We are on the verge of what could be a real revolution in how small and middle market companies finance themselves.
The 2012 JOBS Act is the “change agent” which, when fully implemented, should enable commercial borrowers to find investors and lenders using public means of solicitation, without the aid of middlemen and without registration with the SEC. The effect on brokers and small institutional private equity shops could be significant as companies choose to bypass or supplement costly distribution and funding and instead go directly to family offices, high net worth investors and small institutions.
The JOBS act changes the funding game by eliminating some of the key existing restrictions on the process of seeking investors. Prior to the JOBS Act, the SEC had a say in who companies could solicit for money and how the solicitation had to be structured. Post implementation of the JOBS Act, many of those restrictions will be gone.
For as long as anyone can remember there have been two key SEC rules that have limited debt and equity funding transactions. First, since the 1930s it has been illegal to offer unregistered securities to investors using public means of solicitation. Second, since the early 1980s the SEC has asserted that syndicated loans should in some circumstances be treated as “securities”. As a result of the legal ambiguity caused by this assertion, it has not been standard practice to reach out to potential investors using mass solicitation without first being registered with the SEC – a process that is often costly, time consuming and sometimes even impossible for small issuers.
The current way of doing things hasn’t been good for small and middle market companies. It’s expensive, fraught with transaction risk and puts artificial barriers between investors and investments.
However, the JOBS Act could change everything.
The JOBS Act seeks to change the game by eliminating some of the existing restrictions on the process of soliciting investors, thereby providing companies with potential funding from additional non-public sources. Specifically, it will allow small and middle market companies to use general advertisements to solicit individuals and investment funds for capital (of course fraudulent advertising/disclosure and other actions that were illegal before the JOBS Act are still off limits). And, if they invest, qualified individuals can take the place of banks, private equity firms, mezzanine funds and other sources of capital and liquidity.
For example, once the JOBS Act is fully implemented, businesses will be able to solicit investors by purchasing TV, radio, newspaper or internet ads without breaking the law.
The JOBS Act will take a large step towards leveling the playing field for capital investments between big companies and small companies and between banks and non-bank lenders. Before the JOBS Act, most of the time only big companies could afford the cost of publically offering their debt to investors and only banks and SEC-registered entities could get large amounts of funding from individuals. Post JOBS Act, anyone will be able to receive funding from qualified individuals and small companies will be able to use any means of solicitation that works best.
This could be great news for small companies that feel like they are being held hostage by banks, PE firms, mezzanine lenders, investment bankers and other sources of wholesale funding.
Since the JOBS Act is like a silver lining, we cannot forget the cloud that it lines. There are open questions with respect to JOBS Act implementation, and there is fine print that needs to be read and understood. The JOBS Act imposes some important rules that need to be followed when using general advertisements to solicit investors. While some of the more important rules are set forth below, readers who want to take advantage of the JOBS Act are encouraged to retain experienced counsel. This article is designed to provide general information only and does not constitute formal legal advice.
Below is some of the fine print:
- The JOBS Act can’t be relied upon until the SEC finishes issuing rules. As of the date of writing this article, i.e., February 28, 2013, the SEC has not issued final rules and the new JOBS Act provisions relating to public solicitation for private securities offerings cannot be relied upon. The SEC was mandated by law to issue final rules by July, 2012, a deadline that was missed. The draft rules issued in August 2012 provide some guidance and insight into the new regime, but remain in draft form, and there will likely be changes in the final rules. But, sooner or later, the final rules will come out and the JOBS Act will be ready to go.
- Not everyone can invest – only “accredited investors”, institutional investors and other similar entities can invest. The burden is on the issuer to make sure that the investors qualify. Generally, individual investors will qualify as being accredited if their family net worth is greater than $1 million, exclusive of the value of the primary residence, or their annual family income is greater than $300,000 for married couples and greater than $200,000 for single people.
- All anti-fraud rules continue to apply. The information provided to investors must be materially accurate and complete. Both Federal and state anti-fraud and securities anti-fraud laws continue to apply, and we expect the authorities to be vigilant in this area.
- A broker/dealer may be required to help with the offering. Depending upon the nature of the offering, a registered broker/dealer may be needed to facilitate the process of accepting investor money and executing the offering.
- Size limits will apply on how big companies can become before they need to register with the SEC. Companies will be required to register with the SEC once they have $10 million or more in assets and either 2,000 shareholders of record or 500 shareholders of record who are not accredited investors.
- There are significant legal risks if the borrower defaults. When borrowing from individual investors or having individual investors purchase stock, companies need to be very careful not to borrow money that they cannot pay back and to do a good job for shareholders. As a practical matter, the legal risks of default or loss of investment dollars are very different when money is borrowed from individuals rather than from the bank. Judges and juries often have a harsh view of of a company when “widows and orphans” are harmed.
- All other securities, tax and state and local laws such still apply. The JOBS Act didn’t repeal every law that might apply to a small business issuer. All other laws still apply.
Even so, the JOBS Act is game changing legislation.
Once fully implemented, the JOBS Act should provide small and middle market businesses with access to diversified sources of funding at a reasonable price and with lower transaction risk.
The effect of the JOBS Act on the community of professionals that provide and arrange funding for small and middle market companies will likely be profound and positive for those that make good use of the reforms. However, the future may not be so bright for those companies and executives that don’t change with the changing regulatory environment.
Note: The article is a guest post by Mark Sunshine and Trayton Davis. Mr. Sunshine is Chairman & CEO of Veritas Financial Partners, a leading national financial services firm that provides senior secured credit facilities to small and medium sized businesses. Mr. Davis is a Partner at Milbank, Tweed, Hadley & McCloy, an international law firm.