The SEC’s Office of Small Business Advocate launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat. The Office recently issued its first annual report (“Annual Report”).
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyzing the potential impact of regulatory changes on small businesses and their investors; (v) conducting outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
A highlight of the achievements of the office under the leadership of Martha Legg Miller include: (i) hosted and participated in various engagement events with entrepreneurs and investors; (ii) published its business plan; (iii) participated in National Small Business Week including the Small Business Roundtable and meeting of the Small Business Capital Formation Advisory Committee; (iv) launched explanatory videos on how to participate in and comment on rule making; and (v) hosted the annual Government-Business Forum on Small Business Capital Formation, a forum I have had the pleasure of attending in the past.
The Office’s Annual Report contains discussions on: (i) the state of small business capital formation; (ii) policy recommendations; and (iii) the Small Business Capital Formation Advisory Committee.
The State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in reliance on Rule 506(b) of Regulation D ($1.4 trillion for FYE June 30, 2019) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).
The industries raising the most capital include banking, technology, manufacturing, real estate, energy and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Florida and Texas are responsible for higher amounts of capital raised in aggregate.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited. The SEC recently proposed a change in the definition of accredited investor to open up investment opportunities to additional qualified investors (see HERE).
The Annual Report discusses costs for early-stage companies to raise capital, including attorneys’ fees. According to the report, attorneys’ fees are between $5,000 and $20,000 for very early-stage companies and from $20,000 to $40,000 for venture-stage entities. The Report is in line with fees in my firm.
Interestingly, the Annual Report notes a correlation between the increased availability of venture capital funding and job growth in metro areas. Generally, venture-capital or private-equity-backed companies enter the public markets – 44.8% of companies currently listed on the Nasdaq were formerly backed by a venture-capital or private-equity firm.
The Report contains information related to the much–talked-about growing delay in public offerings (see more information HERE and HERE.) According to the Annual Report, companies are going pubic later in their life cycle, which also results in less funds being raised in the public markets via follow-on offerings. The Annual Report indicates 204 IPO’s from July 1, 2018 through June 30, 2019 and 294 small public company follow-on offerings for the same period. Not surprisingly, 61% of exchange traded companies with less than a $100 million market cap have no research coverage.
Woman are founding more start-ups than previously, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. On the investor side, 29.5% of angel investors are women, 11% of VCs are women, and 71% of VC firms had no female partners.
There has also been a big uptick in minority-owned businesses. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. On the investor side, only 5.3% of angel investors and 1% of VCs are minorities.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.
Policy Recommendations
Modernize, Clarify and Harmonize Exempt Offering Framework
Following up on the SEC’s June 2019 concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework (see HERE), the Office of Small Business Advocate recommends a simplification to the exempt offering structure. The securities laws, including exempt offering regulations, are complex and difficult to navigate. The fact is that without competent securities counsel, the chances that a capital raise will be compliant with the securities laws is nonexistent.
The Office of Small Business Advocate suggests the following guiding principles to consider in restructuring the current exempt offering framework: (i) the rules, including all guidance on compliance, should be readily accessible and written in plain English; (ii) the rules should allow a company to progressively raise money throughout its growth (meaning very easy structures for small start-up capital raises); (iii) consider the Internet and technology advancements in communication (perhaps allow more open solicitation and advertising); (iv) dollar caps should be flexible for future review and adjustment and consider factors such as industry, geography and life-cycle stage; and (v) the principles underlying the current regulatory structure for exempt offerings should be re-examined.
Investor Participation in Private Offerings (the Accredited Investor Definition)
Most offering exemptions limit participation to accredited investors or if unaccredited investors are allowed, the number of such investors may be limited (506(b)), the disclosures required much more robust, or the investment amounts limited. As a result, the question of a change to the hard-line-in–the-sand accredited investor definition has been debated for years and answering the call, in December 2019, the SEC published a proposed amendment (see HERE).
The Annual Report notes that the definition of an accredited investor is designed to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. However, the current definition results in eliminating opportunities for retail investors to diversify their portfolios and participate in the growth of companies in the private markets. Public mutual funds rarely invest in private companies and private-equity, hedge funds and venture-capital funds raise capital using the same offering exemptions as private businesses and thus have the same accredited investor limitations. Also, as a result of poor drafting, some sophisticated entities such as American Indian tribal corporations have been left out of the definition, regardless of their asset value.
The Office believes that although investor protections are important, the current definition prioritizes risk of loss over sophistication and creates too strong a barrier to capital for small and emerging-growth companies. Furthermore, the current accredited investor definition structure (and prohibitions on advertising and solicitation) makes it difficult and time-consuming for accredited investors to source investment opportunities even when they want to.
Supporting the proposed rule changes, the Office agrees that adding financial professional licenses and education goalposts to the current accredited investor definition would be beneficial. Likewise, they would not support an increase in the current financial thresholds. Rather than add to the list of entities that could qualify, the Office suggests that any entity, regardless of corporate form, should be able to qualify if it has over $5 million in assets. The Office recommends that the changes be easy to navigate, providing simplicity and certainty in ascertaining qualification to avoid increasing transaction costs. Although not included in any current rule proposal, the Office also suggests modifying the Investment Company Act rules to allow for more public mutual funds to invest in private companies.
Finders
As all capital markets practitioners know, one of the biggest challenges to raising capital is finding and being introduced to potential investors. Although larger companies engage the services of broker-dealers, there simply aren’t many options for smaller or early-stage entities. Because of the very big need, an industry of unlicensed finders has developed. This is a topic I’ve written about many times (see HERE). Some finders operate within the parameters of the law, such as by providing a multitude of valuable services such as creating pitch materials, consulting on capital structure, helping with general business goals and objectives and marketing materials, and importantly, not collecting a success or separate fee for capital introductions. However, many violate the law, causing a host of potential issues for both the finder and the company utilizing their services. Despite pleas from industry participants, the ABA, committees within the SEC and numerous other groups, the need for a workable regulatory structure remains unanswered.
The Office calls for a clear finder’s framework. In implementing a framework for finders to support emerging businesses’ capital needs and provide clarity to investors participating in the market, it is critical that the rules be clear for marketplace participants to reduce confusion, defining in plain English the activities that do not trigger registration and delineating when the scope of activities rises to the level that registration is appropriate. The framework should make clear what offering exemptions are eligible, whether the introduced investors must be accredited, the nature of compensation the finder may receive, the types of other incidental activities that the finder may engage in on behalf of the business, and the respective roles of federal and state regulators.
As I’ve mentioned several times, I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even support a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.
Crowdfunding
Since 2012, Regulation CF has provided a method for businesses to raise a small amount of capital (capped at $1,070,000) from numerous investors over the Internet utilizing the services of a funding portal. The Annual Report suggests that crowdfunding has been a success, helping many entrepreneurs that may otherwise not have been able to access capital. However, the Annual Report points out some issues with the process including the inability to properly advertise and market and thus drive investors to the opportunity and higher-than-necessary compliance costs. The Office reports that the system overseas is better, with companies raising more capital at a lower cost.
The Office suggests: (i) increase the $1,070,000 cap (no amount is suggested); (ii) remove the investment cap for accredited investors; (iii) revise the various disclosure obligations to reduce compliance costs; (iv) enable the use of special-purpose vehicles for investment; and (v) reduce the compliance burdens for funding portals.
Disclosure Requirements for Small Public Companies
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer, negatively impacting the U.S. public marketplace.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on recent proposed changes to the management’s discussion and analysis section of SEC reports, see HERE. That blog also contains a complete breakdown of the SEC’s ongoing disclosure effectiveness initiative. In addition to supporting the recent initiative, the Office advocates for further changes to reduce compliance costs for smaller reporting companies.
The Small Business Capital Formation Advisory Committee
The Small Business Advocate Act also created the Small Business Capital Formation Advisory Committee, which replaced the SEC’s voluntarily created Advisory Committee on Small and Emerging Companies. The new Advisory Committee is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters related to emerging, privately held small businesses to publicly traded companies with less than $250 million in public market capitalization; trading in securities of such companies; and public reporting and corporate governance of such companies.
The Advisory Committee has made two recommendations to the SEC. In particular, related to the recent SEC’s proposed rule changes to the reporting requirements for the acquisitions and dispositions of businesses (see HERE), the Advisory Committee suggests that the rule change provide differing treatment for Regulation A companies and make Management’s Adjustments optional or not required at all. Overall the Advisory Committee supports the rules changes but would make some tweaks.
The second recommendation relates to the SEC’s proposed amendment to the definitions of “accelerated filer” and “large accelerated filer” (see HERE ). Although the Advisory Committee supports the change, it would go further to add more companies that would qualify as a non-accelerated filers by raising the revenue threshold (currently proposed to be $100 million), increasing the time for such revenue (from the last year to three years) and considering whether all smaller reporting companies should be non-accelerated filers.