Regardless of your political persuasion, if you are an entrepreneur running a startup company you should be nervous about the financial regulation overhaul bill currently being debated in the U.S. Senate. Known as the “Restoring American Financial Stability Act,” the pending bill threatens to do exactly the opposite for startup companies by destabilizing the current regulatory scheme that allows small companies to raise private capital.
Disrupting Regulation D
On page 841 of this 1,408-page bill you’ll find Section 926, entitled “Authority of State Regulators of Over Regulation D Offerings.” The changes begin with a directive that the Securities & Exchange Commission (SEC) devise a rule to determine whether certain classes of securities are “non-covered securities” because of the size of the offering, the number of States in which the offering is made and the nature of the persons to whom the security is offered. Once the bill passes, the SEC would have a year to come up with that rule.
Next, the bill mandates the SEC review “any filings made relating to any security issued under Commission rules or regulations under section 4(2), other than one designated as a non-covered security…not later than 120 days of the filing with the Commission”. In other words, if a startup company’s offering would not qualify as one for “non-covered securities,” the offering could be stalled for up to 120-days. There are more than a few problems with the proposed review requirement. First, unless the non-covered security rule exempts offerings for significant amounts of money, many budding entrepreneurs may find it impossible to raise the equity capital necessary to get their businesses off the ground. At a time when credit markets are so tight and unemployment is creeping upward, it makes no sense (in my opinion) for the federal government to put a regulatory chokehold on startup companies. Yes, some founders may still be able to bootstrap their startups in spite of the new regulations, but many other promising businesses will just never get off the ground.
Second, the language of Section 926 seems intentionally drafted to act as a disincentive to raising private equity capital. The 120-day review period applies to securities that are “issued” (past tense), meaning the 120-day review period would not commence until a purchase and sale of the securities has already occurred. If the SEC were to reject an offering that had already occurred, the startup company would be forced to do a rescission offering and allow investors to cancel their investments and get their money back with interest. The legal costs of conducting the rescission offer could be crushing. To avoid this nightmarish prospect, counsel will certainly advise their startup company clients not to issue any securities until the SEC’s review is favorably concluded. In other words, the regulations quite intentionally force startup companies to wait 120 days before raising capital.
Third, it is unclear what kind of filings startup companies will have to make to commence the review period. The current Form D filing for Regulation D offerings is really a notice filing in that it does not include much information about the offering beyond the amount being raised, the expenses of the offering and the states in which the offering will be conducted. In most states, the Form D is filed after securities have been issued. If the new required filing is to be filed in advance, it seems likely to be a new type of filing and not a Form D. If the new filing is more extensive than a Form D, the increased expense of compliance may be yet another obstacle to securing much-needed capital.
Raising Financial Criteria For “Accredited Investors”
The most common financing structure for startup companies is an offering made only to Accredited Investors. Such offerings are considered not to be public offerings and, therefore, exempt from the legal requirement that a company file a registration statement with the SEC before offering its securities for sale. Preparing and filing a registration statement is expensive and complicated, which is why startup companies seek exemptions when raising capital. Unfortunately, the financial regulation overhaul bill proposes to increase the financial criteria for an “Accredited Investor.” In place for years, the current criteria are $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets. The new criteria would adjust these figures upward “in light of price inflation since those figures were determined.” Such an adjustment could easily double the current figures, thereby shrinking dramatically the pool of potential Accredited Investors. Further adjustments would be required every five years.
The proposed change is also not a great thing for investors. Under the current criteria, many people are already not allowed to make investments in startup companies because they are not Accredited Investors. By some estimates, only 3% of Americans meet the current criteria. Raising the financial criteria will only exclude even more people from the opportunity to invest in startup companies. The regulatory purpose of the change will be explained as an effort to protect investors from making risky investments. Such an excessively paternalistic approach to regulatory reform ensures, more than ever, that only the wealthiest Americans are afforded the opportunity to become wealthier through investments in private companies.
Elimination of the Private Adviser Exemption
Last October, we alerted you to legislation proposed by the Obama Administration to eliminate the private adviser exemption for advisers to private investment fund. In Section 403 of the proposed financial regulation overhaul bill, the Administration is set to make good on its threat. However, the news here may not be entirely bad. Exempted from registration would be advisers to “Venture Capital Funds” and “Private Equity Funds.” The bill does not define these terms, but leaves that task to the SEC to determine within six months of the date the bill becomes law. It may be that the real impact of the elimination of the private adviser exemption will be felt by large, highly leveraged hedge funds. It all depends on the definitions.
In the context of the current economic crisis, it is hard to say the Administration has its heart or head in the right place when it comes to the proposed changes to Regulation D and the definition of “Accredited Investor.” The direct result of these changes is likely to be a disincentive of entrepreneurship and investment in emerging technologies and services. They will also stifle new job creation.
Although I’ve focused here on startup companies, the fact is the proposed changes to Regulation D and the definition of Accredited Investor will affect every company conducting a private placement of securities. As a result, many maturing companies looking to fuel growth or expansion or just stay alive will find it harder to find the necessary investment capital. It’s easy to see how restricting access to private investment capital will lead to more business failures at a time when our national economy can ill afford it.
It may be too early to tell whether the proposed elimination of the private adviser exemption will add to startup company financing woes. If “Venture Capital Funds” and Private Equity Funds” are defined too expansively, fund formation activity may decrease, limiting further the availability of investment capital for private placements.
As of the date of this post, the Senate Democrats have broken a GOP-led filibuster of the proposed legislation, which now means the bill will be openly debated. Hopefully, the debate will lead to the elimination of Section 926. We will keep you posted as the bill wends its way through Congress.