2021 Annual Report of Office of Advocate for Small Business Capital Formation
The Office of the Advocate for Small Business Capital Formation (“Office”) has delivered a report to Congress following the 40th annual small business forum (“Report”). The Report includes recommendations of the Office and its annual forum participants. The forum itself featured panelists and discussions on (i) navigating ways to raise early rounds; (ii) diligence including how savvy early-stage investors build diversified portfolios; (iii) tools for emerging and smaller funds and their managers; and (iv) perspectives on smaller public companies. The forum itself had a focus on diversity, including panel speakers and discussion topics. A clear message across the board is that women- and minority-owned businesses face the biggest challenges in the capital markets.
Background
The SEC’s Office of the Advocate for Small Business Capital Formation launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat.
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
The SEC hosts the annual Government-Business Forum on Small Business Capital Formation pursuant to the Small Business Investment Incentive Act of 1980. The SEC delivers a report to Congress each year following the forum. Since its formation, the Office of the Advocate for Small Business Capital Formation has been responsible for the report’s preparation and dissemination.
Report on the 40th Annual Small Business Forum
Navigating Ways to Raise Early Rounds
From a high level, the vast majority of early financing comes from friends and family. Following that, companies also look to angel investors, venture capital investors, Regulation CF offerings, Regulation A offerings, and public offerings (less common in early stages). To help source investors, companies tend to look to network referrals, broker-dealers, accelerators and incubators, social media, demo days and even the public press.
The largest barriers to early round financings include: (i) networks and finding connections to investors; (ii) navigating laws, policies and regulations; (iii) investor bias; (iv) personal wealth or assets (finding accredited investors); (v) information, education and knowledge; and (vi) valuations or offering terms. In my experience, the biggest barrier to initial capital raising efforts is simply finding investors. The forum spent a significant time touching on the difficulties facing minority and business owned women as well as the social impact of diversity matters in today’s world. Once a company begins to raise capital, puts the funds to good use, and illustrates execution on its business plan, each round of capital raising becomes relatively easier. However, businesses and founders should be particular to work with investors with the same goals and management views.
Forum participants discussed many topics and concerns surrounding early capital raising efforts. Although details of the discussion on preparation were not included in the report, a discussion of this important topic is warranted. Businesses and entrepreneurs should be prepared for capital raising opportunities including by maintaining complete and well-organized corporate records, an up-to-date business plan, executive summary or PowerPoint deck and up to date (conservative) projections. Before a company can package a private placement offering or effectively negotiate with a venture or angel investor, it has to have its proverbial house in order. See HERE for a discussion on pre-deal considerations.
Preparation also means understanding various fund-raising options and structures. All securities offerings must either be registered with the SEC or subject to an available exemption. Generally, very early rounds of financing are completed with friends and family acting as the investor base, but even then there must be an available securities law exemption. Most friends and family rounds rely on an intrastate exemption, such as Rule 504 or Rule 147 (see HERE for more information on intrastate offerings ) or Rule 506 where investors are accredited (see HERE and HERE for more information on Rule 506). Likewise, when accepting funds from angel and venture capital investors, a company generally relies on Rule 506.
As a company passes the initial friends-and-family round, crowdfunding is a great option and gives entrepreneurs an opportunity to learn to pitch and present to a larger audience. For more on crowdfunding, see HERE. Now that the offering limit for crowdfunding has increased to $5,000,000 and special-purpose vehicles can be used to streamline a cap table, crowdfunding has become and will continue to become a great option, either concurrently with or before larger angel and VC rounds. Ultimately, a company can move to public Regulation A offerings (see HERE) and IPO.
In addition to understanding the allowable offerings, a business and entrepreneur needs to be prepared to discuss the offering structure. An equity instrument can take the form of common stock, preferred stock, securities token, LLC membership interest, limited partnership interest, or warrant or option or any other right, title or interest in a company’s ownership, including its profits or revenue streams. In addition, some equity instruments, such as preferred stock or LLC membership interests, can have numerous different features including dividend rights, voting rights, liquidation preferences, conversion rights, redemption or put rights, anti-dilution provisions and negative covenants, just to name a few.
A debt instrument can take the form of a promissory note, convertible note, or debenture each having the same general meaning. A debt instrument can either be convertible into equity or not convertible. Like equity interests, a debt instrument can have a plethora of features and deal terms to best suit the needs of the investor and business. For a detailed discussion of investment structures, see HERE.
Reverting back to the Report, the forum participants made several recommendations to the SEC related to assisting in early capital raising efforts. The SEC responses to the recommendations were unfortunately very generic and political, not providing any assurance of forward action. The recommendations and SEC responses, include:
- Recommendation – Ensure capital raising rules provide equitable access to capital for underrepresented founders and investors.
SEC Response – The SEC points to the exempt offering rule amendments adopted on November 2, 2020. For a summary of those rules, see my five-part blog series – HERE; HERE ; HERE; HERE; and HERE. The SEC indicates that in the rule release, they acknowledged concerns about how capital markets are serving underrepresented founders and investors, encouraged further specific, tangible suggestions for action by the SEC, and expressed its commitment to continued engagement on this topic. Unfortunately, that answer does not move the needle.
- Recommendation – Establish a micro-offering exemption with minimal disclosure requirements.
SEC Response – The SEC has sought and received comment on a micro-offering exemption as part of its general requests for comments related to the exempt offering structure. The SEC will continue to consider comments and recommendations in this regard.
- Recommendation – Revise Regulation Crowdfunding to remove the GAAP financial statement requirement for businesses seeking to raise a small amount.
SEC Response – The SEC sought comment on this prior to the recent amendments to Regulation Crowdfunding and will continue to consider comments and recommendations in this regard.
- Recommendation – Provide state preemption for secondary transactions for shares issued under Regulation A and Regulation Crowdfunding.
SEC Response – The SEC sought comment on this prior to the recent amendments to Regulation Crowdfunding and will continue to consider comments and recommendations in this regard.
- Recommendation – Clarify the status of digital assets to make clear when it is a security
SEC Response – The SEC referred to its DAO Report published in 2017 and the Howey test analysis (see HERE) and its 2019 Analysis Matrix applying Howey (see HERE). Despite the SEC’s rather flippant reference to previous guidance, SEC Chair Gary Gensler has been vocally pushing Congress to expand the regulatory framework related to digital assets and in particular cryptocurrencies to strengthen and solidify the SEC’s role as top regulator over the digital asset marketplace.
Due Diligence
The second topic the forum focused on was due diligence including understanding what savvy investors the importance of introducing minority accredited investors to the work of angel investors and start-up financing as a method to improve financing options for minority- and women-owned businesses. Investors that have trouble finding opportunities can use social media and other public methods of expressing interest, though I note that kind of approach can result in a deluge of unqualified leads.
An integral part of preparation for fund raising, as discussed above, is ensuring that due diligence materials are well organized and complete. Corporate records should be maintained, asset ownership documented, and intellectual property protected. Every company should have a well-put-together investor-facing deck, business plan and/or executive summary. Advisors, friends and mentors are a great source to review materials and issue spot. The forum specifically discussed the importance of having a business thesis that aligns with investment goals of angel and VC groups.
The forum participants made several recommendations to the SEC on this second topic. The recommendations and SEC responses include:
- Recommendation – Expand the accredited investor definition to include other measures of sophistication, such as specialized industry knowledge or professional credentials.
SEC Response – The SEC referred to the amended accredited investor definition adopted in August 2020 – see HERE and the expansion of the definition to include certain licensed securities representatives. The SEC would consider designating additional qualifying professionals and will consider specific requests to do so. Any request must address how a particular certification, designation, or credential satisfies the non-exclusive attributes discussed in the rule release.
- Recommendation – Expand retail investor access to funds that invest in private offerings and support underrepresented entrepreneurs.
SEC Response – The SEC is considering the recommendation.
- Recommendation – Expand the accredited investor definition to include an investor certification course or test whose curriculum has been approved by FINRA or the SEC.
SEC Response – The SEC repeated its response to the fist recommendation above.
- Recommendation – Create more and better wealth-building opportunities for retail investors to build and support resilient and equitable local economies.
SEC Response – The SEC once again pointed to the amended accredited investor definition but also indicates it is open to any specific ideas or recommendations.
- Recommendation – Adopt rules and coordinate with the states to allow community investment funds with sufficient regulatory oversight and flexibility to pursue community-based investments.
SEC Response – The SEC indicates that it will consider any specific recommendations.
Tools for Emerging and Smaller Funds and Their Managers
The third topic of the forum focused on small and emerging fund managers including the challenges for this group such as a lack of track record, access to investors, regulatory barriers to entry and the significant personal financial risk for a fund’s general partner. However, these small and emerging funds are hugely important to our economic ecosystem as a whole and are the most likely institutional investor to invest in women and minority owned businesses.
The recommendations and SEC responses on this third topic include:
- Recommendation – Increase the number of investors allowed in 3(c)(1) funds above the 99 limit.
SEC Response – Any amendment to this provision would require congressional action.
- Recommendation – Increase the $10 million cap for 3(c)(1) qualified venture capital funds to allow a larger number of investors in small funds.
SEC Response – Any amendment to this provision would require congressional action.
- Recommendation – Support underrepresented and emerging fund managers and their investors through targeted resources, in collaboration with other federal agencies.
SEC Response – The SEC clearly believes that it already is making strides in this regard, citing its recent publication of a “Cutting Through the Jargon” glossary helping individuals learn the capital markets lingo. The SEC cited a few other similar initiatives. Like the rest of the responses, I’m sure this response did not resonate as a significant effort.
- Recommendation – Expand venture capital funds’ qualifying investments to include fund-of-funds investment in another venture capital fund, secondary securities acquired from founders and early stage investors, and follow-on investments in emerging growth companies.
SEC Response – An investment adviser to venture capital funds may qualify as an exempt reporting adviser that is not required to register with the SEC if the fund invests at least 80 percent of its assets in “qualifying investments” under Rule 203(I)-1 the Investment Advisers Act of 1940. A “qualifying investment” generally consists of any equity security issued by a qualifying portfolio company that is directly acquired by a qualifying fund and certain equity securities exchanged for the directly-acquired securities. Although such qualifying investment does not now include secondary purchases and investments, the SEC will consider adopting changes.
- Recommendation – Support underrepresented emerging fund managers – specifically minorities and women – building funds that diversity capital allocators, engage sophisticated investors, and challenge pattern matching trends.
SEC Response – The SEC believes it supports such efforts and indicates that it will consider any specific recommendations.
Perspectives on Smaller Public Companies
The final topic of the forum focused on smaller public company issues. The top issues discussed include costs of compliance, the burden of reporting requirements, short-termism or the pressure for short-term results and stock movement, obtaining research coverage and supporting trading volume and liquidity. Generally, all smaller companies have the same top priorities including understanding their shareholder base, meeting the demands of investors including those focused on ESG issues, attracting more institutional investors, engaging with retail investors and communicating effectively with shareholders.
The recommendations and SEC responses on this final topic include:
- Recommendation – Improve research coverage of smaller public companies in light of challenges from the Global Research Settlement, FINRA 2241, MiFID II, and other obligations on broker-dealers.
SEC Response – The SEC is looking into the matter. Also in November 2019, SEC staff extended temporary no-action position until July 2023 and stated its view that the use of certain client commission arrangements does not affect whether the broker-dealer exclusion may be available in connection with the receipt of payments for research under Exchange Act section 28(e).
- Recommendation – Increase the public float thresholds in the “smaller reporting company” and “accelerated filer” definitions.
SEC Response – The SEC amended the smaller reporting company definition in June 2018 (see HERE) and the accelerated filer definition in March 2020 (see HERE).
- Recommendation – Increase the transparency of short selling and dark pool activities.
SEC Response – NYSE, Nasdaq, FINRA and OTC Markets publish short selling information. The SEC is considering the recommendation.
- Recommendation – Facilitate creation of venture markets that provide investors with a transparent and regulated environment for trading in stocks of smaller companies.
SEC Response – A one-size fits-all approach to market structure does not work for many public issuers, particularly small and medium-sized companies. The SEC has invited exchanges and other market participants to submit proposals designed to improve the secondary market structure for exchange-listed equity securities that trade in lower volumes, commonly referred to as “thinly traded securities” (see HERE). I note that the request for input was issued two years ago and the SEC has not taken any action since.
- Recommendation – In connection with any new environmental, social, or governance (ESG) disclosure requirements, provide exemptions or scaled requirements for small and medium-sized companies.
SEC Response – The SEC will consider the recommendation.
« OTCQX And OTCQB Rule Changes SEC Cracking Down on The Crypto Wild West and Other Digital Asset Updates »