Raising Capital in Time of Pandemic: An Alternative for Small Businesses
The impact of the COVID-19 pandemic has been severe on the economy and has been felt disproportionately by small businesses. A recent study found that about 800 small businesses a day are forced to close across the country during the pandemic. Another survey found that only 34% of small business owners claim that their operations are currently profitable as compared to 55% at this point in 2019. And with winter, and a rapidly unfolding second wave of the pandemic, the crisis will only continue to get worse as more small businesses need to fight for their survival. So how can small businesses, new and old, raise money in this economic climate?
It is an age-old rule of the SEC that absent an exemption, all offerings of securities, whether equity or debt, must be registered pursuant to Section 5 of the Securities Act of 1933. The main goal of this rule is to protect investors from fraud. While what actually constitutes a “security” can be thorny question to answer, the tradition grounds for exemption are found in Section 4(a)(2). Rule 506(b), a “safe harbor” under Section 4(a)(2), and 506(c) of Regulation D provide general guidance on applicability of Section 4(a)(2). As a general cannon, registration is not required as long as the investments are privately made by accredited and sophisticated investors subject to certain limitations. Known as capital formation through private placement of securities, the use of this exemption has increased dramatically since the 2008 financial crisis – largely by startups with high growth expectations that aspire to file for an IPO down the line.
Because of the costs associated with SEC registration and filing for an Initial Public Offering (IPO), and that accredited investors are generally interested in large returns on investment, small and mid-size businesses were largely denied access to nonaccredited investment opportunities. As a result, The SEC adopted Section 3(b) of the Securities Act in 1936 to provide an exemption from registration for small businesses. But over the following decades, despite the fact that the SEC increased the annual offering limit to $5 million by 1992, the exemption was used infrequently.
The Jumpstart Our Business and Startups Act (the “JOBS Act”) was adopted in 2013 and amended Section 3(b) of the Securities Act of 1933. It provided registration exemption under Regulation A for offerings of up to $50 million. In 2015, amendments to regulation A were adopted. Known as Regulation A+, the amendments can be thought of as an alternative to an IPO for small businesses, or an opportunity to “test the waters” prior to an IPO.  Most importantly, Regulation A+ rules created two tiers of offerings: Tier 1 offerings, capped at $20 million in a twelve-month period and Tier 2 offerings, capped at $50 million in a twelve-month period.
While Regulation A+ has arguably been successful in providing capital to small companies (157 companies used Reg A+ to raise $1.5 billion between 2015-2018), only a small number of those companies have successfully entered public markets. As of July 2019, out of the 11 companies that have listed on Nasdaq or NYSE using a Reg A+ offering, 10 were trading below IPO price. But filing for an IPO is not a goal that most small businesses aspire to achieve.
Article III of the Jobs Act, known as Regulation Crowdfunding (Reg CF), allows startups to raise money through non-accredited investors. It generally allows investors to invest in U.S startups through an SEC-registered online platform, such as Republic, Kickstarter, and GoFundMe, subject to certain limitations and reporting requirements. While there are different types of crowdfunding platforms (equity-based, reward-based or donation-based), this provision is available to both accredited and non-accredited investors. Due to the risks associated with raising capital in this way, there is a limit on how much a startup can raise initially and how much individuals can invest. Startups used to be limited to raising a maximum aggregate amount of $1.07 million in a 12-month period, while the amount that an investor was allowed to invest in any 12-month period through crowdfunding was limited based on factors such as income and net worth.
Several recent developments in Reg CF make it a more attractive fund-raising alternative for small businesses. On November 2020, the SEC voted to raise the offering limit in Reg CF to $5 million in a 12-month period to further provide small businesses with access to capital,  eliminate investment limits for accredited investors, provide more flexibility for non-accredited investors,and to provide financial statement review exemptions to further facilitate raising capital crowdfunding platforms.
Furthermore, with the introduction of Rule 206, issuers are permitted to “test the waters” prior to filing a Form C, which helps to further lower the costs associated with securities offerings. Under this rule, issuers who want to make an offering using Reg CF may make written or oral offers prior to filing a Form C. They can do so without any restrictions concerning the content of the communications, as long as no money is solicited, no offer of sales of securities is accepted and no party has undertaken an obligation or a commitment of any kind. Rule 204 was also amended to permit oral communications after filing Form C subject as long as such communications are in compliance with Rule 204. Additionally, certain “demo day” communications are permitted under the new Rule 148, and such communications do not constitute “general solicitation” or “general advertising” if the conditions enumerated in Rule 148 are met. The new changes also allow the use of special purpose vehicles (“crowd funding vehicle”), whose sole business purpose of facilitating investing in a single crowdfunding issuer through Reg CF offerings.
In light of the impact of the COVID-19 pandemic on the economy, the abovementioned amendments to Reg CF are likely to be a viable way to provide more capital to small business owners while at the same time protecting investors from fraudulent investment schemes.
 I like to extend my gratitude to Professor Arina Shulga, whose research and guidance was used to substantiate the findings of this post.
 See generally Sandy McKenzie, Small Businesses Feel Biggest Impact of Coronavirus Pandemic, Businesswire (Oct. 8, 2020), https://www.businesswire.com/news/home/20201008005232/en/Small-Businesses-Feel-Biggest-Impact-of-Coronavirus-Pandemic; Alexander W. Bartika et al., The Impact of COVID-19 on Small Business Outcomes and Expectations, Proc. of the Nat’l Acad. of Sci. of the U.S.A. (2020), https://www.pnas.org/content/pnas/117/30/17656.full.pdf.
 Tom Cherveny, Pandemic Continues to Challenge Minnesota Businesses, W. Cent. Trib. (Nov. 22, 2020, 6:00 AM), https://www.wctrib.com/business/6775187-Pandemic-continues-to-challenge-Minnesota-businesses.
 Annie Pilon, SCORE Looks at Impact of COVID-19 on Small Business in the US, Small Bus. Trends (Dec. 8, 2020), https://smallbiztrends.com/2020/12/score-survey-covid-impact-small-business.html.
 Ruth Simon, For Small Firms, Covid-19 Cuts Deeper; ‘It’s Getting Worse Every Day’, Wall St. J. (Dec. 19, 2020, 12:00 AM), https://www.wsj.com/articles/for-small-firms-covid-19-cuts-deeper-its-getting-worse-every-day-11608354002.
 Registration Under the Securities Act of 1933, SEC, https://www.investor.gov/introduction-investing/investing-basics/glossary/registration-under-securities-act-1933#:~:text=In%20general%2C%20all%20securities%20offered,SEC%20provide%20significant%20information%2C%20including%3A&text=Information%20about%20the%20management%20of%20the%20company%3B%20and.
 Securities Act of 1933, 15 U.S.C. § 77d.
 Rule 506 of Regulation D, SEC, https://www.investor.gov/introduction-investing/investing-basics/glossary/rule-506-regulation-d.
 Scott Bauguess et al., Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009‐2017, Div. of Econ. and Risk Analysis (DERA), SEC, 1 (2018) https://www.sec.gov/files/DERA%20white%20paper_Regulation%20D_082018.pdf.
 Amit Smingh, Regulation A+, Helping Small Businesses Raise Capital, Startupblog (July 26, 2020), https://www.startupblog.com/regulationaplus/.
 Anzhela Knyazeva, Regulation A+: What Do We Know So Far?, SEC, 2 (2016) https://www.sec.gov/files/Knyazeva_RegulationA%20.pdf.
 Id. at 2.
 Id. at 3.
 Spencer Israel, 4 Years In, Is Reg A+ Working?, Benzinga (July 31, 2019, 9:37 AM), https://www.benzinga.com/government/19/07/14163314/4-years-in-is-reg-a-working.
 Emma McGowan, The SEC JOBS ACT and Title III Crowdfunding, Startups (Aug. 25, 2017), https://www.startups.com/library/expert-advice/american-jobs-act-title-iii-crowdfunding#:~:text=Title%20III%20is%20the%20section,technically%20invest%20via%20equity%20crowdfunding.
 Crowdfunding and the JOBS Act: What Investors Should Know, FINRA (May 17, 2017), https://www.finra.org/investors/alerts/crowdfunding-and-jobs-act#:~:text=What%20Are%20the%20Rules%3F,provisions%20of%20the%20JOBS%20Act.
 McGowan, supra note 19.
 Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers, SEC (April 5, 2017), https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051316.htm.
 Id. (specifying that [i]f either your annual income or your net worth is less than $107,000, then during any 12-month period, you can invest up to the greater of either $2,200 or 5% of the lesser of your annual income or net worth. If both your annual income and your net worth are equal to or more than $107,000, then during any 12-month period, you can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $107,000”).
 SEC Harmonizes and Improves “Patchwork” Exempt Offering Framework, SEC (Nov. 2, 2020), https://www.sec.gov/news/press-release/2020-273.
 Id. (“[U]sing the greater of their annual income or net worth when calculating the investment limits for non-accredited investors”).
 Id. (“[Extends] for 18 months the existing temporary relief providing an exemption from certain Regulation Crowdfunding financial statement review requirements for issuers offering $250,000 or less of securities in reliance on the exemption within a 12-month period.”).
 SEC Updates Offering Exemption Framework, Paul, Weiss, Rifkind, Wharton & Garrison LLP, SEC Updates Offering (Nov. 6, 2020), https://www.paulweiss.com/media/3980595/sec_updates_offering_exemption_framework.pdf ( Explaining that [s]imilar to Rule 255 (permitting issuers to test the waters in a Regulation A offering), issuers are required to include legends and file the solicitation materials with Form C. Unlike Regulation A, issuers can only use Rule 206 prior to the filing of Form C (thereafter, any offering communications must be made in compliance with Regulation CF)”).
 Samson Williams, CrowdCheck’s Analysis of the New Exempt Offerings Rules: Testing the Waters Comes to Reg CF, Crowdfunding Ecosystem (Nov. 12, 2020), https://www.crowdfundingecosystem.com/kb/article/crowdcheck-s-analysis-of-the-new-exempt-offerings-rules-testing-the-waters-comes-to-reg-cf.
 Id. at 5.
 Id. at 9.