Equity Financing Alternatives for Small Business: A Review of Best Practices in the United States

11. Financing Flow Linkage Systems

Linkage systems increase the accessibility of investors to entrepreneurs and vice versa. In addition, they increase the aggregate level of equity financing for small business. The larger the number of effective linkage systems in a given investment setting the more accessible risk capital is for entrepreneurs. It is important to note that many flow linkage systems facilitate the creation of other systems. For example securities exchange exemptions for small businesses seeking equity financing has fostered the development of a number of private Angel networks such as garage.com (reviewed in more detail in section 11.2.3) and other public networks such as ACE-net (section 11.2.1)

11.1 Government Initiatives

11.1.1 Securities Exchange Exemptions¹⁸

The Securities Act generally requires companies to provide full disclosure of all "material facts" investors require to make an informed investment decision. Companies wishing to trade sell securities in the US must register with the SEC. However, there are a number of exemptions that only require limited registration or none at all.

Intrastate Offering Exemption

Section 3(a)(11) of the Securities Act, is known as the Intrastate Offering Exemption. This exemption facilitates the financing of local business operations. The name of the exemption indicates its nature. In order to qualify the company must be incorporated in the state in which it is offering its securities; it must carry out a significant amount of business in and offer and sell securities only to residents of that state. There is no limit on the size of the offering or the number of purchasers. Securities cannot be resold to residents living outside the state for nine months after the offering is complete.

Private Offering Exemption

Section 4(2) of the Securities Act exempts from registration "transactions by an issuer not involving any public offering." This exemption refers to the common type of private investment in equity finance. To qualify for this exemption, the purchasers must be "sophisticated investors" which should not be confused with accredited investors. "Sophisticated" simply means the investor must be able display that they fully understand the risks associated with investing, must be able to understand basic financial calculations and statements and, must be able to bear the risk of investment. They must have access to relevant information and agree not to resell or distribute the securities to the public.

Regulation A

Section 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities offerings. Regulation A is an exemption for public offerings not exceeding $5 million in any 12-month period. The company must file an offering statement consisting of a notification, offering circular, and exhibits for review. Regulation A offerings are similar to registered offerings (i.e. one that will be freely traded on a stock exchange) in many respects. For example, purchasers must be provided with an offering circular. Also, the securities can be offered publicly and are freely tradable in the secondary market after the offering is complete. However, the exemption has some key differences primarily intended to promote small business financing. For example, the initial financial statements do not need to be audited and there are no reporting obligations after the offering, unless the company has more than $10 million in assets and more than 500 shareholders. Once the SEC has conducted a brief and informal evaluation, the offering can be advertised prior to filing. This will allow entrepreneurs to determine demand for their securities prior to incurring the legal costs of filing the statement of offering.

Accredited Investor Exemption – Section 4(6)

Offers and sales of securities to accredited investors not exceeding $5 million are exempt from registration. No general advertising or solicitation is permitted. Financial reporting is not required.

According to the SEC an "accredited investor" is:

• a bank, insurance company, registered investment company, business development company, or small business investment company;
• an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
• a charitable organization, corporation or partnership with assets exceeding $5 million;
• a director, executive officer, or general partner of the company selling the securities;
• a business in which all the equity owners are accredited investors;
• a natural person with a net worth of at least $1 million;
• a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
• a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.

Source: Securities Exchange Commission Web site: http://www.sec.gov

Regulation D

Regulation D was established primarily to facilitate investment in small business and has three rules.

Rule 504

Companies are exempt for offerings up to $1 million within a 12-month period. Freely tradable securities can be sold under the following circumstances:

• the offering is registered in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;
• the offering is registered in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors and sold in another state without requirements, as long as the disclosure documents required by the state in which the offering is registered are provided to all purchasers; or,
• the offering is completed according to state law exemptions that permit general solicitation and advertising and securities are sold to "accredited investors" (see v) for SEC definition of accredited investor).

Rule 505

Companies are exempt for offerings up to $5 million within a 12-month period. Securities may be sold to an unlimited number of "accredited investors" and up to 35 other investors. The issued securities are not freely tradable and general solicitation or advertising cannot be conducted. An independent public accountant must certify financial statements.

Rule 506

Rule 506 is a called a "safe harbor" for the SEC's private offering exemptions. This rule is similar to 505 except that an unlimited amount of capital can be raised to an unlimited number of accredited investors and 35 other purchasers. However, the other purchasers must be "sophisticated", meaning that they must have sufficient knowledge of financial and business matters as to be capable of making sound investment judgments. General solicitation or advertising of securities is not permitted.

California Limited Offering Exemption – Rule 1001

Companies are exempt for offerings up to $5 million that also satisfy the conditions of section 25102 of the California Corporations Code*. California companies can offer securities to "qualified purchasers" whose characteristics are similar to, but not the same as, accredited investors under Regulation D. This exemption allows some form of general solicitation prior to sales.

* Section 25102 of the California Corporations Code is similar to Regulation D described above and provides the list of exemptions form state securities laws.

Exemption for Sales of Securities through Employee Benefit Plans: Rule 701

Rule 701 exempts sales of securities intended to compensate employees. This exemption is available only to companies that are not subject to SEC reporting requirements. $1 million in securities can be issued without providing financial statements to employees. Additional securities can be offered according to asset and share ratios set by the SEC. If more than $5 million in securities are offered in a 12-month period, employees must be provided limited disclosure documents. Securities are not freely tradable.

Additional Information: http://www.sec.gov/smbus/qasbsec.htm#eod6

Summary of Exemptions

By legislating securities exchange exemptions, many dating back as far as 1933, the US government has functioned as a catalyst in increasing the overall number of linkage systems within the entire equity capital setting. The impetus was provided for investors and entrepreneurs to develop new equity finance markets and networks beyond traditional securities exchanges. Also, many established exchanges now offer new services to small businesses as the level of demand for these investments continues to grow. It is also important to note that these government programs have been proactively adapting to new developments. In particular, SEC exemptions led to an increased demand by investors for private placements. As a result, the government created ACE-net to increase the level of interaction between private investors and entrepreneurs beyond the local environment. By adapting to new developments in information technology (i.e. the Internet), ACE-net has provided an early model for the many online private angel networks now in existence.

11.1.2 ACE-net

The Access to Capital Electronic Network (ACE-Net) was developed by the U.S. Small Business Administration's Office of Advocacy in order to create a national online network where accredited investors can locate and invest in small businesses. It has only been widely used during the past few years with the proliferation of the Internet. In order to qualify for the database, small businesses must acquire a "no-action letter" issued by the Securities Exchange Commission. This letter states that the company is "in full compliance with the appropriate filing and registration requirements of federal and state securities laws and regulations."¹⁹ A small company can raise up to $5 million using ACE-net. However, up to $1 million can be raised without having to register a securities offering under the SEC's Regulation D, Rule 504, by taking advantage of the Accredited Investor Exemption or similar state variations.²⁰

ACE-net has been successful in addressing some important obstacles in small business equity finance. First, it has begun to reduce geographical barriers between investors and entrepreneurs. Previously, entrepreneurs found it difficult to identify investors outside of their local area. The Internet allows the "distance" between entrepreneurs and investors to be reduced while direct communications can be established. Ultimately, most parties will eventually have to meet in person before any investments are made; however, the screening process for both parties now includes candidates across the country. Second, the development of an online database of entrepreneurs and business plans saves time for investors. The length of time spent on the initial screening process has been dramatically reduced. Investors (and entrepreneurs) do not have to spend valuable time traveling a meeting in order to determine the attractiveness of an investment. Once a few investments have been determined to fit the requirements of a particular investor, then the traditional presentation process can begin. Time spent attracting investors can also be reduced for the entrepreneur. Information is created once and accessed by multiple investors from across the country. The end result is that the equity finance process has been rationalized to a certain degree. Investors and entrepreneurs that do commence communications have already been screened which will likely speed up the process of investment.

Additional Information: https://ace-net.sr.unh.edu/pub/

11.2 Private Initiatives

11.2.1 Securities Exchanges

Although most assume that Initial Public Offerings (IPO's) are the domain of large corporations, small businesses can often attract large amount of growth capital through IPO's. There are a number of Stock exchanges in the United States that serve small businesses. The major incentive for investors is the level of liquidity that is provided. As long as there is a secondary market for a specific stock, investors will be more likely to invest. Stock exchanges have quantitative and qualitative listing and maintenance standards and stringent reporting obligations (most often to the SEC), which are often deterrents for small businesses. In many cases, a small business simply cannot afford the costs associated with an IPO. However, successful SMEs with high growth potential can often finance IPO's through banks and VCs. This is called mezzanine financing.

American Stock Exchange (AMEX)

AMEX, the second largest floor-based exchange in the US, has the following requirements for listing²¹.

• Size: Stockholders' equity of at least $4,000,000
• Income: Pre-tax income of at least $750,000 in its last fiscal year, or in two of its last three fiscal years.
• Distribution: Minimum public distribution of 500,000 shares together with a minimum of 800 public shareholders or minimum public distribution of 1,000,000 shares together with a minimum of 400 public shareholders.

Additional Information: http://www.amex.com

National Association of Securities Dealers (NASDAQ)

The Nasdaq Stock Market has two tiers, the Nasdaq National Market and the Nasdaq SmallCap Market. Each tier has its own set of financial requirements and standards of corporate governance.

National Market

• Size: $6 million in Net Tangible Assets
• Income: $1 million
• Distribution: 1.1 million shares with a minimum market value of $8 million and 400 shareholders and a minimum bid price of $1.

SmallCap Market

• Size: $4 million in net tangible assets or $50 million in market capitalization
• Income: $750,000
• Distribution: 1 million shares with a minimum market value of $5 million and 300 shareholders and a minimum bid price of $1.

Additional Information: http://www.nasdaq.com

Philadelphia Stock Exchange (PHLX)

The PHLX is the oldest stock exchange in the US. It's Tier 2 listing is especially catered to small business listings.

• Size: $3 million in net tangible assets
• Income: Net income of $100,000 in 2 of past three years
• Distribution: 500,000 shares with a minimum of and 800 shareholders.

Additional Information: http://www.phlx.com

Boston Stock Exchange

• Size: $4 million in net tangible assets
• Income: pre-tax income of $750,000 and net income of at least $400,000
• Distribution: 750,000 shares with a minimum of and 600 shareholders and a minimum bid price of $2.

Additional Information: http://www.bostonstock.com

Chicago Stock Exchange

Tier 1- Basic

• Size: $4 million in net tangible assets
• Income: pre-tax income of $750,000 and net income of at least $400,000
• Distribution: 500,000 shares with a minimum of and 800 shareholders and a minimum bid price of $5.

Tier 2

• Size: $2 million in net tangible assets
• Income: pre-tax income of $750,000 and net income of at least $400,000
• Distribution: 250,000 shares with a minimum of and 500 shareholders and no minimum bid price.

Additional Information: http://www.chx.com/

Other Exchanges

There are also other exchanges which meet the needs of small businesses. These include the Cincinnati, San Diego the Pacific stock exchanges.

11.2.2 NASDAQ Over the Counter Bulletin Board

The Over-the-Counter Bulletin Board (OTCBB) is a regulated quotation service for over-the-counter (OTC) equity securities. An OTC equity security generally is any equity that is not listed or traded on a national securities exchange. Issuers of these securities often have no reporting obligations to any federal regulatory authority. OTCBB does not provide issuing services and there are no minimum requirements to be included in the bulletin board. There is no formal relationship between the OTCBB and issuers of stock. However, issuers of securities which began quotation on the OTCBB after January 4, 1999 are subject to minimal periodic filing requirements with the SEC. OTCBB securities are traded by a community of "Market Makers" that enter quotes and trade reports through a closed computer network.

Additional Information: http://www.otcbb.com/

11.2.3 Private Angel Networks

Traditional investment clubs have now been transformed into what are commonly known as Angel networks. Local investment clubs now primarily consists of friends pooling funds to invest in publicly traded equities. Angel networks are primarily coordinated by for-profit companies that solicit information from entrepreneurs and investors. This information is then entered into a database and processed in order to find entrepreneur-investor matches. Not all angel networks are automated or operate for a profit. In such cases, angel networks are often informal meetings between potential entrepreneurs and angel investors, however more networks are using information technology to improve efficiency. As stated earlier, online databases have not only reduced the overall time it takes to match investors to entrepreneurs, but it also allows for interactions between geographically dispersed parties.

For-profit angel network companies earn revenues through annual subscription fees charged to entrepreneurs and/or investors in exchange for access to the network. The entrepreneur submits business plans or online forms to the network, while investors prepare a profile of the type of business they wish to invest in. Most often it is left to the investor to contact the entrepreneur and details of investment are left to the two parties. Examples of online Angel Networks include:
www.garage.com
www.rule506.com
www.angelnetwork.com
www.business-angels.com

11.2.4 SCOR and Direct Public Offering Networks

The Small Corporation Offering Registration (SCOR) was adopted in 1989 by the North American Securities Administrators Association. It was designed to make the process of equity financing easier for small companies raising less than $1 million. Although Regulation D eases the process of securities offerings for small businesses, it does possess certain obstacles for entrepreneurs. Specifically, most offerings in excess of $500,000 are limited to no more than 35 investors, while general solicitation is not permitted. In addition, these securities are not freely tradable until registered with the SEC, which can be extremely costly and time consuming. Thus, many offerings must be discounted to reflect their lack of liquidity.

SCOR eliminates most of the red-tape associated with SEC registration and allows entrepreneurs to raise up to $1 million. There are no restrictions on trading of these securities, thus, investors obtain much more liquidity resulting in higher prices for the securities. The SCOR has only been widely used since 1992. From 1992 to 1995 approximately 754 companies filed for approval to sell securities under SCOR regulations with state securities commissions. Of the 476 approved applications 110 succeeded in raising capital.²²

Under SCOR, small business owners complete a fifty-question form, called a U-7. It is then submitted for approval to the state where the securities will be sold. Also, a Form D must be submitted to the SEC for reference purposes. Most states require some form of additional information beyond the U-7. The review process is conducted by securities regulators, who will often request clarifications. In addition, certain states evaluate the "merits" of the offering. Once the regulators are satisfied, the company can begin to sell its securities.

Direct Public Offering (DPO) Networks

The rapid growth of SCOR during the past few years has provided an incentive for the creation of networks devoted to matching investors to this type of investment. There is only one well established DPO network, Direct Stock Market, Inc. It is an online service created to facilitate the exchange of information between investors and emerging growth companies with the purpose of increasing equity financing options for entrepreneurs. The Direct Stock Market is very different from Angel networks as it offers both private placements for SCOR and other eligible small business equities, but it also provides a much needed secondary market for these securities.

Additional Information: http://www.dsm.com