Q&A: Small Business and the SEC
A guide to help you understand how to raise capital and comply with the federal securities laws
Table of Contents
I. What Are the Federal Securities Laws?
In the chaotic securities markets of the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits - without disclosing any meaningful information to investors. These conditions contributed to the disastrous Stock Market Crash of 1929. In response, the U.S. Congress enacted the federal securities laws and created the Securities and Exchange Commission (SEC) to administer them.
There are two primary sets of federal laws that come into play when a company wants to offer and sell its securities to the public. They are:
The Securities Act generally requires companies to give investors "full disclosure" of all "material facts," the facts investors would find important in making an investment decision. This Act also requires companies to file a registration statement with the SEC that includes information for investors. The SEC does not evaluate the merits of offerings, or determine if the securities offered are "good" investments. The SEC staff reviews registration statements and declares them "effective" if companies satisfy our disclosure rules. We describe this process in more detail beginning on page 7.
The Exchange Act requires publicly held companies to disclose information continually about their business operations, financial conditions, and managements. These companies, and in many cases their officers, directors and significant shareholders, must file periodic reports or other disclosure documents with the SEC. In some cases, the company must deliver the information directly to investors. We discuss these obligations more fully beginning on page 11.
Your company may be exempt from these registration and reporting requirements. We discuss exemptions beginning on page 16.
II. How Can I Get Answers to My Questions?
The SEC tries to meet the needs of small business through its rules and regulations. It also offers informal guidance by answering your questions over the phone, through the mail or by e-mail. The SEC offers you a number of ways to express your views and get help from the staff. Of course, you should always retain competent counsel before engaging in any securities offering.
Special Ombudsman to Serve You
In 1996, we appointed a Special Ombudsman for Small Business to serve you and to represent the concerns of smaller companies within the SEC. You can tell the Ombudsman your concerns about any SEC proposal or rule. The Ombudsman also can answer your general questions or help you find the answers to your specific questions. The Ombudsman's telephone number is (202) 551-3460.
The Office of Small Business
The Division of Corporation Finance's Office of Small Business directs the SEC's small business rulemaking initiatives and comments on SEC rule proposals affecting small companies. Its staff works with Congressional committees, government agencies, and other groups concerned with small business. The Office also specializes in the review of filings from small companies. Its telephone number is (202) 551-3460.
Town Hall Meetings
The Office of Small Business also sponsors small business town hall meetings across the country. These meetings help the SEC convey basic information to small businesses and learn more about the problems small businesses face in raising capital. These meetings help the SEC design programs that meet small businesses' needs while protecting investors.
Government-Business Forum on Small Business Capital Formation
In addition to the town hall meetings, the SEC sponsors the Government-Business Forum on Small Business Capital Formation. This annual meeting provides the only national forum for small businesses to let government officials from different parts of the federal government know how the laws, rules and regulations impact the ability of small companies to raise capital. You can get more information about this forum from the Office of Small Business.
Internet Web Site
We also maintain a home page on the World Wide Web at http://www.sec.gov. Our site includes recent SEC releases and other updating information of interest to small companies. Through our Web site, small companies and investors can also find documents publicly filed on the SEC's Electronic Data Gathering, Analysis, and Retrieval, or EDGAR, system. Most registration statements and other documents must now be filed electronically via that system.
III. Should My Company Go Public?
When your company needs additional capital, "going public" may be the right choice, but you should weigh your options carefully. If your company is in the very early stages of development, it may be better to seek loans from financial institutions or the Small Business Administration. Other alternatives include raising money by selling securities in transactions that are exempt from the registration process. We discuss these alternatives later.
There are benefits and new obligations that come from raising capital through a public offering registered with the SEC. While the benefits are attractive, be sure you are ready to assume these new obligations:
IV. How Does My Small Business Register a Public Offering?
If you decide on a registered public offering, the Securities Act requires your company to file a registration statement with the SEC before the company can offer its securities for sale. You cannot actually sell the securities covered by the registration statement until the SEC staff declares it "effective," even though registration statements become public immediately upon filing.
Registration statements have two principal parts:
The Basic Registration Form - Form S-1
All companies can use Form S-1 to register their securities offerings. You should not prepare a registration statement as a fill-in-the-blank form, like a tax return. It should be similar to a brochure, providing readable information. If you file this form, your company must describe each of the following in the prospectus:
Information about how to describe these items is set out in SEC rules. Registration statements also must include financial statements audited by an independent certified public accountant.
In addition to the information expressly required by the form, your company must also provide any other information that is necessary to make your disclosure complete and not misleading. You also must clearly describe any risks prominently in the prospectus, usually at the beginning. Examples of these risk factors are:
Alternative Registration Forms for Small Business Issuers
If your company qualifies as a "small business issuer," it can choose to file its registration statement using one of the simplified small business forms. A small business issuer is a United States or Canadian issuer:
Form SB-1 - To Raise $10 Million or Less
Small business issuers offering up to $10 million worth of securities in any 12-month period may use Form SB1. This form allows you to provide information in a question and answer format, similar to that used in Regulation A offerings, a type of exempt offering discussed on page 19. Unlike Regulation A filings, Form SB-1 requires audited financial statements.
Form SB-2 - To Raise Capital in Any Amount
If your company is a "small business issuer," it may register an unlimited dollar amount of securities using Form SB-2, and may use this form again and again so long as it satisfies the "small business issuer" definition.
One advantage of Form SB-2 is that all its disclosure requirements are in Regulation S-B, a set of rules written in simple, non-legalistic terminology. Form SB-2 also permits the company to:
Staff Review of Registration Statements
SEC staff examines registration statements for compliance with disclosure requirements. If a filing appears incomplete or inaccurate, the staff usually informs the company by letter. The company may file correcting or clarifying amendments. Once the company has satisfied the disclosure requirements, the staff declares the registration statement effective. The company may then begin to sell its securities. The SEC can refuse or suspend the effectiveness of any registration statement if it concludes that the document is misleading, inaccurate, or incomplete.
V. If My Company Becomes Public, What Disclosures Must I Regularly Make?
Your company can become "public" in one of two ways - by issuing securities in an offering registered under the Securities Act or by registering the company's outstanding securities under Exchange Act requirements. Both types of registration trigger ongoing reporting obligations for your company. In some cases, the Exchange Act also subjects your company's officers, directors and significant shareholders to reporting requirements. Let's discuss these requirements individually.
Reporting obligations because of Securities Act registration
Once the staff declares your company's Securities Act registration statement effective, the Exchange Act requires you to file reports with the SEC. The obligation to file reports continues at least through the end of the fiscal year in which your registration statement becomes effective. After that, you are required to continue reporting unless you satisfy the following "thresholds," in which case your filing obligations are suspended:
If your company is subject to the reporting requirements, it must file information with the SEC about:
All of this information becomes publicly available when you file your reports with the SEC. As is true with Securities Act filings, small business issuers may choose to use small business alternative forms and Regulation S-B for registration and reporting under the Exchange Act.
Obligations because of Exchange Act registration
Even if your company has not registered a securities offering, it must file an Exchange Act registration statement if:
If a class of your company's securities is registered under the Exchange Act, the company, as well as its shareholders and management, are subject to various reporting requirements, explained below.
Ongoing Exchange Act periodic reporting
If your company registers a class of securities under the Exchange Act, it must file the same annual, periodic, and current reports that are required as a result of Securities Act registration, as explained above. This obligation continues for as long as the company exceeds the reporting thresholds previously outlined on page 11. If your company's securities are traded on an exchange or on Nasdaq, the company must continue filing these reports as long as the securities trade on those markets, even if your company falls below the thresholds.
A company with Exchange Act registered securities must comply with the SEC's proxy rules whenever it seeks a shareholder vote on corporate matters. These rules require the company to provide a proxy statement to its shareholders, together with a proxy card when soliciting proxies. Proxy statements discuss management and executive compensation, along with descriptions of the matters up for a vote. If the company is not soliciting proxies but will take a vote on a matter, the company must provide to its shareholders an information statement that is similar to a proxy statement. The proxy rules also require your company to send an annual report to shareholders if there will be an election of directors. These reports contain much of the same information found in the Exchange Act annual reports that a company must file with the SEC, including audited financial statements. The proxy rules also govern when your company must provide shareholder lists to investors and when it must include a shareholder proposal in the proxy statement.
Beneficial ownership reports
If your company has registered a class of its equity securities under the Exchange Act, persons who acquire more than five percent of the outstanding shares of that class must file beneficial owner reports until their holdings drop below five percent. These filings contain background information about the beneficial owners as well as their investment intentions, providing investors and the company with information about accumulations of securities that may potentially change or influence company management and policies.
A public company with Exchange Act registered securities that faces a takeover attempt, or third party tender offer, should be aware that the SEC's tender offer rules will apply to the transaction. The same is true if the company makes a tender offer for its own Exchange Act registered securities. The filings required by these rules provide information to the public about the person making the tender offer. The company that is the subject of the takeover must file with the SEC its responses to the tender offer. The rules also set time limits for the tender offer and provide other protections to shareholders.
Transaction reporting by officers, directors and ten percent shareholders
Section 16 of the Exchange Act applies to your company's directors and officers, as well as shareholders who own more than 10% of a class of your company's equity securities registered under the Exchange Act. It requires these persons to report their transactions involving the company's equity securities to the SEC. Section 16 also establishes mechanisms for a company to recover "short swing" profits, those profits an insider realizes from a purchase and sale of a company security within a six-month period. In addition, Section 16 prohibits short selling by these persons of any class of the company's securities, whether or not that class is registered under the Exchange Act.
VI. Are There Legal Ways To Offer and Sell Securities Without Registering With the SEC?
Yes! Your company's securities offering may qualify for one of several exemptions from the registration requirements. We explain the most common ones below. You must remember, however, that all securities transactions, even exempt transactions, are subject to the antifraud provisions of the federal securities laws. This means that you and your company will be responsible for false or misleading statements, whether oral or written. The government enforces the federal securities laws through criminal, civil and administrative proceedings. Some enforcement proceedings are brought through private law suits. Also, if all conditions of the exemptions are not met, purchasers may be able to obtain refunds of their purchase price. In addition, offerings that are exempt from provisions of the federal securities laws may still be subject to the notice and filing obligations of various state laws. Make sure you check with the appropriate state securities administrator before proceeding with your offering.
A. Intrastate Offering ExemptionSection 3(a)(11) of the Securities Act is generally known as the "intrastate offering exemption." This exemption facilitates the financing of local business operations. To qualify for the intrastate offering exemption, your company must:
There is no fixed limit on the size of the offering or the number of purchasers. Your company must determine the residence of each purchaser. If any of the securities are offered or sold to even one out-of-state person, the exemption may be lost. Without the exemption, the company could be in violation of the Securities Act registration requirements. If a purchaser resells any of the securities to a person who resides outside the state within a short period of time after the company's offering is complete (the usual test is nine months), the entire transaction, including the original sales, might violate the Securities Act. Since secondary markets for these securities rarely develop, companies often must sell securities in these offerings at a discount.
It will be difficult for your company to rely on the intrastate exemption unless you know the purchasers and the sale is directly negotiated with them. If your company holds some of its assets outside the state, or derives a substantial portion of its revenues outside the state where it proposes to offer its securities, it will probably have a difficult time qualifying for the exemption.
You may follow Rule 147, a "safe harbor" rule, to ensure that you meet the requirements for this exemption. It is possible, however, that transactions not meeting all requirements of Rule 147 may still qualify for the exemption.
B. Private Offering ExemptionSection 4(2) of the Securities Act exempts from registration "transactions by an issuer not involving any public offering." To qualify for this exemption, the purchasers of the securities must:
In addition, you may not use any form of public solicitation or general advertising in connection with the offering.
The precise limits of this private offering exemption are uncertain. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption. You should know that if you offer securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.
Rule 506, another "safe harbor" rule, provides objective standards that you can rely on to meet the requirements of this exemption. Rule 506 is a part of Regulation D, which we describe more fully on page 24.
C. Regulation ASection 3(b) of the Securities Act authorizes the SEC to exempt from registration small securities offerings. By this authority, we created Regulation A, an exemption for public offerings not exceeding $5 million in any 12-month period. If you choose to rely on this exemption, your company must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review.
Regulation A offerings share many characteristics with registered offerings. For example, you must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not "restricted," meaning they are freely tradeable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are:
All types of companies which do not report under the Exchange Act may use Regulation A, except "blank check" companies, those with an unspecified business, and investment companies registered or required to be registered under the Investment Company Act of 1940. In most cases, shareholders may use Regulation A to resell up to $1.5 million of securities.
If you "test the waters," you can use general solicitation and advertising prior to filing an offering statement with the SEC, giving you the advantage of determining whether there is enough market interest in your securities before you incur the full range of legal, accounting, and other costs associated with filing an offering statement. You may not, however, solicit or accept money until the SEC staff completes its review of the filed offering statement and you deliver prescribed offering materials to investors.
D. Regulation D
Regulation D establishes three exemptions from Securities Act registration. Let's address each one separately.
Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. Your company may use this exemption so long as it is not a blank check company and is not subject to Exchange Act reporting requirements. Like the other Regulation D exemptions, in general you may not use public solicitation or advertising to market the securities and purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption. However, you can use this exemption for a public offering of your securities and investors will receive freely tradable securities under the following circumstances:
Even if you make a private sale where there are no specific disclosure delivery requirements, you should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. This means that any information you provide to investors must be free from false or misleading statements. Similarly, you should not exclude any information if the omission makes what you do provide investors false or misleading.
Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, you may sell to an unlimited number of "accredited investors" and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are "restricted." Consequently, you must inform investors that they may not sell for at least a year without registering the transaction. You may not use general solicitation or advertising to sell the securities.
An "accredited investor" is:
It is up to you to decide what information you give to accredited investors, so long as it does not violate the antifraud prohibitions. But you must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well. You must also be available to answer questions by prospective purchasers.
Here are some specifics about the financial statement requirements applicable to this type of offering:
As we discussed earlier, Rule 506 is a "safe harbor" for the private offering exemption. If your company satisfies the following standards, you can be assured that you are within the Section 4(2) exemption:
E. Accredited Investor Exemption - Section 4(6)
Section 4(6) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.
The definition of accredited investors is the same as that used in Regulation D. Like the exemptions in Rule 505 and 506, this exemption does not permit any form of advertising or public solicitation. There are no document delivery requirements. Of course, all transactions are subject to the antifraud provisions of the securities laws.
F. California Limited Offering Exemption - Rule 1001
SEC Rule 1001 provides an exemption from the registration requirements of the Securities Act for offers and sales of securities, in amounts of up to $5 million, that satisfy the conditions of §25102(n) of the California Corporations Code. This California law exempts from California state law registration offerings made by California companies to "qualified purchasers" whose characteristics are similar to, but not the same as, accredited investors under Regulation D. This exemption allows some methods of general solicitation prior to sales.
G. Exemption for Sales of Securities through Employee Benefit Plans - Rule 701
The SEC's Rule 701 exempts sales of securities if made to compensate employees. This exemption is available only to companies that are not subject to Exchange Act reporting requirements. You can sell at least $1,000,000 of securities under this exemption, no matter how small your company is. You can sell even more if you satisfy certain formulas based on your company's assets or on the number of its outstanding securities. If you sell more than $5 million in securities in a 12-month period, you need to provide limited disclosure documents to your employees. Employees receive "restricted securities" in these transactions and may not freely offer or sell them to the public.
VII. Are There State Law Requirements in Addition to Federal Ones?
The federal government and state governments each have their own securities laws and regulations. If your company is selling securities, it must comply with federal and state securities laws. If a particular offering is exempt under the federal securities laws, that does not necessarily mean that it is exempt from any of the state laws.
Historically, most state legislatures have followed one of two approaches in regulating public offerings of securities, or a combination of the two approaches. Some states review small businesses' securities offerings to ensure that companies disclose to investors all information needed to make an informed investment decision. Other states also analyze public offerings using substantive standards to assure that the terms and structure of the offerings are fair to investors, in addition to the focus on disclosure.
To facilitate small business capital formation, the North American Securities Administrators Association, or NASAA, in conjunction with the American Bar Association, developed the Small Company Offering Registration, also known as SCOR. SCOR is a simplified "question and answer" registration form that companies also can use as the disclosure document for investors. SCOR was primarily designed for state registration of small business securities offerings conducted under the SEC's Rule 504, for sale of securities up to $1,000,000, discussed on page 20. Currently, over 45 states recognize SCOR. To assist small business issuers in completing the SCOR Form, NASAA has developed a detailed "Issuer's Manual." This manual is available through NASAA's Web site at http://www.nasaa.org.
In addition, a small company can use the SCOR Form, called Form U-7, to satisfy many of the filing requirements of the SEC's Regulation A exemption, for sales of securities of up to $5,000,000 (discussed on page 19), since the company may file it with the SEC as part of the Regulation A offering statement.
To assist small businesses offering in several states, many states coordinate SCOR or Regulation A filings through a program called regional review. Regional reviews are available in the New England, Mid-Atlantic, Midwest and Western regions.
Companies seeking additional information on SCOR, regional reviews or the "Issuer's Manual" should contact NASAA.
VIII. What Resources Are Available Through the U.S. Small Business Administration?
When assessing your capital needs, you should consider programs offered through the U.S. Small Business Administration (SBA). Congress established the SBA in 1953 to aid, counsel, and protect the interests of the Nation's small business community. The SBA accomplishes this in part by working with intermediaries, banks, and other lending institutions to provide loans and venture capital financing to small businesses unable to secure financing through normal lending channels. The SBA offers financing through the programs listed below.
7(a) Loan Guaranty Program:
This is the SBA's primary lending program and was designed to meet the majority of the small business lending community's financing needs. In addition to general financing, the 7(a) program also encompasses a number of specialized loan programs. The following are a few of the many specialized loan programs:
This program is designed to increase the availability of funds under $100,000 and streamline or expedite the loan review process.
An umbrella program to help small businesses meet their short-term and cyclical working-capital needs with five separate programs.
If your business is preparing to engage in or is already engaged in international trade, or is adversely affected by competition from imports, the International Trade Loan Program is for you; and
Defense Loan and Technical Assistance is a joint SBA and Department of Defense effort to provide financial and technical assistance to defense-dependent small firms adversely affected by cutbacks in defense.
This program works through intermediaries to provide small loans from as little as $100 up to $25,000.
Certified Development Company (504 Loan) Program
This program, commonly referred to as the 504 program, makes long term loans available for purchasing land, buildings, machinery and equipment, and for building, modernizing or renovating existing facilities and sites.
Small Business Investment Company Program
Small Business Investment Companies (SBICs), which the SBA licenses and regulates, are privately-owned and managed investment firms that provide venture capital and start-up financing to small businesses.
To find additional information on these and other financial programs please contact your local SBA District Office (call 1-800-8-ASK-SBA for the nearest office) or look on SBA's Web site (http://www.sba.gov).
Additional Financial Resources and Information from the SBA's Office of Advocacy
Angel Capital Electronic Network (ACE-Net)
The Office of Advocacy of SBA has established an Internet site where small companies may list their Regulation A and Regulation D 504/SCOR stock offerings. ACE-Net is a cooperative effort between SBA and nine universities, state-based entities, and other non-profit organizations to provide a listing service where small companies may list their stock offering for review by high net worth investors (accredited investors). In addition, ACE-Net anticipates providing mentoring and educational services for small companies needing business planning and securities information. You can find the ACE-Net Internet site at the following URLs: http://www.sba.gov/ADVO/ or http://www.ace-net.org.
Small Business Lending in the United States
The Office of Advocacy of SBA has ranked the nearly 10,000 banks in the country on a state-by-state basis to determine which banks are "small business friendly." The state-by-state directory helps small businesses locate which banks in their area are more likely to lend to small business. The directory is available over the Internet at: http://www.sba.gov/ADVO/stats/.
IX. Where Can I Go for More Information?
The staff of the SEC's Office of Small Business and the SEC's Small Business Ombudsman will be glad to assist you with any questions you may have regarding federal securities laws. For information about state securities laws, contact NASAA or your state's securities administrator, whose office is usually located in your capital city.
The entire text of the SEC's rules and regulations is available through the U.S. Government Printing Office or from several private publishers of legal information. In addition, numerous books on this subject have been published, and some are available at public libraries. As of this writing, the following volumes of Title 17 of the Code of Federal Regulations (the SEC's rules and regulations) were available from the Government Printing Office:
For additional information about how to obtain official publications of Commission rules and regulations, contact:Superintendent of Documents
Government Printing Office
Washington DC 20402-9325
For copies of SEC forms and recent SEC releases:Publications Section
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0019
Other useful addresses, telephone numbers, web sites and e-mail:SEC's World Wide Web site: http://www.sec.gov
SEC Office of Small Business
North American Securities Administrators Association
NASAA's World Wide Web site: http://www.nasaa.org
SBA's World Wide Web site: http://www.sba.gov
ACE-Net World Wide Web site: http://www.ace-net.org
X. How Can We Improve this Guide?
If you have any suggestions about how we can make this booklet more useful, please contact the SEC staff at the mailing address, phone number or e-mail address noted above.http://www.sec.gov/info/smallbus/qasbsec.htm