Raising Money Under the JOBS Act

Everybody knows that there’s no such thing as a free lunch. Raising money on the market costs money; but how much? As usual, the answer is: it depends.

According to Fusion-io’s (FIO) S-1 prospectus, they estimated that it would cost them $1.2M to raise $120M for their IPO. Similarly, HomeAway (AWAY) estimated that their cost for raising $140.7M was $3.5M. Simple math gives us a figure of about 1-2% for estimated costs, as a percentage of expected amount raised — and that only includes the direct costs.

Public companies also incur additional costs to stay public, such as costs related to annual reporting, compliance, etc. But these costs do not scale down well enough. That is, the $1.2M for FIO included fixed costs, and so did the $3.5M for HomeAway. So, for companies that are on the market for a smaller amount, it is not always feasible to go public.

One of the most popular ways to accomplish non-IPO money-raising today is a private placement under Rule 506 of Regulation D. Rule 506 permits the sale of securities to an unlimited number of accredited investors and up to 35 unaccredited investors. Unlike with an IPO, under Regulation D investors get restricted securities which cannot be freely resold in a secondary market.

Another way of offering securities is through Regulation A. Regulation A permits the issuance of liquid, unrestricted securities to unaccredited investors. However, there is a $5M limit on the amount of the offering under this regulation.

The JOBS Act passed recently by Congress is intended to help companies that are in need of extra capital. The act creates a new category of company, the “emerging growth company,” which is defined as a company that had less than $1B in revenues during its most recently completed fiscal year, and that completed its IPO after December 8th, 2011. To qualify as an emerging growth company — and therefore to qualify for the reduced regulatory burden mandated by the JOBS Act — the company must meet these criteria, and must declare itself as an emerging growth company in its SEC filings.

To date, 608 companies have identified themselves as “emerging growth companies”.

The JOBS act removes some disclosure requirements for these companies, thus potentially reducing the costs associated with regulatory compliance and capital-raising activities. In particular, it gives a company more time (up to 5 years instead of just 2) to become compliant with Section 404 of the Sarbanes-Oxley Act. Companies that fall under the act are also exempt from certain provisions of Section 14A of the Securities Exchange Act of 1934.

But being an “emerging growth company” has consequences beyond those outlined in the JOBS Act. It may also expose the company to additional risks, including the risk that investors may not accept such limited disclosures. Also, if a company decides to elect an extended adoption period for new accounting rules and regulations, as is permitted under the act, its financial statements may not be comparable to those of other public companies. These risks should be clearly disclosed in financial statements. Since April 2012, the SEC issued comments to 84 companies asking them to provide additional disclosure about risks that the emerging growth election might pose.

The act also brings changes to the rules of sale of unregistered securities. For the Regulation A election, the JOBS Act lifts the ceiling to $50M (up from the current ceiling of $5M), which may make such sales much more attractive for some businesses.

A recently released GAO report shows that, between years 2008-2011, 12 Regulation A offerings, 15,711 Regulation D offerings, and 1,289 Registered Public Offerings under $5M were filed. Yet the report indicates that there is a major impediment that is not related to the total amount restriction. GAO lists the state blue sky laws and lengthy state registration requirements as the main reasons for choosing not to use Regulation A. In other words, registration under Regulation A is costly.

The increased offering amount may sweeten the deal for some, since the fixed costs related to reporting would now constitute a smaller portion of the money-raising costs. The practical implication of the GAO report is that unless states change the Regulation A registration process, the $500M exemption under the JOBS Act may not significantly increase the number of Regulation A offerings — and Regulation D will remain the primary way for small companies to raise capital.

What about companies that need to raise seed money — the initial funding needed to start a new business? Until recently, options were limited to traditional angel investors or a circle of family members and friends. The crowdfunding provision of the JOBS Act may open new ways of raising initial investments.

Under that provision, companies would be permitted to raise up to $1M without registering shares with the SEC. To qualify for the exemption, the issuance must be executed through a broker (which may prove to be costly for such a small offering) or a funding portal. It is not yet clear how those portals would operate. The SEC is currently soliciting comments on the implementation of the crowdfunding provision, with the final regulation expected in January 2013.