The Route to Capitalization: The Transcendent Registration Exemptions for Securities Offerings as a Means to Small Business Capital Formation *

I. IntroductionThe necessity of a new "route to capitalization" for small businesses is born out of costly registration requirements and ongoing reporting requirements under the Securities Acts of 1933 and 1934, respectively. These registration, disclosure, and reporting requirements operated as consumer protection laws by ensuring that investors had access to full and fair disclosure of all material facts associated with the investment.1 However, compliance with these laws is a costly and burdensome process, which acts as a barrier to small businesses' access to capital markets and goes beyond consumer protection to effectively bar consumer-investors from participation altogether.2 Accordingly, small businesses and investors alike began lobbying for a change, to which the legislative response was the Jumpstart Our Business Startups (JOBS) Act of 2012.3The underlying issues are the substantive registration requirement for businesses seeking to raise capital by selling equity in their companies and the considerable transaction costs associated with such registration. The requirement originated with the Securities Act of 1933 (the "1933 Act"), which was passed in the wake of the Great Depression in the late 1920s and early 1930s.4 In response to the market's failure and the public's overwhelming distrust of the stock market, the 1933 Act was ultimately intended to prevent fraud in the sale of securities by providing "full and fair disclosure" of the character of securities sold and of all the material facts associated with those offerings.5In furtherance of that purpose, the 1933 Act requires all "securities" within the meaning of the Act to be registered with the Securities and Exchange Commission (SEC). 6 What constitutes a security is defined broadly by the statute7 and is interpreted even more broadly by courts.8 The critical inquiry, as established in SEC v. W.J. Howey Co.,9 is "whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. "10 Sweepingly characterizing offerings as securities for registration purposes, the Supreme Court has elsewhere noted that "Congress' purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called. "11Under that formalization, almost any investment offering by a business capitalizing through outside investment will qualify as a security and accordingly be subject to registration requirements. While this broad application is in line with the prophylactic purpose behind the legislation, it does not come without a cost. In addition to the base filing fee requisite to any registration under the 1933 Act,12 which can be as much as $100,000 even for a small offering,13 businesses must also incur substantial legal, accounting, and underwriting fees associated with filing. As estimated by the IPO Task Force, regulatory compliance for an initial public offering (IPO) costs an average of $2.5 million initially, followed by an average ongoing cost of $1.5 million per year.14Take, for example, a small start-up business called Oculus Rift with an unprecedented idea for a virtual-reality headset.15 First and foremost, the company will need capital to get off the ground-to research and experiment, to develop a prototype, and to begin limited production. But absent a registration exemption, the company will also need capital to ask for capital-an estimated $2.5 million of it.And clearly for many smaller companies seeking to capitalize, the aforementioned cost is prohibitive. However, with public investment otherwise unavailable, small businesses cannot easily turn to other options. Debt financing is not readily accessible for smaller companies like Oculus Rift, especially early-stage start-ups without a history of revenue to rely on.16 These loans, assuming attainability, may also be excessively expensive.17From the individual investor's standpoint, this situation is similarly unideal. …