Funding from Public Investors – Reg. A or Reg. D? [Guest Post]
Venture capitalists and angels fund a very small group of companies each year and the companies have little control over who gets funded and who does not. Many start-ups and smaller companies are looking to public investors. This has been made easier by the JOBS Act.
After the stock market crashed in 1929, Congress set up a basic framework to regulate the securities markets. Reduced to one sentence, securities get registered with the government before they are issued and people who sell the securities get licensed to sell them.
The process of registering securities for sale requires the issuing company to file a registration statement, audited financial information and a prospectus with the Securities and Exchange Commission (SEC) for approval. The approval process can involve multiple rounds of comments and amendments. It can take months and a lot of time may be put in on the issuer’s behalf by very expensive lawyers.
There have always been exceptions to the registration requirement so that companies could sell shares to their own employees, family and friends and large institutions. The government always felt that the latter were sophisticated investors who could ask the right questions and fend for themselves in these transactions.
Spurred by the high tax rates in the 1970s, an industry grew up selling unregistered private placements of securities to wealthier individuals. These were often structured as limited partnerships with tax losses, tax credits and other benefits flowing through to the investors. In some cases the tax savings to the investors was greater than the cost of the investment.
To deal with this surge in the sale of unregistered securities, the SEC promulgated Regulation D in 1982. Reg. D provided a “safe harbor” for companies issuing unregistered securities and the sales of unregistered securities took off.
Today more than $1 trillion worth of securities are sold every year under Reg. D, far more than the dollar value of all registered offerings. These private placements can still only be sold to larger institutions and wealthier investors who are referred to as “accredited investors.” To be an accredited investor an individual needs a net worth of $1 million (excluding their home) or an annual income of $200,000.
In 2012 the JOBS Act made it easier to sell both registered and unregistered securities. It modified Reg. D to permit general advertising of private placements and allowed them to be sold on unlicensed websites.
The JOBS Act also created a new Regulation A that allows for smaller offerings of up to $50 million to be registered with a less cumbersome process than a full IPO. Reg. A offerings can be sold to any investor although there are limitations on how much a single investor can purchase.
Reg. A offerings still require audited financial information and pre-approval by the SEC but the shares are freely tradable after the offering. Shares purchased in a Reg. D offering are illiquid and cannot be resold.
Here is a side by side comparison of the two regulations.
Any company considering raising funds under either regulation will certainly want to compare the relative costs. In almost every case a Reg. A offering will cost the company substantially more up front. There have not been that many Reg. A offerings to date but legal and accounting costs can easily top $100,000. Legal fees for a Reg. D offering are more likely in the $35-$50,000 range and may be less.
Both Reg. A and Reg. D offerings can be sold through a licensed brokerage firm which will charge underwriting fees and sales commissions. They can also be sold on-line with the issuing company shouldering the bulk of the marketing costs. If an issuer does not use a brokerage firm to sell the shares, it is faced with the task of speaking with investors to answer questions and close sales.
One of the “advantages” of Reg. A is that you can sell small amounts of stock to a lot of people. This may work well if the company already has a large retail customer base that it can contact. Even then, soliciting customers to become investors does not work every time. Several of the more successful Reg. A offerings, those that raised in excess of $10 million, report marketing costs of more than $150,000.
Marketing costs for Reg. D offerings should always be less if for no other reason than the issuer is soliciting larger investments from fewer people. E-mail lists for accredited investors who have previously invested in Reg. D offerings are readily available. That is one reason Reg. D offerings have made up the vast majority of offerings made under the JOBS Act on crowdfunding websites.
Overall, if you want to raise $10 million for a start-up and intend to make your offering under Reg. A it would be wise to budget $250,000- $350,000 for legal and marketing costs. You can probably raise the same amount using Reg.D for under $100,000. For real estate offerings, even less. With Reg. A there are additional annual fees for audits and federal filings that are not required under Reg. D.
Reg. D also provides a significant amount of flexibility when it comes to structuring the offering. Because they are not liquid, Reg. D offerings are more likely to be structured in such a way as to offer investors income every year. Reg. D is especially popular to finance the purchase of commercial real estate where distributions of rents can be made to investors and oil and gas properties that pass along revenue from production.
Start-ups have begun to appreciate that they can use Reg. D to finance plant and equipment off balance sheet without giving up ownership of the company. Some start-ups are adopting a revenue sharing model, providing investors with a portion of revenue on a per unit sold basis. This works especially well when the company has proprietary patents or intellectual property that can be licensed.
There has been a lot of hype about Reg. A. Much of it comes from younger investors who do not have the income or net worth to be accredited and are convinced that they are being left out of some huge opportunity to invest in start-ups.
Actually, because the shares are not liquid, Reg. D shares are always considered to be high risk investments and all Reg. D investors are told not to invest unless they can afford to lose their investment. Notwithstanding, Reg. D remains the most common method of raising funds from investors in the US and is likely to remain that way for some time to come.
About Irwin Stein, Esq.
Irwin Stein is a Wall Street trained attorney with 4 decades of experience working in finance. He has represented banks and brokerage firms, venture funds and large private investors. He advises established companies and start-ups in need of funding. He blogs on Law and Economics in the Capital Markets. http://laweconomicscapital.com/
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