Until recently, small companies interested in raising cash through the sale of their own stock were almost always faced with the time-consuming and costly task of registering their offering with the Securities and Exchange Commission.
Since April, however, a new set of SEC rules, called Regulation D, has allowed small firms to enter the equity capital market with significantly less red tape. A company seeking up to $500,000, for example, can now sell stock through a brokerage firm to an unlimited number of investors without having to register the offering. A year ago, no broker would have touched such a deal because commissions on small private offerings weren't permitted.
Regulation D also has important advantages for companies needing more than $500,000 but less than $5 million. They, too, can sell unregistered shares as long as they follow the SEC's special rules on investor qualifications discussed below.
Wall Street professionals still see some obstacles in the practical application of the new rules, but nearly everyone agrees that Regulation D is good news for many companies that previously were shut out of the equity capital markets. The SEC has been receiving hundreds of calls from businesses asking for more details, according to SEC staff attorney Daniel Abdun-Nabi.
Here's how a company seeking capital may benefit from Regulation D:
Up to $500,000. Perhaps the biggest break for small private companies comes from rule changes that apply to securities offerings of less than $500,000. The SEC's commissioners think that some deals are simply too small to warrant Uncle Sam's involvement, so an exemption from federal regulation is allowed. Under previous rules, this advantage used to apply only to stock offerings of $100,000 or less.
The section of Regulation D, called Rule 504, that applies to private offerings in the less-than-$500,000 category permits equity and debt issues, limited partnership interests in oil and gas ventures, and any type of security to be sold without registration to an unlimited number of purchasers. Prior to Rule 504, the number of investors was restricted to 100.
One of the most promising features of Rule 504 is that brokerage firms, which previously had no incentive to take part in such deals, are now allowed to charge as high a commission as the market will bear. (Observers expect those fees to be 15% to 20% of the offering.) In the belief that broker-dealer involvement provides safeguards for investors, the SEC chose to remove the ban on commissions on small offerings in order to bring the expertise and sales organization of investment bankers and brokerage firms to the aid of small businesspeople.
Yet despite the new opportunity, brokerage firms aren't rushing to underwrite Rule 504 offerings. They cite the economics of handling an issue as small as $500,000 as the principal deterrent. At 15%, the commission would be only $75,000, points out Mike Novom, a vice-president of Philips, Appel & Walden, a New York City brokerage firm. Out of this fee would come commissions to salespeople, the firm's overhead, and days or weeks of research time. Thus, few think that large or even medium-size Wall Street firms will hustle after Regulation D deals.
One drawback to Rule 504 is that securities sold under the Regulation D exemption are "restricted" securities. A warning must appear on each stock certificate stating that it was sold without registration and that its resale is limited. Investors must hold restricted securities for two years before selling them again. "People tend to wonder if the company will even be around after two years," comments Seymour Zwickler, an executive vice-president in the Miami office of Rooney, Pace Inc., a Wall Street firm. "So unless the restricted stock offers an outstanding venture situation or an excellent tax shelter, it's difficult to market."
Regulation D or not, any sale of stock must also meet the provisions of the securities laws of the states where potential investors live. Because these rules, known as "blue sky" laws, vary greatly from state to state, a company's attorneys would have to analyze the firm's proposed offering thoroughly before giving the go-ahead for the sale of securities that may draw investors from more than one state.
When Regulation D was first proposed last year, SEC chairman John Shad urged states to model their rules after those of the SEC, thus simplifying small securities offerings to investors across state lines. However, getting states to make the necessary changes won't happen overnight and many experts expect it to take years.
$500,000 to $5 million. Once you get over the $500,000 ceiling, a different exemption from SEC registration applies. Regulation D, under separate Rule 505, lets all companies, closely held or public, sell unregistered securities for up to $5 million as long as specified conditions are met. To begin with, as in the under-$500,000 category, shares can't be resold in the first two years. But unlike Rule 504, the number of investors permitted to buy Rule 505 securities is limited to 35, unless some of them can pass a test as "accredited investors."
Who are accredited investors? In essence, they are savvy sophisticates who the SEC figures are able to fend for themselves without the protection provided by registration. Included in the commission's definition of accredited investors are banks; insurance companies; investment companies; pension plans and tax-exempt organizations such as college endowment funds with more than $5 million in assets; directors and officers of the company raising the equity capital; and individuals with net worth of more than $1 million, or annual income of at least $200,000 for the last two years and an expectation of at least the same amount in the third.
Under Rule 505, a company can place unregistered securities with an unlimited number of accredited investors, and, as long as the total offering doesn't exceed $5 million during a 12-month period, with 35 nonaccredited investors as well. Investment banker Zwickler believes that the strict definition of the accredited investor is one of the most important features of Regulation D. "The determination of whether an investor qualifies is no longer left to the broker's subjective judgment, so possible legal liability is greatly reduced," he notes.
Because accredited investors are expected to be able to take care of themselves and get investment information through their own research, there are no requirements for prospectuses, financial statements, or annual reports, provided the entire offering is sold to those who are accredited. But if just one of the investors fails the "accredited" test, the issuing company must provide a disclosure document listing financial and corporate information to all its investors.
What happens if, after the entire offering is sold, it turns out that an investor didn't qualify? Rule 505 has an escape clause for this purpose. If the issuing company and its underwriter "reasonably believe" that all investors meet the requirements at the time of the sale, nobody can be held liable for not making a disclosure document available.