The Office of the Advocate for Small Business Capital Formation (“Office”) has published its Annual Report for fiscal year 2022 (“Report”). The Report is delivered to the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate and the Committee on Financial Services of the U.S. House of Representatives directly by the Office, without review or input from the SEC at large.
Background
The SEC’s Office of the Advocate for Small Business Capital Formation launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). The mission of the Office is to advocate for pragmatic solutions to accessing capital markets and business growth.
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyze the potential impact of regulatory changes on small businesses and their investors; (v) conduct outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
The Office utilizes several tools in support of its functions, including in-person events, web events, speakers, web content including educational tools, and community outreach. The main web content for the Office can be found on the Capital Raising Hub, part of the SEC’s main site. The Capital Raising Hub attempts to explain exempt and registered offerings using plain English and simple videos.
The Report summarizes the findings of the Office derived from its programs as well as an analysis of public filings with the SEC. The fiscal year period for the report is June 2021 through June 2022.
Small and Emerging Businesses
It is indisputable that small and emerging businesses are the core of employment (small businesses employ 46.4% of all U.S. employees), innovation, and growth. Access to capital is key to the formation and growth of these small businesses. The Report delves into factors that can help entrepreneurs with that access including mentorship and local accelerators.
Generally, small businesses are funded in their early stages by the founders together with friends and family. Grants and donations, angel investors, credit cards, lines of credit and bank debt financing are also utilized. However, capital remains elusive and a constant struggle, especially as the economy has a downturn, such as it has since the beginning of 2022. On the upside, since 2018 there has been a growth in micro funds (less than $50 million) that focus on investments in local, small and emerging businesses.
As a business continues to grow, capital sources become more sophisticated and institutional, including venture capital, private equity and public markets. However, venture capital remains only available to a select few entities in high-growth sectors.
Capital Formation by the Numbers
The following data is derived from public filings with the SEC. Although it is best practice, not all companies or funds file a Form D when completing an exempt offering, and as such the information on Regulation D offerings is likely understated by a relatively large percentage. For more on Form D, see HERE.
In any event, public information indicates the following capital formation figures, including total and median amounts: (i) $2.3 trillion under Rule 506(b) – $1.3 million median; (ii) $148 billion under Rule 506(c) – $800,000 median; (iii) $1.8 billion under Regulation A – $2.2 million median; (iv) $624 million under Rule 504 – $250,000 median; (v) $368 million in Regulation CF Crowdfunding – $100,000 median; (vi) $126 billion in initial public offerings – $150 million median; (vii) $1.1 trillion in other registered offerings; and (viii) $2 trillion in other exempt offerings, including Regulation S and Rule 144A – $450,000 median.
In order of amount from largest to smallest, the following industries have completed registered offerings: (i) banking and financial services; (ii) technology; (iii) health care; (iv) energy; (v) manufacturing; (vi) real estate; (vii) business services; and (viii) hospitality, retailing and restaurants. The industry mix is a little different when looking at IPOs: (i) technology; (ii) manufacturing; (iii) banking and financial services; (iv) business services; (v) health care; and (vi) hospitality, retailing and restaurant.
Most Regulation D offerings – 85% – are completed by pooled funds, meaning venture capital, private equity and private hedge funds, which in turn tend to invest more established businesses or prominent entrepreneurs. Excluding pooled funds, in order of amount from largest to smallest, the following industries, have raised capital in Regulation D offerings: (i) technology; (ii) banking and financial services; (iii) real estate; (iv) health care; and (v) energy.
Industry insiders are well aware that Regulation A is most often used by real estate companies, and alternative asset entities (Masterworks, Rally Road, My Racehorse, etc.). According to the Report, in order of amount from largest to smallest, the following industries have raised capital in Regulation A offerings: (i) real estate (by a huge margin); (ii) banking and financial services; (iii) business services; (iv) manufacturing; (v) technology; and (vi) health care.
The Report also breaks down types of capital raise by geography. As expected, most Regulation D offerings are in the coastal states such as Florida, New York, Texas and California with Georgia, Minnesota, Illinois and Pennsylvania also pulling big numbers. Although a similar pattern can be seen in Regulation A, Florida, California, Georgia and New York pulled ahead of all other states. Also not surprisingly, the lower population states such as Oklahoma and Montana have minimal Regulation D raises. However, when turning to Regulation Crowdfunding, the map seeps inward with Regulation CF offerings distributed fairly widely.
Registered offerings are similarly concentrated in the coastal states with New York having the highest number of offerings, followed by California, Texas, then Florida and Illinois.
Moving on to demographics, interestingly, 41% of Regulation Crowdfunding offerings had minority founders and 46% had women founders. The numbers buttress the proposition that smaller investors are motivated to support small businesses – the average investment size was just $1,057. Crowdfunded businesses employed 160,000 people.
Small Public Companies by the Numbers
The number of small exchange-listed companies has drastically declined over the last several decades, while the number of large exchange-listed companies continues to increase. In particular, the number of small exchange-listed companies went from 4,144 in 1982 to 1,587 in 2022. Likewise, total market capitalization of small public entities has declined, going from 13% of total public market capitalization to just 0.4%.
Interestingly, the Report points out that much of the active IPO market in 2020-2021 came from the SPAC boom, and subsequent business combinations with larger entities as opposed to IPOs by operating smaller companies. With the decline of SPAC IPOs and larger public offerings in 2022, the overall percentage of smaller companies to the total market capitalization has increased, even though the number of smaller IPOs has not increased.
The Report notes that small public companies are often the target in M&A transactions. I think this bolsters the efficacy of a small company IPO. Not only does the company gain the advantages of going public (liquidity, continuous access to capital, exit for early investors and employees, attracting top C-suite with stock options, research coverage, employee loyalty with equity incentive plans, increased valuation, and public exposure to products and services) but also the opportunity for a larger exit for shareholders and insiders through an M&A transaction.
Public company compliance costs, including increased disclosure regulations such as climate disclosures, continue to be a significant challenge for small public companies and a deterrent to accessing public capital markets. The Report cites a 27% increase in compliance costs from 2021 to 2022, which is a significantly disproportionate negative impact compared to larger companies.
Policy Recommendations
Policy recommendations were broken down into issues and proposed solutions. The following is a summary of each.
Issue – Entrepreneurs and their investors need accessible tools and educational resources to navigate complex securities laws.
Proposed Solution – Rather than a specific policy recommendation, the Office will continue its outreach and educational resources.
Issue – Targeted regulatory changes can improve access to capital.
Proposed Solution – The Report recommends the following:
- Change the accredited investor definition in include additional qualitative professional criteria and offer more opportunities to demonstrate financial sophistication as an alternative to the income and net worth thresholds;
- Amend Regulation Crowdfunding to increase the offering size threshold in which a company must provide reviewed or audited financial statements and instead allow principal executive officer certifications at this amount.
- Amend Regulation Crowdfunding to allow investment companies to use the exemption; and
- Do not amend Regulation D or Form D to make them more burdensome than they already are.
Issue – Connecting founders with savvy investors is essential to capital raising.
Proposed Solution – Create a workable system to allow companies to use finders to assist in capital raising effort.
Issue – Emerging fund managers play a key role in small business capital formation and need support.
Proposed Solution – The Report recommends the following:
- Amend the “venture capital fund” definition in the Investment Advisors Act of 1940 to include fund to fund investments as qualifying investments under the Act.
- Increase the 100 beneficial owners limit for funds that rely on the exemption in Section 3(c)(1) of the Investment Company Act of 1940; and
- Amend the definition of “qualifying venture capital fund” in the Investment Company Act to increase the number of allowed investors and expand the $10 million maximum threshold.
Issue – Scaled disclosures for small public companies help them stay public. Small public companies, compared to larger ones, receive less research coverage, attract lower levels of institutional investors, and are more sensitive to fixed compliance costs.
Proposed Solution – The SEC should scale any new disclosure requirements and delay compliance requirements.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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