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What the New Regulation A Really
Means to Your Company
Disclaimer This is not legal or
investment advice
Seek competent advice from qualified attorneys and investment bankers
This is a only a summary – study the rules in depth
Your situation may vary
The more you know about finance and business, the more you can profit
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The new Regulation A (so-called “Regulation A+”) was recently
announced by the SEC in Release No. 33-9741.
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The new Regulation A exemption creates two tiers of Regulation A
offerings:
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Tier 1, offerings of up to $20 million in a 12-month period, including up
to $6 million for the account of selling security-holders.
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Tier 2, offerings of up to $50 million in a 12-month period, including up to $15 million for the account of
selling security-holders.
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For offerings up to $20 million, the company could elect whether to
proceed under Tier 1 or 2 but audited financial statements are
needed for Tier 2. Tier 2 offerings are exempt from state “Blue Sky”
regulations.
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These rules will take effect 60 days after publication in the Federal
Register.
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We now look at factors important to to you as company management. This is based on our experiences
with small, fast growing companies looking for financing.
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We believe the following factors are material to a company's decision to
use the new Rule:
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Audited Financial Statements
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First question you ask is how long will it take to get the money?
If you can get funds faster than your competition, you win. The speed of
funding largely dictates how fast you can grow.
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Second question, what will it cost in out of pocket cash before we get
the money?
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If you have not been getting audited as part of your historical
operations, it will take time to get the audit done.
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Accountants in my experience are almost always late. They can run
into unforeseen issues you have in the books or they can just be slow.
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Once an accountant is engaged, you are stuck with them.
An accountant can drag out the work and if you replace them, it will cost
you more time and money.
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With Reg A+, if you want to raise a small amount of money, you can offer stock without an audit and hope that investors who do not
know your company will trust you. Or you can wait and pay to get the
audit.
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You do not need a full PCAOB audit. You may have an
accountant who is familiar
with your work and can do a relatively fast audit.
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I would suggest you compare the cost of a non-PCAOB audit with a PCAOB audit to see if you might prefer the PCAOB audit which
could be useful later on.
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State Filing
under “Blue Sky” laws
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State filing was one of the reasons old Reg A was not used. If you
wanted to do an offering in many states, your Blue Sky fees were
huge.
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Even in one state,
the state regulator could
hold you up for
what seemed like forever
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You would almost inevitably be subject to merit review rules which imposed severe, if not impossible,
limitations on new, speculative companies.
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Many years ago I had one state regulator tell me off the record that
his state would never approve a Reg A offering. Presumably they intended to delay approval until
the issuer gave up.
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Under Tier 1, you can have
one state designated
as the lead state
for coordinated state review.
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However, you may still be stifled by stringent merit review in a merit review state. Merit review can be difficult for a small startup that is
incurring red ink because it is spending money to grow.
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Under Tier 2, you are exempt from state filing review. However, you
have to face the delay and expense of getting an audit.
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Advertising
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If you have exhausted friends and family, advertising is vital.
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You have to either get an underwriter who will do a small deal, and there are very few of
those, or have an effective promotional campaign.
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These campaigns cost money up front and are much more likely to
succeed if the company is in a
hot industry.
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If the issuer is limited to a tombstone ad, sales will be
hampered.
While Tier 2 seems to have few limits on the presentation itself, in
Tier 1, almost all states limit advertising to a tombstone ad.
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The test the waters feature may be useful in seeing if an offering is viable without committing to the
whole cost.
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However, a huge marketing effort is often needed to place stock in a
new and unknown company with a limited history and this is the type of company we might think of as a
crowdfunding company.
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A limited amount spent on testing the waters may not be enough to
show sufficient response to create confidence in the issue's
marketability.
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Approximately 12.4 million U.S. households are accredited
investors, based on either the income or net worth. Most have not invested in the types of deals
contemplated under the new Regulation A.
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Speed of Processing
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The SEC was kind enough to provide a very enlightening discussion of the
existing ways to raise up to $50 million.
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The SEC reported that the average offering under the old Reg A took 300
days to qualify with the SEC.
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We doubt that many companies would use any avenue to raise money if they knew it would take 300 days just to start selling, after the delay involved
in preparing the filing.
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If it takes three months to prepare the filing, and three months to place the deal, 480 days could have elapsed between the decision to make the offering and having the money in the bank. For a fast growing
company, this is impractical.
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The SEC statistics revealed that Reg D, Rule 506 was much more popular than
the old Reg A.
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If it takes 300 days to qualify, as it did under old Regulation A,
you would have been much better off filing a full S-1.
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In calendar years 2012 to 2014, only 26 Regulation A offerings
were qualified by the SEC.
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Compare this to 11,228 Regulation D offerings in 2014 that would have been
potentially eligible to be conducted under amended Regulation A.
Of those, 10,671 offerings relied on Rule 506, only 376 on Rule 504, and
only 181 on Rule 505.
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Consider the time to completion for a Reg D, Rule 506 offering. Using the same
three months to prepare the offering and the same three months to sell, gives us less than half the time of an old Reg A
offering, assuming only accredited investors subscribe so there is no state
Blue Sky review.
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If the time to qualify with the SEC does not accelerate, you will see more companies opting for private placements, including Rule 506(c) which allows advertising to accredited investors. After a successful 506 offering, the company can then go
public at its leisure.
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Resales by Affiliates
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One of the sensible provisions of some state securities laws is to limit fast resales
of insiders by various rules, including escrow of insider stock. This forces the
insiders to develop the company in order to see capital gains.
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Reg A+ allows 30% of the stock sold to be sales by existing holders even if the issuer has no net income
from continuing operations.
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As we know, many successful startup companies, companies that have been acquired at huge prices, have never
had net income.
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Allowing insiders to sell is very beneficial if the insiders have been making a large
financial sacrifice to build their company, as is quite common. For example, the founders may be of an age where they want to send their children to college.
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Selling stock allows the key executives to get back into decent financial condition.
However, investors may be less enthusiastic about an offering if they see large sales by insiders in the offering.
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Secondary Market
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Secondary trading is important to those who want to sell their investment, be they
investors or insiders.
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The Reg A company can trade on OTCMarkets Pink Sheets, giving the
company limited visibility and costing $4,200 per year with a $500 setup fee.
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To move up on OTCMarkets to OTCQB status, the company would have to pay to OTCMarkets $2,500 application fee and
$10,000 per year.
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These are not very attractive options. Pink Sheet stocks are shunned by
serious investors and costs are important to small companies.
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The SEC believes that “Tier 1 offerings will be conducted by issuers that are
unlikely to seek the creation of a secondary trading market in their
securities.”
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The new Reg A may be used bycompanies that do not want a secondary
market, but are seeking simply to take in money in lieu of classic venture
capital investment.
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These companies may have failed to get venture capital, or they may not be willing to accept the terms offered
by venture capitalists.
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Reg A+ amends Exchange Act Rule 15c2-11(a) so that an issuer’s ongoing reports filed under Tier 2 will give the specified
information about an issuer and its security that a market maker must review
before publishing a quotation.
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There are advantages in forgoing venture capital money and instead seeking private investors. Venture capitalists may drive a harder bargain than private investors. The company insiders will not have to give up
a large degree of control. The company can advertise widely in a Tier 2 deal.
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However, all investors look to have an exit strategy which could be an immediate
secondary market, registration rights, or some other method.
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Rule 144
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It would be impossible to overestimate the importance to small, growing companies of Rule 144, which allows the resale by investors of securities purchased outside of a public offering. Having such an exit
strategy encourages investors to write checks.
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Under the new rule, Tier 2 ongoing annual and semiannual reports do not satisfy the
current information requirements of Rule 144 for the entire year.
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The SEC did not believe that the frequency of the required Tier 2 ongoing reporting merits a broad determination that such reports will constitute “adequate public
information” or “reasonably current information” on a year-round basis. Only
quarterly reporting can do this.
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Semiannual reporting is required under the final rules for Tier 2 offerings. Thus companies will only have “adequate current public information” for the
portions of the year during which the financial statements of such issuers
continue to satisfy the respective rules.
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The company may voluntarily submit on Form 1-U quarterly financial statements or other information necessary to satisfy Rule 144.
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Issuers wishing to register Regulation A securities under the Exchange Act
can file a Form 8-A with the qualification of a Form 1-A. Only issuers that follow
Part I of Form S-1 in the offering circular can use Form 8-A.
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Application to a Developing Company
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Some believe the new Rule is a great boon to companies needing
crowdfunding. We assume that a company like this has a hot new technology, one that might grow
rapidly with proper funding.
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Typically such companies are making losses to get developed. The founders are
often taking limited salaries and have invested most of their own capital. The company is seeking outside investors because it has exhausted friends and
family.
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The company may or may not have angel money. It may not have successfully
gotten venture capital or it may find that VC terms are too rich or the founders may
not want to give up control.
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Often the company does not have large cash reserves for up front costs.
Being publicly traded will help the company attract money as it will allow
investors to have an exit strategy.
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Let us look at how the new Reg A might impact such a company. In
terms of time, if the offering is processed rapidly, the new rule may help. In terms of time and money the company has a key decision to make
in getting an audit or not.
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Personally, I believe that an audit will increase the marketability of the deal
because an audit will increase investor confidence. Further, a company without
an audit can only trade in the Pink Sheets. Pink Sheet stocks are shunned by many
investors.
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However, the company must be careful in its selection of an auditor as time
and money can be lost here.
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As always with small companies, a huge marketing effort is needed to overcome
the fact that the company is unknown and overcome the prejudice against small
companies. The new Rule may be of some help here if the company is Tier 2, another
reason to go for an audit.
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Summary
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Small issuers have to look to the time and expense of getting an audit and
weigh that against the costs and limits of state rules in Tier 1.
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The issues presented are time, up front expense, restrictions on advertising, and
merit review. As an audit will create more trust, it may be desirable for
marketing reasons. The audit will move the company into Tier 2 which may allow the company more options for advertising.
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In Tier 2, the company will also escape state merit review. The
company should also look to how it wants to approach having a secondary
market for its securities.
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Overall, any rule which increases the options of small, growing companies is a good rule. Much will depend on how it is implemented and the speed
of processing filings.
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Questions – email me at John.Lux@ Securities-Law.info
(240) 200-4529
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