On Thursday, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act). This Act, comprised of several bipartisan-supported bills designed to ease capital-raising for small businesses, will undoubtedly be a major game-changer for capital raising and the business of investing in startups. What follows is an analysis of the most important sections and what these changes will mean for startups.
“Crowd funding” typically connotes a way of financing a project or business, usually through online means of bringing investors and capital-raisers together. Congress in its ever-clever acronymous legislative action gave Title III a short title of “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012″ — or the CROWDFUND Act.
The CROWDFUND Act allows companies to raise startup capital from a large number of investors each investing just a small amount. Investors are limited in the amounts they can invest: if the investor’s annual earnings or net worth is less than $100,000,they can invest the greater of $2,000 or 5% of their annual income; if their net worth and annual earnings is greater than $100,000, they can invest 10% of annual income or net worth, not to exceed $100,000.
On the issuer’s side, the aggregate amount of stock sold to all investors cannot exceed $1 million per year. The Act also imposes other disclosure requirements on the issuer such as providing investors with certain company information and a stated purpose describing the uses for which the capital raised will be used. Most notably, the Act requires the issuer to sell its stock through an intermediary “broker or funding portal,” who must register with the SEC.
The usefulness of this is still unclear and we’ll have to wait until the final regulations are released (due in 270 days) to really know. There is cause for doubt, though, in the act itself. First, the Act requires a great deal of information to be provided about the company, its issuers, the founders, and the securities being offered. In most cases, to get this right is going to require a lot of time by lawyers and accountants (who, by the way, still bill by the hour). Second, the bill provides a pretty broad cause of action against the issuer, AND its officers and directors, for material misstatements or omissions. Given that most startups fail, the real winners here may be plaintiffs attorneys, who will undoubtedly be reviewing with a fine-tooth comb the offering materials of every failed crowd-funded startup looking for some technical misstatement.
General Solicitations in Regulation D Offerings
Regulation D of The Securities Act of 1933 allows companies to avoid costly SEC registration for certain securities offerings. Before the JOBS Act, companies could only offer Reg D securities to persons with whom they had a pre-existing relationship, what is termed a “private offering”. Now, the Act expands this exemption to allow for general solicitations, whereby companies and their brokers can advertise the offering to the general public, although importantly, only accredited investors can purchase.
Every entrepreneur who has ever tried to raise capital (according to the rules) has experienced the frustration stemming from the inability to tell people about the opportunity. This will indeed make it easier for startups to get the word out. Critics though, worry that this allows brokers too much freedom to aggressively advertise stocks to unsuspecting investors — for example, the elderly. I also worry about the noise investment scheme advertisements will generate and the likelihood that it may actually drown out the voices of entrepreneurs seeking capital.
“IPO On Ramp” and “Emerging Growth Companies”
In what has been dubbed the “IPO on Ramp,” the Act designates a new category of “emerging growth” companies and outlines a streamlined IPO process for those companies. The classification for an “emerging growth company” is simple: businesses earning under $1 billion in gross revenue fall within this category’s scope. This classification allows companies to publicly issue stock while exempting them from burdensome disclosure and governance requirements to which larger public companies are subject. It also exempts these companies from Dodd-Frank rules giving shareholders a non-binding vote on executive compensation. The real winners here are VC’s and angel investors as this will create an opportunity for earlier liquidity events. In theory, this should “trickle down” in the form of more active angels and VC’s and perhaps better valuations for the startups.
Private Company Flexibility and Growth
Title V of the Act raises the threshold level on the number of shareholders before a company must go public from 500 to 2,000, thus encouraging a company’s marginal growth without it facing the prospect of filing costly disclosure documents. The need for this stems largely from startups using equity compensation for their employees. Think Facebook.
Regulation A Offerings
Companies who raise under $5 million through an IPO could file under Regulation A to avoid filing periodic reports to shareholders, which conventional publicly-held companies must do. The JOBS Act raises the $5 million ceiling to $50 million, thus easing one burden in issuing an IPO. Regulation A was originally designed as a simplified way to go public in a small way. It has been used rarely in the last decade, however, as the $5 million limit was seen as too low given the costs of compliance with the still someone onerous rules, both before and after the offering. There hasn’t been much attention to this, but we suspect this could generate a new cottage industry of service providers promoting direct private offerings (DPO’s) as again a viable option to raising capital from the public without going through an investment banker.
Should the startup community be happy that legislation permitting crowd funding has finally passed? The bottom line is that it is too soon to tell what kinds of regulations the SEC or state regulators will impose and how the markets will react to these new freedoms. But it is certainly is going to be an exciting couple years watching this play out.
13 Feb 2012
We’ve updated our compilation of startup incubators in Ohio. One notable addition, specifically for Cleveland-based startups, is Dan Gilbert’s Bizdom U, which launched in May 2011. Our goal is to have this resource be as complete and accurate as possible, so if you have any recommended additions or changes, please let us know.
The chart is embedded below, but you can access it directly by clicking here.
26 Jan 2012
Each month the Gillespie Law Group compiles the most recent legislative and regulatory developments that could affect startups, tech companies, and website owners.
“Crowdfunding” Update: As we reported last month, the House approved the Entrepreneur Access to Capital Act, H.R. 2930, known to many as the “crowdfunding” bill. This bill would allow businesses to raise money selling unregistered securities using “crowdfunding,” which is the raising of money through mass aggregation of small investments. Although the bill is strongly supported by the Obama administration, the Senate corollary bill, the Democratizing Access to Capital Act, S.1791.IS, is having a hard time getting out of the Senate because of efforts by the North American Securities Administers Association (NASAA) who has been lobbying heavily against the bill because it would infringe on state regulatory power. Additionally, the bill has been slowed because of two Senate hearings that highlighted the potential for increased fraud under the bill.
The House version of the bill would allow issuers, in any 12-month period, to raise up to $2 million if the issuer provides potential investors with audited financial statements, which is not always cheap. Crowdfunders then must comply with a variety of protective measures including warning investors that certain risks are associated with the issuer and that resales are restricted, as well as by providing the SEC with certain other information. Importantly for crowdfunders wanting to avoid SEC registration, investors who purchase securities under the crowdfunding exemption would not count toward the 500-shareholder threshold for SEC registration in Section 12(g) of the Securities Exchange Act of 1934. The Senate version of the bill does have some significant differences from the House version:
- Securities could only be issued through a “crowdfunding intermediary,” which would exclude raising funds through websites like Facebook and Twitter
- Each investor would be limited to investing only $1,000 in any 12-month period
- While the House bill preempted State registration law, the Senate bill would allow for some State registration requirements
A second Senate bill over this issue is also in the Senate, S.R. 1970, painfully entitled “CROWDFUND,” for “the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act.” The CROWDFUND bill even more narrowly defines what intermediaries investments can be sold through as “funding portals” and investors are limited to the greater of $500 or a 1-2 percentage of his or her annual income, per company to invest in.
General Solicitation. In addition to the the Access to Capital for Job Creators Act, H.R. 2940, the House bill we reported on last month, the SEC’s Advisory Committee on Small and Emerging Companies had made formal recommendations that the SEC should permit general solicitation and advertising in private offerings under Rule 506 where the securities are only sold to accredited investors.
The Access to Capital of Job Creators Act, which passed in the House, would amend Section 4(2) of the Securities Act of 1933 by exempting from SEC securities regulation “transactions by an issuer not involving any public offering, whether or not such transactions involve general solicitation or general advertising.” Importantly, both this bill and the SEC Advisory Committee’s recommendations would generally go against the long-held goal of the securities exemption rules of prohibiting general solicitation of investors by general and open advertising. Instead, both would actually permit general solicitation or advertising provided that all purchasers of the securities are accredited investors and that the issuer has taken reasonable steps to verify that purchasers of the securities are accredited investors.
Internet Law. SOPA and its detractors became major news in the past month with websites such as Google and Reddit actually removing their services from the web for 24 hours on January 18. Recently SOPA and PIPA, a similar bill in the Senate, have been opposed by President Obama and have seemingly been shelved for the time being, however it is likely that new legislation or changes to these proposed bill are coming. For an in-depth look at SOPA, please read our analysis of the bill: SOPA – Cutting Through the Hype.
Prior to entering into negotiations with an angel investor or venture capitalist there are multiple due diligence-related items the VC will want evaluate in order to make the decision whether to invest in your company, and if so, how much they want to invest. Failing to properly plan for these issues can at best slow down the process and at worst completely derail the deal. However, the good news is that with some forethought and preplanning, you can have many these issues squared away from the beginning.
Register Your Company
First, regardless of whatever entity type you have chosen (Delaware C-Corp is the most typical for venture capital investment), you need to make sure that you have properly registered with the formation state and that all of your formation documents are in place and organized in a way that can easily be shared with an investor. These documents should clearly state the ownership, include vesting provisions for the founders, and be structured in a way that will allow for future investment from outside parties without too much procedural difficulty. Additionally, it is important to keep detailed corporate records. The lawyer who helps you with your initial formation can help you understand and plan these details.
When it comes to intellectual property, an investor is going to want assurances that no one outside the company will have any claim to the IP the company claims to own. To do this, somewhere in the company’s formation agreements should be language that assigns all IP to the company and if not, it should explicitly outline what is owned by whom and under what arrangement the Company is using those rights. Additionally, you may want to have started registering any trademarks, copyrights, or patents your company has created.
Similar to IP ownership, you should make sure to have all of your contractual agreements solidified. This includes everything from referral agreements to perhaps the most important, employment agreements. You should be able to identify who is an employee and who is an independent contractor and have the documentation to back it up. Not only will documentation suggest to the investor that you are highly organized and a good investment, but these agreements will ensure no surprises down the line with employees and independent contractors, regardless of whether there is impending investment or not. Employment issues, especially when dealing with intellectual property ownership, can be a particularly difficult problem if not dealt with early.
Having these issues dealt with before engaging with an investor will help to ensure smoother negotiations and possibly more company-friendly terms once V.C. or angel investment becomes a reality. While you may be able to handle some of these issues on your own, your lawyer can help to ensure that some of the trickier issues like vesting provisions and intellectual property assignment are completed properly.
30 Sep 2011
Over the past year, the tech startup world has seen a significant increase in the number of incubators throughout the country. Incubators – sometimes called startup accelerators – are organizations that work with entrepreneurs to develop their startups. Often, in exchange for a small stake in the startup, an incubator’s staff of advisors and mentors assists the startup in areas such as product development, concept evaluation, capital acquisition, strategic business planning, and technology support. Many also provide their clients a small amount of funding to develop their products. The best incubators may be most valuable for the access they can provide to potential investors and a huge pool of talent.
Entrepreneurs and startups have taken notice of the resources incubators can offer as both supply and demand of the incubator market has increased drastically over the past year. As of August 2011, we’ve counted at least 64 known U.S. incubators. This number has grown from 34 in 2010, and new incubators are springing up from California to Texas to Massachusetts and to most major cities in between. Existing incubators are also expanding their operations and increasing their number of startup clients.
Although the incubator market has undeniably taken off, the recent expansion of the number of incubators has led to questions over whether the incubator market is sustainable. Some critics argue that the increase of incubators has created (or perhaps just indicative of) a bubble that is bound to pop. Under the typical model, an incubator earns money when one of its clients hits it big, and the incubator is able to sell the stake it holds in the company for a profit. Obviously not every startup an incubator works with is going to be the next Facebook, so there is no guarantee that an incubator will profit from working with and investing in a given startup. Since the number of incubators looking to work with startups keeps growing, critics worry that there will not be enough successful startups to keep incubators profitable. Plus, the more startups that incubators produce, the harder existing startups will have to compete to attract investor attention.
In contrast, proponents argue that the current incubator boom is sustainable and has even become a necessity in some areas of the country. With the Obama administration, other government agencies, and private investors pledging billions to spurring startup development lately, supporters of incubators point to the increase of startups looking for professional help. The rise of incubators is simply a response to the rise of startups and the increased focus on small business development. In communities like Detroit that are in desperate need of an economic boost, incubators are needed to rapidly develop and refine startups so that they can start having an impact on the local economy as soon as they are financially viable.
Whether the current incubator boom is sustainable or not, these companies can serve as a valuable resource and guide for tech startups. Leading incubators like Y Combinator and TechStars have paved the way for successful startups like Dropbox and Justin.tv. Incubators have the potential to rapidly accelerate an entrepreneur’s business over a relativity short period of time and can sometimes provide much needed sources of funding and expertise. Not all programs are created equal, however, and as always it’s important to do your homework before entering into any equity sharing arrangement.
The good news for local startups looking for an incubator is that they do not have to travel to the west coast as Ohio is home to a number of established incubators. Three of the most established are highlighted below:
The Brandery, a Cincinnati incubator, was recently rated the 10th best startup accelerator in the U.S. (click here for the Top 15 list). In exchange for a 6% diluting warrant in a startup, The Brandery offers $20,000 in seed funding, free office space, product development, consumer research, legal support, brand identity, and a number of other services. The incubator also maintains a staff of over 50 mentors comprised of chief marketing officers, company executives, attorneys, and marketing experts.
TechColumbus, based in Columbus, OH, focuses on working with information technology, bioscience, and advanced material startups. TechColumbus offers office and lab space, a team of experts, executives, and Ph.Ds, and access to capital from a variety of sources. An incubator with a proven record, TechColumbus has had almost 90 companies gradate from its program, and 75% of those companies have realized sales or commercialization success.
JumpStart, Inc. focuses on startups in Northeast Ohio. A private, nonprofit organization, JumpStart seeks to assist startups who have the potential to generate $30-50 in revenue within five to seven years after working with the incubator and who will be located in the 21-country-area of Northeast Ohio. JumpStart invests in a startup using convertible debt, i.e. providing a loan that eventually converts to equity, and in exchange, the company provides 18 to 24 months of intensive development and $250,000 or more in early-stage investment.
For more information on incubators, see this list of Ohio startup accelerators maintained by The Gillespie Law Group.
The chart is embedded below, but you can access it directly by clicking here.
TechColumbus recently released its annual Central Ohio Innovation Capital Report which provides a comprehensive overview of funding trends within Central Ohio for 2010. The full 2010 Central Ohio Innovation Capital Report is available here.
TechColumbus research indicates that over the past year (2009-2010), innovation capital increased nearly 73% to over $307 million in Central Ohio. Innovation capital, which includes all sources of funding—venture capital, angel investments, loans, grants, etc.—provides crucial financial support to entrepreneurial businesses. In 2010, 117 enterprising companies received a share of the record-setting funding. This figure represents a nearly 43% increase over the number of young companies receiving such capital funding in the prior year.
Not only did a record number of companies receive a share of record levels of innovation capital, but, according to TechColumbus, the capital was distributed across all stages of growth. Startup firms need seed capital to cover expenses and to help expand the brand before the company is profitable. In 2010, TechColumbus reported that more than $113 million went to 66 earliest-stage companies (representing a 44.56% increase from 2009 levels). Venture capital and angel investors provided over $48 million in funding with Central Ohio investors committing just under half of this amount. (For more information on seed funding for Ohio companies, see this list of capital sources maintained by The Gillespie Law Group.)
Earliest-stage innovation capital ($113 million) was spread across various sectors with Healthcare and Advanced Material companies obtaining the most funding. The table below provides a breakdown of funding by sector for 2010.
|Earliest-Stage Innovation Capital by Sector||Total Innovation Capital||Percent of Innovation Capital|
|Advanced Material||$30.18 Million||26.69%|
|Information Technology||$16.21 Million||14.34%|
|Retail & Consumer||$8.44 Million||7.47%|
Equally important, however, is a source of exit funding for the founders of a successful business. A lack of such funding can inhibit startup companies because founders do not have a clear way to get out of their investment. TechColumbus reports that more than $194 million in exit funding was brought in by seven companies in 2010 (a dramatic increase over 2009 levels).
The report concludes that the availability of early-stage funding and late-stage exit funding provides entrepreneurs vital capital at critical times and has helped contribute to a friendly entrepreneurial climate in Central Ohio. However, in order to continue attracting later-stage capital, young companies must be funded when they are in the early-stage and growth phases. Without a continuous supply of companies—at all stages of growth—in the entrepreneurial pipeline, later-stage innovation capital may be stymied. The report ends with the cautiously optimistic view that investment activity in Central Ohio is increasing, but that there is still a significant need for future funding if the region is to retain its growth trajectory.
25 Mar 2011
I’ve updated our compilation of sources of capital available to startup companies in Ohio. The list includes angel groups, venture capital funds, innovation funds and some incubators offering financing alternatives. Our goal is to have this resource be as complete and accurate as possible, so if you have any recommended additions or changes, please let me know.
The chart is embedded below, but you can access it directly by clicking here.
05 Jan 2011
Venture Capitalists (“VCs”), Angel investors (“Angels”) (i.e., accredited investors), and Business Development Companies (“BDCs”) fulfill generally the same role: to help small and medium-sized companies obtain financing when more traditional means of funding (e.g., bank financing) are unavailable. Bank financing, though, almost always requires accounts receivable, inventory, buildings, equipment or other assets that can be held as collateral for a loan or line of credit. Smaller companies, startup companies, individuals with a business idea, or medium-sized companies that do not have sufficient funds to grow their business often do not have the capital required, nor do they have the requisite assets or accounts receivable required by traditional banks to meet their loan requirements. This is where Angels, VCs and BDCs come in.
Angels are regulated by the Securities and Exchange Commission (“SEC”) and generally must be “accredited investors” with a net worth of at least $1,000,000 in order to invest in startups. VCs are generally partnerships of accredited investors that provide the same type of funding. In the case of both Angels and private VC firms, these activities are, by regulation, the realm of wealthy investors and beyond the reach of most individuals.
In 1980, Congress created BDCs to provide public investors or retail investors a means to invest in small-to-middle market, private U.S. businesses. BDCs investors are not required to be accredited or high-worth individuals. Typically, BDCs are structured to originate and hold debt and equity investments to maturity and can invest across a portfolio company’s capital structure. While BDCs and VCs have similar investment goals, BDCs and VCs differ in that the shares of BDCs are traded on the major exchanges, and anyone can own them. BDCs typically pay significantly higher dividends than the average company, and many consider BDCs a valuable part of a diversified portfolio.
Start up companies might consider turning to BDCs as an additional source of capital. Some of the larger, more established BDC’s are Ares Capital Corporation, American Capital Strategies Ltd., Apollo Investment Corporation, BlackRock Kelso Capital Corporation and Prospect Capital Corproation. Since all BDCs are registered with the Securities and Exchange Commission, more information can be found in the offering materials available at www.sec.gov.