Crowdfunding 102 - Regulation A
Welcome back.
We’ve broken this overview of Regulation A (or “Reg A”) into two parts, to cover the two different categories of Reg A.
Counterintuitively, we talk about Tier 2 (a/k/a “Reg A+”) first and Tier 1 second, because Tier 2 is the path that more issuers choose by a pretty wide margin.
Regulation A (Tier 2, also known as Reg A+)1
TL/DR – What’s The Difference?: Overall, you’re going to notice a lot of similarities between Reg A and Reg CF from an investor standpoint. At the end of the day, these two ways for companies to crowdfund come down to a difference in scale. Reg A issuers are allowed to raise a lot more money than CF issuers. And because of that, the regulators make Reg A issuers jump through a lot more hoops than CF issuers. That makes running a Reg A deal a good bit more expensive and time-consuming than running a CF. But the process to invest in either type of deal is very similar. You might not even notice which type of deal you’re investing in, unless you’re paying close attention.
Who Can Invest: Open to all investors, but investment limits apply based on income and net worth.
Investment Limits:2 As we saw with Reg CF, there is a limit for nonaccredited investors in Reg A offerings (again, we’ll explain accredited investors next time when we discuss Reg D, just know for now that they are typically wealthier folks). But the limit in a Reg A deal isn’t quite as restrictive as the limits under CF.
In a Reg A offering, investors are capped out at a maximum of 10% of the greater of their annual income or their net worth (again, not counting home equity). But there are two key differences between the limit on Reg CF and on Reg A.
First, there’s no maximum cap like there is with Reg CF, which has a ceiling for nonaccredited investors to invest in CF deals.
Second, the 10% maximum for Reg A investing is calculated separately for each Reg A you invest in. This is different than CF, where as we explained last time, you’ve got to divvy up your maximum CF investment amount for the year among however many CF deals you invest in. If your max is $50,000, and you want to invest in ten CF deals that year, you’ve got to divide that $50k among all of those deals.
For Reg A, if your limit is $50k, you could invest up to $50k in each Reg A offering over the same period.
Again, as with CF, there’s no maximum limit for accredited investors in a Reg A.
Investment Process: As we said earlier, the experience of investing in a Reg A deal is very similar to that of investing in a Reg CF offering, with a few key “behind the scenes” differences. You’re still going to have to enter all of your information through a specialized process.
However, the funding portals that run Reg CF deals are not allowed to host Reg A offerings. There are a few exceptions, but for the most part, most Reg A offerings are on websites that are all about them, a “direct listing”, and not in a marketplace with a bunch of other deals.
Not only are funding portals not involved in Reg A deals, but Reg A issuers technically aren’t even required to use a broker-dealer, and sometimes they don’t. Again, you’ll need to look at the fine print on the website—or read their filings with the SEC—to figure that out for sure.
There are some good reasons for issuers to use a broker-dealer even though they don’t have to. But for our purposes here, while Reg A deals tend to be higher risk than large companies on the stock market, let’s just say it’s reassuring to know that there’s at least SOME regulated third party in the mix on these deals to try to keep them honest. And—at least in my experience—the deals with broker-dealers attached tend to have incrementally better value propositions.
Risks and Returns: You know the drill by now.. the risk in all of these types of deals is high. It’s startup investing. Lots of startups fail.
But Reg A deals do have one distinct advantage on the risk/return front when compared to both Reg CF and Reg D offerings: liquidity.
Unlike securities sold through those two other offering types, shares sold through a Reg A offering are freely transferrable, right out of the gate.3 That means you are allowed to sell the shares whenever you want, much like a company on a stock exchange.
But not so fast. Just because you’re allowed to sell a Reg A issuer’s shares, that doesn’t mean it’s easy, or even practical. Shares of publicly traded companies are listed in a marketplace, a centralized place where buyers and sellers know they can go to do business. Reg A shares aren’t necessarily listed ANYWHERE. A few specialized marketplaces called Alternate Trading Systems (or ATSs) have sprung up over the past few years to try to take on that matchmaker role for these investments.
But your company might not be listed there. And even if it is, a marketplace is only as good as the number of folks congregating there, and many of these ATSs don’t have many account holders. So just because you CAN sell the shares, it doesn’t mean you’ll find a buyer. And if you do, you might not like the price you get.
Think of it this way. Have you ever bought a penny stock, and then wanted to sell it later? The bid/ask spreads for those stocks (the difference between how much buyers are currently offering, and how much sellers are willing to sell for) can be very large. You might get way up on a stock, but by the time you unload it, you end up having to take 15% or 20% less than the listed price, because there just aren’t enough buyers in the market looking for it.
Now take that situation and apply it to a company that doesn’t even have a ticker and isn’t centrally traded in any one location.
I’m saying all of this like it’s a bad thing, but ultimately, for all of those challenges, it’s a nice advantage for Reg A shares that you are allowed to sell them at all. Even if it’s to your brother-in-law at a price you’ve agreed on arbitrarily.
A few more wrinkles on this. If you do sell the shares, you’ll need to get in touch with the company to notify them of the sale, so they can update their shareholder records.
Lastly, this liquidity feature, plus a few other aspects of how the rules are written around Reg A, has started to turn Reg A into a pathway for companies to become fully listed publicly traded companies on a stock exchange.
This process can be a lot cheaper for companies than a traditional IPO, which can cost millions. And since most investors are thinking about their ultimate payday, that dynamic has the potential to make Reg A offerings a little less risky for investors than CFs or Reg D offerings.
I will conclude by saying that many of the companies who have used Reg A, and then gone public later, have seen their share prices fall soon after they get listed. There’s no rule that this will always be the case.
It doesn’t even mean that the companies going public in this way are bad companies. It could just mean that they didn’t have a plan to protect their share price against short sellers with a good investor relations strategy.
But until we start to see some examples of company share prices for Reg A issuers rising after they get listed, if you own Reg A shares and the company gets them on a stock exchange, it might not be a bad idea to consider taking your profits at that point, and not sticking around for the hangover.
Remember: this is what the private equity fat cats do. For many of them, a company going public is their exit point, when they pawn their shares off on the market after the growth has already happened. We’re breaking into their rigged system. There’s nothing wrong with being on the same side of the trade as them for a change.
Issuer Characteristics: Primarily startups and early-stage companies raising up to $75 million annually. Reg A issuers have a little more flexibility in terms of their base of operations than CF issuers—they may be based in the US or Canada. Why Canada, of all the countries on Earth that Congress could have chosen? Nobody knows. Or if they
do, they ain’t sayin’. But here we are.
Additionally, there’s more wiggle room in terms of type of issuer. In addition to operating companies, there are some carveouts for investment vehicles in real estate and energy. Other “investment companies” are still prohibited, as are “blank check” companies pooling cash without identifying an acquisition target.
More interestingly, companies can use Reg A to set up a sort of “series” structure where the company technically serves as the issuer, but where it uses the offering to conduct a series of mini-offerings nested inside it, with each mini-offering focusing on investment in a specific asset or project.
This fast-growing segment of crowd has resulted in a number of opportunities to invest in specific luxury goods (sports cars, race horses) and collectibles (everything from paintings to old comic books). There is talk of expanding this approach further, to specific real estate properties, and even to royalty interests in the future income streams of pro athletes and musicians. Watch this space.
One of the most important distinctions for Reg A issuers relative to Reg CF is that Reg A issuers are allowed to already be publicly traded companies at the time they conduct their Reg A offering. Issuers can sell the same type of securities that already trade publicly, a separate class of securities, or even hybrid “units” consisting of a mix of both.
This adds some flexibility for privately owned companies wanting to use Reg A to become publicly traded, and it also plays strongly into our discussion in the “Reg A Classic” section, below.
As far as types of security, while you’ll still see a lot of variety, unlike Reg CF, you’re not going to see SAFEs (because they’re not technically a security) or SPVs (CFs got specific recent rule changes permitting SPVs, while the Reg A rules did not).
The reporting standards for Reg A+ issuers are more strict than for CF issuers. Reg A issuers must provide annual and semi-annual reports, and they are required to make special filings any time something “material” happens.
But the biggest compliance difference for Reg A issuers is that their filings are reviewed by the SEC, and the SEC needs to formally sign off on those filings, prior to the Reg A issuer selling any securities.
The SEC is careful to say it is not “approving” the sale, they are just “qualifying” it. They don’t want anyone to think they are endorsing these deals, just that they’ve reviewed them to confirm they meet minimum compliance standards.
Either way, this qualification requirement is the primary driver for the cost difference for issuers between Regs CF and A—a difference which can often reach at least six figures. After all, if it were all the same difference otherwise, many companies would like to try to raise more than the $5 million allowed under CF. This requirement is the main reason that many don’t.
Regulation A (Tier 1, or Reg A ‘Classic’, Reg A ‘Original’, or Reg A ‘Don’t Do It’)
Tier 1 of Regulation A, sometimes called “Old Reg A” or some of the other names mentioned in the title of this section, is a very niche option for issuers, made largely obsolete by Tier 2 Reg A and Reg CF, and you don’t really see it done too often anymore.
It is similar to those approaches in that regular people can invest in the deals. The maximum is $20 million.
It differs from Reg A+ in that issuers don’t need to have their financial statements formally audited by an accounting firm. This can be a significant cost and delay item, and some issuers prefer to avoid it. There are also no ongoing reporting requirements to SEC, as you find under Reg A+. Additionally, there’s no upper limit on how much a nonaccredited investor can invest in a Reg A standard deal.
The major downside for an Old Reg A issuer is that—unlike Reg A+—offerings conducted under Old Reg A are regulated not just by the federal government, but also by every state where the issuer wants to sell its securities. That means if you want to market your deal nationwide, you face regulation by more than 50 separate securities regulators, as opposed to just one (the SEC) under Reg A+.
Not many companies see this trade-off as anywhere near reasonable. The “use case” for Old Reg A ends up being extremely narrow. Nearly every Old Reg A offering we see is some variation on the following scenario.
An already publicly traded company files an Old Reg A offering, selling the same securities already traded on an exchange, but priced at a discount to recent stock prices. The issuer has typically pre-identified their investors, which consist of a handful of investment firms. Because those investors are in 1-2 states, they only end up needing to file the offering in a few states, as opposed to nationwide. That changes the value proposition on regulatory expense.
We believe that, in most of these cases, the investors dump the new shares on the market at a higher price than they paid for them under the Reg A offering. We also believe that those investors are shorting the public stock at the same time—betting that prices will fall. The reason the shares fall is that the new shares the investors just bought end up diluting the existing shares on the market.
Essentially, the issuer and the investors are setting up the company’s shares to fall, getting the issuer the money they seek, while helping the Reg A investors make a profit on both sides of the trade. Any regular investors who happen to already own the shares get caught in the crossfire.
None of the above is illegal, or at least not strictly illegal. It’s just kind of gross, certainly not “market healthy” activity, and we have not seen a lot of companies we would view as “higher quality” taking this approach.
It is not impossible that there might be an opportunity for our readers at some point under Old Reg A. But that would likely be a situation extremely limited to residents of certain states where the issuer planned to file. Generally speaking however, because of the above considerations of very limited access to these offerings, and reduced accountability for issuers under Old Reg A, these deals should typically be avoided by regular or “retail” investors.
Tune in next time, when we’ll wrap up our overview of crowd investing with a rundown of Reg D private placements.
Til next time!
Sean Levine
Managing Editor
Disruptors Network
1 There’s a Tier 1 as well, but we’re reversing the order for reasons I’ll explain later. Everything in this section only pertains to Tier 2, Reg A+ offerings.
2 https://www.sec.gov/resources-small-businesses/regulation-guidance-issuers
3 As usual, there are exceptions. A Reg A issuer can restrict transferability of its securities if it chooses to do so. But because most investors see liquidity as a good thing, they usually don’t. If a Reg A offering’s securities have restrictions on transfer, you’ll find that in the filings.
