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At the State Science & Technology Institute's September conference in Portland, Thomas Vass, of the Private Capital Market, Inc., is going to address the conference on how the new Regulation D 506(c) rules can promote regional economic growth. His presentation is titled “How Economic Developers Can Fill The Crowdfunding Capital Market Gaps In Regional Innovation Ecosystems: Economic Developers Can Manage The Regional Deal Flow Pipeline.” The first part of his presentation, which we are sharing below, addresses the current myths about Reg. D offerings. You can view the full paper here.
The State Science & Technology Institute (SSTI) is a national research consortium comprised of hundreds of regional economic development member agencies, all of which believe that technology-based economic development provides great economic and social benefits to metro regions in terms of job creation and increased incomes.
The SSTI September conference in Portland is called “Dynamic Innovation Ecosystems: Bringing It All Together,” and is focused on how research, capital, workforce, and manufacturing fit together into a coherent strategy. One of their sessions is dedicated entirely to how crowdfunding can be integrated into a regional innovation economic strategy.
Integrating Title II Regulation D Rule 506 offerings under the JOBS Act into regional economic development strategies will require a completely different method of promoting technology-based economic development than the prevailing university tech transfer – venture capital model currently favored by members of SSTI.
The best way for SSTI members to fit Reg. D crowdfunding into regional innovation economic policy is to promote a division of labor between crowdfunders and economic developers, so that each group specializes in what they do best.
That would mean having economic developers (like SSTI members) doing the tasks that crowdfunders cannot do themselves in managing the regional deal flow pipeline. In order to manage the deal flow pipeline, members of SSTI would need to bust the five big myths about Reg. D offerings.
As a way of introducing the five myths, it is useful to review the chart prepared by the SEC on the total amount of private capital issued in the U. S. between 2009 and 2012.
From a report mentioned in the statement at the SEC Open Meeting by Chairwoman Mary Jo White, U.S. Securities and Exchange Commission, Eliminating the Prohibition on General Solicitation and General Advertising in Certain Offerings, July 10, 2013, Washington, D. C.
Myth #1: Private capital market transactions that promote economic development rely on VCs and angels as the primary sources of capital.
The Reg. D Rule 506 private placement market in 2012 provided about $800 billion in capital to deals, and the 144A market added about $700 billion.
For comparison, the best guess of all venture capital in 2012 invested in private deals was about $26.5 billion in 3,698 deals. 1
In other words, the entire amount of VC/angel capital invested in 2012 deals was about 1.5 percent of the total capital invested in private deals, allowing for some minor statistical data issues of double counting from both sources of data.
The important point about this data for promoting technology based economic development, as it relates to Myth #1, is that Rule 144A capital is nearly as big, and as important, as all Reg. D capital.
Economic development professionals would want to expand their framework of how Reg. D capital fits into a larger capital market by including 144A offerings. In the logical chronology of events surrounding technology based economic development, Reg. D offerings occur first, and then later, as if capital funding occurred in a pipeline of deals, 144A offerings occur to assist the early investors take their gains and exit the deal.
The venture capital and angel funding is significant at the very earliest stages of the deal pipeline, but it is a very small part of the bigger capital market picture.
Myth #2: There is rampant fraud in private securities offerings.
Section 501 of the 2002 Uniform Securities Act, titled “General Fraud,” states that it is unlawful, in
connection with the offer, sale, or purchase of a security, to employ a device, scheme, or artifice to
defraud; to make an untrue statement of material fact; to omit to state a material fact; or to engage in an
act, practice, or course of business that operates as a fraud or deceit upon another person.
The North American Securities Administrators Association (NASAA) is comprised of U. S. state securities officials, who coordinate regulation of state investment advisors and stock brokers, across state lines.
Each year, NASAA prepares a report on the cases of fraud that its members investigate. The survey traditionally gauges the extent and prevalence of enforcement efforts by state securities regulators, and identifies trends and issues in national investor protection.
The 2012 NASAA enforcement report states, “The majority of fraud cases featured unregistered individuals selling unregistered securities. More than 800 reported actions involved unregistered securities, and more than 800 actions involved unregistered firms or individuals.” 2
“A total of 632 reported actions involved unregistered individuals and 485 actions involved unregistered firms,” the report continues. “This compares to 399 reported actions against investment adviser firms, the largest number of actions in any registered category and nearly double the reported investment adviser actions the year before. There were 359 reported actions against registered broker dealers and 297 actions
against registered broker dealer agents. In addition, 151 actions were taken against investment adviser
To place this data in its accurate context, NASAA members regulate about 20,000 state registered investment advisors, and in 2012, there were about 18,000 new Reg. D Form D filings for private offerings. As stated by the SEC in its proposed public solicitation rules, “For the year ended December 31, 2012, 16,067 issuers made 18,187 new Form D filings, of which 15,208 issuers relied on the Rule 506 exemption. Based on the information reported by issuers on Form D, there were 3,958 small issuers.”
In other words, out of 20,000 state registered investment advisors, and over 18,000 Reg. D private securities offerings, involving 4000 companies, NASAA captured 151 advisor representatives and captured about 800 firms who were not properly registered in 2012.
The SEC also emphasized the issue of fraud in Reg. D offerings in its public solicitation proposed rules. The SEC cited an independent scholarly economic research article on actions involved with rights of rescission of contracts, when a Reg. D offering goes bad. 3
In this case, investors in a bad deal have the right to rescind their contract, and get their investment money back from the company.
As the SEC reports notes, “A more recent study has identified 245 lawsuits (both federal and state) involving 200 venture capitalists as defendants between 1975 and 2007, and has shown that VC funds that are older and have a larger presence in terms of size and network are less likely to be sued.” 4
To summarize the research report on fraud, over a 22 year period of time, in both state and federal courts, the SEC notes a total of 245 lawsuits involving venture capital firms related to Reg. D offerings, some of which may have involved fraud.
The important point about busting Myth #2 for economic development professionals is that they need to be able to recognize fraud when they see it, but that the issue of fraud is primarily a political red-herring that is being dragged across the floor by opponents of crowdfunding to delay and limit its implementation.
Reg. D Rule 506 offerings can easily be used to promote regional technology strategies with a very minor risk of increasing the current rate of fraudulent offerings.
Myth #3: Most Reg. D private offerings involve new venture, entrepreneurial startups.
Most Reg. D offerings in the past four years have been for established, operational companies, with top line revenues in a range of around $1 million, according to the SEC's proposed rules for public solicitation. The median size of the Reg. D offering was $1.5 million in 2012.
The proposed rules state, “Offerings conducted in reliance on Rule 506 account for 99% of the capital reported as being raised under Regulation D from 2009 to 2012, and represent approximately 94% of the number of Regulation D offerings. The significance of Rule 506 offerings is underscored by the comparison to registered offerings. In 2012, the estimated amount of capital reported as being raised in Rule 506 offerings (including both equity and debt) was $898 billion, compared to $1.2 trillion raised in registered offerings. Of this $898 billion, operating companies (issuers that are not pooled investment funds) reported raising $173 billion, while pooled investment funds reported raising $725 billion.”
The SEC continues: “An analysis of all Form D filings submitted between 2009 to 2012 shows that approximately 11% of all new Regulation D offerings reported sales commissions of greater than zero because the issuers used a broker intermediary. The average commission paid to these intermediaries was 5.9% of the offering size, with the median commission being approximately 5%. Accordingly, for a $5 million offering, which was the median size of a Regulation D offering with a commission during this period, an issuer could potentially save up to $250,000 if it solicits investors directly rather than through an intermediary…”
In other words, over a 4-year period, only 11 percent of the Reg. D offerings involved the payment of commissions, yet this 11 percent of the market is driving the political red-herring agenda at the SEC in issuing rules on crowdfunding.
The significance of busting Myth #3 for economic developers is that their primary focus will shift from the prevailing focus on the university tech transfer model to targeting investments to the population of established, operational, small manufacturing, and IT firms within a metro regional economy.
For the median offering of $5 million that involve commissions for the venture capital intermediary, those small firms will save an average of $250,000 in commissions by conducting a Reg. D Rule 506(c) crowdfunding self-underwriting.
Myth #4: There are not many investors who will be interested in crowdfunding, and therefore the status quo approach under Title II of the JOBS Act is the most important focus.
The NASAA report cited above suggests that there are only a small number of potential accredited investors who may be interested in crowdfunding. This statement about the future numbers of potential accredited investors for crowdfunding is a myth.
There are about 5 million U. S. households with incomes that would qualify as a potential Reg. D accredited investor under the Reg. D Rule 506(c) rules for crowdfunding. More importantly for regional economic development strategy, clusters of very wealthy investors exist in distinct geographical locations, primarily in the 350 U. S. metro regions with over 150,000 population.
That population of potential accredited investors in each metro region has an existing affinity interest in promoting local economic development in their home communities.
According to the data in the proposed rules on general solicitation, about 234,000 accredited investors made Reg. D investments in 2012. As the SEC states, “In 2012, approximately 153,000 investors participated in offerings by operating companies, while approximately 81,000 investors invested in offerings by pooled investment funds.”
The 153,000 investors who made direct investments in operating companies are the target market for economic developers who want to integrate crowdfunding into regional economic strategy. They were primarily individual investors, not angels or venture capitalists, who made investments in existing operational companies, not entrepreneurial new ventures.
The 81,000 investors who made Reg. D investments in pooled funds, primarily invested in venture capital limited partnerships, and the VCs then turned around and invested in private deals, primarily the type of deals that look a lot like the ones that come from the university tech transfer office.
In busting Myth # 4, the language used to describe potential Reg. D Rule 506 investors would make a clear distinction between the 153,000 investors who made direct investments, and the 81,000 investors who made investments through pooled accounts.
The 153,000 direct investors are generally called “Lone Wolf Investors.” The 81,000 other investors are commonly called “Angels.”
The primary target investor population for technology based economic development would shift from the emphasis on angels to a focus on finding lone wolf investors among the potential population of about 5 million American households in 150 metro regions.
Myth #5: The financial interests and legal rights of non-accredited investors should be the primary public policy focus on implementing crowdfunding rules.
In its September 2012 proposed rules on eliminating the prohibition on general public solicitation of a Reg. D offering, the SEC combined a long and complicated list of factors that a company must first assess, before they could raise crowdfunding capital. 5
The SEC proposed rules stated, “These factors are interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accredited investor, which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status.
Seven months later, as the rules noted, “90 percent of the Regulation D offerings conducted between 2009 and 2012 did not involve any non-accredited investors.”
In other words, the political red herring of fraud in Reg. D offerings is connected to the exploitation of non-accredited investors, but the evidence suggests that non-accredited investors are not a significant population of Reg. D investors.
More than two thirds of all Reg. D private offerings in 2012 had 10 or fewer investors, and less than 5 percent of all offerings had more than 30 investors.
In other words, 95 percent of Reg. D offerings in 2012 involved less than 30 investors per deal and involved very small amounts of capital, invested in very small operational companies, with very few non-accredited investors.
This population of small firms and very few Reg. D investors per deal, will become the target market for economic development professionals interested in integrating Title II Reg. D crowdfunding into regional economic strategy.
Most of the small Reg. D deals between 2009 and 2012 involved equity, and almost 1/3 of all offerings during that period involved the issuance of bonds, not stock or equity interests.
As the SEC noted, “Between 2009 and 2012, approximately 66% of Regulation D offerings were of
equity securities, and almost two-thirds of these were by issuers other than pooled investment funds.”
In busting Myth #5, it is important to remember that the JOBS Act was not passed by Congress in order to help the CEO of a small company assess the credentials of an investor. The main public policy goal addressed by the JOBS Act is how to stimulate economic growth and job creation by small technology companies.
This is the same mission and goal shared by members of SSTI who seek to integrate the new form of crowdfunding capital into regional economic development strategies.
1 (MoneyTree Report by PricewaterhouseCoopers LLP and the National Venture Capital Association, based on data from Thomson Reuters)
2 (2012 Enforcement Report, Prepared by NASAA Enforcement Section, Washington, D. C., October 2012)
3 (Eliminating the Prohibition on General Solicitation and General Advertising in Certain Offerings, FACT SHEET, SEC Open Meeting, July 10, 2013)
4 (Vladimir Atanasov, Vladimir Ivanov, and Kate Litvak, Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence From Litigation Against VCs, 67 Journal of Finance 2215 (2012)
About Thomas Vass: Vass is the owner and manager of The Private Capital Market, Inc., a fee-based subscription crowdfunding website. Much of the analysis of this article is based upon his economic research and theory of technology, contained in Predicting Technology (2007). For more of his scholarly papers, click here.