CHAPTER 2
Pre‐2012: The History of Regulation A and the Death of Small‐Company IPOs
Regulation A—Not Too Popular Before 2012
Before learning about the details of Regulation A and the new Regulation A+, it is helpful to understand where we stood in 2012 before the passage of the Jumpstart Our Business Startups (JOBS) Act of 2012. That law updated this and other rules relating to the ability of smaller companies to access capital for growth.
As we will outline ahead, Regulation A offers a method for companies to complete a public offering that generally raises less money and involves a more streamlined process than in a traditional IPO. In 2012, however, very few companies were utilizing Regulation A. The SEC noted this in its commentary to its proposal for new rules regarding Regulation A under the JOBS Act. There they acknowledged that, in the year 2012, only eight Regulation A offerings seeking to raise a total of $34 million were approved, or, the term of art we will learn, qualified, by the SEC.
At the time, as will be discussed, the most a company could raise under Reg A was $5 million. The SEC compared these numbers to private securities offerings under SEC Regulation D in the same year seeking to raise no more than $5 million to see which was utilized more. That comparison is laid out following this brief overview of Regulation D.
Reg D, which enjoys continuing strong popularity, operates as a safe harbor under the Securities Act of 1933. In that seminal Depression‐era statute, the Congress declared that public offerings of securities were to be scrutinized separately, ultimately setting up the registration process that requires SEC review and approval of almost all public offerings of securities, with substantial disclosure and in many cases post‐offering reporting obligations.
Implied in the law was that non‐public offerings (often called private offerings or private placements) generally would not require SEC scrutiny. However, the Securities Act did not define “public offering,” which would have helped issuers determine whether they needed SEC review and detailed disclosure. Between 1933 and 1982, courts grappled with determining which offering was public and which was not.
The courts mostly did agree, in analysis under what is now known as Section 4(a)(2) of the Securities Act, on the factors to be reviewed in determining whether a company is conducting a public offering. These factors included the amount to be raised, the number of offerees, their sophistication, their access to company information, and what portion of their net worth was being invested.
Courts were, however, unable to agree on how to weight the various factors. About all we knew for sure was that if the only person you talk to about investing in your company is Bill Gates and you are asking him for $10,000, it was not a public offering. It was also clear that if you make an offer to 10,000 uneducated grandmas and grandpas, each of whom was investing their last $100,000, you had a public offering. Everything in between frankly was uncertain.
Thus, in 1982 the SEC decided to pass Regulation D, a safe harbor making clear to companies that if they comply with the rules in Reg D, their offering would not be deemed a public offering. The most popular rule within Reg D (we will discuss recent changes to Reg D Rule 504 later), known as Rule 506(b), focuses on two things: which investors are accredited and what information is provided to them.
In general, accredited individuals have either an income of $200,000 (or $300,000 with their spouse) or a $1 million net worth not counting their primary residence. These numbers have not changed in the rules since 1982 (although the exclusion of your primary residence in the net worth calculation was added more recently), but as of this writing the SEC is conducting an examination as to whether to change or update these standards.
Reg D allows companies to offer stock with no dollar limit in a private placement to any number of accredited investors with no specific information required to be given to them. You can have up to 35 unaccrediteds but then detailed disclosure information has to be provided to them. This great flexibility has made Reg D 506(b) very popular.
The rule does prohibit any “advertising or general solicitation” of the offering. Later we will review Reg D 506(c), adopted as part of the JOBS Act, which allows private offerings to accredited investors only, but with advertising and online promotion permitted so long the company takes “reasonable steps” to verify their accredited status. The rule also prohibits the participation of “bad actors” in Reg D deals. These are individuals generally with securities‐related legal issues in their relatively recent past.
So in comparing Reg D offerings in 2012 versus Regulation A deals, how many Reg D offerings did the SEC count against the eight Reg A deals? Nearly 8,000 Reg D deals seeking less than $5 million each and looking to raise a total of $7 billion were filed in 2012. Quite the contrast from the eight Reg A deals seeking a mere $34 million that year.
In addition, frankly, there were a few questionable players in the small group of Reg A dealmakers around the time of the JOBS Act. This added to the unattractiveness of Reg A to many—a perception, somewhat born of reality, that the space was populated with unsavory types. “How great is this?” these shady actors would say. Raise money from unsuspecting small investors with very little disclosure and no reporting obligations after the IPO and you can trade the stock without revealing down the road who owns your stock or even too many details about financial performance.
As we will discuss later, most believe the low offering threshold and burdensome state review and approval of Reg A IPOs under pre‐JOBS Act rules dissuaded companies from utilizing it in the years leading up to 2015 when the SEC approved new Reg A rules. But the negative perceptions did not help, either.
Reg A Through the Years
Now that we understand the world as it existed in 2012, let us return to the beginning. In 1936, the fairly new SEC issued what unconfirmed lore claims was its first regulation—Regulation A (hence the name, goes the story). The rule allows smaller issuers to raise smaller amounts of money in a public offering with lower disclosure and reporting obligations than larger companies. The nation was battling the Great Depression and anything to make it easier to raise money, especially for the engine of job growth, small business, was attractive.
Before the Securities Act was passed in 1933, the states generally governed securities regulation. The stock market crash of 1929 finally led Congress to take over, or at least supplement, that state regulation with federal oversight of the stock exchanges and securities markets.
Congress followed in 1934 with the passage of the Securities Exchange Act, which governs broker‐dealers, helped establish the uniform disclosure system now known as Regulation S‐K, and organized the SEC. Not many know that the first chairman of the SEC, from 1933 to 1935, was Joseph P. Kennedy, father of future President John F.
Joe Kennedy later became Ambassador to Britain and famously got out of the stock market a very wealthy man before the 1929 crash. He was, however, alleged to be a bootlegger during Prohibition, an insider trader before the Securities Act, and was known to many as a bit of scoundrel. Many believe then‐President Franklin Roosevelt thought it a good idea to “put the fox in charge of the henhouse.”
Before Reg A was adopted, it was, as described on the SEC's website, “a collection of individual rules issued by the Federal Trade Commission during the period of 1933–1936. Each such rule exempted particular classes of securities from registration under the Securities Act.”
Now remember as noted above that Section 4(a)(2) of the Securities Act regulates initial public offerings and requires the shares that are proposed to be publicly offered to be registered with the SEC. The need to file a registration statement and obtain SEC approval of the IPO disclosure is the basic requirement. Reg A operates as an exemption from that requirement to register; thus it is both a public offering and an unregistered one.
The result is essentially the same; however, with Reg A you can offer shares to the public and after you do the shares are freely tradeable. Reg D is an exemption from registration that is a private unregistered offering where shares are not tradeable (except in limited circumstances under Reg D Rule 504 raising $5 million or less as we will discuss).
In the original 1936 rule, Regulation A's annual offering limit was $100,000. According to www.dollartimes.com, $100,000 in 1936 had the same buying power as $1,749,507 in 2017. That is still low even by today's standards. After World War II, the SEC increased the maximum limit to $300,000. They raised it again in 1970 to $500,000, then $1.5 million in 1978, and finally to $5 million back in 1992. That $5 million is worth $8,753,879 today, an amount still well below what would attract many legitimate investment banks and dealmakers.
Before 2012, though, as we will outline in the next chapter, “old” Reg A allowed you the option to conduct a public offering with relatively limited disclosure, even in a Q&A format if you preferred. You also did not have to take on long‐term SEC reporting obligations, even if your stock was trading after your Reg A public offering. There was, therefore, some theoretical attraction to use the technique to obtain a trading stock with pretty low upfront and ongoing compliance cost, even though the offering limit also was low.
The dollar limit, however, was not the only problem. Like most public offerings through the years, Reg A deals also had to be reviewed and approved by each state in which you wanted to offer the stock to the public. In larger “big‐company” IPOs, however, that process was managed with a large and very expensive legal team. In addition, the states seemed to provide more deference to the SEC and did not seem to be as skeptical of the larger companies seeking public offerings. The delays and substantial cost of state “blue sky” reviews to smaller companies seeking a Reg A public offering simply were overwhelming.
Why was it such a problem dealing with the states? The various state securities regulators presumably are well intentioned and seek a reasonable balance between encouraging capital formation and protecting investors. In reality, however, the state regulators have been, and to some extent still are, in your author's humble opinion, all over the lot in terms of their skills, responsiveness, experience, and at times even intelligence. Remember these are generally low‐paid local government workers. Of course some are diligent, smart, responsive, and reasonable. Many, however, unfortunately are not.
The federal agency employees at the SEC's Division of Corporation Finance oversee review of public filings. While they are tough at times, they generally are smart and accessible and rarely unpredictable. Most SEC examiners of public offerings are attorneys or accountants and are well trained. Many end up leaving the SEC for lucrative private law and accounting firm positions.
Before 1996, every single IPO, even the large ones planning to list on national exchanges, had to go through this full state blue sky review. This was a mega‐task. Large law firms had dozens of blue sky lawyers doing nothing but dealing with these local regulators on public offerings.
In 1996, the Congress passed the National Securities Markets Improvement Act (lovingly known as NSMIA and pronounced “niss‐mee‐uh”). NSMIA created the concept of “covered securities” that would be preempted from state blue sky review. How can Congress just do this?
The good old U.S. Constitution: Article VI's Supremacy Clause basically says federal law trumps (you should excuse the expression) state law when they conflict and that the feds can take over regulating something from the states. Of course the Tenth Amendment to the Constitution says the feds only have those rights given to them in the Constitution and the rest belong to the states. The feds do, however, get to control interstate commerce. So if a public offering is happening across state lines, guess who wins? (Note that states are free to regulate offerings happening solely within their states, called “intrastate” offerings.)
So NSMIA said it's too much of a burden for large companies doing IPOs onto national exchanges to also go through the states, especially since many of these large IPOs were being sold in all 50 states. The SEC review of their offerings, plus the protections of the exchanges, were deemed sufficient.
In addition, in most cases these larger deals included major law and accounting firms, adding to the comfort level. The only real exception: mutual funds going public still have to go through state review. Great for companies, not so great for the blue sky lawyers. They had to all reinvent themselves, and most did. A small shout‐out to decades‐old friend Joe Krassy, the true dean of the blue sky lawyers both pre‐ and post‐NSMIA, who recently retired. Joe responded to NSMIA by becoming the part‐time blue sky lawyer for a handful of major law firms. Joe, we will miss your practical approach to this arcane area of law.
But what did NSMIA not do? It did not include securities sold in IPOs onto the lower over‐the‐counter trading platforms in the definition of covered securities. So if you want to do an IPO but not list on Nasdaq, NYSE, or similar national exchanges, and prefer to trade in the over‐the‐counter markets, as of 1996 you still have to go through full state review—hence one of the major negatives (along with the $5 million limit) of old Reg A if you planned, as almost all did at the time primarily due to the small offering limit, not to list on a national exchange.
So it was indeed a big deal that the JOBS Act, as we will see, increased the Reg A limit from $5 million to $50 million and preempted blue sky review of Reg A IPOs planning to trade in the over‐the‐counter markets. It seems equally impressive to me that something designed in the 1930s, when radio and talking movies were new, to help the country survive one of the, if not the most calamitous time in our country's economic history, has survived to be molded into a modern, Internet‐savvy technique that has attracted hundreds of companies since the rules became effective in June 2015.
Why did Congress decide to do this? Patience, dear reader, the chapters ahead will explore.
Why Small Companies Struggled to Go Public Before the JOBS Act
There was another problem in 2012. There was no shortage of emerging companies interested and seeing benefit in having a publicly trading stock. Small‐company IPOs, however, which had been dominant in the go‐go Internet years of the 1990s, had virtually disappeared starting in the late 1990s. In addition, “reverse mergers,” in which private companies went public by merging with an existing public vehicle, often deemed a shell, also were facing significant challenges. Let's discuss each.
Death of Small IPOs
There has been a tremendous amount of time and money devoted to analyzing why smaller company IPOs virtually disappeared at the end of the Internet boom. A recent article published in the Harvard Business Law Review (HBLR) (Paul Rose and Steven Davidoff Solomon, “Where Have All the IPOs Gone? The Hard Life of the Small IPO,” 6 Harv. Bus. L. Rev. 83 (2016), http://scholarship.law.berkeley.edu/facpubs/2601) provides the startling facts. Here is the blunt opening to the article: “The small company initial public offering (IPO) is dead. In 1997, there were 168 exchange‐listed IPOs for companies with an initial market capitalization of less than $75 million. In 2012, there were seven such IPOs, the same number as in 2003.”
Rose and Solomon conducted a thorough analysis to conclude that, despite the existence of a number of theories, no one really knows for sure what caused the small‐company IPO market to dry up. That also means it may be tough to figure out what will retrigger the deal flow. They appear to side a bit with those who believe that investors simply got tired of investing in small companies that had a lower likelihood of success than IPOs of larger companies. It is not exactly clear what caused that to happen around the time of the end of the Internet bubble. Here is a review of the potential causes cited by the article.
Sarbanes-Oxley
First, they say, many believe the Sarbanes‐Oxley (SOX) Act of 2002, implemented after the massive Enron, Tyco, and WorldCom scandals, is the culprit. SOX was the subject of rapid Congressional adoption with virtually no hearings, and in particular no discussion of the potential impact on smaller public companies, even though its goal was to prevent the next multibillion‐dollar fraud.
There is indeed no question that SOX added burdens to public companies, especially smaller ones. The most significant: (1) requiring public companies to have an outside auditor attest to the adequacy of the company's internal financial controls and (2) requiring CEOs and CFOs to personally certify to this adequacy in every public company periodic report.
When SOX was adopted, I informed the CEO of a public client of mine that this was now his responsibility. He took out a pen, wrote something down, and slid it across the table to me. I looked at the note, which said, “I resign.” He didn't, but we got the point. Since then the rules have been relaxed so that so‐called “smaller reporting companies” (generally below $75 million in market capitalization) do not have to hire an outside auditor to assess financial controls, but management still has to certify that they have done the assessment and opine as to the adequacy thereof. The JOBS Act codified this and expanded it, providing that “emerging growth companies,” which are companies going public with as much as $1.07 billion in revenues, also are exempt from the outside auditor attestation.
The HBLR article points out that smaller company audit bills initially more than doubled after SOX, but after 2008 came back to earth and now are around 25 percent higher than pre‐SOX. The law certainly caused a ruckus of frustration, and was used by foreign stock exchanges as leverage to convince companies to stay out of U.S. trading. Over time, however, that concern has been proven to have been significantly overhyped.
Market Ecosystem Theory
The next alleged culprit, according to Rose and Solomon, of the death of small company IPOs: the so‐called “market ecosystem” theory. This posits that the adoption by the SEC in 2000 of Regulation FD and the 2002 massive Global Research Analyst Settlement (GRAS) are partially to blame. This theory suggests that market analysts' incentives to follow smaller stocks were significantly reduced by these changes.
Another part of this theory says that 1997 changes in the so‐called “order handling rules” (OHRs) and reductions in tick‐size spreads around 2001 contributed as well. Here is a review of these various potential villains.
Regulation FD, which one would think always should have been the law, says a public company cannot selectively disclose material nonpublic information. In other words, the old small conference calls with a few select stock analysts who get a jump on the overall market were over. The major exception is you can disclose things to people who sign a nondisclosure agreement. It seems rather obvious that this did take away certain benefits from the analysts.
The GRAS was a huge coup for then‐not‐yet‐disgraced New York Governor Eliot Spitzer. Things were just too cozy between the major Wall Street houses' investment banking and analyst arms. The bankers want to sell a deal and the analysts are looking for objective research, which do not necessarily always jibe. There was some evidence that the analysts were being pressured by the bankers to produce, shall we say, not‐so‐objective research, and that this practice was rather pervasive throughout the industry.
The settlement required the separation of the analyst and investment banking functions, taking away analyst compensation for equity research. It also prohibited the analysts from attending investor roadshows promoting deals. The HBLR article points out that analyst coverage, on average, tends to increase a public company's stock price by about 5 percent. So less of it would clearly not be good. As we will see, to some extent the JOBS Act sought to reverse this.
Moving on, without getting too much into a super‐complicated set of rules, the OHRs required much more disclosure of price quotes than before, which many believe negatively affected the economics of market makers, who secure trading in public stocks, and made their involvement in smaller public companies less attractive.
Then, there is the tick‐size problem. In 2009, Grant Thornton published a wide‐ranging study asserting that the main cause of small company IPOs disappearing was the reduction in spreads between “bid” and “ask” prices in 2001. (See the study at David Weild and Edward Kim, “Capital Market Series: Market Structure Is Causing the IPO Crisis,” Grant Thornton LLP 9 (2009), http://www.grantthornton.com/staticfiles/GTCorn!Public%20companies%20and%20capital%20markets/FilesllP0%20crisis%20‐%20 Sep%202009%20‐%20FINAL.pdf.)
Market participants, especially in electronic markets such as Nasdaq, were able to share pieces of this price spread with those who helped bring buyers and sellers together. This was how now‐infamous Bernard Madoff allegedly made his first legitimate fortune when he was also chairman of the Nasdaq. Some say that the change in the tick‐size spreads dried up his income, leading to his more nefarious Ponzi scheme that stole billions from many, including his close childhood friends. We may never know, however, as old Bernie is not talking from his jail cell. More on the Madoff scandal and its impact on the SEC is to come.
Once the bid–ask spreads went to one penny, after having been as high as 25 cents, there is no question many were driven out of the market. The idea of decimalization of the spread was to put more money in investors' pockets as opposed to pulling out the money in the spreads to hand out like candy. The result, however, certainly was not positive for the small‐company IPO market.
As of this writing and since October 2016, the SEC has been conducting a two‐year pilot tick‐size study. The purpose of the study is to see if it would be worthwhile to move back to larger spreads. They are sampling about 1,400 small capitalization stocks (with less than $3 billion in market capitalization) with a five‐cent tick‐size spread.
Their hope is the study will show less volatility and increased liquidity in the selected stocks. If so, they might consider expanding the study, increasing tick sizes across the board, or possibly giving companies the right to determine their own tick spreads. What the study shows: The SEC realizes that decimalization, while it had understandable aims, may have had some unintended negative consequences.
A last part of this theory suggests that the move to online brokerage accounts made IPOs tougher. Without the usual salesforce at a brokerage firm pushing stocks, it was tougher to find investors interested in participating in IPOs. The Grant Thornton study suggests this caused many brokers to move to jobs in asset management, taking them away from the day‐to‐day selling process of IPOs and helping kill the Internet IPO craze.
Economic Scope Theory
The last major explanation for the small‐company IPO problem is laid out in yet another fairly recent paper on the subject (Xiaohui Gao, Jay R. Ritter, and Zhongyan Zhu, “Where Have All the IPOs Gone?,” 48 J. Fin. Quantitative Analysis, 1663, 1688 (2013)). This one is a little depressing as it suggests that there are bigger, more fundamental changes in the markets that simply reward larger businesses more than the small ones, that the only way for businesses to succeed is to be large, to grow by acquisition, and eventually be sold themselves rather than go public. Under this theory, as our world gets smaller and technology faster and more complex, being larger is simply a necessity.
So what caused the death of small IPOs before almost anyone had heard of a thing called Facebook? No one knows for sure. Is that important? It can be, if part of the purpose of this book is to help answer the question or whether it is a good idea for small companies to be public, and if so, what the best way is to get there. We may never know for sure, and it is important for any company considering the public route to keep these factors in mind.
Death of Reverse Mergers?
The end of IPOs might not have been the worst thing ever, but there was another problem small businesses faced in 2012. We will delve into reverse mergers much more starting in Chapter 8. For the purposes of the discussion here, however, it is important to note that as IPOs disappeared, in many cases reverse mergers rose to take their place and help small companies go public, albeit in a nontraditional manner. In a reverse merger, a private company goes public by merging with an already‐existing public entity that in many cases has no operations and is deemed and in many cases actually called a “shell” company.
As we will discuss in greater detail later, in the late 1990s and into the 2000s, shell mergers slowly increased in popularity. The technique mostly shook off its previously shady reputation developed in the 1980s, which resulted from some bad players being in the space at the time. The death of small IPOs only accelerated the need to find legitimate methods for small companies to go public to access capital and grow.
There were several hundred reverse mergers completed annually through most of the 2000s, many with contemporaneous financings and follow‐on public offerings. Venture‐backed companies mostly stayed away, with the exception being companies in the life sciences industry. Biotechs embraced the technique vigorously, especially after some major successes like Cougar Biotechnology, which was sold to Johnson & Johnson for about $1 billion just a few years after its reverse merger in 2006.
In addition, in the second half of the 2000s, hundreds of Chinese companies went public in the United States through reverse mergers. This added dramatically to the deal flow, and investment banks and deal participants had a field day. Sadly, around 2010, in part resulting from research published by some short sellers betting on stocks to go down, several dozen of these companies ended up accused of fraud.
Lawsuits and SEC investigations of these alleged Chinese frauds ensued. Some cases were dismissed, others settled. A few ended up with actual legal determinations of fault and fraud. Fingers were pointed at advisors to these companies. It goes without saying that all the stocks of these Chinese companies, even those not accused of anything and showing strong earnings, suffered tremendously.
Some of these “innocent” Chinese companies simply gave up and went private. Some remained public and their stocks have mostly rebounded. But it was a mess for sure. Not helping the matter was the 2008–2009 Wall Street and economic meltdown. It was not a good time for small and microcap players.
Let us briefly review what frauds the Chinese companies were accused of, which we will cover in greater depth in Chapter 9. Again we say alleged and in most cases not proven. Here, however, are a few examples. In several cases, the companies were accused of colluding with local bank branch employees to phony‐up bank statements. Opening and closing balances could not be changed, but they would insert much more in and out in between, to allow companies to show more revenues (and expenses)—allegedly. Result: Smart auditors now realize they ask for bank statements only from the bank's headquarters. In other alleged frauds, one day the CEO, and all the company's assets, allegedly disappeared and neither can be located.
In another series of alleged frauds, the company's tax returns filed with the Chinese tax authorities showed financial results that were significantly different from the audited financial statements filed with the SEC in the United States. This actually happened in a number of cases. Most of these cases, however, were thrown out. The plaintiffs first had to prove that the results were actually different, since they were prepared with different accounting principles. Assuming they could do that, they had to be able to prove that the U.S.‐filed accounting information was in fact the wrong set of financials, as opposed to the ones filed with the Chinese tax authorities. Plaintiffs' attorneys mostly realized this was going to be extremely difficult to do.
After this, and I believe because of the Chinese alleged (and some actual) frauds, the SEC took action that mostly shut the door on how many reverse mergers were completed. As we will describe later, in 2011, it “encouraged” the major stock exchanges to request, and the SEC approved, new regulations known as the “seasoning rules.”
An extremely popular method of reverse merger involved two steps. First a private company would merge with a so‐called Form 10 shell (again, more on this later) and complete a private financing, say of around $5 million. Now as a public reporting but nontraded company, they would immediately file for a public offering of $15–20 million and immediately start trading on Nasdaq or the NYSE American (then known as the American Stock Exchange).
At least one of my clients at the time, who had created dozens of these Form 10 shells and operated a broker‐dealer, completed many, many deals this way. The seasoning rules, unfortunately, now require that after a merger with a shell company, the merged company must trade on the over‐the‐counter markets (as opposed to national exchanges such as Nasdaq) for at least one full fiscal year before even applying to uplist to the national exchange. Only a public offering of at least $40 million lets you bypass this speedbump under the new rules. Most small companies are not big enough to justify this type of raise.
We will get into some of the (in my view significantly flawed) reasoning for these new rules later. We will also discuss how some players have tried to get around these restrictions by merging with public entities that are not technically shell companies. Unfortunately, in the last several years a number of players, including previously prominent attorneys, have been sued by the SEC, criminally charged, or jailed for misdeeds in creating bogus public vehicles pretending to be operating businesses to avoid the shell designation.
Reverse mergers are not quite dead. Clients of mine completed one in December 2016 and another in March 2017. The biotech world still likes the shells'. To be frank, however, as we will see, Regulation A+ IPOs offer much more to companies that would have considered a reverse merger, especially after implementation of the seasoning rules made reverse mergers more problematic.
Reg A versus Private Offering Under Regulation D
This seems as good a place as any to compare a Regulation A IPO to a private offering under Regulation D, since many of the comparisons apply both before and after the JOBS Act improvements. There are really six major differences between the two.
Reg D Is Faster
Both before and after the JOBS Act changes, Reg A IPOs still have to be filed with and approved by the SEC. Reg D offerings do not. You can complete a private offering under Reg D as quickly as you can prepare subscription and disclosure documents and get investors to sign them. Then within 15 days after closing you complete a simple filing of something called Form D with the SEC and any state in which you complete the offering.
If there is a need for speed, Reg D may be a better choice. In fact, many companies working on Reg A IPOs complete an interim “bridge” financing under Reg D first. Many companies, however, do not have an urgent need for capital. They have raised prior funds or have profits to fund operations.
We are also very pleased that, as will be discussed, the SEC has instructed its examiners to provide a very limited and expedited review of Reg A filings. This has dramatically reduced the average time that issuers are spending in SEC review of Reg A submissions, reducing the difference in time to completion as against Reg D.
Reg D Is Cheaper
With Reg D, if you accept only accredited investors, there are no specific information delivery requirements as long as there is nothing misleading or fraudulent going on. If you have some unaccredited investors (Rule 506(b) allows up to 35), in most cases you must provide them a full disclosure document, often referred to as a Private Placement Memorandum (PPM). The cost of preparing that PPM, however, is still meaningfully less than a full Reg A IPO. This is another reason that some companies choose a Reg D deal followed by a Reg A IPO.
If you choose a Reg D 506(c) offering as now permitted under the JOBS Act (see Chapter 13), you can advertise or publicly solicit investors as noted earlier. In those transactions, costs might be higher if a company engages a marketing or investor relations firm to develop a social media or crowdfunding campaign for the offering.
Reg D Can Raise More than $50 Million
Reg D Rule 506 offerings have no dollar limit. Some larger companies find a benefit in being able to raise significant funds this way. Even post‐JOBS Act, as we will outline, Reg A IPOs are limited to $50 million per 12‐month period, although the SEC has the authority to raise that amount and as of this writing a bill is moving through Congress to raise the limit to $75 million. Most companies contemplating a Reg A offering, however, do not need to raise more than $50 million.
Reg D Rule 504 offerings allow a company to raise up to $5 million from an unlimited number of accredited and unaccredited investors with no specific information delivery requirements. This expands the pool of potential investors but obviously limits the amount that can be raised compared to Reg A.
Reg D Rule 506 Limits Investor Status
Reg D Rule 506 limits who can invest. In 506(b), an unlimited number of accredited investors and up to 35 unaccredited investors can participate with no advertising. With 506(c), advertising is permitted so long as your offering is limited to accrediteds. Reg A offerings can include an unlimited number of investors regardless of accredited status.
The one limitation, as we will see in Chapter 4, is that an issuer in a Reg A offering that plans to trade its stock in the over‐the‐counter markets must limit the amount that each unaccredited investor purchases based on their income or net worth. Those limits do not apply to a Reg A deal where the plan is to trade the stock on a national exchange.
Reg A Offers Liquidity
Possibly the most significant advantage of Reg A over Reg D is that shares issued in the Reg A offering are immediately tradeable. Only in certain Reg D 504 offerings (limited to $5 million) is trading possible, and even then generally only on the least desirable trading platforms. It is typically much easier to raise money from investors when they know there is a current path to near‐term liquidity of their investment. A company also may be able to sell stock at a higher per‐share price when investors know they will have an option to sell their stock publicly soon thereafter.
It appears likely, though not yet clear as of this writing (in fall 2017), that most companies conducting Reg A IPOs will choose to trade their stock over‐the‐counter. The platforms operated by OTC Markets Group include the OTCQX, the OTCQB, and OTC Pink, in reducing order of stature. Most Reg A deals this writer is aware of plan to trade on QX or QB, and not national exchanges such as Nasdaq or the NYSE.
In many cases they simply will not be able to satisfy the listing standards of the larger exchanges. As previously noted, however, trading of the first group of Reg A IPOs on the larger national exchanges such as Nasdaq and NYSE began in June 2017.
In general, the volume of trading and liquidity is better on the exchanges than in the over‐the‐counter markets. The exchanges, however, have many more requirements with respect to corporate governance, board independence, shareholder approval of certain actions, and the like. Many companies whose management is new to being public find a benefit to ease into public status where the compliance obligations are a bit less in the over‐the‐counter markets.
Reg A Offers Unlimited Testing of the Waters to All Investors
As we will discuss, Reg D Rule 506(c), created under the JOBS Act, does allow a private offering with advertising, general solicitation, and “testing the waters.” That rule, however, only allows accredited investors to invest in these deals, and in many cases they must obtain a certification from a third party as to their accredited status or the company must otherwise take “reasonable steps” to verify the investor's accredited status. In Reg A+, advertising and testing the waters can take place before or after SEC filing of your proposed disclosure (on what we will learn is called an offering statement) seeking interest from any investor, whether or not accredited.
As a result of this change, a brave new world of social media and online marketing of Reg A+ deals has developed. In some cases it represents the only source of potential funding; in other cases it is combined with proceeds raised by investment banks or funds brought to the table from a company's own crowd of fans, followers, and customers (much more on this later).
And so . .
The world in 2012 before the JOBS Act was not too interested in Reg A. The low dollar limit and state blue sky review pretty much killed any attraction Reg A may otherwise have had as a public offering with testing the waters. Reg D was (and remains) tremendously popular but retains restrictions. How the two will play together will be an interesting development to watch.
As we get ready to talk next about how Reg A+ developed under the JOBS Act, understanding why the small‐company IPO market dried up around 2000 remains mostly a mystery despite the best efforts of some very smart researchers. Whether updated Reg A+ will solve the challenges that are still unclear is, well, unclear. What is clear is that there are a number of experienced Wall Street players getting very excited about, and helping dozens of companies reap, the benefits of a Reg A+ IPO for smaller companies, so let's go there now.