Good afternoon Chairman Garrett, Ranking Member Maloney, and Members of the Committee. My name is
First, I'd like to describe
My Background and
I was born and raised in
Our technology has also substantially evolved as we have invested millions of dollars into our online platform, which provides a central market and greater efficiency, an improved user experience, and a streamlined sales process for transactions in these asset classes. Moreover,
Over the years,
Need for Private Company Secondary Liquidity
Based on our considerable experience with private company shareholder transactions described below, I strongly support Section (5) of the proposed legislation referred to as "A bill to amend the securities laws to improve the small company capital formation provisions, and for other purposes" to adopt Section 4(a)(7) of the Securities Act of 1933 and to make securities sold pursuant to that exemption covered securities for purposes of Section 18 of the Securities Act of 1933. In my view, this legislation merely codifies a long-standing legal framework applicable to resales of private securities by shareholders who cannot meet the requirements of Rule 144 as described below. In addition, I would note that all of the securities eligible to be resold under Section 4(a)(7) are securities that were originally issued in transactions that were themselves exempt from registration, such as Rule 506(b), Rule 506(c) and Rule 701 (which exempts from registration issuances of securities to employees under certain equity compensation plans), and preempted from state law registration. It seems sensible to put these securities on equivalent legal footing in both the primary and secondary sale context for the reasons outlined below.
Rationale for Codifying Existing Legal Practice
The average time a company remains private has essentially doubled in recent years. Based in part on the provisions of the Jumpstart Our Business Startups (JOBS) Act of 2012, a private company now has the ability to defer an IPO and Securities Exchange Act of 1934 reporting and remain private longer than it might have done in the past. Moreover, the profile of companies going public has changed dramatically. Today, only the very largest companies are undertaking IPOs, and receiving the sales and equity research support needed to succeed as public companies.
It may be commonly understood that venture-backed companies fuel job growth in this country, n1 but most people do not appreciate the staggering extent to which this statement is true. In its 2010 study entitled The Importance of Startups in Job Creation and Job Destruction, the
Thus, it is essential that the regulatory framework responds to this dynamic and creates an environment in which startups can flourish. Every member of
I'd like to explain why facilitating shareholder liquidity is so important to the overall success of private companies. We were first approached about facilitating sales of private company stock in late 2007. A former Facebook employee contacted us and asked if we could help him sell his stock. He had read that we facilitated transactions in restricted stock of public companies. Since Facebook was not a public company, the stock had never been registered for public sale and Facebook did not have any IPO plans. We facilitated the transaction but then spent nearly a year conducting diligence to assess the viability of the market. Once we understood that companies were remaining private much longer than they had in the past, and that systemic changes in the public markets had made it increasingly difficult for companies to go public, we were convinced that we could help provide liquidity opportunities for private companies.
As a result of our experience,
We have also found that private companies are better able to attract and retain talented employees if those employees have the ability to monetize at least part of their equity compensation via a centralized liquidity event held on an annual or semi-annual basis. The pay structure at startup companies generally relies heavily on stock-based compensation in the form of options representing common shares that vest over several years. The options provide an economic incentive that allows employees to realize the financial upside of contributing to a successful startup. Startup companies prefer to give equity in lieu of cash compensation because startups generally need to conserve capital in order to grow the business, so making equity compensation more attractive to prospective employees will facilitate job creation and startup growth.
Options granted as part of a private employee's compensation package typically vest over a four year period and expire (a) a specified number of years after grant (e.g., five to seven years after grant date) or (b) at a point in time after the employee leaves the company (e.g., 60 or 90 days after employment ends). Exercise of employee options, however, requires that the employee pay the option exercise price at the time of exercise and also triggers an income tax event for employees resident in states that impose an income tax.
A minority of private company options are exercisable on a cashless basis, meaning that the employee forfeits options in an amount equal to the cost of the exercise price and any applicable taxes in order to exercise the remainder. Most options, however, require that the employee go out of pocket to pay the applicable exercise costs, which can be significant. The significant consequence of this requirement for rank and file employees cannot be understated. Most employees cannot fund these exercise costs; they must structure an exercise and immediate sale of common shares to order to cover these costs. Under the current legal framework, it is very difficult, if not impossible, for employees to navigate the federal and state requirements applicable to the exercise of their options and resell of the common shares on their own, and engaging legal counsel to do the analysis on their behalf can be cost prohibitive. As a result, a substantial amount of private company employees' options may not be exercised and, thus, expires, resulting in the forfeiture of economic value and loss of potential income.
Challenges Presented Under Current Legal Framework for Private Company Shareholder Liquidity
As a general matter, in order for a private company shareholder to sell his shares, the shareholder must engage his own legal counsel and pay them to provide an opinion confirming that the shares were sold pursuant to valid federal and state exemptions from registration. The legal opinion is delivered to the company's transfer agent, along with a transfer fee that may be as high as
The challenge comes into play, however, where the shareholder cannot rely on Rule 144 because they are an affiliate of the company, as is the case for officers, directors and control persons, or where the shareholder has not held the shares to be sold for the requisite 12 month period, as in the case of a private company employee who holds options, but not the common stock underlying the options. In either case, the shareholder needs to identify both a federal and state exemption from registration for the resale transaction since the transaction is not preempted from state blue sky laws.
On the federal level, no specific statutory safe harbor exists for these types of resale transactions. Instead, a legal construct referred to as Rule 4(a)(1 1/2) has developed as a result of case law and legal analysis over the past 60 years. n6 The basic requirement of Rule 4(a)(1 1/2) is that the transaction satisfy certain elements of both Section 4(a)(1), the non-issuer exemption, and 4(a)(2), the issuer exemption, such as that there is no public offering and that all buyers are accredited investors. While the
The most significant disadvantage of the lack of a specific federal safe harbor for these transactions is that each transaction must also satisfy the blue sky laws of the state of residence of every potential accredited investor buyer. The difficulties imposed by this obligation are clearly understood when you consider our efforts to provide liquidity for shareholders of private community bank shares. Starting in 2011,
The community banks that we worked with throughout 2011 and 2012 were generally focused on providing liquidity to their existing shareholders in a forum where individual accredited investors, rather than institutions, would buy their shares. The banks saw a tremendous benefit in attracting new shareholders who were members of their communities or surrounding areas and expressed the belief that providing regular secondary share liquidity events would make it easier for them to raise primary capital and, subsequently, lend more money to local businesses. Most of the banks' shareholders are account holders or employees, including officers and directors, so allowing those shareholders the opportunity to monetize even a portion of their shareholdings on an annual or semi-annual basis would also inject additional capital into the community in the form of discretionary income, capital gains taxes and additional income taxes.
Before launching our community bank initiative, we conducted an in-depth analysis of the various private company selling shareholder transaction exemptions provided by all 50 states. We found that state regulations relating to these transactions are generally inconsistent, which made it very difficult to establish a nationwide approach to implementing liquidity programs for shareholders looking to sell their shares. Since private company secondary transactions have the potential to generate significant income and capital gains tax revenues at the state level, the lack of clarity as to the availability of these exemptions across the states may limit a shareholder from transacting in a particular state, resulting in lost revenue for that state.
Our nationwide analysis demonstrated that most states provide for one or more variations of four non-issuer transaction exemptions. The specific requirements of these exemptions, however, vary significantly across the states, creating confusion and increasing the costs associated with obtaining liquidity in situations where the shareholder in a single liquidity program seeks to sell shares to accredited investors located in more than one state.
The variability of the requirements relating to each exemption also make it extremely difficult, if not impossible, for an intermediary, such as a broker-dealer, to assist a private company in locating buyers to provide liquidity for its shareholders. For example, forty-four states provide an exemption for transactions effected through a broker-dealer resulting from an unsolicited offer from a buyer interested in purchasing private company shares from an existing shareholder. In the case of this exemption, individual states impose a wide variety of limitations and restrictions on the use of the exemption. For example, some states require that a purchaser acknowledge or confirm in writing that the bid for the security was unsolicited. In addition, some states limit the use of this exemption by affiliates of an issuer.
The following chart represents the patchwork of state blue sky laws applicable to the unsolicited broker transaction exemption as of
To make matters even more difficult, this exemption generally prohibits broker-dealers from soliciting customers that were previously known to the broker-dealer, an approach that is inconsistent with FINRA rules and regulations and the guidelines applicable to primary offers made under Rule 506(b) of Regulation D. State regulations that require that bids be unsolicited unnecessarily restrict the ability of broker-dealers to identify potential accredited investor buyers for private company shareholders even among a broker's existing client base. n8 As a result, shareholders and broker-dealer intermediaries acting on their behalf have greater difficulty finding liquidity for their shares.
In light of the state law limitations on our ability to efficiently locate potential buyers for the shares of private community banks across multiple jurisdictions, even within our membership base of over 25,000 accredited investors, we ultimately ceased our efforts to create efficient liquidity events for community banks.
In 2013, I participated in the
Conclusion on Proposed Section 4(a)(7)
In light of the specifics provide above, I strongly support Section (5) of the proposed legislation referred to as "A bill to amend the securities laws to improve the small company capital formation provisions, and for other purposes" to adopt Section 4(a)(7) and to make securities sold pursuant to that exemption covered securities for purposes of Section 18 of the Securities Act of 1933.
Proposed Regulation D Legislation
I would also like to comment on the draft legislation referred to as "To direct the
Consider the reality of how most startup businesses actually raise capital. Early and mid-stage startup private companies are under constant pressure to raise capital in order to grow and expand their businesses. Capital is generally sought by the company's CEO on a continuous basis. The company seldom prepares a formal private placement memorandum, but, instead, uses an investor deck as a tool to explain the company to potential investors.
With respect to the specific provisions of the draft legislation that I view as necessary to preserve a functional capital raising environment for startup businesses, I have the following comments.
Section 1(1) - Advance Filing of Form D
Many startups will be unaware of the legal technicalities and may unintentionally run afoul of the proposed rules. The continuous offerings of startup businesses often lack a clear "commencement date" that can be relied upon to mark the start of the proposed 15-day filing period. This creates confusion for issuers trying to determine when the Advance Form D filing requirement would be triggered.
In the release outlining the proposed rules, the
The Advance Form D filing requirement also has significant implications for state law compliance. While the
I strongly believe that the imposition of the requirement to file an Advance Form D will deter a wide range of private issuers from relying on Rule 506(c), and significantly diminish a central focus of the JOBS Act. Therefore, I support Section 1(1) of the proposed legislation.
Section 1(2) - Failure to file Form D
The proposed amendment to Rule 507 to disqualify an issuer who failed to comply with the Form D filing requirements within the past five years from relying on Rule 506 for any new offering for a one year period is clearly contrary to the intent of the JOBS Act and punitively disproportionate to the impact that such failure would have on investors and the market. There is absolutely no basis for an amendment that would penalize an issuer for the failure to properly file the Form D by imposing a one-year ban from reliance on the exemption for future offerings.
Such a ban would serve as a death knell for many startups and other issuers that inadvertently fail to comply with highly technical legal filing requirements due to a lack of sophistication or lack of access to legal counsel. Investors participating in a Rule 506 offering will be accredited investors and will have access to all of the information that they consider necessary to make an investment decision. Investors will surely suffer no harm if the issuer fails to properly file a Form D (or possibly multiple variations of Form D). The
Section 1(2) of the proposed legislation will eliminate this overly burdensome penalty.
Section 1(6) - Submission of Written General Solicitation Materials
Rule 510T of Regulation D would require that an issuer conducting a 506(c) offering submit to the
The absence of a definition of "written general solicitation materials" will cause widespread confusion and noncompliance. Startups seeking capital will likely utilize social media as a means to solicit investor interest, a communication format that does not allow for long and complicated legal legends. Notwithstanding that it is difficult to know which communications would be subject to the disclosure requirement, many private issuers will be intimidated by an obligation to provide every written communication used in investor communications in the context of a Rule 506(c) offering to the
As a result, of all of the Commission's proposed changes to Regulation D, proposed Rule 510T would likely prove the greatest deterrent to an issuer considering whether to raise capital under Rule 506(c). Accordingly, I support Section (6) to require the submission of materials in a single filing after the closing of an offering but would also request that the
In summary, I want to thank Chairman Garrett, Ranking Member Maloney, and the members of the Committee for the opportunity to participate in this important Hearing.
n1 Venture-backed companies in
n2 The Importance of Startups in Job Creation and Job Destruction, Kauffman Foundation Research Series: Firm Formation and Economic Growth,
n5 When a company uses
n6 See The Section "4(1 1/2)" Phenomenon: Private Resales of "Restricted" Securities, 34 Business Law 1961 (1978-1979).
n7 Securities Act Release 6188, footnote 178, 45
n8 In 2012, we submitted an interpretative request to the
n9 Final report pending.
n10 SEC Release No. 33-9416; 34-69960; IC-30595; File No. S7-06-13.
Read this original document at: http://financialservices.house.gov/UploadedFiles/HHRG-113-BA16-WState-ATierney-20140501.pdf
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