The Office of the Advocate for Small Business Capital Formation (“Office”) issued its 2020 Annual Report and it breaks down one of the strangest years in any of our lives, into facts and figures that continue to illustrate the resilience of the U.S. capital markets. Although the report is for fiscal year end September 30, 2020, prior to much of the impact of Covid-19, the Office supplemented the Report with initial Covid-19 impact information.
Background on Office of the Advocate for Small Business Capital Formation
The SEC’s Office of the Advocate for Small Business Capital Formation 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 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) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
Despite the shift to virtual, the Office managed to attend or speak at numerous conferences, sit on panels, host roundtables and otherwise engage in a surprising number of events in 2020.
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 secondary registered offerings ($1.5 trillion), followed by Rule 506(b) of Regulation D ($1.4 trillion), Rule 506(c) ($69 billion), initial public offerings ($60 billion), Regulation A ($1.3 billion), Rule 504 ($171 million), and Regulation CF Crowdfunding ($88 million). Another $1.2 trillion was raised in a variety of other exempt offerings such as Rule 144A, Regulation S and Section 4(a)(2) directly.
I note this represents a change since last year when the numbers were: Rule 506(b) of Regulation D ($1.4 trillion) 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). Interestingly, the amount of registered offerings increased substantially (including Regulation A which is technically an exempt public offering) and the amount of once popular Rule 506(c) offerings dropped by more than half.
Both years fail to take into account the new exempt offering rules and structure which went into effect on March 14, 2021. My 5-part blog on the new rules can be found here broken down by topic – Integration (HERE), offering communications (HERE), Rule 504, 506(b) and 506(c) (HERE), Regulation A (HERE), and Regulation CF (HERE). My belief is that we will continue to see a big uptick in Regulation A. Regulation CF will also garner more interest due to the increased offering limits and ability to use special purpose vehicles (SPVs) to complete the transaction.
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 and angel investor financing has remained strong. The SEC amended the definition of accredited investor in August 2020 (see HERE) to add a few more categories of individuals and entities that qualify. I would like to see further expansion to the list including based on education level and professional expertise.
As the typical seed round is approximately $1.1 million, by the time a company reaches seed financing stage, it is generally a little further along in its life cycle. Following a seed round there is typically a Series A ($2-$15 million), Series B ($10 million ++), possibly a Series C (also $10 million ++) and finally IPO. Venture Capital funds often participate in the Series A and B rounds. However, 70% of VC funds are in the San Francisco, New York or Boston areas and many of those funds prefer to say local. Moreover, venture capital funds generally take a control position, or assert management control, and set a timeline for exit. That can cause a lot of pressure on a growing company. As a result, many groups such as family offices and other institutions that historically invested in venture capital funds are now investing directly in these growing companies. Covid-19 increased that impact with a drop of over 40% in the first quarter alone.
The industries raising the most capital include banking, technology, energy, manufacturing, real estate, and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Colorado, Florida and Texas are responsible for higher amounts of capital raised in aggregate. Regulation A is particularly popular in Florida, California and New York.
Although the Office’s fiscal year end only accounted for the first quarter of the Covid-19 crisis, the Report does discuss its impact. The economic impact was felt most acutely by founders and investors in historically underrepresented groups, in emerging ecosystems, and among smaller fund managers. Reduction in spending has been particularly harsh at businesses that require in-person interaction, such as retail, entertainment, transportation, personal services, food services and hospitality.
From January 2020 through September 2020, the number of small businesses decreased by 27% across the U.S. That number represents an average. The percentage decrease in certain states such as California, Texas, Alaska and states in the northeast was higher. Not surprisingly, the hardest hit industry was leisure and hospitality with a decrease of 37% in small businesses. Even those businesses that managed to stay open saw a dramatic decrease in revenue during the same period.
Those businesses that were able to adopt new technology and virtual processes have the best chances of surviving. As such, businesses in the fintech, ed tech, telemedicine and cloud computing and collaboration software have accelerated. In fact, in the midst of the pandemic, Americans started new businesses at the fastest rate in more than a decade. As with any crisis, entrepreneurs have spotted opportunity. Many of those businesses relied on Regulation CF for capital raising. During July and August of 2020, more money was raised through Reg CF online fundraising then in the full prior year.
IPOs have continued strong, flourishing despite, or maybe because of, a shift to virtual roadshows (see HERE for more information about virtual roadshows and roadshows in general). The Report notes many benefits of the virtual roadshow, including (i) shorter roadshows; (ii) decreased market risk due to the reduction in launch time; (iii) cost savings associated with travel, printing and employee time on the road; (iv) longer test the waters meetings; (v) greater visibility in pricing with prospective investors indicating interest earlier in the process; (v) increased accessibility with video conferencing allowing for access to a wider pool of investors; and (vi) more sophisticated and detailed disclosures. The Report does not opine on whether these systemic changes to the process will continue post pandemic, but I firmly believe they will.
While last year’s annual report glumly talked about the decrease in IPO activity and jumped on the news headlines of the time, this year, IPOs are way up. The number of IPOs increased by 51% and the amount of proceeds raised went up by 81%. Of course, a huge percentage of the increase is a result of the unprecedented increase in SPACs (for more on SPACs see HERE). However, business services, manufacturing, and banking and financial services all saw increased IPO activity. Only technology, health care and hospitality/retail saw a decline.
The new surge doesn’t make up for the prior years’ downturn. The number of public companies has decreased from a high of 7,414 in 1997 to 3,559 in 2020; however, during the same time period, aggregate market cap has almost doubled. The logical reason for that is the dramatic growth of public company giants over the same time period coupled with the trend towards waiting for an IPO until further in the company life cycle.
Women continue to found more start-ups than ever before, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. There has also been an uptick of minority-owned women start-ups. Interestingly, although revenue is up for all woman-owned businesses, the increase in revenues for Asian American woman owned businesses far outpaces that of other groups. Companies with women on their founding teams on average exited 1 year faster than all-men founding teams, returning capital back to investors faster.
Besides minority women, all minorities are increasing business ownership. 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. With that said, while all-white founding teams raise the majority of funding rounds, when diverse founding teams do raise capital from VCs, they tend to raise more.
Covid-19 is not the only disaster creating challenges. Natural disasters (hurricanes, fires, tornadoes, etc.) have a significant impact on capital raising and business failures. Ninety-six percent of companies that are in geographical areas that are hit with a natural disaster see a decline in revenues, and 90% of business will fail within a year if they do not resume operations within 5 days.
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. Covid had a crippling effect. Employment in nonmetropolitan communities, including rural communities, is heavily concentrated in the services sector, which includes health care, food, administration, professional, arts, education, and management.
Policy Recommendations
Education to Ease Challenges of Offering Complexity and Friction
Last year the Office recommended rule changes to modernize and clarify the exempt offering framework in line with what was then just a concept release on the subject. This year, following the adoption of those final rule changes, the Office is recommending education. Although the new laws are a simplification of the old system, securities laws, of any kind, are complex and difficult to navigate. It is unlikely that even the most well-intentioned business owner could do so properly without securities counsel, which is expensive. However, a well-educated client can use counsel more efficiently and certainly with less stress.
The Office recommends targeted educational programs that (i) provide information to help promote compliance with the federal securities laws; (ii) provide tools (forms possibly) and other information to understand the offering choices; and (iii) target different groups including minorities and those in rural communities.
Clear Finders Framework
Although the SEC proposed a conditional finder’s exemption (see HERE), the exemption remains a proposal and even if passed, leaves the arena needing more guidance and a much deeper bench of regulation. I have advocated in the past and continue to 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. Although the SEC proposal does have bad actor prohibitions, it is limited to private companies, does not have a cap on the amount of the raise, and other than as related to the finder and his/her compensation, does not require specific disclosures.
Most if not all small and emerging companies are in need of capital but are often too small or premature in their business development to attract the assistance of a banker or broker-dealer. In addition to regulatory and liability concerns, the amount of a capital raise by small and emerging companies is often small (less than $5 million) and accordingly, the potential commission for a broker-dealer is limited as compared to the time and risk associated with the transaction. Most small and middle market bankers have base-level criteria for acting as a placement agent in a deal, which includes the minimum amount of commission they would need to collect to become engaged. In addition, placement agents have liability for the representations of the issuing company and fiduciary obligations to investors.
As a result of the need for capital and need for assistance in raising the capital, together with the inability to attract licensed broker-dealer assistance, a sort of black-market industry has developed, and it is a large industry. Despite numerous enforcement actions against finders in recent years, neither the SEC, FINRA nor state regulators have the resources to adequately police this prevalent industry of finders. The Office continues to encourage the SEC, as it has in the past, to provide certainty and to finalize a framework that delineates the legal obligations of persons who match small businesses with investors.
Pooled Funding
Small businesses also look for capital from private funds, such as venture capital funds and private equity funds that operate under various exemptions from registration. The increasing concentration of capital into larger, private funds has resulted in a growing unmet need among entrepreneurs looking for seed and early-stage capital, with larger funds finding it inefficient or lacking bandwidth to make multiple small investments.
The Office advocates for increased diversity among fund managers, the location of funds, and the size of funds. To achieve the goal, the Office encourages Congress and the SEC to explore initiatives to increase diversity among investment decision makers to help shift the pattern matching that historically has negatively impacted women and minority entrepreneurs.
Attractiveness of Public Markets
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.
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 changes to the management’s discussion and analysis section of SEC reports, see HERE and on business descriptions, risk factors and legal proceedings see HERE. The Office encourages further initiatives to incentivize public offerings, including through more liberal direct listing rules and continued use of SPACs.