By Sang Hyun Park
For the unsuspecting entrepreneur, the announcement of an “A+” regulation in the venture capital ecosystem may seem like remarkably good news. A closer examination of the terms, however, will leave many venture heads disappointed.
A new amendment to SEC Regulation A, called Regulation A+, now allows young companies to raise up to $50 million in new capital online through “mini-IPOs.” However, the lack of appetite for such offerings since the revision last June points to an unfortunate reality: the amendment is hardly the sea change in crowdfunding that entrepreneurs had imagined.
The concept of a mini-IPO as a way of raising capital has been in existence for some time, but has largely been ignored. The high costs associated with the complex registration process and the ownership costs of going public have been key reasons why small businesses have preferred alternatives such as equity crowdfunding. The recent Regulation A+ was an effort to jumpstart the old system of small offerings by providing several attractive new features. In particular, it substantially increased the amount that young private companies could raise in the offering through general solicitation. Furthermore, it created registration exemptions that would lay off the burden of following through with state blue sky-law compliance. The new regulation was made in hopes of spurring business startups by making capital formation much easier and simpler.
At first sight, entrepreneurs may see many reasons to be excited about Regulation A+. The tenfold increase in the possible amount of capital that can be raised is likely to delight many young executives with ambitions of making a conspicuous splash in the venture capital community. There is also the matter of the considerable savings that small businesses would enjoy from the registration exemptions. Previously, small companies attempting a mini-IPO were required under blue-sky law to register in each state in which their securities would be sold. Companies pursuing second-tier offerings amounting up to $50 million would no longer need to worry about going through such an exhaustive registration process. Perhaps the most notable feature of the regulation is the flexibility of the solicitation process. Issuers would be allowed to “test the waters” by communicating to investors via social media and measuring possible investment amounts before deciding to formally register. Moreover, even non-accredited investors in the public would be allowed to chip in, no matter how miniscule the amount.
So why haven’t we seen more mini-IPOs this past year? It turns out that, despite the hype, small initial public offerings are still not the ideal funding path for ventures for a number of reasons. Ventures seeking to go public under newly expanded rules may find relief from registration exemptions but will have to stomach the ongoing costs of audits and reports to the SEC. According to a report by the Financial Executives Research Foundation, latest estimates for the average audit fees that public companies pay on a yearly basis is approximately $1.5 million. While such fees will be drastically lower for smaller firms, they will still materialize to a significant slice of their revenues. This has created an incentive to cut corners by turning to unqualified registration consultants for their offerings, oftentimes leading to faulty registrations that would ultimately be rejected by the SEC. Thus, even for ventures with stellar prospects of expanding their businesses, the extra layer of costs to their operations from having to prepare audited statements will be hard to ignore.
This is not to mention the traditional reasons why young ventures hesitate in going public: ownership dilution and mandated transparency. For young companies just beginning to scrape together a viable business model, the dilution in ownership and pressure from venture capitalists could create complications and distract them from their company goals. Moreover, the transparency required from having to publicly disclose financials at a regular basis can hurt any competitive advantage companies may already possess or will develop with additional capital. Especially for young ventures, it is entirely possible to overlook such long-term difficulties in a rush to secure short-term funds.
It’s also worth noting that the costs do not end with simply registering the products. There are considerable costs involved in marketing the products to the public. In a traditional IPO issued by mid- to large-cap companies, the investment banks advising on the deal would easily take care of this by turning to their equity capital markets and sales force teams, taking the issuer on a roadshow to meet with institutional investors and carefully structuring offerings based on an analysis of the issuer’s needs and investor demand. Such a system will be hard to duplicate in the mini-IPO environment; without the same level of expertise that large investment banks can provide, microcap companies will find it more challenging to market their products to the public. More fundamentally, the investors themselves will not only be harder to identify but also be a tougher crowd to convince. As the amendment allows growth companies to raise from unaccredited investors, the sources of funding will be less predictable than when raising from recognized institutions. In addition, while institutional investors will typically examine each investment opportunity through careful analysis of the financial merits, investment decisions by the everyday American will typically be more psychologically-driven. Companies looking to issue a mini-IPO will thus need to spend extra attention to their marketing investors, recognizing that they will address a completely different investor base.
This is hardly to say, however, that Regulation A+ has added no value to the venture capital community. With its flexibility and grander scale, there are still many contexts in which the regulation could make sense for later-stage ventures seeking to raise capital. In particular, venture-backed companies that are either generating or have prospects of generating substantive revenue will most likely be able to sustain the accounting and registration costs that would put small companies without stable revenue-generating ability underwater. In December, real estate crowdfunding company Fundrise raised $38 million through the new regulation. As the world’s first online real estate investment trust, their dominance in the market for real estate crowdfunding fully enabled them to pursue and effectively execute the offering. More recently, Elio Motors raised $16 million in a Regulation A+ offering, topping their $12.6 million hurdle for funding their newest prototype. What was truly impressive about the offering was not the amount of the offering but the time in which it took place. Due to the market volatility caused by record low oil prices, there were very few regular IPOs that took place by February, when the deal was closed.
If this is any indication, mini-IPOs can be successful, and in some cases, wildly so; the only problem is that, in the current environment, they will only work for a very narrow segment of ventures and startups. Both Fundrise and Elio Motors had fully credible business models and ample prospects of growth through the new initiatives they would undertake. They were also well ahead of their competitors. Perhaps most importantly, the executives truly believed in the significance of going public. As CEO of Elio Motors, Paul Elio, put it, “Regulation A+ is how Wall Street was meant to work.” For a large portion of later-stage ventures, it is hard to see all three conditions in place. At the very least, companies will be ill-advised in pursuing a mini-IPO without seeing revenue streams taking shape and prospects of achieving greater profitability by adding the extra millions on their balance sheets.
With all the hype that had built up over the amendment, most startups will find the offering process still less than satisfactory. The regulation may have given a leg up for small companies looking to raise capital, but it has hardly made it more desirable. Early-stage ventures without a clear business model or a revenue stream in progress will do well to stick with existing crowdfunding methods rather than incurring the costs of going public. Until a more refined offering process emerges, the current system will stand as a test for young entrepreneurs to look past the title of an “A+” offering and look closer at their income statements.