By Andy Beal and Matt Crowley
Before Congress passed the Jumpstart our Business Startups (JOBS) Act, startups were prohibited from offering and advertising the sale of stock to the general public. You could not offer shares of stock on your website or in a newspaper.
The JOBS Act attempts to lifts some of these restrictions in an effort to make fundraising easier for startups. One step taken by Congress was to loosen the rules on soliciting the public to buy stock from startups.
The Act required the Securities and Exchange Commission to write new rules to explain how startups can offer stock to the general public. On August 29, the SEC issued 69 pages of proposed rules related to advertising offerings and soliciting the general public. We thought it would be helpful to summarize the proposal for you.
Under the SEC’s proposed rules, a startup can advertise to and solicit the general public, but can still only sell to accredited investors.
What does this mean for a startup?
Under the proposed rules, a startup must take reasonable steps to verify that purchasers are accredited investors. The SEC did not provide a list of reasonable steps, so the rules are not very helpful at the outset.
However, the proposed rule does give some hints:
In short, the rule says that what steps are reasonable depends on the circumstances of the transaction. In other words, every deal is different. What is reasonable under one set of circumstances may not be reasonable under another set of circumstances. To clarify, the SEC included a nonexclusive list of factors that a startup should consider:
What qualifies someone as an accredited investor? Most startups raise money from individuals. An individual who has a net worth of at least $1 million, or with an annual income is at least $200,000 qualifies. Determining whether someone has the requisite net worth or annual income may require requesting individual financial records, tax returns, etc. The SEC understands that this information is not public and may not be easily found. For this reason, the startup may not be required to do as much diligence on an investor who qualified because of his or her net worth or income.
How much, and what kind of, information do you need to obtain about a potential investor? The more information a startup has, and the more credible that information is, the less steps a startup needs to take to verify the status of an investor. Publicly filed information is very helpful in this situation. For example, if the potential investor is an executive of a public or reporting company, the annual report containing his or her compensation information would be a reliable source.
How did you go about the offering, and what are the terms? This is where the “facts and circumstances” of the offering dictate the reasonableness of a startups actions. The SEC provided a rare example to illustrate this factor – if a startup is soliciting investors through email or social media, simply having the investor check a box on a questionnaire is not a reasonable step in verifying the person’s status as an accredited investor. On the other hand, if the issuer advertised the offering to a database of pre-screened accredited investors, having each potential investor check a box on a questionnaire is a more reasonable step. Basically, the SEC is saying that it is not reasonable to rely solely on an investor’s representation that he or she is an accredited investor.
The SEC’s rule writing process involves an open comment period that allows anyone to submit concerns, opinions and suggestions. One comment that the SEC agreed with was that if your offering has a high minimum investment amount, say $500,000, an investor’s ability to satisfy the minimum amount can be taken into account when you are trying to determine whether that person is an accredited investor or not. In other words, the fact that the investor is capable of investing $500,000 can be partially relied upon in concluding that an individual is an accredited investor.
One thing to always keep in mind, regardless of the steps you take, is that every company issuing securities must keep records of the steps taken to verify an investor’s status, because the issuer has the burden of proving that the steps they took were reasonable.