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Meet all your new healthcare investors thanks to SEC Regulation A+

Access to capital and liquidity are two of the fundamental building blocks for innovation and a healthy economy. In passing Regulation A+, the SEC has created the most favorable regulatory environment for early stage capital investment in generations. The new facilitators of capital deployment and liquidity will be equity investment platforms, further democratizing capital by leveraging technology and more specifically, the Internet.

By Tobin Arthur, Jens Francis, and Richard Wohns MD on April 09, 2015

The stage has been set for a disruptive return of the “Small IPO” to the private equity marketplace (Seed, Series A, B etc.).

This go-around, the liquidity boom will not be the exclusive provenance of the Four Horsemen (Alex Brown Inc., Hambrecht & Quist, Robertson Stephens & Co., and Montgomery Securities), the four boutique investment banks that drove liquidity for Silicon Valley during the boom.

The new incarnation of the Four Horsemen will be in the form of crowdfunding marketplaces, not investment banks.

The newly approved SEC Regulation A+ provides the biggest regulatory shift to the early stage private equity* market in decades and primes the pump for new capital solutions to fill the gap left when the Four Horsemen were absorbed by mega banks and subsequently buried. And this time, the retail investor is providing the fuel.

What is Regulation A+?

There is a lot to it, but some of the key attributes for investors and startups include:

  • Non-accredited investors can now participate in private equity offerings handled under Reg. A+.
  • Equity will be transferable, further blending the difference between public and private stock.
  • Generally advertising your offering is ok. (General Solicitation)
  • There are 2 tiers and logistical differences associated with each. (Tier 1: $20M and Tier 2: $50M)
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Implications for Institutional Investors

While there will be a growing tide of new capital in the early stage PE market, institutional investors have an ideal opportunity to leverage this fundamental and generational transformation. If returns follow, institutional allocations will increase.

At scale, early stage capital deployment has always been problematic to manage because it requires many small bets over a widely dispersed landscape. It’s very difficult to put meaningful amounts of capital in play, particularly relative to the total funds that larger institutions have under management. Moreover, early investing has inherent risk that is difficult to systematically manage.

A majority of VCs have proven incapable of managing this risk resulting in a push by their LPs to focus on later stage investments. However, within the new regulatory environment, combined with the right investment platforms, early stage PE capital can look much more like mutual fund style management (managed) than index fund management (largely hands-off).

Implications for Retail Investors

If you are among the estimated 12 million Americans who own individual stocks, we encourage you to keep an eye on the wave of offerings that will be listed on leading equity investment platforms over the coming year. You’ll have platform/market choices based on your areas of interest. (example: real estate, consumer packaged foods, life sciences)

If you are among the 40-50 million who mostly invest via funds and indices, consider allocating some portion thereof to funds and/or high-growth “small-caps” that will now be accessible through investment platforms. With proper diversification and appropriate asset allocation, the next generation of technology-centric companies may prove to be the most interesting, and perhaps most lucrative part of your portfolio.

Implications for the Broader Financial Ecosystem

In 2013, Sandy Miller, GP at Institutional Venture Partners and the former head of investment banking at Montgomery Securities wrote:

The IPO is the lifeblood of our stock markets; it’s the vehicle that helps bring capital, liquidity and a sense of optimism to the U. S. economy.

He went on to describe the 3 critical elements of a healthy market:

  1. Solid companies in the pipeline
  2. A favorable regulatory environment
  3. A banking system equipped for creating liquidity

Reg. A+ provides a solid framework for addressing point #2. Who or what will address point #3 is still an open question, and one of vital importance.

For those who don’t pay attention to the inside baseball of the industry let us share a few snippets of the macro picture:

  • The three major investment banks play “left-lead” (lead banker on a transaction) on over 75% of all IPO offerings. This is indicative of a system that is off-kilter.
  • Most venture capital firms actually returned less than the S&P over the past decade as fund sizes grew larger and larger.
  • Angel capital investments by seasoned investors tend to perform well, but as a class it’s fragmented, provincial and limited almost by definition.

Some have largely blamed the overall malaise of the venture market on the lack of early stage IPOs in contrast to the days when the Four Horsemen rode. According to Bloomberg, in the 1990s there were 500+ IPOs a year. Since then we see 100-200.

Regardless of what’s to blame, the concentration of IPOs into big shops (JP Morgan and Goldman Sachs) has had a deleterious affect on the IPO market. And when liquidity is stunted, early stage capital dries up.

On top of burdensome regulation, the “consumer advocate” crowd has pleaded for years not to meddle with the definition of “Accredited Investor.” Their position is that if you don’t make $200K+ a year or have assets in excess of $1M (Less than 8M people meet this definition in the US.), you are not suited for making private equity investment decisions on your own. They have determined it’s too risky for Joe and Jill Average. This position is elitist and flawed but not in scope for this post.

Quietly in the background big banks supported this position because it meant less competition. Angel capital and venture capital combined are a relatively small $70B a year in the US as compared to the $7T under management in retirement investment accounts. It’s easy to see why big financial institutions have a massive vested interest in preventing “Jill Main Street” from pulling money out of the $7T fund pool and self-directing some of her monies into early stage investments.

Further Details About Regulation A+

(Thanks to SeedInvest for breaking down the new rules. We’ve included some of their material below and posted additional details on our blog.)

When the JOBS Act was passed in April of 2012, many believed that Title IV had the potential to provide the most powerful change in the law, but given that there was no deadline for implementation of the rules, most ignored Title IV.

Last November, however, the SEC surprised the securities community by introducing Proposed Regulation A+ rules that pre-empted state securities regulation.

Despite that announcement, most people figured the final rules would look nothing like the proposed rules and subsequently maintained their focus on Reg. D offerings.

One of the primary open questions from the proposed rules related to the issue of “pre-emption,” – whether it is legal and whether it is appropriate for a federal agency to pre-empt state regulatory involvement. Most in the pro-business community ardently support pre-emption and argue that securities offerings constitute interstate commerce and that state-by-state regulation is antiquated in a world where the Internet blurs state lines. A host of regulators and investor protection groups opposed pre-emption, arguing that state review adds valuable and necessary investor protections. In response, the states introduced a coordinated review process, which was designed to address these concerns. Critics argued that this was too little, too late and only resulted from the states being forced to act by the threat of pre-emption.

In the final rule release, the SEC settled the dispute over “pre-emption” through a compromise confirming pre-emption for Tier II Regulation A offerings up to $50M but also increasing Tier I Regulation A offerings from $5M to $20M and leaving pre-emption intact, thus giving “coordinated review” a chance to prove itself.

Regulation A+ is scheduled to go into affect in less than 60 days after publication in the Federal Register (May 24, 2015).

Highlights of the new Regulation A+

  • Issuers can raise up to $50,000,000 in a 12 month period for Tier 2 and $20,000,000 for Tier 1.
  • Anyone can invest: Not limited to just “accredited investors” – your friends, family, professors, attorneys…all can participate. Tier 2 investors will, however, be subject to some reasonable investment limits.
  • You can advertise your offering: There is no general solicitation restriction so you can freely advertise and talk about your offering, including at demo days, through newsletters and via social media.
  • Shareholder Limits: In a welcome departure from the proposed rules, it appears that the Section 12(g) shareholder limits (2,000 people and 500 non-accredited investors) will not apply to Reg. A+ under certain circumstances.
  • Unrestricted Securities: The securities issued in Reg. A+ will be unrestricted and freely transferable, though many issuers may choose to impose contractual transfer restrictions. This will pave the way for a vibrant secondary market for these securities but will require technology platforms to coordinate the activity.

The Future of Online Capital

Finally, it’s important to note that Reg. A+ facilitates a generational shift in capital that is increasingly moving online. Early stage investing is migrating out of the analog world to join the digital world. In his recap of 2014, leading venture capitalist Fred Wilson noted that one of the biggest trends of the past year was that the capital markets had indeed begun to move online, as evidenced by the successful IPO for Lending Club and similar data points.

It is the position of angelMD that simply facilitating more efficient movement of capital is only half the equation. For viable long-term outcomes, marketplaces must provide investors an edge. If a marketplace simply enables more investors to loose money faster then it will be a short- term phenomenon for certain.

For this reason we believe that focused markets like angelMD provide a significant advantage over the alternatives. Our vertically focused life sciences marketplace is built around subject matter experts (physicians / scientists / industry) who help source, evaluate and advise startups with the sole aim of generating stronger companies and better investment outcomes. (active investment management versus passive)

Conclusions

We foresee several long-term changes as a result of the implementation of Reg. A+ and the forthcoming entrepreneurial activity it facilitates.

  • Expect new marketplaces to enable millions of retail investors to participate in early stage investment offerings.
  • Expect problems and corrections from platforms that simply act as the wild-wild-west for capital deployment.
  • Expect a new wave of household names — the next Alexion, the next Amazon, and even the next Apple will emerge from this evolutionary shift in capital investment.

This seismic shift in early stage investing will, like the broader markets, produce winners and losers. Information-enabled investors and strong startups stand to win big. Conventional venture capitalists and bankers will face head-winds; and only those who can demonstrate value for their respective fees will remain viable financial managers. In the end we expect to see great societal benefits as innovators have more efficient access to capital.

[Photo from Flickr user Kheel Center]

 

Tobin Arthur, Jens Francis, and Richard Wohns MD

The authors are members of angelMD, a life science investment platform and marketplace connecting startups, physicians/scientists, life science investors and industry with the goal of de-risking early stage companies and driving better returns for investors.