SEC Additions To JOBS Act May Create A Legal Minefield For Startups

Life just got more complicated in startup land. While the U.S. Congress last year voted in the Jumpstart Our Business Startups (JOBS) Act to ease New Deal-era regulations on startups, the SEC has since loaded up the Act with even more regulations.

While these changes are unlikely to prevent the next great startup from getting funded, they may well ensure it's reasonably likely to get sued. Several of the industry's most prominent investors, from Mitch Kapor to Fred Wilson, are crying foul.

JOBS Act: A Good, Not Perfect, Start

The JOBS Act, passed in 2012 by an overwhelming 73-26 bipartisan majority, was intended to make life easier for startup companies. Given the role of startups in creating high-paying, high-impact jobs, it's no wonder Congress wanted to smooth the way to greater startup success.

Congress did this by adding four primary provisions to the JOBS Act:

  • An easing of regulations to allow for crowdfunding
  • An increase in the shareholder ceiling for private companies from 500 to 2,000
  • The ability for companies doing less than $1 billion in revenue to file an IPO confidentially with the Securities and Exchange Commission, which latitude Twitter recently used to file for its IPO
  • (In response to the JOBS Act) a loosening of demands around General Solicitation by the SEC, or the ability of startups to more broadly solicit the purchase of shares in their companies

While no one thought the JOBS Act was perfect—former Wall Street financier Steven Rattner called it the "greatest loosening of securities regulation in modern history"—the tech industry generally welcomed the change. As Union Squares Ventures general partner Fred Wilson declared, "These new rules are much-needed regulatory relief for startup companies."

One Year (And Much More Regulation) Later...

Wilson isn't so optimistic anymore. Since the Securities Act of 1933 companies have been prohibited from generally marketing their securities to the general public ("General Solicitation"). But as the SEC has interpreted the JOBS Act, it has loosened these requirements, allowing general solicitation in a company's securities.

So far, so good.

The problem is that the SEC has also introduced new regulations that effectively neuter the impact of this change. As Wilson argues, the SEC has added burdensome regulations to the JOBS Act that "effectively make General Solicitation a non-starter for startup companies." Wilson lists the added burdens:

  • If you want to use General Solicitation, you must limit your investors to accredited investors (investors that satisfy net worth or annual income requirements) and you must undertake some specific efforts to make sure that your investors are in fact accredited;
  • A 15-day filing period for Form D before the company initiates its fundraising process;
  • The requirement to formally file all written materials provided to investors with the SEC is very burdensome when entrepreneurs update their slides and other fundraising material from meeting to meeting; and
  • The penalty for violating any of these rules is a one-year prohibition from being able to raise capital under Rule 506.

More disturbingly, says Lotus founder and active early-stage investor Mitch Kapor, "Practices that have worked well without incident for decades could suddenly become unintentional minefields for honest startups and sophisticated investors alike... This means that some of the most high profile ways new startups raise money transparently may now cause those same startups to go out of business if the penalties are enforced."

In other words, even startups that don't intend to "generally solicit" may be found to be doing so. Things like demo days and even tweets could suddenly impose unexpectedly high hurdles on a startup's funding plans.

A Good Law Gone Bad

For anyone that has raised venture capital, it will be immediately obvious why these rules won't work. For example, usually companies are required to file for Form D within 15 days of raising capital. Requiring them to file before they even start, without even knowing if they'll be able to raise money, is both problematic and potentially cumbersome. Some deals happen very fast and, indeed, speed is critical to getting a particular deal done on advantageous terms. This would ruin that.

Or what about the requirement that startups only sell securities to accredited investors? This seems like a reasonable way to protect investors, until you realize, as The Wall Street Journal's Gordon Crovitz highlights, "[W]hereas in the past investors attested to their financial qualifications, the onus is now on companies to obtain potential investors' tax returns or bank statements—information they're understandably reluctant to share."

More poignantly, imposing a one-year penalty for getting any of these rules wrong "effectively means that a startup that violates any of these rules is likely to be put out of business," as Wilson suggests, given the pace at which startups raise funding.

All of which means that the JOBS Act, intended to liberate startups to create more jobs and generate more wealth, will likely do little of either. In fact, the added regulations, still under public comment, could make things worse. Much worse. 

As such, you can make your voice heard by submitting comments here.