As part of the Jumpstart Our Business Start-ups Act of 2012 (the “JOBS Act”) Congress mandated that the Securities and Exchange Commission (the “SEC”) amend its rules for exempt transactions under Regulation A so that certain qualifying issuers would be able to issue up to $50 million in securities under Regulation A in a 12 month period. From its name, Congress and many industry participants thought that this change to Regulation A would make it easier for start-ups to raise funds. Now that the SEC has issued its new rules under Regulation A (now called “Regulation A+”) it seems more likely that those rules will provide a better platform for more established small and medium-sized businesses (“SMBs”) to raise capital than it will for start-ups.
The mechanics of Regulation A+ have been widely publicized and don’t need to be summarized here. The thrust of Regulation A+ is that a privately-held company may file a prospectus with the SEC on Form 1-A. The prospectus must describe the securities being offered (which may be either debt or equity securities) and provide certain mandatory disclosures. If the issuer intends to raise less than $20 million, the issuer does not need audited financial statements and the rules applicable to its offering (i.e., a “Tier 1” offering) will be generally the same as the rules that applied prior to the SEC’s June 2015 publication of Regulation A+. On the other hand, if the issuer intends to raise more than $20 million (up to the annual cap of $50 million, called a “Tier 2” offering) the issuer must have audited financial statements going back at least two years.
Before the JOBS Act, Regulation A was little-used. Its $5 million cap made it relatively useless. A small, private company looking to raise less than $5 million would find it easier to have a private offering to accredited investors under Regulation D. The relatively high transactional cost of filing a prospectus would not be justified by the size of the offering. In addition, until the year 2000, growing private companies looking to raise up to $50 million in growth capital often looked towards an IPO as the platform to raise equity in that amount.
The Sarbanes-Oxley Act of 2002, however, with its extensive requirements and high compliance costs, has made it uneconomical for companies with a market cap of less than $500 million to go public. One SEC-sponsored survey of officers at pubic companies in 2008 estimated that the annual cost of compliance (resulting mostly from accounting and legal fees) was approximately $2.3 million. Such high compliance costs have virtually eliminated IPOs for companies with market valuations of less than $500 million. For example, from 1991 to 2000 there were more than 50 IPOs each year of companies with less than $50 million in sales. During the decade that followed there was not a single year in which there were more than 50 IPOs of that same size.
So, for SMBs that are established and profitable, looking for growth capital, and with annual sales of $50 million or less, how can Regulation A+ serve as a platform for a strategic exit? I believe there are several alternatives.
The Public Option
One alternative is for the growing SMB to raise growth capital through Regulation A+. The offering could be structured as common or preferred stock, but the investment thesis is to show investors that they can achieve better-than-market returns. After a successful offering, the issuer can list its shares for resale on the OTC bulletin board or another secondary marketplace. Doing so will provide investors with liquidity and creates a public forum for communications about the company. If the company is able to grow with the funds it raises through the offering, the company will be well-situated for a true underwritten IPO in a relatively short period of time. Regulation A+ requires its Tier 2 issuers to publish semi-annual and annual reports on financial results (similar to a “light” Form 10-Q and Form 10-K). Developing the internal procedures and discipline to publish financial results regularly will help the growing SMB get ready to become a public company.
The Merger Option
Using Regulation A+ as a means of developing growth capital can also help an SMB publicize its success as a precursor for being acquired. Finding a merger partner for a private company can be an expensive and time-consuming effort. Many investment banks eschew private companies with valuations of less than $100 million and those that work in this space often require significant upfront fees and sizeable success fees (sometimes ranging from 2% to 10% of the sale price).
A profitable and growing SMB that raises growth capital through Regulation A+, however, creates a platform to publicize its business and will inevitably attract attention from possible suitors. That publicity effect will be enhanced if the issuer causes its shares to be available for resale on the OTC bulletin board or another secondary exchange. Using a Regulation A+ offering to generate publicity may speed the SMB towards an acquisition in a way that bypasses some of the inevitable investment banking fees.
Options for Real Estate
Since the market crash of 2008, real estate developers have looked for alternatives to traditional bank financing to fund both commercial and residential real estate investments. In some states, intrastate crowdfunding has made it possible for developers to raise relatively small sums (generally less than $1 million) from non-accredited investors within the state. Regulation A+ may also play a role.
GroundFloor recently became the first real estate company to use Regulation A+ as a platform for issuing asset-specific notes to finance real estate projects under the rule. GroundFloor’s approach is to amend its prospectus from time to time in order to qualify “limited recourse obligations” or “LROs” for sale under Regulation A+. Each LRO represents a debt security that will pay principal and interest to the holder based upon the financial outcome of a specific real estate investment. Using this structure allows GroundFloor to raise funds under Regulation A+ without become an investment holding company that would be prohibited from utilizing Regulation A+.
Other options may also be possible for other types of real estate developers. For example, an aggregator of residential real estate, using more expensive bank financing to acquire and rehab its properties, might create a holding company to purchase the portfolio (once the properties are rehabilitated and rented), financing all or some of the purchase price through a Regulation A+ offering.
In a similar vein, a developer of commercial properties might also use more expensive bank financing or private equity, to acquire and renovate one or more commercial properties. The developer could thereafter create its own purchaser to buy the portfolio of completed assets, using a Regulation A+ offering to fund all or a portion of the purchase price.
In both alternatives, the developer would be able to complete a strategic exit more quickly than through a sale to a strategic purchaser or in a private sale. Completing the strategic exit with greater speed will allow the developer to increase its returns by allowing it to re-commit its capital more quickly.
The SEC’s Regulation A+ rules have been effective for less than a year and it remains to be seen how the marketplace will receive them. The initial news appears to be positive, but it will take time for the marketplace to truly understand how well Regulation A+ will work. Until then, advisors to SMBs should consider how they can use these new rules to develop strategic transactions with greater speed and certainty.
Meet Jonathan Wilson “Speaker at REG Plus Master Class Conference October 26th Las Vegas “
About the Author
Jonathan B. Wilson is a partner in the Atlanta business law firm of Taylor English Duma. He has practiced as an attorney for nearly 25 years and has served as the in-house general counsel for two public companies. He represents Fortune 100, middle-market and start-up companies in matters involving securities, corporate finance and governance, mergers and acquisitions, and intellectual property. He is a frequent speaker and writer on the JOBS Act, crowdfunding and Regulation A+.