[The following guest post is contributed by Surya Kumar Gheda, a final year law student. The author can be contacted at firstname.lastname@example.org]
Last week, two capital market regulators, the Securities Exchange Commission (SEC) in the United States (US) and the Securities Exchange Board of India (SEBI), have announced frameworks to enable startups to obtain easy access to capital through the securities markets. The SEC has come out with final rules, often referred as Regulation A+, to implement Title IV of the Jumpstart Our Business Startups (JOBS) Act, 2012, and SEBI released a discussion paper on Alternative Capital Raising Platform for startups. Both the frameworks are aimed at easing regulatory requirements for the startups in accessing capital markets.
The framing of Regulation A+ was mandated by the JOBS Act to revive the framework of Regulation A which was an exemption from SEC registration requirement provided to small and medium sized companies to raise $5 million by selling securities in a 12- month period. However, companies issuing securities under Regulation A were still required to prepare and file a prospectus with SEC, along with complying with the registration requirements of applicable state securities laws (“blue sky laws”). The costs of compliance with these requirements – combined with the $5 million limitation on offering size – had made Regulation A offerings unattractive. Title IV of the JOBS Act required the SEC to authorize exempt offerings under Regulation A of up to $50 million of securities, subject to new regulatory conditions. Title IV also authorized the SEC to formulate regulations to preempt the blue sky laws therefore reducing the cost of compliance for Regulation A offers. It is in this backdrop, now SEC has come out with final rules referred as Regulation A+.
SEBI in October, 2013 issued the Listing of Specified Securities on Institutional Trading Platform Regulations, 2013 to enable small and medium enterprises and startups to get their securities listed on the institutional trading platform (ITP) without carrying out an IPO by complying with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the ICDR Regulations). Until now, companies listed on the ITP can raise capital through private placements and right issues of their securities. The recently released SEBI discussion paper has proposed a framework under which professionally managed startups having an innovative business model and belonging to knowledge-based technology sector can bring an IPO to get their securities listed on the ITP.
Interests of Retail Investors
Each capital market regulator is the sentinel of the interests of small and unsophisticated investors. Market regulators ensure that only companies with a good track record can have access to the nation’s capital markets. Investment by the general public in startup companies could prove a very risky proposition given the high rates of failure associated with the startups.
Regulation A+ provides a two tier system to raise funds; under Tier 1, companies can raise funds up to $ 20 million in a 12-month period, and under Tier 2, companies can raise funds up to $ 50 million in a 12-month period. Tier 1 requires SEC qualification along with state approval, whereas Tier 2 requires only SEC approval. Regulation A+ allows unaccredited investors to invest under Tier 2 the greater of 10% of income or 10% of net worth, on the basis of self-certification. However, there is no such limitation on the investment to be made by unaccredited investors under Tier 1. Since Tier 1 is subjected to blue sky laws, the protection of unaccredited investors is taken care of by the respective state laws. Companies can raise funds on the basis of reviewed financial statements under Tier 1, but Tier 2 requires audited financial statements.
SEBI’s proposed framework recognizes the need for an alternative capital raising platform, but at the same time it bars Retail Individual Investors (RIIs) from investing in the offers for listing on the ITP. SEBI has proposed that only Qualified Institutional Buyers (QIBs) and Non-institutional investors (NIIs) should be eligible to participate in the offers for listing on the ITP. The minimum application size for the offers has been proposed to be Rs. 10 lakhs. These provisions not only bar RIIs, but at the same time they ensure that only high net-worth individuals can participate in the offers.
SEBI has proposed that only professionally managed startups having an innovative business model and belonging to knowledge-based technology sector will be qualified as eligible issuers. A startup in which no person (individually or collectively) holds 25% or more of the pre-issue share capital, will be considered as a professionally managed startup. Often, the holding of promoters in startups after many rounds of funding comes down to below 25% thus qualifying as professionally managed startups.
Regulation A+ does not restrict the issuers only to the knowledge based technology sector. Development stage companies with a specific plan or purpose are eligible issuers.
Listing is the most preferred exit route for venture capital investors (VCs). In a regular IPO, VCs sell their stake to the general public at the listing price therefore reaping the benefits of high valuation of securities at the time of public offer. The ICDR Regulations exempt VCs from lock in requirements. The ICDR Regulations also require at least 20% of post issue capital should be locked in for three years post public issue.
SEBI has proposed that entire pre-issue share capital should be locked in for six months, and this requirement will apply uniformly to all shareholders. This proposal bars VCs from selling their stake at the time of the offer. VCs will be able to sell their stake after the cooling off period of six months, perhaps with adequate time for the frenzy surrounding the offer to subside.
Regulation A+ mandates that at the time of an issuer’s first Regulation A+ offering and within the following 12 months all existing shareholders cannot sell securities worth more than $ 6 million under Tier 1, and not more than $ 15 million under Tier 2. The final rules also limit secondary sales by affiliates that occur following the expiration of the first year after an issuer’s initial qualification of an offering statement to no more than $6 million, in the case of Tier 1 offerings, or no more than $15 million, in the case of Tier 2 offerings, over a 12-month period.
SEBI has ensured that proceedings of offer should only result in capital for the startup companies by locking-in entire pre-issue share capital for six months, and existing shareholders can offload their holding only through trading on ITP following the expiration of six month period. Whereas, SEC has allowed existing shareholders to make secondary sales of securities during Regulation A+ offering, but at the same time it has ensured that affiliates shareholders i.e. the promoters remain invested at least for two years by imposing the limitation on secondary sales of shares for two years.
SEBI has proposed that a prospectus for the offer needs to be in compliance with the various ICDR Regulations, subject to few proposed exemptions. The proposed framework has provided relaxation in the matters of objects of the issue, pricing of the issue, disclosure on litigation, disclosure on creditors etc. to make disclosures apposite to the startups’ needs, and at the same time ensuring prospective investors make informed decision. Startups bringing the offer do not need to outline objects of the issue in greater details as required in regular IPO, they, rather, can indicate general corporate purposes as their object in offer document. The proposed framework confers greater autonomy upon startups in the pricing of their issue, except there cannot be any forward looking statement while disclosing the basis of the pricing of the issue.
Issuers under Regulation A+ need to file form 1-A with the SEC for its approval. Form 1-A is the shorter version of form S-1 which is required to be filed with SEC for a regular IPO. The Form 1-A offering statement contains itemized information similar to Form S-1 for registered IPOs, but is scaled back. It has three parts: notification, offering circular, and exhibits. The SEC staff would review and comment on it. And companies cannot use an offering circular for sales until the SEC approves. Generally, two years of financial statements are required, but only Tier 2 offerings require audited statements.
World over, startups are increasingly being recognized as the next big employment generator as big corporates are often compelled to focus on increasing their margins to keep up with the expectations of stock markets. But, the funding for these startups is still a vexed issue. Though there are many parallels between the two frameworks, only time will tell the efficacy of these frameworks. While the framework of Regulation A+ is the second attempt by the SEC to meet the funding requirements of startups, the obvious question from an Indian perspective is – will SEBI get it right in its first attempt?
- Surya Kumar Gheda