By Sean Levine, Entoro Capital
Finally, change for the better is officially afoot in the world of private placements. With the world engulfed in the COVID-19 pandemic, this exciting regulatory policy shift comes not only as a much-needed opportunity for the little guy, but could prove to be a significant driver of America’s economic recovery, as well.
On March 4, the SEC proposed sweeping changes to several rules covering private capital raise registration and regulation exemptions, in an effort to “provide a more rational framework, eliminate complexity and increase access to capital while preserving and enhancing important investor protections.”
Historically the go-to mechanism for most larger, institution and high net worth-focused capital raises is either Reg D 506b or 506c. Reg D will see only minor adjustments. The other expected changes will be to Reg A+, where the maximum annual cap raise limit will increase 50%, from $50 million to $75 million and secondary shareholder participation will also increase 50%, from $15 million to $22.5 million.
The most extensive proposed changes however lie within the rules governing Regulation Crowdfunding (Reg CF for short). The Reg CF exemption has—until now—been effectively useless for raising capital due to the $1.07mm cap. Frankly, Reg CF was considered a joke that only a small niche of companies ever utilized, tainted as a trivial way to raise capital. Philosophically, Reg CF has been more akin to a Kickstarter or GoFundMe campaign than to a mainstream method to raise growth capital.
With the envisioned Reg CF changes, the private capital universe will experience a positive shockwave for early stage issuers at the Seed and Series A capitalization round levels.
Democratization of Private Investment
Reg CF is the progeny of the 2012 JOBS Act, with the governing rules not taking effect until four years later in 2016. The act sought to create a mechanism for regular, non-accredited (i.e., for lack of better shorthand, “not wealthy”) investors to participate to a greater degree in private capital markets. Additionally, the SEC recognized the difficulty start-ups and early stage companies had accessing capital markets relative to their larger peers. Reg D offerings are only available to accredited investors and institutions often unwilling to take a chance on unproven companies, and frequently involve significant fundraising costs. Meanwhile, Reg A raises are burdened by onerous filing and disclosure requirements often making that type of offering equally unsuitable.
From these policy interests, Reg CF was born—an exemption featuring both the ability to attract capital from regular, non-accredited investors like a Reg A offering, as well as a fairly streamlined filing process more akin to Reg D, with no SEC review of the offering. Liquidity characteristics of Reg CF are similarly a hybrid between Reg D’s general illiquidity and Reg A’s free tradability, with shares largely locked up for the first year, but subsequently liquid.
Because of the dual perception of the lower degree of sophistication of Reg CF investors, and an associated greater risk of fraud in combining this investor pool with small, comparatively speculative capital raises, the SEC imposed certain limitations on these kinds of deals.
Reg CF raises must either take place on specially registered and regulated “funding portals”, which are in turn mandated to serve in a financial educational capacity for their investor members, or be orchestrated by licensed broker-dealers (some portals are also broker-dealers). Issuers are required to make financial statements available to investors, and to file offering materials with the SEC. Subject to additional limitations and more stringently than either Reg D or Reg A placements, only US-based companies not already registered with the SEC are eligible.
Individuals are limited in regard to the amount of money they can invest in Reg CF offerings each year. Investors can deploy the lesser of 5% of net worth or income each year if either is less than $107,000, or the lesser of 10% if both are equal to or greater than $107,000, capping out at a maximum Reg CF investment ceiling of $107,000 per year. Even accredited investors are subject to this cap, although the ability of issuers to run a concurrent Reg D offering provides a de facto relief valve there. Additionally, investments are cancelable and fully refundable during the bulk of the time the raise is under way, and subsequent material changes to the raise result in automatic refunds to investors unless they reaffirm their commitment.
Perhaps the most dominant characteristic of Reg CF capital raises—and also the one which has until recently relegated the structure to the realm of niche, quasi-Kickstarter-dom—is a maximum offer size of $1.07 million.
But the SEC’s announcement promises to change all of that.
Reg CF 2.0 – In a $5 Million Stance & Ready to Dance
By far, the most interesting and disruptive change announced in the SEC’s March 4 press release is that the commission will be increasing the maximum offer limit for Reg CF raises from $1.07 million to $5.0 million. Until now, the very lean cap raise limit for Reg CF geared it primarily toward issuers just past the “friends and family” investment stage (again, unless running a concurrent Reg D raise). A limit of $1.07 million just doesn’t make much sense for most companies with any degree of track record and/or momentum needing capital to grow.
And at the same time that limit pretty dramatically narrowed the universe of potential issuers able to utilize Reg CF, it also assured that many institutional investors would steer clear, with $1.07 million falling below the minimum investment levels for many entities. Again, there is the concurrent Reg D workaround, but that dynamic is rather clunky and inefficient.
The SEC is also making it easier for investors to individually put more capital to work under the Reg CF structure. The calculation for the individual investment cap for non-accredited investors is being flipped to being contingent on the greater of annual income or net worth (again, the old scheme uses the lesser of the two numbers for the calculation). Moreover, for accredited investors the hard cap of $107,000 per investor per year is being eliminated entirely.
An additional benefit will be that prospective Reg CF issuers will now be permitted to “test the waters” via communication with institutions regarding their cap raise prior to filing, in order to assess the degree of interest. This was previously an option available to Reg A/A+ filers, but not CF, so the move appears to be yet another effort to “legitimize” CF and propel it into the big leagues.
All told and in spite of their existing limitations, Reg CF raises have already seen a significant uptick in activity since launch, rising from $27.6 million in capital raised using the offering structure in 2016 to approximately $137 million as of last year , thus proving the strong market appetite for this sort of structure and providing a glidepath for expansion.
With these new changes, the true potential of the Reg CF structure should be fully realized, making it—for the right sized issuer at least—much like what the limited liability company (LLC) has become in the universe of corporate structuring: a hybrid taking the best aspects of two legacy structures, and ultimately superior to both of its parents.
Cap Table Capers
One other comparatively niche change is also in the works. Previously, investors were prohibited from using special purpose vehicles (SPVs for short) to aggregate capital for deployment in Reg A or Reg CF offerings. The new proposed rules are intended to eliminate that restriction..
Want to roll some accredited investors up into a SPV to take a consolidated chunk of a Reg CF or A cap raise? Soon you should be able to do that.
Running a 3(c)(1) venture capital fund and want to add Reg CF and Reg A deals to your portfolio? Soon you should be able to do that.
Given the various structured finance applications for SPVs, there are probably other use cases here as well, but we’ll leave those eggs to the financial engineers to hatch.
The bottom line is that by permitting SPV participation for Reg CF and Reg A, the SEC is providing issuers utilizing these approaches the ability to try to keep their cap tables under control. The quintupling of the Reg CF capital raise limit brings with it five times the potential to clutter an issuer’s cap table into oblivion with small investors. But by allowing greater capital participation, increased engagement with institutions and a means to aggregate at least some (admittedly accredited and institutional) participants into a single investing entity, the regulator seems to be trying to offset that risk a bit.
And this is important, because the prospect of a cluttered cap table can serve as a headwind for early stage issuers. Lead investors in later stage financing rounds aren’t particularly fond of having to deal with thousands of often financially unsophisticated, sometimes impatient, and occasionally litigious de minimis investors. And while at first blush this dynamic could be thought of as one downside to the SEC’s proposal, the commission is at least attempting to blunt the impact with some of its secondary modifications to the current scheme.
All of these proposed changes are going to make it significantly easier for early stage companies to obtain access to capital and give regular investors the opportunity to participate in private capital markets to a degree never seen before. At the same time, the changes will leave some meat on the bone for interested institutions and HNW investors, as well.
And considering the recent volatility and uncertainty hanging over public equity markets these days like a shroud, that’s an opportunity well worth considering.
What Are You Going To Do About It?
Entoro Capital is excited about the expected Reg CF changes—we view them as a significant disruption to the status quo and thus, a great opportunity to get involved.
As such, we’ll be making technology changes to manage the Reg CF process and activities on OfferBoard. Entoro’s expanded securities offering brings differentiated value-add for both issuers and investors. Moreover, the firm will leverage its existing ties to the family office space (Family Office Networks and other family office groups) to bring lead investor potential to our Reg CF placements.
Entoro is increasing exposure to smaller capital raises once the regulatory changes take effect. We expect to be a leader in the Reg CF space because of our experience with online investing using OfferBoard and affiliates such as Entoro Wealth (RIA) and Clear Rating (valuation), amounting to a full suite of tools for the early stage issuer and its investors.
Sean Levine is managing director of Entoro Capital, a tech-enabled investment bank and advisory firm.