While the COVID-19 pandemic has made capital formation more challenging for start-ups, the situation isn’t nearly as dire as one SEC Commissioner suggests. As we have seen firsthand, many entrepreneurs and startups are successfully funding and growing their businesses.
Last month, Commissioner Hester Peirce of the U.S. Securities and Exchange Commission (SEC), delivered a lovely paean to an 18th Century founding father of modern Japan in a speech she gave to the Institute for Excellence in Corporate Governance at its 18th Annual Corporate Governance Conference. But in what I view as a misguided portion of her otherwise scholarly presentation on Japanese economic history, Peirce criticized America’s regulatory system for startup and early-stage corporate fundings, claiming there are "intricately thick regulatory barriers" that make it difficult for entrepreneurs and start-ups to raise capital. Among other views with which I disagree below, Peirce stated "Regulatory barriers are surmountable by the wealthy, well-connected and entrenched, but the people who could benefit the most by joining forces with friends and neighbors to build a profit-making enterprise that serves their communities have a much more difficult time."
Ms. Peirce owns respected credentials as a researcher and public servant, but my decades of actual experience in assisting hundreds of entrepreneurs and start-ups to go from zero capital and zero sales to funded business operations, and many to becoming publicly-traded companies, shows America’s capital formation rules and regulations to be much friendlier than her dark description. Simply put, our system doesn’t need fixing. As new ideas arise or become popular, tweaking the rules can be beneficial. The JOBS Act is an example. Live examples are plentiful, including several offerings I counseled recently: three $50 million dollar SPAC IPO’s, a number of venture fundings in the millions of dollars, and a $100,000 SAFE (Simple Agreement for Future Equity) funding for a college student’s startup described below.
The Existing Exempt Offering Framework Works Just Fine for Start-ups
Peirce pointed specifically to exempt offering rules under federal and state securities laws that she claimed make it difficult for startups to raise capital. Contrary to her positing of “barriers,” I have been writing and lecturing for years about how the various exemptions, many adopted or significantly improved over recent years, have made raising start-up and early-stage capital easier than ever. Rules and regulations adopted or modified in the last decade helped make it relatively simple to raise start-up and early-stage capital in “friends and family,” in SAFE and in Series A early capital raises, which can readily raise from tens of thousands to hundreds of thousands, and even many millions of dollars of capital with relatively little paperwork and almost no government filings required for the offering of securities by a startup or early-stage enterprise to a few investors.
Just last week, William, an entrepreneur (still in college) with a start-up with no sales or revenues, found an investor through a college friend for a $100,000 seed capital SAFE investment. The investor thought highly of William’s business idea. Before even consulting me, William found a model form investment agreement for a SAFE, a usable six-page form readily available on the Internet. William sent the investor the model form for the proposed SAFE investment in his startup and asked the investor to confirm his interest. I anticipate requiring only a brief discussion (assuming no substantial negotiations) in order to draft a subscription agreement with appropriate risk acknowledgments and minimal modifications of the SAFE William sent to the investor. For such a one-on-one type of transaction, the exemptions from the actually thin “regulatory barriers” are so readily apparent, that all that is needed for a closing is the business plan presentation William developed, the signed subscription agreement containing appropriate risk disclosure, the signed SAFE, and a review and “clean-up” of the corporate kit William ordered. This documentation can satisfy exemption requirements – so where is the $20,000 (or even the $5,000) cost Peirce derides? The legal fees for this SAFE funding transaction are more likely to equal the cost of a good laptop. Maybe Peirce meant to include major firm accounting fees and other costs in her estimates that William’s transaction and most early capital rounds don’t require.
When an entrepreneur’s business is in a more advanced stage than William’s start-up, reviewing the existing corporate records for corporate clean-up adds to the cost, as does offering a more complicated investment vehicle, such as a convertible loan, a unit with stock and warrants, and an employee stock option plan. Here again, accountant’s fees may become involved, raising the costs, but attorneys’ fees for more sophisticated offerings than Willams’ SAFE remain only a very small percentage cost of the funds raised; it’s a percentage comparable to what credit card companies charge businesses that accept payment by their credit cards. Even an offering to a number of investors in various states and countries can be relatively free of the “thick regulatory barriers” the report on Peirce’s speech didn’t identify. Exemptions from registration are readily available from federal law and from the state blue sky laws, but filing notification of the offering with certain states where investors reside, and a simple Form D filing with the SEC is recommended. None of this fits the “intricately thick regulatory barriers” Peirce decries. And her estimates of fees are not in line with the legal fees charged by most firms for many start-up transactions.
Legal Fees Are Not a Barrier for Start-ups and Entrepreneurs
In a nutshell, any entrepreneur with a modicum of business skills and a start-up or early-stage company, who seeks to raise funds to develop or to grow the business, can do a family and friends initial financing round at the cost of a quality laptop or two. I have done multi-million dollar venture capital raises at similar relatively low costs to the issuer, where the funding was a typical Series A preferred convertible stock structure or a convertible loan. Absent time-consuming negotiations, or correcting past missteps by the entrepreneur, there is no good reason for a start-up that must husband its raised capital, to incur legal fees that Peirce is reported to assess as “up to $40,000” for a venture capital raise. This is not to say that Peirce’s “up to” is never true, but it is as limited and incorrect for smaller deals like Williams’ transaction as the “up to 70% off” discount sales prices one sees in store windows.
"Compliance does not come cheaply," Peirce said. Here, I disagree again with regard to the start-up costs she was reportedly critiquing. Start-up compliance requirements with federal and state securities laws is easily accomplished and not costly. To the extent Peirce means to reference compliance with registration, even where that is required, it is an inexpensive process with little paperwork for startups and early-stage financings.
I also disagree with Peirce’s off-base analysis that: "For startups not located near or connected to angel investor and venture capital networks in major coastal cities, the accredited investor definition severely limits their pool of potential investors.” The world-wide reach of the Internet, the exemptions from registration for an offering of any size made to accredited investors located almost anywhere in the world, along with the trillions that have been raised this way, all contradict Peirce’s unsupported claim that our system is inferior to Japan’s. In her speech, she dramatically (and politically) described our system as "[a] highly regulated environment, which minutely prescribes what companies can and cannot do, [and] undermines the integrity that [the Japanese system] understood to be key to capitalism...." Conversely, she described the Japanese system as making the investment opportunity to all, “regardless of class” (whatever that means). People with spare money, risk-able capital, invest; those without money they can’t easily afford to lose shouldn’t invest in start-ups. It is called risk capital for a reason. Hence, the definition of “accredited” investors, which was recently expanded to included those with lesser wealth and greater experience in investing. That said, a limited number of non-accredited investors are permitted, which usually can be found to have occurred in the initial formation fundings and in the friends and family round, “regardless of class.”
Peirce’s several general statements notwithstanding, Congress and the SEC have done well in easing regulations for capital formation. America’s system for creating and financing the most influential and numerous new businesses in all areas of industry, science and thought is historic, well-documented and exampled daily, with newly-minted, privately-held, college student developed Unicorns. We look forward to helping William in his progress to such a result. We’ve done it before, with one doctor’s startup idea, which we incorporated, helped structure and fund privately, and then bring public, having achieved a trading market capitalization today of $63 billion.
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If you have any questions or if you would like to discuss these issues further,
please contact Dan Brecher or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.