(Editor’s note: “Ask the Attorney” is a weekly VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)
Question: I’ve read a few articles and blog posts over the past couple of days regarding Senator Dodd’s financial reform bill, and some of them suggest that it’s going to be more difficult for startups to raise money if the bill is signed into law. Why is that? I thought the bill was supposed to address the problems on Wall Street that led to our financial crisis.
Answer: I’m as puzzled as you are, to be honest. Yes, the legislation is designed to address financial reform and regulation of the big banks, including the “too big to fail” issue; however, buried deep in the 1,336-page bill are certain changes to the federal securities laws that will indeed make it more difficult for startups to raise seed and angel financing.
First, a quick primer on federal securities laws, which I have previously discussed in detail. (I know this is very technical stuff, but I think it will be helpful for you to understand the issues.)
As a general rule, a company may not offer or sell its securities unless the securities have been registered with the SEC and registered/qualified with applicable State securities commissions or there is an applicable exemption from registration. The most common exemption for startups is the so-called “private placement” exemption under SEC Regulation D, which comprises three different types of private offerings under Rules 504, 505 and 506.
If a startup sells stock only to “accredited investors” (defined below), compliance is much simpler, faster and cheaper because it can rely on Rule 506, which has two important advantages over the other SEC rules. First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC). Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.
On the other hand, if one or more of the investors is not accredited, SEC Rule 506 generally may not be relied upon – which opens-up a Pandora’s box of compliance and disclosure issues. Generally, the cost, risks and onerous disclosure requirements generally outweigh the benefit. That’s why startups have been overwhelmingly (and effectively) relying on Rule 506 for nearly 15 years in connection with their seed and angel financings.
So who is an “accredited investor”? With respect to individuals, he or she currently must have a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or income exceeding $200,000 in each of the two most recent years (or joint income with his/her spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.
Under Dodd’s bill, the definition of “accredited investor” would be revised to require individuals to have a net worth of at least $2.3 million or annual income of $449,000 (or $674,000 of joint income with his/her spouse). According to Business Week, this revision would lower the number of individual accredited investors by 77 percent.
It gets worse. Even if all the investors are “accredited investors” under the new definition and the startup is thus relying on Rule 506, a filing (presumably a Form D) must be made with the SEC, and the SEC will have 120 days to review it.
That’s right – 120 days. And if the SEC does not review the filing within such 120-day period, then the applicable States securities commission(s) would have the right to review the merits of the financing.
Alternatively, the SEC can designate that certain financings under Rule 506 are too small in size or scope to warrant SEC review and push such review to the State securities commissions.
The bottom line is that not only is this second change confusing (and sadly it’s even more complicated than I have described), but also it will create significant delay and cost in connection with seed and angel financings and put the State securities commissions back in the game – which is exactly what Rule 506 is designed to prevent.
The frustrating reality is fewer and more expensive seed and angel financings means less and less job creation. Wake up Washington!
Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.