c) offering (i.e., generally solicited) permits zero non-accredited investors. In contrast, non-accredited investors can freely participate in Regulation A+ offerings, though in the case of Tier 2 offerings, an investor can invest no more than 10% of the investor’s annual income or net worth, whichever is greater.

Regulation A+ – How It Fits Into the System

The SEC recently adopted final rules implementing significant changes to securities offerings done under Regulation A.  Because of the greatly expanded scope of the offerings, they are referred to colloquially as Regulation A+ offerings.  The SEC announced the final rules with a press release and fact sheet.

The Latest on Possible Tweaks to the Accredited Investor Definition

As most readers of this blog know, one of the key concepts in securities law compliance for private offerings is the definition of “accredited investor” in Regulation D. Although it is possible to include non-accredited investors in private offerings (e.g., Rule 506(b) permits offerings to up to 35 non-accredited investors), many issuers choose to limit their offerings to accredited investors only, which can simplify the offering from a documentation perspective.

Should You Be Making Blue Sky Filings in New York?

blue sky filingsOne of the oddities of New York securities law is that a core legal requirement imposed by the state was preempted by federal law almost 20 years ago, and yet the requirement remains on the books. The National Securities Markets Improvement Act, or NSMIA, enacted by Congress in 1996, expressly restricts the level of regulation that states can impose on private offerings done in reliance on Rule 506 of Regulation D or Section 4(a)(2) of the Securities Act of 1933. Following NSMIA’s enactment, most states amended their “blue sky” securities regulations accordingly and basically only require the filing with the state of a copy of the federal Form D and the payment of a filing fee, which NSMIA permits. New York, in contrast, still requires a relatively involved form to be filed with the state under the Martin Act, requesting more information than is permitted by NSMIA.

In 2002, the Committee on Securities Regulation of the New York State Bar Association issued a position paper flatly stating that the requirements imposed by the Martin Act for these offerings are preempted by NSMIA. In the following years, many of my fellow corporate and securities attorneys accordingly advised their clients that no New York filing need be made for Rule 506 or Section 4(a)(2) offerings, on the theory that an enforcement action by New York is unlikely and, even if there is one, there would be a solid defense of federal preemption.

However, I’ve had a recent experience with a new client that may call for a reassessment of this approach. I was asked to prepare blue sky filings for a New York real estate developer that was the subject of an enforcement action by the Attorney General for failure to make the filings as required by the Martin Act. (I was not involved with this client in connection with the securities offerings that triggered the action; I was brought in after the Attorney General demanded that the filings be made.) Now, this client could have taken an aggressive approach and challenged the action on preemption grounds, but the client took a practical, cost-benefit approach to the issue and decided it was better just to comply with the filing requirement as requested by the state.

I don’t know if this case is part of a new and concerted effort on the part of the Attorney General to enforce these laws. There are some facts specific to this case that may set it apart – for example, the client allegedly engaged in some active public solicitation and advertising that are not permitted for private offerings of this type, and it may be that these activities put the developer on the state’s radar. Nevertheless, those conducting private offerings in New York might want to consider complying with the Martin Act filing requirements to avoid the later cost and headache of an enforcement action.

Streamlining of Blue Sky Filings

Under U.S. law, every sale of securities must either be registered or fall under an exemption from registration. This determination must be made both with respect to federal law and the law of the particular state (the “blue sky” law) in which the securities are being offered. In the bad old days – pre-1990s – each state had its own unique set of exemptions and filing requirements, meaning that a securities offering in multiple states required a significant amount of research and form preparation. In 1996, Congress passed the National Securities Markets Improvements Act (NSMIA), which effectively pre-empted most state regulation of “covered securities,” including securities sold under Rule 506. Post-NSMIA, states can’t do much more in these transactions than require the issuer to send in a copy of a Form D (as filed with the SEC) and pay a filing fee.