Who Should Invest in Seed-stage Companies under Reg A+?
Published on July 6, 2016
By David M. Freedman and Matthew R. Nutting
¶ Nobody, in our opinion, should invest in seed-stage companies that raise capital under Regulation A+. This new securities exemption, based on Title IV of the JOBS Act of 2012, is structured primarily for growth- and later-stage companies. Prominent securities lawyers agree with us on this, but I’m going to present a dissenting opinion below. As the Reg A+ exemption is so new, we just don’t know for certain how the market will react and adjust to it.
Title IV, launched in June 2015, allows securities offerings up to $50 million by private companies, to tens of millions of non-accredited angel investors. Issuers can list their offerings on crowdfunding platforms, or via old-style brokers, or both. Some of the platforms that currently host Title IV offerings include W.R. Hambrecht, SeedInvest, and Wefunder.
Title IV, colloquially referred to as Regulation A+ because it blasts Regulation A wide open, went into effect Friday (June 19, 2015). Before this new regulation, Regulation A offerings were capped at $5 million.
A number of companies that have been planning their Reg A+ offerings have hired CrowdCheck, a Virginia-based compliance and due diligence firm, to help them meet the requirements of Title IV and other relevant securities regulations. According to Sara Hanks, CEO of CrowdCheck, those companies include some that she considers seed-stage startups. Certainly they are entitled to attempt to raise capital under Reg A+, but investors should question the wisdom of their decision to do so. Sam Guzik, a Los Angeles-based securities lawyer and past president of the Crowdfunding Professional Association , said on April 7, 2015: “I do not recommend Reg A+ for startups.” Here’s why:
- Reg A+ is a relatively expensive way to raise capital, and requires a lot more legal expertise than Regulation D offerings, for example. Reg D offering platforms (bolstered by Title II of the JOBS Act) have been operating for a few years now; they allow companies to raise an unlimited amount of capital but only from accredited investors.
- Offerings up to $20 million, in Tier 1 of Reg A+, still require state-by-state (blue sky) review and compliance, which can be very costly and time-consuming. On the other hand, for offerings up to $50 million in Tier 2, blue sky review is preempted. Reg D preempts blue sky review.
- Reg A+ financing results in a “mini-IPO” because of its scaled-down SEC registration process and ongoing reporting requirements; so it might change the entrepreneurial culture of a startup, bogging down its decision-making process and limiting its flexibility.
There will be plenty of growth- and later-stage companies raising money under Reg A+ that you can consider investing in. But seed-stage is too early for Reg A+, and you should ask founders of seed-stage companies why they chose an expensive and perhaps culture-shifting way to raise capital—and how they plan to grow, in terms of revenue and market share, fast enough to justify the expense and disruption of a Reg A+ raise.
CrowdCheck’s Hanks, who is also a securities lawyer, disagrees with our perception of Reg A+ as too expensive and culturally disruptive for seed-stage startups. “I think Tier 2 of Regulation A is a viable option for startups,” she comments. “The initial compliance costs for a $5 million offering need not amount to more than 1 percent of the overall raise. Providing a company is willing to comply with the ongoing disclosure requirements, I don’t think startups should automatically reject Reg A as a capital-raising option.” CrowdCheck’s comprehensive disclosure and compliance review for a Reg A+ raise would cost a startup about $40,000. And a CPA who knows the crowdfunding scene would charge as little as a few thousand bucks for an audit. “Even on a $1 million raise, this is not insane,” Hanks says.
For the sake of the entrepreneurial community and non-accredited investors who have not had access to angel capital deals, I actually hope Hanks is right. Until we have some anecdotal evidence, at least, of the effectiveness of Reg A+ for seed-stage companies, we advise caution for inexperienced angel investors and novice entrepreneurs alike.
David M. Freedman and Matthew R. Nutting are the authors of Equity Crowdfunding for Investors: A Guide to the Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (John Wiley & Sons, June 15, 2015). For details, please visit www.ec4i.com. This article was originally published by Accredited Investor Markets 6/24/15.
Categories: Regulation A+