Monday, December 9, 2013
If you have an interest in entrepreneurship and innovation, or if you just want to know more about the company whose boxes are currently appearing on porches across the nation, read Brad Stone’s new book, The Everything Store: Jeff Bezos and the Age of Amazon.
Stone is not a corporate shill; his portrait of Bezos is not always flattering. But the book is well written and entertaining, and a good study of what made Amazon successful. Budding entrepreneurs could derive a number of important lessons from Jeff Bezos.
The Goal of a Business is to Serve Customers
Entrepreneurs often chase the wrong rabbit. The goal of a business is not to create the fanciest technology. The goal of a business is not to get ready to make a public offering. The goal of a business, and the way it makes money, is to serve customers—to fulfill some customer need more effectively than any other company.
It’s clear that customers have been Bezos’ top priority from the beginning, and that’s what has made Amazon successful. The most obvious example of that philosophy? Putting both positive and negative customer reviews on the Amazon web site. We take that for granted now—many online retailers do it—but it was business heresy at one time. I have foregone some purchases because of those negative reviews, but those reviews are also one of the main reasons I keep going back.
Innovation: You Have to Break Eggs to Make an Omelet
Forgive the cliché, but innovation depends on risk-taking. For every success, there are many, many failures. Jeff Bezos has wasted a lot of money going down blind alleys, but once in a while, those ideas have paid off in a major way. Amazon is successful because of its willingness to fail.
“Good Enough” is Not Good Enough
It is clear from The Everything Store that Bezos is driven to succeed. He demands results and he doesn’t tolerate failure. I don’t think I would want to work for Bezos. If Stone’s portrayal is accurate, Bezos can sometimes be an unpleasant person; ridicule is one of his tools. But that drive, that demand for results, is one of the reasons Amazon has become such a giant.
Costs Matter Too
Profitability depends on two things, revenues and expenses. You have to be willing to spend money to make money (Cliché No. 2). But that doesn’t mean you should spend as much money as possible. I read a lot of business history and the level of extravagance at some start-up companies amazes me.
Bezos is, to put it bluntly, cheap. He doesn’t waste money. He may take the idea so far as to make it a fetish, but that’s better than the alternative.
The “Everything” Store
I highly recommend Stone’s book. It’s an entertaining look at how one company went from start-up to behemoth.
Friday, December 6, 2013
There's an interesting slide show available on Forbes, 10 Terms You Must Know Before Raising Venture Capital.
It's interesting, but it overlooks the most important thing entrepreneurs should know before raising venture capital: the need to hire an experienced lawyer. Learning the terminology won't substitute for representation by someone who knows what he or she is doing.
Monday, November 11, 2013
The SEC’s crowdfunding proposal offers small, startup businesses a new way to raise capital without triggering the expensive registration requirements of the Securities Act of 1933. But the capital needs of small businesses are often uncertain. They may need to raise money again shortly after an exempted offering. Or they may want to sell securities pursuant to another exemption at the same time they’re using the crowdfunding exemption. How do other offerings affect the crowdfunding exemption? The proposed crowdfunding rules are unexpectedly generous with respect to other offerings, but they still contain pitfalls.
Other Securities Do Not Count Against the $1 Million Crowdfunding Limit
The proposed rules make it clear that the crowdfunding exemption’s $1 million limit is unaffected by securities sold outside the crowdfunding exemption. As I explained in an earlier post, only securities sold pursuant to the section 4(a)(6) crowdfunding exemption count against the limit.
Crowdfunding and the Integration Doctrine
But the integration doctrine, the curse of every securities lawyer, poses problems beyond determining the offering amount.
Briefly, the integration doctrine defines what constitutes a single offering for purposes of the exemptions from registration. The Securities Act exemptions are transactional; to avoid registration, the issuer must fit its entire offering within a single exemption. It cannot separate what is actually a single offering into two or more parts and fit each part into different exemptions.
Unfortunately, the application of the integration doctrine is notoriously uncertain and unpredictable, making it difficult for issuers who do two offerings of securities at or about the same time to know whether or not those offerings qualify for an exemption. (For a critical review of the integration doctrine, see my article here.)
The SEC’s crowdfunding proposal begins with what appears to be absolute protection from integration. The proposal says (p. 18) that “an offering made in reliance on Section 4(a)(6) should not be integrated with another exempt offering made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied on for the particular offering.”
However, the SEC giveth and the SEC taketh away. First, this isn’t really a rule, just a pledge by the SEC. The anti-integration language does not appear anywhere in the rules themselves; it’s only in the release discussing the rules. Other integration safe harbors, such as Rule 251(c) of Regulation A and Rule 502(a) of Regulation D, appear in the rules. It’s not clear why the SEC was unwilling to write an integration provision into the crowdfunding rules, but an actual rule would provide much more comfort to issuers than the SEC’s bare promise.
And, unfortunately, the SEC doesn’t stop with the broad anti-integration pledge. It adds (pp. 18-19) that
An issuer conducting a concurrent exempt offering for which general solicitation is not permitted, however, would need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Similarly, any concurrent exempt offering for which general solicitation is permitted could not include an advertisement of the terms of the offering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6) and the proposed rules.
These qualifications may prove particularly mischievous. Assume, for example, that an issuer is offering securities pursuant to section 4(a)(6) and, around the same time, offering securities pursuant to Rule 506(b), which prohibits general solicitation. The issuer would have to verify that none of the accredited investors in the Rule 506(b) offering saw the offering on the crowdfunding platform. Since crowdfunding platforms are open to the general public, that might be difficult.
As a result of the second sentence quoted above, there’s also a potential problem in the other direction. Assume that an issuer is simultaneously offering the same securities pursuant to both section 4(a)(6) and Rule 506(c). Rule 506(c) allows unlimited general solicitation, but the crowdfunding rules severely limit what an issuer and others may say about the offering outside the crowdfunding platform. The SEC seems to be saying that a public solicitation under Rule 506(c) would bar the issuer from using the crowdfunding exemption to sell the same securities. Since the same securities are involved in both offerings, the 506(c) solicitation would arguably “include an advertisement of the terms of the offering made in reliance on Section 4(a)(6).”
Double-Door Offerings Redux
Before the SEC released the crowdfunding rules, I questioned whether “double-door” offerings using the crowdfunding exemption and the new Rule 506(c) exemption were viable. I posited a single web site that sold the same securities (1) to accredited investors pursuant to Rule 506(c) and (2) to the general public pursuant to the crowdfunding exemption. I concluded that, because of the integration doctrine, such offerings were impossible. The SEC anti-integration promise may change that result, if the SEC really means what it says.
The anti-integration promise doesn’t exclude simultaneous offerings, even if those offerings involve the same securities. And I don’t see anything in the rules governing crowdfunding intermediaries that would prevent both 506(c) and crowdfunding offerings on a single web platform, with accredited investors funneled to a separate closing under Rule 506(c). Funding portals could not host such a double-door platform, because they’re limited to crowdfunded offerings, but brokers could.
However, both the issuer and the broker would have to be careful about off-platform communications. Ordinarily, an issuer in a Rule 506(c) offering may engage in any general solicitation or advertising it wishes, on or off the Internet. But the SEC crowdfunding release, as we saw, warns that “any concurrent exempt offering for which general solicitation is permitted could not include an advertisement of the terms of the offering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6) and the proposed rules.” To avoid ruining the crowdfunding exemption, any off-platform communications would have to be limited to what the crowdfunding rules allow, and that isn’t much.
Monday, November 4, 2013
I support crowdfunded securities offerings, but I have criticized the crowdfunding exemption in the JOBS Act. I won’t repeat those criticisms here, but, after wading through the 585-page SEC rules proposal, I am happy to report that some (but not all) of the proposed rules would significantly improve the exemption.
1. The proposed rules clear up the statutory ambiguities relating to investment limits and the amount of the offering
Title III of the JOBS Act includes a number of ambiguities relating to the investment limits and the amount of the offering. The proposed rules clear up those ambiguities. I have already discussed this aspect of the proposed rules and won’t repeat that discussion here.
2. Both issuers and intermediaries can rely on information provided by investors to determine if the investment limits are met.
The amount that an investor may invest in a crowdfunded offering depends on that investor’s net worth and annual income and also on how much that investor has already invested in section 4(a)(6) offerings in the last 12 months. I have argued that crowdfunding issuers and intermediaries should not be required to verify these numbers--that investors should be able to self-certify.
I am happy to report that the SEC’s proposal recognizes the substantial burden that verification would impose and allows both issuers and crowdfunding intermediaries to rely on the number furnished by investors.
Proposed Rule 303(b)(1) allows crowdfunding intermediaries to rely on an investor’s representations as to net worth, annual income, and previous investments unless the intermediary has reason to question the reliability of the investor’s representations. And Instruction 3 to proposed Rule 100(a)(2) allows the issuer to rely on the intermediary to ensure that investors don’t violate the limits, unless the issuer knows an investor is exceeding the limit.
3. The proposed rules include a “substantial compliance” rule that preserves the exemption in spite of immaterial violations.
The crowdfunding exemption’s requirements are detailed and extensive, and the availability of the exemption is conditioned on the issuer’s and intermediary’s compliance with all of those requirements. Most crowdfunding issuers will be relatively inexperienced small businesses and often won’t have sophisticated securities counsel, so violations are likely. The exemption could be lost due to a relatively minor technical violation of the exemption’s requirements.
The SEC solved this problem in Regulation D by adding a “substantial compliance” rule, Rule 508, that sometimes preserves the Regulation D exemptions even when issuers are not in full compliance.
The SEC has included a similar rule in the proposed crowdfunding rules. Proposed Rule 502 provides that a failure to comply with a requirement of the exemption will not result in loss of the exemption as to a particular investor if the issuer shows:
(1) The failure to comply was insignificant with respect to the offering as a whole;
(2) The issuer made a good faith and reasonable attempt to comply with all of the exemption’s requirements; and
(3) If it was the intermediary who failed to comply, the issuer was unaware of the noncompliance or the noncompliance was solely in offerings other than the issuer’s.
4. The proposed rules require the intermediary to provide communications channels for issuers and investors.
As I have discussed elsewhere, the statutory exemption
omits a crucial element of crowdfunding—an open, public communications channel allowing potential investors to communicate with the issuer and each other. Openness of this sort would allow crowdfunding sites to take advantage of “the wisdom of crowds,” the idea that “even if most of the people within a group are not especially well-informed or rational . . . [the group] can still reach a collectively wise decision.” Open communication channels can help protect investors from both fraud and poor investment decisions by allowing members of the public to share knowledge about particular entrepreneurs, businesses, or investment risks. Open communication channels also allow investors to monitor the enterprise better after the investment is made. [C. Steven Bradford, The New Federal Crowdfunding Exemption: Promise Unfulfilled, 40 SEC. REG. L. J. 195 (2012)]
(For more on why I think open communications channels are a good idea, see here, at pp. 134-136.)
Proposed Rule 303(c) requires crowdfunding platforms to provide “communication channels by which persons can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform.” Those communications channels must be accessible by the general public, although only investors who have opened an account with the crowdfunding platform may post.
Thursday, October 31, 2013
I have argued that, because of excessive regulatory costs, the new crowdfunding exemption in section 4(a)(6) of the Securities Act is unlikely to be as successful as hoped. (Rule 506(c) is another story; I expect that to be wildly successful.)
We now know what the SEC anticipates. Hidden deep within the SEC’s recent crowdfunding rules proposal is the Commission’s own estimate of the likely impact of the new exemption. (It’s on pp. 427-428, in the Paperwork Reduction Act discussion, if you want to look at it yourself.)
How Many Crowdfunded Offerings?
The SEC estimates that there will be 2,300 crowdfunded offerings a year once the new section 4(a)(6) exemption goes into effect, raising an average of $100,000 per offering. That’s a total of $230 million raised each year.
How Many Crowfunding Platforms?
The SEC estimates, “based, in part on current indications of interest” (p. 380) that 110 intermediaries will offer crowdfunding platforms for section 4(a)(6) offerings. Sixty of those will be operated by registered securities brokers and the other fifty will be operated by registered funding portals. (Non-brokers may act as crowdfunding intermediaries only if they register as funding portals.)
The Fight to Survive
If the SEC’s figures are correct, and who really knows, that’s an average of approximately $2 million raised per crowdfunding platform. I would expect many of those 110 platforms to fail rather quickly. Given the regulatory and other costs involved, crowdfunding intermediaries won’t survive for very long on 10-15% of $2 million a year. The SEC doesn’t appear to think so, either. They note (p. 380) that “it is likely that there would be significant competition between existing crowdfunding venues and new entrants that could result in . . . changes in the number and type of intermediaries as the market develops and matures.”
Of course, as the proposal itself indicates, it’s impossible to predict exactly what will happen when the rules become effective. But it’s at least interesting to see the SEC’s own guesses.
Monday, October 14, 2013
The JOBS Act offers two new opportunities to offer securities on the Internet without Securities Act registration. Both the Rule 506(c) exemption and the new crowdfunding exemption could be used to sell securities on web sites open to the general public. But could a single web site offer securities pursuant to both exemptions at the same time (assuming the SEC eventually proposes and adopts the regulations required to implement the crowdfunding exemption)?
Background: The two exemptions
Rule 506(c) allows an issuer to publicly advertise a securities offering, as long as the securities are only sold to accredited investors. Rule 506(c) is not limited to Internet offerings, but it could be used by an issuer to advertise an offering on an Internet site open to the general public—as long as actual sales are limited to accredited investors.
The new crowdfunding exemption, added as section 4(a)(6) of the Securities Act, allows issuers to sell up to $1 million of securities each year. The offering may be on a public Internet site, as long as that site is operated by a registered securities broker or a “funding portal,” a new category of regulated entity created by the JOBS Act.
Could a single intermediary do both 506(c) and crowdfunded offerings?
Yes, but only if the intermediary is a federally registered securities broker.
Rule 506(c) does not limit who may act as an intermediary, but the crowdfunding exemption says that only registered brokers or funding portals may host crowdfunded offerings. By definition, funding portals appear to be limited to offerings under the crowdfunding exemption. A funding portal is “any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6).” Exchange Act section 3(a)(80), as amended by the JOBS Act. Thus, funding portals could not act as intermediaries in Rule 506(c) offerings.
The JOBS Act does not impose a similar limitation on brokers, so brokers could act as intermediaries in both Rule 506(c) and crowdfunded offerings.
Could a broker include both types of offerings on the same web site?
The answer to this is probably yes.
Rule 506(c) does not limit the content of the web site, so any limitations are going to come from the crowdfunding exemption. Crowdfunding intermediaries are subject to a number of requirements, but the crowdfunding exemption does not appear to prohibit the inclusion of other offerings on the same web site.
Operating a dual site could be cumbersome. For example, Rule 506(c) offerings could appear on the site's main page, but no investor may see crowdfunded offerings until they satisfy the crowdfunding exemption’s investor education requirements. But unless the SEC rules implementing the crowdfunding exemption prohibit it, dual-exemption sites should be possible.
Could an issuer do a double-door offering, using a single web site to simultaneously sell the same securities in both types of offerings?
I have heard that some ill-advised fledgling intermediaries have plans to do this, but the answer to this question is no. The integration doctrine would not allow it.
Rule 506(c) incorporates the requirements of Rule 502(a) of Regulation D, and Rule 502(a) indicates that “[a]ll sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D.” Section 4(a)(6) of the Securities Act, the crowdfunding exemption, exempts “transactions” that meet the criteria of the exemption.
Under that transactional language, as consistently interpreted by the SEC and the courts over the years, the entire offering must comply with the requirements of the exemption, or none of the sales is exempted. An issuer cannot sell parts of a single offering pursuant to two separate exemptions.
Unless an integration safe harbor is available, and none would apply here, the SEC uses a five-factor test to determine whether ostensibly separate offerings are part of the same transaction. This test considers (1) whether the sales are part of a single plan of financing; (2) whether the sales involve issuance of the same class of securities; (3) whether the sales are made at or about the same time; (4) whether the issuer receives the same type of consideration; and (5) whether the sales are made for the same general purpose.
Under this test, an issuer could not sell a security pursuant to the Rule 506(c) exemption and at the same time sell the same security on the same web site pursuant to the crowdfunding exemption. Those two ostensibly separate offerings would be integrated and would have to fit within a single exemption. (There is vague language in the crowdfunding exemption that might arguably protect against integration, but the argument is a weak one. For a discussion of that argument see pp. 213-214 of my article here.)
Monday, September 30, 2013
The crowdfunding exemption added by the JOBS Act allows issuers to sell securities to anyone, accredited or not, but the amount of securities each investor may purchase depends on the investor’s net worth and annual income. (For more on the new crowdfunding exemption, see my article here.)
Because of these requirements, it is important under both exemptions to know the net worth and annual income of each investor.
NOTE: Many people are referring to Rule 506(c) as “crowdfunding” but the actual crowdfunding exemption is something different. Brokers and others selling under Rule 506 began calling that crowdfunding as a marketing ploy to capitalize on the popularity of crowdfunding. Some academics have adopted that usage, which I think is unfortunate and only leads to confusion.
The simplest way to deal with these requirements would be to allow investors to self-certify. If an investor tells the issuer his net worth is $1.5 million, the issuer should be able to assume this is correct, unless the issuer has reason to suspect otherwise. This is not, unfortunately, the SEC’s approach in Rule 506(c). The SEC still has not adopted the rules required to implement the new crowdfunding exemption, but it’s unlikely to take this simple self-certification approach in those rules either.
In a Rule 506(c) offering, Rule 506(c)(2)(ii) requires “reasonable steps” to verify that any natural person who purchases is an accredited investor. The issuer may do that verification itself, or it may rely on written representations from registered broker-dealers, registered investment advisers, licensed attorneys, or CPAs that they have taken reasonable steps to verify the investor’s status.
Under the non-exclusive safe harbor in Rule 506(c)(2), those reasonable steps could include review of, among other things, the investor’s tax filings, bank statements, brokerage statements, credit report, tax assessments, and appraisal reports. Obtaining and reviewing this information will increase the cost of using the exemption and force investors to divulge confidential financial information that they would probably prefer to keep to themselves.
Why not self-certification? Obviously, people might lie. I might exaggerate my income or net worth in order to qualify to invest in a Rule 506(c) offering or to purchase more securities in an offering pursuant to the crowdfunding exemption. Securities would be sold under Rule 506(c) to investors who aren't supposed to buy them. In crowdfunding offerings, investors could buy more securities than they're supposed to buy.
But these requirements are designed to protect the investors. If I choose to lie about my status, why shouldn’t I forfeit that protection? Why should the issuer be burdened with additional costs just because some investors are willing to lie? As long as the issuer acts in good faith and has no reason to know an investor is lying, what’s the argument for punishing the issuer by denying the exemption? If we want to discourage people from lying about their net worth and annual income, we should punish the liars, not the innocent issuer.