Since the increase in the maximum offering amount to $5 million a couple of years ago, we’ve seen more interest in Reg CF offerings by venture-backed companies. Sadly, it doesn’t work for a lot of them.
This is because of what we refer to as the “issuer aggregation rule”. Rule 100(c) explains that “issuer” for the purpose of calculating the $5 million limit (and also determining whether an issuer is a first-time user of Reg CF) includes all entities controlled by or under common control with the issuer and its predecessors. “Control” under securities law has a very broad definition: it includes officers and directors and 10% shareholders. (And you are never going to convince a good securities lawyer that a holding above 10% but under 50% doesn’t constitute control. We hear that argument all the time.)
This causes problems with venture-backed companies. It is common for VCs to appoint one or more directors to their portfolio companies. And they often take more than a 10% shareholding.
So let’s say Gritty Mound VC invests in a few companies, appointing a couple of directors to each. They take 20% of Portfolio Company A and appoint Chad and Brad to the board. They take 15% of Portfolio Company B and appoint Brad and Tad to the board. They take 9.9% of Portfolio Company C and appoint Chad and Tad to the board.
Company A makes a successful offering under Reg CF, raising $4 million. Company B then seeks to raise $1 million. They had hoped to use only reviewed financial statements, but because they are not a first-time issuer (Company A used up that allowance) they must prepare audited financials for any amounts above $618k. And once they make their offering, Company C is completely frozen out of the market until such time as headroom frees up under the maximum offering amount (it’s calculated on a rolling 12-month basis).
There’s no SEC relief available here since the issuer aggregation rule is embedded in the Securities Act. So from the VC’s point of view they can either take their people off the board, or reduce their holdings, both of which are unlikely.
From the point of view of intermediaries and issuers, make sure the company is eligible to use Reg CF before starting the process.
(We note, by the way, that there is no equivalent rule under Reg A.)