Statement on Harmonization of Securities Offering Exemptions
Nov. 2, 2020
Today’s rule significantly expands private market access to investors without first putting in place appropriate investor protections.[1] As a result, issuers will be able to conduct larger and more frequent private offerings with fewer restrictions. These offerings will be made to a pool of investors with varying levels of risk tolerance, information access, investment experience and bargaining power. There are tradeoffs in that decision. Unfortunately, today’s release fails to engage in any substantive way with the crucial threshold question of whether those tradeoffs are – or even can be – balanced in a way that adequately protects retail investors. Not only that, the rule fails to address the fact that in the private markets, the rich and well-connected typically have better access to the most promising companies, while retail investors get the leftovers – too often, unfortunately, the losers.[2] Instead of providing retail investors access to that elusive high return rate, the majority’s steady march of expanding the private markets will only further entrench the country’s increasing and concerning economic divide.[3]
I commend the staff for considering the utility of harmonizing the exempt offering framework. Entrepreneurs, particularly very small and traditionally underserved businesses, should have efficient access to capital. We should consider whether there is a fair way to broaden access for small, diverse companies while still fulfilling our duty to protect investors. Right now, high growth companies are increasingly deciding to remain private, benefitting groups of experienced and well-funded professional investors.[4] It seems that “you have to start rich to get rich” in the private markets.[5] Today, we do not fix that problem. Expanding access to the private markets as the Commission has done repeatedly recently[6] not only fails to serve the majority’s stated goal of advancing the interests of small businesses and retail investors, it opens these markets to a class of investors who do not have the capital to survive one or two failed ventures. This approach will serve only to further widen the wealth and access gaps between investors who start rich and those who don’t.
***
Presently, many companies in the private markets have a ready pool of investors, including accelerators, venture capital firms, angel investors, private equity funds, and many others, which I will collectively call venture capitalists.[7] What these investors share are structural advantages that have led to their success. Venture capitalists employ trained professionals skilled at evaluating early stage companies. They have the market power to demand detailed information, which investors must negotiate because these issuers are not legally required to supply robust disclosures.[8] This is because private offerings have historically been targeted, at least generally, at investors who can bear the risk of a total loss.[9] Typical venture capital investors have diverse portfolios structured specifically to absorb the inevitable losses associated with early stage investing.[10] They also understand how risk and reward profiles change as start-ups progress from seed funding through later funding rounds, and can adjust their risk exposure accordingly. Just as importantly, venture capitalists have professional advisors and lawyers to protect their interests by preserving voting rights, ensuring good governance, and protecting against dilution. The system is set up for their success. Not for anyone else’s.
Estimates indicate that there is more than $1 trillion in private capital ready and waiting to be invested in existing private offerings.[11] For this portion of the private markets, it does not appear that more money or further relaxed restrictions are necessary to build those companies. The exemptions are more than fulfilling their promise, as these companies and these investors are awash in money and opportunities.[12]
To be sure, not all viable companies readily attract this funding, even despite the surplus of capital clamoring to be invested.[13] The solutions this rule presents are to allow private companies to raise capital by selling more risky offerings, in greater dollar amounts, with less information, and fewer rights, to unprepared and unprotected investors.[14] Nowhere does the release examine whether this is a good idea.[15] It could be that venture capital investors avoid these offerings because the potential payouts are too small to justify their time, or that they deem the investments too speculative.[16] The release does not say. But as with most things, understanding the problem is key to crafting effective solutions. Without that analysis, I fear today’s response will make matters worse for those small businesses and those investors currently left out of these growth opportunities. Here’s why.
At the core of this rule is the assumption that retail investors will successfully buy offerings that professional investors reject. We apparently believe that retail investors can better assess the risk adjusted returns and find value that venture capital overlooks. This is unlikely to be true. First, it is not supported by any data. Second, smaller investors do not have the same bargaining power to compel private issuers to provide robust information disclosures, and the offering exemptions do not require issuers to do so. Third, smaller investors often lack the money or the assets necessary to create the diverse portfolios of private companies needed to successfully withstand the inevitable losses.[17] Retail investors face plenty more disadvantages, but you get the idea.[18]
Some might argue that although retail investors have been excluded from investing in the most promising private companies,[19] they can make up the difference by investing in other exempt offerings.[20] Unfortunately, because private markets are so opaque, we do not have the data to analyze this. This highlights a persistent problem with our approach to the private markets, in that issuers do not report the data needed to allow us to study them and their results, and thereby develop appropriate regulatory strategies.[21] That won’t change under this rule, and without that information, I simply cannot conclude that these changes balance our mission imperatives of facilitating capital formation while also protecting investors. Based on the evidence we do have, these changes appear likely to offer only at best marginal benefits to the companies who need the most assistance, while increasing risks but not rewards for investors.
I believe in the vital contributions offered by our country’s small businesses. In particular, I am committed to helping facilitate capital formation for minority, women, and veteran-owned businesses. That’s not just good policy; it’s good economics. There are real problems today with access and representation that leave promising companies and the entrepreneurs behind them on the outside looking in.[22] Unfortunately, this proposal is not tailored toward solving those problems. Instead, it proposes a variety of changes to exemptions rarely used by these underserved businesses.[23] In the end, we are expanding offerings we have not studied, to make it easier to sell to the investors who have the most to lose if a new venture fails. I’d like to believe that some of the small businesses that raise money because of this rulemaking will succeed. But others will fail entirely – or fail to pay retail investors the same high rate of return that venture capitalists demand to justify the risks of early venture investing.[24]
***
As always, my dissent today does not detract from my respect and appreciation for the efforts of staff. I am grateful for their hard work and dedication to advancing our agency’s mission. In particular, I recognize the fine work done by the members of the Division of Corporation Finance, the Office of the Advocate for Small Business Capital Formation, the Office of General Counsel, the Division of Investment Management, and the Division of Economic Risk Analysis. I look forward to working together to solve the problems faced by small businesses and investors, but today I respectfully dissent.
[1] See Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, Release No. 33-10844 (Nov. 2, 2020) at 268 (“Adopting Release”) (“The amendments may increase aggregate potential investor losses. Increased offering limits under Regulation A Tier 2, Regulation Crowdfunding, and Rule 504 may make it easier for smaller, higher-risk issuers to access capital through these exemptions.”).
[2] Between 2015 and 2019, for Reg A offerings that listed on exchanges, the “annualized buy-and-hold returns from listing” had mean performance of -23.5% and median performance of -47.7%. For OTC-quoted Reg A offerings during this period, the “annualized buy-and-hold returns from listing” had a mean performance of -2.9%, and the median performance was -23.9%. See Sec. & Exch. Comm’n., Report to Congress on Regulation A / Regulation D Performance at 99, Table 30 (2020). According to a study of Reg A+ offerings, investor outcomes were “abysmal.” See Subcomm. on Investor Protection, Entrepreneurship, and Capital Markets, 115th Cong. 10 (2019) (written testimony of Michael S. Pieciak, NASAA Past-President and Vermont Commissioner of Financial Regulation) (citing Bill Alpert, Brett Arends & Ben Walsh, Most Mini-IPOs Fail the Market Test, Barron’s (Feb. 13, 2018)); CFA Institute, Comment Letter on the Proposed Rule on Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, (June 12, 2020) (“Adverse selection is already a major issue for investors in exemptive markets, and we believe the proposed amendments would further exacerbate the challenges.”).
[3] The Pew Research Center observed in January of this year that since 2009, “[e]conomic inequality, whether measured through gaps in income or wealth between richer and poorer households, continues to widen.” Juliana Menasce Horowitz, Ruth Igielnik & Rakesh Kochhar, Trends in Income and Wealth Inequality, Pew Research Center: Social & Demographic Trends (2020).
[4] Retail investors have largely been shut out from those opportunities. See Elisabeth de Fontenay et al., Comment Letter on the Concept Release: Harmonization of Securities Offering Exemptions (Sept. 24, 2019) (“Law Professor Comment Letter”) (noting that retail investors are largely confined to the public markets and that “private capital-raising now outpaces public capital-raising by a substantial factor”). See also Alexander Lazovsky, Investing in Unicorns: the Perils and the Promise, Forbes, Mar. 4, 2020 (“[T]he same tight community of VCs and innovators that invigorate Silicon Valley make it hard for outsiders to participate. The VC community is a caste system with rules shrouded in mystery. Just as investors compete for the most promising unicorns, the unicorns compete for the most prestigious investors. Brand matters both ways.”).
[5] See, e.g., U.S. Sec. & Exch. Comm’n., Office of the Advocate for Small Bus. Capital Formation, Ann. Rep. (2019) at 43 (“Small Business Advocate Annual Report”).
[6] See Accredited Investor Definition, Release Nos. 33-10824, 34-89669, 85 Fed. Reg. 64234 (October 9, 2020); Notice of Proposed Exemptive Order Granting Conditional Exemption From the Broker Registration Requirements of Section 15(a) of the Securities Exchange Act of 1934 for Certain Activities of Finders, Release No. 34-90112, 85 Fed. Reg. 64542 (October 13, 2020).
[7] Between July 2018 and July 2019, private offerings pursuant to Rule 506(b) exemptions raised more money than was raised by all U.S. public offerings. See Small Business Advocate Annual Report at 11.
[8] Almost all of the private company offerings sold to professional investors rely on the Rule 506(b) exemptions from registration. See id. That rule precludes general solicitations, which is not a barrier for companies that obtain funding from venture capitalists. See 17 C.F.R § 230.506(b). It also states that as long as they sell only to accredited investors, which is typical, issuers are not legally required to provide significant information about their operations, finances, risks, team, or growth prospects. See id. The only disclosure-related legal obligation they have is not to commit fraud. See id.
[9] See, e.g., Aswath Damodaran, Valuing Young, Start-Up and Growth Companies: Estimation Issues and Valuation Challenges (June 12, 2009) (“Most young companies don’t survive the test of commercial success and fail.”).
[10] See, e.g., J.P. Morgan Asset Management, Investing in Private Equity, Essentials for Achieving Enhanced Private Equity Returns at 4 (2018) (noting discerning investment selection and an “in-depth due diligence process” are crucial elements to success in private equity investment because the “dispersion of returns among private equity is substantial in absolute terms and relative to other segments of the investment universe”).
[11] See Bain & Company, Global Private Equity Report 2020 at 11 (2020) (identifying more than $2.5 trillion in worldwide private equity “dry powder” more than half of which is attributable to North America).
[12] See Adopting Release at 207, 209.
[13] For example, in 2018 women founders received less VC funding than their male peers despite indications that companies founded or co-founded by women generate more revenue. See Small Business Advocate Annual Report at 27.
[14] Of the commenters who wrote to support this rule, notably few represent the interests of venture capitalists or retail investors. See Comment File for Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, File No. S7-05-20 (proposed Mar. 4, 2020). That is likely because the venture capitalists don’t require help. And retail investors do need help, but this rule will not provide it.
[15] The rule notes that its changes are not directed at 506(b) offerings. “Exempt offering integration amendments are most likely to affect issuers that rely on multiple exemptions, particularly ones involving non-accredited investors. We believe that the added flexibility and reduced cost of capital raising may be highly beneficial to the affected issuers – particularly for smaller issuers and issuers that lack an established network of angel investors or venture backing and thus rely on a combination of capital raising strategies to finance their growth. Nevertheless, for the majority of non-reporting issuers that raise financing from accredited investors without general solicitation…, the integration amendments will likely have limited effects.” Adopting Release at 209 (emphasis added).
[16] See Ben Schiller, Why Venture Capitalists Aren’t Funding the Businesses We Need, Fast Company, Sep. 28, 2017 (explaining that many VC firms prefer to fund companies like companies they’ve funded before or that they deem most capable of delivering 10x returns).
[17] According to the U.S. Bureau of Labor Statistics, before COVID, 20% of new businesses fail in their first year, and 50% fail by their fifth year. See U.S. Bureau of Labor Statistics, Business Employment Dynamics, Survival of Private Sector Establishment by Opening Year.
[18] Many commenters noted that encouraging retail investment in exempt offerings carries substantial risks these investors may be ill-prepared to identify or withstand. For example, a group of law professors from across the ideological spectrum noted, “[t]hese investments would be highly unlikely to meet FINRA’s ‘suitability’ standard and the SEC’s recently adopted Regulation Best Interest in order for brokers to recommend them to retail investors.” See Law Professor Comment Letter at 7. Others might suggest alternative paths to retail investment in private markets, like diversified pooled investment funds. Since today's release goes in a very different direction that I do not support, this does not seem like the appropriate forum to address those alternatives.
[19] The rule suggests that one benefit of the changes might be to give retail investors more access to invest in private markets. But importantly, the changes are not designed to give them access to the high-profile future unicorns that venture capitalists fund, because that market is self-selecting in both directions. Not only do venture capitalists have structural advantages in evaluating and choosing investments, but the most promising new companies prefer to get funding from venture capitalists. In choosing among investors, private company founders look for those who can provide mentorship, partnerships, and access to other companies or experts that can help their company grow. See Jyoti Bansal, How to Choose the Right VC for Your Startup: A Founder’s Guide, Battery: Company Culture & Market Trends (Jun. 28, 2017). Individual retail investors are unlikely to help on any of these fronts. And the rule does nothing to address this issue.
[20] Anecdotal data indicates the answer is no. See Adopting Release at 199. For example, Angel List submitted a comment letter, but also prepared a report based on its own internal data to identify the optimal strategy for investing in the private companies who raised money through its portal. See Abraham Othman, Startup Growth and Venture Returns, (2019). The conclusions of the report are concerning, but so too is the assumption built into its methodology. In analyzing investment strategy, Angel List used as its dataset only the 684 offerings with “non-negative returns” out of more than 3,000 offerings that raised money with Angel List. Id. at 7. To the extent their aggregated results are representative of other funding intermediaries and private companies seeking capital from retail investors, the odds are therefore terrible that retail investors will even achieve a non-negative return. And in choosing how to invest in the non-negative return offerings, Angel List concludes that investors should essentially invest in all of them, because the returns are so varied and change so much over time as companies mature. Id. at 20-22. That advice is of essentially no help for retail investors who lack the capital, time, and ability to invest in even a meaningful fraction of offerings.
[21] NASAA, Comment Letter on Proposed Rule on Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, (October 21, 2020) (“Our overall view is that there should be greater transparency concerning all private offerings. Regulatory proposals affecting the private markets should be based on solid data, and the Commission should measure the efficacy and impact of any such changes once they have been adopted.”).
[22] For example, women led startups face significant bias that has made it difficult to attract venture capital funding. See Why VCs Aren’t Funding Women, Knowledge@Wharton (May 24, 2016); Press Release, HSBC, Over a Third of Female Entrepreneurs Experience Gender Bias (Oct. 1, 2019). See also Savannah Dowling, Menstruation Startups Say Women Don’t Have to Settle. Period. Crunchbase News, (Oct. 25, 2018) (noting how founders of products aimed specifically at women have faced difficulty attracting venture capital funding). This is a significant problem that today’s rule does not address.
[23] “These are populations of business owners who are notoriously underserved by traditional capital raising, such as through private placements to accredited investors.” Small Business Advocate Annual Report at 46.
[24] Information asymmetries are already a problem in private markets. Today’s rule makes this problem worse by taking away important disclosures from investors. See Elizabeth Pollman, Information Issues on Wall Street 2.0, 161 U. PA. L. Rev. 179, 235–36 (2012). For example, it repeals the requirement to provide audited balance sheets to non-accredited investors for Rule 506(b) offerings of up to $20 million. See Adopting Release at 258-260. The Adopting Release acknowledges that audited financial statements are valuable for informed investment decision, See Adopting Release at 258-259 note 651, and that eliminating this requirement “might cause some non-accredited investors to incorrectly value the offered securities and to make less well informed investment decisions.” Id. Further, it “might encourage some issuers with relatively higher information risk to sell securities to non-accredited investors given the absence of investment limits in such offerings.” Id. The rule would also allow crowdfunding issuers engaging in offerings up to $250,000 in a 12 month period to not have to provide financial statements reviewed by a public accountant that is independent of the issuer. Without an independent review, investors may not receive reliable information about the issuer’s financial statements and may make less informed decisions. See Adopting Release at 290. Finally, as I also mentioned, retail investors typically lack the bargaining leverage to negotiate crucial deal terms such as good governance and anti-dilution provisions. That is certainly the case in Reg A and crowdfunding markets, which are primarily retail in nature. NASAA, Comment Letter on Concept Release on Harmonization of Securities Offering Exemptions, (Oct. 11, 2019) “(NASAA Comment Letter”). For example, Reg A securities often carry no voting rights and Reg CF which often have very complex contingent securities, which are presented on a take it or leave it basis. See, e.g., Adopting Release at 315-317; NASAA Comment Letter. The Commission had an opportunity to address these issues, but chose not to. So even if these investors do well, they will not do as well as they would if they were venture capitalists. We do nothing today to change that tiered structure that offers regulatory advantages to those who least need them.