By Mark Hiraide
In late May, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act. Although the president and many Republican members of Congress had threatened to repeal and replace Dodd-Frank, the new law’s actual changes are relatively minor. The new law rolls back some of the post-financial crisis legislation enacted in 2010, particularly for smaller community banks and credit unions. But it largely leaves intact the core framework of Dodd-Frank.
Less publicized but worthy of attention is the new law’s Title V—Encouraging Capital Formation, which amends the Securities Act of 1933 and Investment Company Act of 1940 with regard to early stage companies. Like the amendment to Dodd-Frank, the new law’s amendments to the federal securities laws are modest.
The most noteworthy changes for early stage companies are the following:
- The Act increases from 100 to 250 investors the investor limit under an exemption commonly relied upon by smaller VC funds to avoid registration under the Investment Company Act of 1940, the regulatory regime applicable to mutual funds;
- The Act increases from $5 million to $10 million the 12-month sales threshold beyond which an issuer is required to provide employees and consultants with additional disclosures related to options, stock and other securities grants under compensatory benefit plans; and
- The Act expands Regulation A+ (which exempts certain smaller offerings from securities registration requirements) to publicly reporting issuers.
Small VC Funds
Private funds, including hedge funds and venture capital funds, typically rely on two exemptions under the Investment Company Act of 1940 to avoid registration under that Act. Section 3(c)(1) under the ’40 Act excludes from the statutory definition of “investment company” a fund whose securities are owned by not more than 100 persons. Many new and smaller VC funds rely on this exemption rather than on the second most common exemption, Section 3(c)(7) of the ’40 Act. This exemption requires every fund investor to be a “qualified purchaser” (essentially, a natural person with at least $5 million, or an entity with at least $25 million in investments).
The new 250-investor limit applies only to venture capital funds (and not, for example, to private equity and hedge funds) and only to those VC funds with not more than $10 million in aggregate capital contributions and uncalled committed capital. By increasing the number of investors these small funds may accept, the average minimum commitment by each investor is effectively reduced from $100,000 to $40,000. Alternatively, the expansion to 250 investors, will allow the creation of multiple integrated funds with an aggregate limit of 250 investors.
Employee Stock Options and Stock Grants
Cash-starved startups rely on issuing equity instead of salaries as compensation to employees, consultants and advisors in the form of stock options and stock grants. Absent an exemption from registration under the Securities Act of 1933, companies must register the offer and sale of such securities with the SEC. The exemption most commonly relied upon is SEC Rule 701. It exempts certain offers and sales under compensatory benefit plans and compensation contracts and sets forth the disclosures companies are required to deliver. The Rule allows privately held companies to issue securities for compensation without incurring the obligations of public registration and reporting, while ensuring that essential information about the investment is provided to employees.
Under Rule 701, offerings are exempt from registration requirements if total sales (sales of securities underlying options must be counted as sales on the date of the option grant) of the compensatory securities during a 12-month period do not exceed the greater of:
- $1 million
- 15% of the issuer’s total assets (measured at the most recent balance sheet date) or
- 15% of all the outstanding securities of the class (measured at the most recent balance sheet date)
Rule 701(e) requires that any company issuing more than $5 million in compensatory securities over a 12-month period provide, in a reasonable period of time before the date of the sale, detailed financial statements and risk disclosures to the recipients of the securities issued. The new law requires the SEC, not later than 60 days after the law’s enactment, to amend Rule 701(e) to increase the $5 million threshold for disclosure to $10 million.
In March 2018, the SEC charged San Francisco-based Credit Karma with failing to meet the disclosure requirements of Rule 701. Credit Karma issued almost $14 million in stock options to employees over a one-year period. According to the SEC, even though financial statements and risk disclosures were available and confidentially provided to potential institutional investors, Credit Karma failed to provide this information to its own employees.
In 2012, the Jumpstart Our Business Startups (JOBS) Act raised the offering limit for exempt public offerings under Regulation A from $5 million to $50 million. Regulation A under the JOBS Act came to be known as Regulation A+ and it was seen as a boon for small-to-medium-sized companies that were having trouble raising capital.
Originally, the Regulation A+ exemption from SEC registration was available only to nonreporting companies – companies that aren’t required to file registration statements and other reports with the SEC. The new law allows certain “fully reporting” companies to be eligible for Regulation A+ exemptions, which allows a greater number of businesses to offer securities under a more streamlined registration and disclosure approach that will lower the cost of raising capital and theoretically encourage economic growth.