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When the JOBS Act was finalized, one of the rule changes that had a lot of fanfare around it was the increase in the number of shareholders a private company could have. Prior to the JOBS Act, it was 500, after which point the company had to register and report to the SEC just like it was a public company (even if it hadn’t gone public.) This was a major issue for many fast growing companies that either went through strange contortions not to have 500 investors, or filed with the SEC to get no-action letters. There were plenty of nuances around this rule and I was in the middle of several situations that structured around it legally. Each time it was a lot of overhead for the company in question, none of which added anything to the system except fees to the lawyers.
Lifting the number of investors to 2000 seemed to make sense. In the situations I was involved in it would have immediately solved the specific problem. So that’s good.
But ever since we started working with AngelList on FG Angels, we’ve been wrestling with something called we’ve been referring to as the 99 Investor Problem. We structure our investment in companies via an LLC that has all the individual FG Angels syndicate members in it. This simplifies life for the company as they only end up with 1 investor – the FG Angels syndicate LCC – rather than a bunch of individual investors. At this point we have 217 backers in our syndicate, so with us each company would end up having 218 separate investors if we didn’t use the LLC.
If everyone was on the cap table, the company would have to chase down 218 signatures for everything. Instead, using our approach, they have effectively two investors – our FG Angels syndicate (one investor) and Foundry Group (another investor). Two signatures. Much easier. We handle the Foundry Group signature. AngelList handles the syndicate signature.
Except it doesn’t work that way. The SEC limits an LLC to having 99 investors. So we can only have 99 of the 217 syndicate members participate. Now, there’s a nuance that excludes “qualified purchasers” (QPs) – individuals with $5M in assets and firms with $25M in assets – from the 99 investor count. Overall our QPs + the top 99 investors in our syndicate represent $321,000 based on committed amounts to FG Angels. If you include the balance of the 237 members, we end up at a syndicate of $439,000. The company then gets our commitment of $50,000 on top of that.
As a result of this 99 investor limitation, we have two disappointing problems. First, we have over 100 investors who would like to invest in our syndicate with us who get excluded because of the 99 investor rule. Next, there is $118,000 per investment that we’d like to include in each syndicate that the companies we are investing in won’t get. Bad for the companies and bad for the investor.
We’ve spent lots of time over the past 60 days trying to solve the 99 investor problem. At this point, we’ve run into a dead end. We’ve tried multiple LLCs – that doesn’t work as they end up getting viewed as a single entity. We’ve tried other structures – that doesn’t work. We’re certainly open to ideas at this point.
In the mean time, until we solve this, AngelList is making the following changes to their Syndicates product.
- Qualified Purchasers: AngelList will include all Qualified Purchasers (individuals with $5M in assets and firms with $25M in assets) in each syndicated deal as they are exempt from the SEC’s 99-investor limit. We will soon email your backers to determine if they are Qualified Purchasers (QPs) and we will update your syndicate management interface to indicate the QPs.
- Top 99 Backers: The next time you syndicate a deal, we will include all QPs and the top 99 non-QPs by commitment amount. You can override this default to include specific backers who are not in the top 99. The top 99 backers will change dynamically as backers adjust their backing amounts.
- Funds: We are working on new funds products to allow additional investors who are not in your top 99 backers or QPs to participate in your syndicated deals.
- Notifying Backers: Finally, we will notify your backers of the SEC’s 99-investor restriction this week and give them the opportunity to change their backing amounts.
We are bummed about this because part of our goal is to build a very large angel network as a result of the FG Angels activity. The 99 investor rule directly undermines this, and limits the amount of investment and support for the companies we are investing in. It’s another example of the challenges of the JOBS Act and another discovery on our part of the “miss” between the goal of the new law and the implementation.
Did you know Twitter is going public? Of course you did – it’s all the mainstream media could seem to write about last week after the now infamous twitter tweet about it.
We’ve confidentially submitted an S-1 to the SEC for a planned IPO. This Tweet does not constitute an offer of any securities for sale.
— Twitter (@twitter) September 12, 2013
After all the speculation about valuation, who owns what, what it’ll price at, how much money will be made, is Twitter growing or shrinking, what is a tweet after all, will their stock symbol be TWIT?, and all the other nonsense that seemed to consume the business press, I noticed a perplexing thread from some people expressing how indignant they are they Twitter is going public in secret.
I watched it play out and tried to understand what people were reacting to. Eventually, I realized it was two things. The first is a misinterpretation of the JOBS Act and what a confidential S-1 filing actually is. Somehow there was the view that there wouldn’t be the normal public disclosure prior to Twitter going public, which is just incorrect. The second was some weird reaction to Twitter suddenly being “secretive” and a view that this was in fundamental philosophical conflict with what Twitter is.
After four days of chatter about this, Dan Primack wrote the first definitive article I saw that made sense of all of this titled Twitter’s IPO will not be done in secret. As is typically the case, Dan wrote a super clear and fact based article about what was going on with the confidential filing, how it would work, and why – in Dan’s words – “Twitter’s decision to file confidentially is neither bad nor good. It’s largely irrelevant.”
I won’t repeat Dan’s awesome article – go read it if this topic interests you.
Having been involved in numerous IPOs, I can tell you that the JOBS Act confidential filing process is a great thing and improves the overall process of taking a company public. Anyone who has been through taking a company public knows that there are numerous steps between the first S-1 filing with the SEC and the final filling where the SEC says “ok – you are ready to go public now.” This process is almost never smooth, is unpredictable in terms of timing, and often ends up being an bizarre and byzantine interactions between the SEC, accountants, lawyers, investment bankers, and management team members who scratch their heads and realize that the process isn’t really making anything any clearer, it’s just racking up massive fees for the lawyers and accountants.
The end result is a fully vetted S-1 filing. When a company has this cleared by the SEC, it is ready to go public. Prior to the JOBS Act, you made your first filing before any feedback from the SEC and then spent the next three to six months wrestling with the SEC – on their time frame and their rules – to get the filing finalized. If you didn’t time it right, you’d have to do new financial disclosure. If the SEC was slow because they had a backlog, it would take longer. If the SEC didn’t agree with your auditors on revenue recognition, you’d end up in a crazy escalating set of discussions. And – each amendment to the S-1 (basically a new filing) was done in public, so everyone – including your competitors – got to see everything that was going on. And dissect it. And criticize it. And analyze it. And act on it. And say anything they wanted about it.
During this time, you were in a “quiet period” so you couldn’t say anything in response. Your competitors attack you based on data in your S-1 filing through a plant in an article in the WSJ – nope, you can’t say anything. The NY Times writes a long article and misinterprets a bunch of the data – nope – silence. A blogger tears you apart for something buried on p.123 of the S-1 which ends up getting changed in a future filing anyway – nope silence.
Or worse – for some reason the IPO window closes and you don’t go public. You withdraw your filing. But the public data is still out there for everyone – especially your competitors and customers to see. Oops.
Under the new rules you do all of this work to get to a final filing in confidence. You make it public three weeks before you go on the roadshow. You make all the documents public, but the only one that really matters is the final one. The sausage got made in private and now you are ready to go public. All the expected articles come out. Everyone dissects all the data. But you are ready for this since you are now ready to go public.
I’m glad Twitter used the new confidential filing process. We’ve already used it for companies in our portfolio, and will continue to. In a few years, the process of taking a new company public will be much cleaner as a result. And while there will always be a huge amount of noise around the process, especially for high profile companies like Twitter, at least there will be a clearly defined timeframe for all the pre-IPO noise.
The JOBS Act, which was approved by Congress and signed by President Obama with much fanfare over a year ago, was intended to help small business. It is, after all, called the Jumpstart Our Business Startups Act. A number of the provisions have been slow to get written into law and the SEC has missed their deadlines on a bunch of stuff, including the often talked about equity crowdfunding activity.
Recently, the SEC weighed in on a number of the things they were required to with much fanfare. Fred Wilson wrote Let The Games Begin in response to the SEC lifting the General Solicitation Ban. However, Fred, and many others, missed the new proposed Amendments to Regulation D, Form D and Rule 156 under the Securities Act. And they look like one scary mess that could undermine the whole thing if approved.
Some posts with analysis of this have finally started to appear. A good summary is by Joe Wallin at his Startup Law Blog titled Proposed Rules Hard on Startups. And I’ve gotten a number of emails with similar analysis. My favorite summary was from a very experienced law firm.
“The SEC giveth (as mandated by Congress) and taketh away (by its own mandate).
It is incredible that the SEC finally got around to implementing rules to remove the ban on solicitation (as it was required by statute to do so in 2012), but concurrently proposes new rules intended to retard the benefits of easing the capital formation process (the goal of the JOBS Act).
The new proposed rules will require a Form D to be filed 15 days in ADVANCE of a Reg 506 offering and after, substantially expand the scope of information required to be disclosed in Form D and disqualify an issuer from relying on Rule 506 for one year if the issuer does not comply with the new filing requirements (including a requirement that the Form D be timely filed). The new rule also would require filing with the SEC of all written general solicitation materials. So much for deregulation!”
Seriously? More commentary from one of the emails I received follows:
“The new rules and rule proposals were a kind of packaged effort to address the Congressional mandate in the JOBS Act, while attempting to maintain investor protection. Apparently, the package was enough to mollify Commissioner Walter, but Commissioner Aguilar was unwilling to go along. In his view, the rules adopted come at the expense of investor protection. He reiterated that the record supports the argument that elimination of the ban on general solicitation will facilitate fraud and viewed the adoption of the rules without appropriate safeguards as “reckless.” He also contended that the proposal to study the practical effects and then adopt rules if necessary would come too late – closing the barn door after the horses have already escaped. Although he voted for adoption of the disqualification rule, he also objected to the narrowing of the categories of individuals covered, as well as the application to only prospective events, especially given the two-year delay in adoption of the final rule. On the other side of the aisle, Commissioners Paredes and Gallagher both objected to the proposal to facilitate monitoring of market changes resulting from elimination of the prohibition. They both viewed the proposal as placing an undue burden on capital formation and undermining the objectives of the JOBS Act.”
While the “proposed rules” are still “proposed”, hopefully the SEC will reject these new proposals, especially in the context of Congress’s mandate to Jumpstart Our Business Startups.