SCOR Registration — an alternative to 2023 Crowdfunding?

The well-kept secret is that Washington and many other states have already had in place a way to sell securities very similar to Washington’s recently effective crowdfunding law,  ESHB 2023.   Referred to as the “Small Company Offering Registration” or “SCOR”, this other method of registering a stock offering has  been around since the 1990s, but seldom used.  The DFI reports that they only had 9 SCOR offerings in Washington since 2005 (as of October 2014).  It is not clear why SCOR offerings have not been popular, given that the DFI has gone out of its way to provide helpful information on its website and to help companies complete SCOR offerings even when not represented by legal counsel.

Similarities between SCOR and  ESHB 2023

Washington Internet Offerings – Both types of offering allow you to sell up to $1,000,000 of equity securities per year to Washington residents using the internet.

DFI Review.  Both types of offering require you to prepare an offering memorandum that must be reviewed and approved by the DFI.  The same staff members at the DFI administer both programs.  The form for SCOR offerings, called the U-7, is used by all states using the SCOR process.  The form for  ESHB 2023 was recently finalized and it can be found here.  Both forms ask for much of the same information, but the  ESHB 2023 form is the DFI’s own form and they have tried to make it more user friendly than the U-7.

GAAP Financials.  For both offerings, financial statements are required for the last fiscal year.  They must be prepared in accordance with Generally Accepted Accounting Principles, including preparation of footnotes.   ESHB 2023 also requires that you provide the most recent fiscal quarters for partially completed years.

500 Shareholder Limit.  The 500 non-accredited shareholder limit applies to both offerings in the same way.  (Section 12(g) of the Securities and Exchange Act requires registration under that Act if a company with $10 million or more in assets has more than 2000 shareholders or more than 500 shareholders who are non-accredited investors.)

Minimum Amount and Escrow Agent.  Under both offering methods, you will be required to set a minimum funding amount (minimum dollar amount of subscriptions received) before you can close any subscriptions.   Before you reach the minimum funding amount, all funds must be held by an escrow agent, which you, the issuer, must hire.  Before they approve the offering, the DFI will carefully review your minimum target and require you to raise it if they think it is too low to accomplish your business plan.

Differences between SCOR and  ESHB 2023

Available for non-Washington Companies.  To do a SCOR offering, it is not necessary to be incorporated or have your primary operations in Washington, but offers and sales are limited to Washington residents (unless you do a regional offering – see next topic).  So, for example, a Seattle startup that was incorporated in Delaware could use the SCOR registration without the need to reincorporate in Washington.

Coordinated Regional Offerings.  Under SCOR, there is a process for doing coordinated regional offerings using protocols developed under the auspices of the North American Securities Administrators Association.  Under that process, one state agency takes the primary role of reviewing and passing on the offering memorandum.  Eleven western states participate in the Western Region (California being the notable exception).  If my memory is correct, only one or two coordinated offerings have been tried in Washington.  But in conversations, member of the DFI staff have been positive towards making coordinated regional offerings work. You can read more about coordinated review on the DFI’s website and on the NASAA’s website.

Merit Review; Promotional Share Escrow

A SCOR offering is actually a registered state offering subject to merit review by the DFI.  In contrast, an offering under  ESHB 2023 is technically an exemption from registration.  In some ways it is a distinction without a difference since the DFI must approve the offering memorandum in both methods.  But under SCOR, the DFI is required to conduct a merit review, meaning that it will judge the proposed offering on the merits and apply several statements of policy regarding corporate equity offerings adopted by the NASAA.  The DFI’s standards are available here, and cover  things like the terms of the securities, financial condition, voting rights, and use of proceeds.  The DFI, for example, can require the issuer to have independent directors if there is a history of affiliated transactions (transactions between shareholders or directors and the company, such as loans or leases)

One thing that may trip up startups is the standard for “promotional shares”.  Shares issued to founders, management, or major owners of the corporation would be considered promotional shares, and DFI will determine whether these shares can be considered “fully paid”.  According to the DFI website, this is determined by dividing the amount of consideration paid in past purchases of the shares by 85% of the proposed public offering price in the offering. Tangible property used as payment in past purchases is counted at its fair value, if that is readily and objectively ascertainable.  Most founder stock in a startup would not pass this standard.

According to the DFI website, there may be an unlimited number of promotional shares in a SCOR offering. However, those in excess of 60% of the shares to be outstanding after the offering must be escrowed for a certain period of time, usually four years, or until the company satisfies other release provisions in the escrow agreement.   In lieu of an escrow, the company may enter into a lock-in agreement that does not involve the expense of a third party escrow agent, and the DFI has a form lock-in agreement  available.

So in other words, the escrowed stock will be similar to vesting restrictions, which most founders are familiar with.  However, unlike unvested stock, which typically vests immediately in the case of a liquidity event, escrowed promotional shares remain in escrow.  While in escrow, payout in the case of a distribution of company assets is according to purchase price paid.  So founders who paid pennies for their restricted stock would not receive a significant distribution until other purchasers received their original purchase price back.  In most cases, this would not be problematic, since it would mimic the results of a typical 1X preferred stock liquidation preference.

Transfer Restrictions.  Securities sold in a SCOR offering are freely transferable (except for transfers designed to thwart the intrastate offering restriction).  HB 2023 offerings are not freely transferable.  Under the Washington rule (WAC 460-99C-170), for the first year they may only be transferred to the issuer, an accredited investor, or family members.  Under federal Rule 147 (the federal exemption HB 2023 relies on), crowdfunded securities  must be held by the purchasers at least nine months, and then any transfers may only be transferred to another resident of Washington.  In either case, transfers will not be likely because there will be no public trading market and most companies will have shareholder covenants imposing restrictions on transfers.

Convertible Debt and Warrants.  Unlike  ESHB 2023 offerings, warrants, debt, and other securities are actually permitted under SCOR offerings.  However, in the case of debt, the issuer must be able to demonstrate an ability to pay back the borrowed money from current earnings.  That is typically not the case with a startup company, so popular convertible debt securities would not be available.

Right to Withdraw.  Though not required by the statute, the DFI created a rule that gives investors the right to cancel their subscription of an ESHB 2023 offering for any reason until the minimum funding amount is reached.  There is no such right in SCOR offerings.  In my comments during the rule making process I objected to the cancellation right since it basically gives investors an option on the company and could make it hard to reach the minimum funding amount.  I recommended that cancellation should only be allowed when there has been a material change in the issuer’s prospects, which they are required to report.  But the DFI, which sees the worst securities law abuses, wasn’t swayed and felt that the cancellation right was important to protect consumers.  In practice, we will see if this becomes a significant problem for issuers.  I am optimistic that it won’t.

Quarterly Information Requirements.   Quarterly information reports are not required under SCOR offerings, unlike  ESHB 2023, which requires you to make executive compensation, identity of 20% shareholders, and a business summary “publicly accessible” on your website on a quarterly basis as long as the crowdfunded securities are outstanding.  In most circumstances, the crowdfunded securities will be outstanding for a long time, usually until the company is sold or there is a major restructuring.  So this may be a material consideration for some companies or founders, who may be fine with sharing such information with their shareholders but do not want to share it with the general public.

So which offering method is best for your Company,  ESHB 2023 or SCOR?

If you happen to be incorporated in Delaware, want to do a regional offering, need to offer warrants or convertible debt, or don’t want to make your compensation or the identity of your 20% shareholders publicly available on an ongoing basis, a SCOR offering may be your best choice.  Given the 500 shareholder restriction, the lack of investment limits in SCOR offerings may not make a significant difference, unless you believe you will have access to investors who are willing to put in more than $100,000 each (in which case maybe neither type of crowdfunding makes sense for your company?)

On the other hand, the more complicated form, the merit review, and  the promotional shares lock-in of SCOR registrations might sway you in favor of ESHB 2023.  As indicated earlier, the same staff members at the DFI administer both offerings, and they are very willing to help.   Though protective of consumers, they manifest a desire to help responsible small businesses raise capital as efficiently as possible.  Even though the U-7 and 2023 forms ask for similar information, my guess is that getting through the 2023 process will be a bit quicker for three reasons: (1) the 2023 form is actually simpler than the U-7, liberally employing a “check-the-box” format, (2) since they created it, the DFI staff understand their own form, and want it to be used and  accepted, we can assume, and (3) there has been a lot of investment in 2023 by many people around the state who have their eyes on it and want it to work.  DFI knows this and has invested significant resources of their own to make it happen.

How long will it take you to complete the registration process?    Experience with SCOR offerings is limited but six months is not unusual.  But my understanding is that none of these companies were represented by legal counsel, and the DFI staff spent a lot of time helping issuers understand the form and revise it.  DFI director William Beatty suggested in an open meeting that an application prepared with the assistance of a seasoned securities lawyer would be much quicker, perhaps in a few weeks.

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