SEC Rule Changes

Two significant rule changes came out of the U.S. Securities and Exchange Commission this week. First, there was a change in the definition of “accredited investor”. If you don’t know what that term means, then you’ve never tried to invest in a start-up — or invest in a VC fund, or buy pre-IPO stock, or participate in a private investment in public equity, or any number of other things that the SEC describes as “participation in private capital markets”. One can argue that one should be able to do whatever one wants with one’s own money. Nevertheless, there have for a very long time been rules limiting who could invest in any number of deals, the characteristics of which cause them to be considered overly risky for the unsophisticated investor. The problem has been, in order to be a sophisticated investor (or, more properly, “accredited investor”), the benchmarks one had to meet had nothing to do with one’s sophistication; instead, they had to do with one’s income or net worth. There are more details, but the three biggest changes are that certain people related to accredited investors can now, themselves, count as accredited (spouses of accredited investors, certain employees of private funds (e.g., investment analysts at venture capital firms, who would previously not have qualified as individuals), “clients” of family offices); those who hold certain certificates (Series 6, 65, or 82 licenses); and a broader category of entities that are otherwise investing and have more than $5 million in assets. Certainly, this definition is not perfect; and, absolutely, one could argue that no such limitations should exist at all. Nevertheless, this is a huge improvement.

The SEC also changed the rules for direct listings, to enable companies to raise funds as part of the listing. A “public offering” is when a private company agrees to sell part of itself to the general public. The main thing this changes is the liquidity of the stock. If your company isn’t “publicly traded”, there are strict rules around who can buy shares (see above, re: accredited investors). Most commonly, this is done as part of an “initial public offering” (an IPO), where the company issues new shares and sells those shares to the market — and gets the cash. Not only is the stock more liquid, but the company has more cash on the balance sheet with which to operate. Such IPOs are underwritten by investment banks. Those banks agree to buy the shares for a fixed price, and then sell them to their constituents at small markup, and the stock begins “trading”. As part of this deal, the banks generally require certain shareholders to enter a “lockup” agreement, whereby they can’t sell any shares for a certain period of time (anywhere from six months to two years is common). Mostly this works fine, though there have been an increasing number of recent listings where the IPO appeared to be substantially underpriced (let’s say I’m ABC Co. I decide to “go public” by issuing 10% more shares and selling them through an IPO. The investment bank and I agree that the target IPO price will be $11-$13, and the bank will buy them from me for $10.50. The bank then resells those shares to their preferred clients, and the stock starts trading. That all is well and good; but of the 109 IPOs this year in the U.S., the average first day of trading has seen an increase of 35.7%. That’s the average, and that’s a lot of money I left on the table). A DPO (Direct Public Offering, also known as a direct listing) is when a company sells shares directly to the public, rather than having them underwritten by a bank. The difference is, since there’s no bank involved, there’s no underwriting, and therefore no guaranteed price. Moreover, the rule had been that a DPO could only offer for sale existing shares — that is, the company couldn’t issue new shares; instead, existing shareholders needed to sell some of theirs — which meat the company wouldn’t generate any cash as part of the transaction (it would purely generating liquidity). That’s the second SEC change: now, companies doing DPOs can sell a combination of existing and new shares. This rule change applies to the NYSE, but NASDAQ had made a similar request, and although there may be minor modifications, there’s no reason to believe it won’t go through as well.

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