By Sarah Kaplan
Businesses will soon be able to advertise their stock and debt offerings publicly, without an expensive legal registration, and raise an unlimited dollar amount for the first time since 1933.
To understand what a big deal this is, think about this: $898 billion of private capital was raised in 2012. In 2011, $849 billion was raised privately. These numbers are around 40 percent of all capital raised in this country. (Source: the SEC’s publication in the Federal Register. See pages 18-19 for a helpful chart.) This money-raising was all done privately, because securities law prohibits public advertising of unregistered securities—but only for a couple more weeks. As of September 23, 2013, new federal rules will allow advertising to the public.
I think a shift in the investment landscape is coming. People are hungry for ways to move away from business as usual, and make an impact with their investment dollars instead. So I think social and environmental businesses have a huge opportunity here if they offer small investments (e.g. $500 or $5000) and advertise publicly.
But first—to make clear what we’re talking about, I’ll give an extremely quick primer on securities law. Any time a business offers someone the opportunity to invest and get a return without the investor actually doing any work, that’s a “security.” Stocks, loans, and revenue-sharing agreements, for example. Securities must either be “registered” or must fit into some exemption from the registration requirement. National registration is a gigantically expensive process—think IPO. It involves very large legal and accounting fees, and that’s why only big companies do it. Most businesses raise capital through exemptions, and most use “Regulation D.” These offerings are called “private placements.” Right now, offers and sales of unregistered securities must be done privately, to people with whom the business has a preexisting, substantive relationship. That all changes, though, when the new rule takes effect on September 23, 2013.
Under new Rule 506(c), a business wanting to raise capital may advertise an offering of stock or other investment to the public. To take advantage of this rule, you MUST make sure everyone who purchases the offering is an accredited investor. The term “accredited investor” means individuals with a net worth greater than $1M (excluding the primary residence); individuals with an income greater than $200,000 or married couples with an income greater than $300,000; businesses and trusts with assets greater than $5M; and banks and other institutions. (Regs are here. An easier-to-read definition is here.)
A business offering a security must gather enough information to form a reasonable belief that each buyer is an accredited investor. That could look like asking for and reviewing W2s, 1099s, or other IRS forms, bank and brokerage statements, appraisals of property, credit reports, and a written statement that the investor has disclosed any liabilities. (These are examples, NOT requirements.) It is OK to hire someone to do this accredited-investor-checking for you as long as you have a reason to trust that third party.
So there are some costs to raising money this way. Business owners will need to do the advertising, gather the info from prospective purchasers to verify accredited investor status (or pay for that service), keep records to show they followed the rule, provide disclosure docs to avoid fraud claims, and, of course, provide a return on the investment. But these costs should be lower than the cost of finding and pitching to a VC, plus the business owners will probably be able to keep more control over their business.
The SEC estimates that there are about 8.7 million households that qualify as accredited investors in the U.S., or 7.4 percent of all U.S. households. On September 23, a business raising capital will potentially be able to connect with millions of investors, rather than being limited to people known for being investors, who may be getting pitched to constantly. Instead of doing significant networking and playing a game to become an insider, a business will simply … advertise. Now you might be thinking, wow, this is huge. As of Sept. 23, your company will have access to many more investors who care.
How will this change our economy—our cities, towns, and countryside? It’s true that this rule change is not the beginning of real crowd investing. We’re still waiting for the SEC to issue rules that will allow the investment crowdfunding part of the JOBS Act to take effect. The rule change on September 23 will only open up sales to “accredited investors”—wealthy people. But I think this rule alone will still allow for real change in local economies. The real impact will be that more and more investors will put small amounts of money into businesses they believe in.
Here’s why. Most wealthy people aren’t venture capitalists, they’re just people who’ve saved money or own a successful business. Now that they have extra money, they have to put it somewhere. So they put it in brokerage accounts. They invest in big companies’ stocks, and funds (made of big companies’ stocks). Do they do this because they’re passionate about it? No. That’s just what’s available.
But the story in a lot of people’s minds is: “I know I’m supporting Monsanto and Raytheon, and I don’t like that, but I don’t know what else to do. The social index fund isn’t a great alternative. I think I’d like to really diversify, like going in on a local business.” When businesses that are values-based offer this kind of investor the chance to invest small amounts – $50? $500? $2,000? – plus a basis to believe they’ll get a return – they’ll go for it. I know I would.
The result: a lot more solar panels. More fresh local food available in more places. Businesses in low-income neighborhoods that showcase the passion and creativity of people who live there. And stronger local businesses. This local bike shop was funded by friends. A building with affordable apartments in Chicago was financed by the developer’s friends, rather than by a bank. A small shift in the amount of money each investor puts towards values-based investments, times a large number of investors, very well might make a huge change in our communities.
The SEC is not predicting a boom in social enterprise. That federal agency has to make its best guess on the effects of each rule change, and when it estimated the effect of new Rule 506(c), it said some things that don’t take people’s values into account. The SEC concluded that “only a small percentage of these households [accredited investors] are likely to participate in securities offerings, especially exempt offerings.” (See p. 24 of this Federal Register pdf.) That was based on the fact that right now, only a small percentage of investors participate in private offerings, and only a small percentage of investors have sizeable direct stock holdings. The SEC assumed that direct stock ownership of publicly-traded stocks is a “gateway” to making direct investments through new Rule 506(c). This overlooks the possibility that many accredited investors will make many small investments (but not too small to make a difference), and that many people think of direct investments in local businesses as a way to diversify from traditional investments. The SEC does say it’s reasonable to predict that the rule change will make it easier for issuers to find investors, and that it will reduce the cost of conducting offerings and raising money.
As passion-driven social entrepreneurs connect with values-driven investors, the rule change has the potential to change the landscape of investing, which will actually change our physical landscape too.
Do you think my predictions are wrong? How can investors best support the businesses they’d like to see in this world while doing their best to make money?
Sarah Kaplan is a business attorney serving green businesses, co-ops, and social enterprise. She focuses on community capital and cooperative development, and she’s super excited to be a fellow at the Sustainable Economies Law Center in 2013-2014. See more for green business and social enterprise on her blog.