When startups are seeking to obtain seed capital through a friends and family financing, most of the time, those friends and family members make a direct cash investment either in their individual capacity or through a business entity that acts as an investment vehicle. Another option that is not widely known is for the investor to use tax-deferred retirement funds for the investment, via what’s known as a self-directed IRA. Essentially, IRA funds can be used for many investments other than the familiar publicly-traded stocks, bonds, mutual funds, ETFs, etc., and among the other permitted investments are private company securities. However, the investment must be made through a custodian who administers the process, executing transaction documents on behalf of the investor, etc. The custodians are not the familiar brokerages like Fidelity and Schwab, but others you probably haven’t heard of that specialize in this area. …
Financing Transactions/Securities Offerings
As much as I am always inclined to mock West Coast trends, there is a recent one that I grudgingly find intriguing: so-called “safe” equity (simple agreement for future equity), which is an alternative to convertible notes for startups seeking bridge financing to keep the lights on until they can raise substantial funds in a “real” equity round. Y Combinator offers open source safe equity forms with some background information. With a convertible note, the seed investor acts temporarily as a lender, with the note being converted to equity if and when the company has a qualifying equity financing. With safe equity, the investor simply receives the right to receive preferred equity when the financing is completed, without the need to temporarily treat it as a loan. There is no interest, maturity date, repayment terms or any other provisions that you’d associate with a debt instrument.
When companies are in need of financing, the threshold question is whether the financing will take the form of equity or debt. Of course, there are hybrid forms such as convertible debt, and some financings will involve equity investment completed simultaneously with a bank loan. And sometimes debt will not be an available option, particularly for start-ups with no steady revenue that a lender could rely on for assurance of payment. But in many cases, a company will have a choice of which way to proceed. …
An advisory committee set up by the SEC, as directed by the Dodd-Frank law, has issued a report with recommendations for changing the “accredited investor” definition used for purposes of determining investor qualifications to participate in Regulation D private offerings. The report correctly identifies the flaws with a system that uses income and net worth as proxies for investment sophistication. It goes on to make a series of recommendations for changes to the system that, in my view, are on the right track.
I wanted to focus for this post on a few specific recommendations that I found particularly noteworthy.
In Recommendation 2, the report advocates relying on more direct measures of financial literacy, such as having securities or financial planning credentials or passing a basic test. There could be challenges in implementing something like this, but clearly we’d rather have a financial planner with a relatively modest income participating in private investments ahead of a 21-year old musician (not that there’s anything wrong with music) who just inherited a $1 million estate.
Recommendation 3 gets into possible limitations on amounts to be invested in private offerings if someone’s income or net worth barely meets the applicable thresholds. This is akin to the limits on investments in the not-yet-enacted Title III crowdfunding rules. This addresses one of the main goals of the securities laws, which is to try to prevent investors from losing a big chunk of their nest egg. If someone who makes $200,000 per year wants to plunk $5,000 in a private investment with a lottery-like risk-reward profile, it may not be the most prudent thing to do, but it’s not going to ruin the investor, so it’s appropriate to regulate it lightly.
Finally, Recommendation 4 promotes third party verification of accredited investor status, which is a somewhat overlooked part of the new rules permitting general solicitation for all-accredited investor offerings. Having trusted third parties in this role helps keep issuers out of the business of sifting through sensitive private financial information of their investors.
I blogged recently about an SEC crackdown on failure to make required filings under Sections 13 and 16 of the Exchange Act, and continuing with that theme, the SEC recently announced a enforcement program against several public companies for failure to disclose unregistered offerings of securities.
First, some background: Any sale of securities by a company must either be registered under the Securities Act, or it must be sold under some exemption, such as a Regulation D private placement under Section 4(2) of the Securities Act. The SEC’s concern is that all sales of any kind be effectively disclosed to the public, so investors are aware of dilution that may have recently occurred when making their investment decisions. The public is aware of registered sales because the registration statement and prospectus filings are made via Edgar. When the sales are unregistered, public companies are required to make a filing on a Form 8-K if the sale exceeds a certain threshold (5% of the outstanding common stock for smaller public companies), and otherwise on the next Form 10-Q or 10-K.
In the cases brought by the SEC, ten companies failed to report transactions on Form 8-K as required by these rules, and three of them also had faulty disclosure when they disclosed the transactions in a later report. None of these companies is a household name. The issue of disclosure of unregistered offerings is more likely to come up in the context of smaller public companies, since larger ones tend to have more flexibility to conduct registered offerings (takedowns from shelf registration statements, etc.), while their smaller counterparts rely on PIPEs and similar transactions, which trigger the disclosure requirement. Often, these microcap public companies don’t rely on experienced or competent securities counsel in preparing their filings. (Yes, that is a not-so-subtle pitch for my services.)
The broader point is that the SEC is well aware that certain of its disclosure requirements are not complied with religiously, and while the agency doesn’t have the budget to police each failure individually, it is attempting to send a message with these coordinated multi-company enforcement efforts that the rules shouldn’t be ignored.
Last month, the SEC issued a user-friendly guide for potential investors in avoiding fraudulent unregistered offerings. I highly recommend the advice given here, but I have a few specific clarifications:
- In point 1, the SEC identifies promises of high returns with little risk as a red flag. This is of course true, but one shouldn’t necessarily be concerned if a PPM contains projections of future financial results that look rosy, as long as there is appropriate risk disclosure included. Particularly if the company is a startup without meaningful historical financials to disclose, you’re likely to see projections in the PPM, and even the most scrupulous and honest companies are not going to have projections that make the investment opportunity look like a sure-bad thing.
- Point 4 implies that you should be concerned if the offering doesn’t have a PPM, but as I’ve noted before, it’s not uncommon for private placements to go without a PPM for all-accredited investor offerings. The other point made here about sloppy documentation is well-taken.
- Point 5 notes correctly that many exempt transactions rely on the accredited investor definition. In such cases, as noted, it would be a red flag if the documentation did not ask about the investor’s accredited investor status. However, the heading of this point could be interpreted to mean that you can’t participate in these offerings without the requisite net worth or income, but of course several of the exemptions permit a certain amount of non-accredited investors.
- Point 8 says it’s a red flag if the entity isn’t in good standing in its state of incorporation/organization. It’s pretty common for smaller companies to be delinquent in franchise tax payments and therefore not in good standing pending the payment, and in the great majority of these cases, it’s probably more about inattention to detail than a scam. A reasonable investor could deem such sloppiness to be a red flag, but not necessarily as an indicator that the promoter will abscond with the investor’s funds.
Back in the day, by which I mean the mid-2000s, I worked on a few reverse mergers. The term is kind of a misnomer, because it sounds like the unwinding of a merger, but it actually refers to an alternative way for private companies to go public by merging with a public “shell” company. The shell has little or no current operations and files its 10-Ks and 10-Qs, waiting to complete the reverse merger and acquire the private company. A private company would go this route, rather than doing a traditional IPO, mainly because it is not large enough to attract the interest of first-tier investment banks, and because completing the reverse merger can be done relatively quickly, without the SEC review process associated with a traditional IPO. However, there are a number of caveats and restrictions that should be considered by any private company before proceeding down this route:
- Several SEC rules limit the activities of issuers and stockholders of former shell companies, including issuers’ ability to conduct certain types of offerings and stockholders’ ability to sell their shares. Basically, the SEC hates reverse mergers, in part because they historically attracted unsavory promoter-types, and in part because the transaction is viewed as an end run around the SEC’s usual procedures, even if it’s technically permitted.
- The cost of being a public company is significant, especially with Sarbanes-Oxley internal control and other requirements, and such costs may be too much for the former private company to bear.
- The major stock exchanges will no longer list a former shell’s shares immediately after the reverse merger, meaning that at least for some time, the shares will be quoted on the OTC Bulletin Board or Pink Sheets, which are shunned by most institutional investors.
- Perhaps because of these factors, companies that have completed a reverse merger tend not to be successful long-term, though surprisingly, a recent study found that reverse mergers of Chinese companies (which have attracted particularly bad press in recent years) performed fairly well on average.
Reverse mergers are not as common as they were, and they may become less so following the enactment of Regulation A+, which will permit mini-public offerings of up to $50 million, which will presumably be attractive to those companies that currently would consider the reverse merger route.
Keith F. Higgins, the Director of the Division of Corporation Finance at the SEC, recently spoke at the 2014 Angel Capital Association Summit. His speech came in the midst of much JOBS Act rulemaking that I’ve blogged about frequently, and his remarks provide some useful insight into what the SEC is thinking about these days, although he includes the standard disclaimer that he’s speaking for himself and not the whole agency. In particular, I thought the following topics that he covered were worthy of note: …
I’ve noted in past posts that the SEC tends to take a paternalistic attitude toward the notion of non-accredited investors participating in private offerings, with income and net worth enshrined in the applicable rules as a rough proxy for sophistication and ability to take investment risk. However, the risk to non-wealthy investors of being wiped out is real. Needless to say, placing one’s entire nest egg in one basket, particularly a high-risk/high-reward-type of an investment, is a recipe for disaster. The JOBS Act provisions on crowdfunding, and the SEC’s proposed rules enacting those provisions, seek to address this issue through limitations on the amount that can be invested in any one offering and all crowdfunded investments together by those with modest income and net worth. …
The Private Placement Memorandum (PPM) is the disclosure document used in private securities offerings, providing to prospective investors detailed information about the company’s business plan, terms of the offering, risk factors, management, financial history and/or projections, etc., to enable the investors to make an informed decision on whether to participate in the offering. For Regulation D offerings, Rule 502 requires that a PPM be provided to any non-accredited investor and goes on to recommend that the same PPM also be provided to the accredited investors. Therefore, in an offering that is made solely to accredited investors, as is often the case, a PPM is not required. So the question is whether, in such cases, a PPM should nevertheless be prepared and provided.