SMALL BUSINESS

Efforts to Facilitate

Equity Capital

Formation

United States General Accounting Office

GAO Report to the Chairman, Committee on

Small Business, U.S. Senate

September 2000

GAO/GGD-00-190

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

B-283890

September 29, 2000

The Honorable Christopher S. Bond

Chairman, Committee on Small Business

United States Senate

Dear Mr. Chairman:

As you requested, this report discusses U.S. small businesses’1 access to

equity capital financing.2 According to the Small Business Administration

(SBA), in 1998, the small business sector generated about half of the

private gross domestic product. The development and survival of many of

this country’s fastest growing small businesses depend on equity capital

financing. Because of the vital role that small businesses play in our

economy, you asked that we study recent trends in small business equity

capital financing and the potential effects of market practices and

securities law regulations on such financing.

The specific objectives of this report are to (1) provide an overview of the

major sources of external equity capital for U.S. small businesses and

describe SBA’s Office of Advocacy (SBA-OA) estimate of their perceived

needs for equity capital financing, (2) determine trends for the period of

1994-99 in small business equity capital financing, (3) describe how market

practices and securities law regulations for equity capital-raising activities

could affect small businesses, and (4) describe any efforts undertaken by

federal and state agencies to facilitate small businesses’ access to equity

capital.

Markets that provide equity capital financing to U.S. small businesses

include informal, unregulated markets and regulated securities markets.

The primary providers of private equity capital in informal, unregulated

markets are

1

For the purpose of our study, a business is “small” if it has $25 million or less in annual revenues or

500 or fewer employees. We define a business as “large” if it has more than $25 million in annual

revenues and more than 500 employees.

2

Equity capital is money raised by a business by selling shares of ownership, or potential ownership, of

the business. According to SBA’s Associate Administrator for Investment, subordinated debentures

with equity features are the common investment vehicle for many of SBA’s Small Business Investment

Companies (SBIC) and are considered by SBA to be the functional equivalent of convertible preferred

stock financing used by venture capital funds. Therefore, we include such SBIC investments as equity

in this report.

Results in Brief
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• “business angel” investors—wealthy individuals who provide private equity

financing to early-stage, high-growth small businesses and

• venture capital funds (which include Small Business Investment

Companies (SBIC))—private partnerships that provide private equity

financing to early- and later-stage, high-growth small businesses.

Small businesses that raise equity capital in regulated securities markets

do so through

• Private placement of securities—an offering of securities exempt from

federal registration, which is limited in distribution to certain types of

investors.

• Public offering of securities—an offering of stock to the general public.

For a small business, this could take the form of an initial public offering

(IPO)—a private business’ first offering and sale of securities to the

general public (i.e., going public). Another type of public offering is a

direct public offering (DPO)—a business’ attempt to raise capital in the

public markets without the aid of a securities underwriter.3

In 1996, SBA-OA sponsored a study to estimate the need of small

businesses for equity capital. From the results of this study, SBA-OA

estimated that about 10 percent of the businesses started in a year (i.e.,

start-ups) would need equity capital, as well as about 25 percent of faster

growing small businesses. Therefore, in 1996, about 50,000 start-ups and

about 75,000 fast-growing businesses were estimated to need equity capital

financing. Partly on the basis of focus group results, SBA-OA also stated

that the greatest equity capital financing need of small businesses was for

amounts in the range of $250,000 to $5 million. SBA-OA estimated that for

1996, the total unmet need for early-stage equity financing for small

businesses was about $60 billion annually.

Available data are insufficient for updating the estimate of small

businesses’ equity capital needs, but indicate for the 1994-99 period that

the level of small business equity financing increased dramatically. Data

indicate that the total of small business equity capital financing provided in

1999 by venture capital funds, SBICs, IPOs, and private placements of

securities was about $107 billion. This amount represents almost a six-fold

increase from the amount in 1994 (about $18 billion) and an increase of

3

An underwriter is a brokerage firm, securities dealer, or investment banking firm that sells company

securities to investors, other brokerage firms, securities dealers, and investment banking firms. The

selling of securities to investors can occur either through a private placement or public offering.
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about 270 percent over the total estimated amount from those sources in

1996 (about $29 billion).

However, the extent to which the recent increases in equity financing have

helped to fill the unmet need suggested by SBA-OA’s 1996 estimate is not

clear. The average amount of a venture capital investment has increased,

suggesting that, in general, venture capital funds may have become a less

likely source of equity financing in the $250,000 to $5 million range. In

addition, venture capital investments tend to be concentrated in certain

geographical areas and certain industries, raising questions about whether

unmet needs in different parts of the country and industries are being

addressed. Furthermore, business start-ups have also increased. Finally,

business angel investors, for whom financing data are not available, are

considered an important source of equity capital funds for small

businesses. SBA-OA officials we interviewed continue to believe that,

despite the growth in the total dollar volume of venture capital fund

investments, available evidence supports their assessment that a major

equity financing shortage persists for small businesses in the amounts of

$250,000 to $5 million.

In the 1994-99 period, high-tech companies had the widest use of venture

capital, IPO, and private placement financing. According to some market

participants we interviewed, many small businesses have difficulty

attracting venture capital financing because of the selection criteria used

by venture capitalists in deciding where to invest their funds. Some market

participants also told us that many small businesses are restricted in

issuing equity securities by the high costs and complexities resulting from

state and federal securities law regulations and by the inability to attract

underwriters to market their securities. According to an investment banker

we interviewed, small business issues are viewed unfavorably by

underwriters because they are too small in size to be profitable.

Equity capital formation in the unregulated equity capital market is

affected by market practices, which reflect efforts of investors and other

market participants to maximize returns and manage risks on investments.

In the regulated securities markets, market practices as well as federal and

state securities laws and regulations, which are designed to protect

investors and the integrity of the securities markets, affect equity capital

formation of both large and small businesses. In general, however, equity

capital is widely viewed as less accessible and more costly per dollar

raised for small businesses compared with large businesses.
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The results of our analysis of IPO offerings indicate that the average total

cost to conduct a small business IPO during 1994-99 was about 10 percent

of total offering proceeds, while the average total cost for a large business

IPO was about 8 percent. Federal securities regulators have simplified

federal registration of securities offerings and exempted certain small

business securities offerings from several requirements to reduce the

regulatory burden and costs for small businesses in equity capital

formation. However, some market participants we interviewed believed

more can be done, including, for example, increasing dollar limits on

securities offerings allowed under certain exemptions and encouraging

greater commonality in certain federal and state registration requirements.

In addition to simplified registration and exemption initiatives, states and

the federal government have initiated actions to help reduce the regulatory

burden and costs for small businesses seeking equity capital financing in

the regulated securities markets. They have also initiated actions to help

increase the availability of information about small businesses’ seeking to

raise equity capital in the informal, unregulated equity capital markets.

Most state governments have also initiated actions to help encourage

business angel investment in small companies through training programs

and a variety of events intended to introduce entrepreneurs and potential

investors. These initiatives alone have not solved the perceived problem of

the equity capital gap.

SBA; the Securities and Exchange Commission (SEC); the North American

Securities Administrators Association, Inc. (NASAA); and the National

Venture Capital Association (NVCA) provided technical comments on this

report that were incorporated where appropriate. NVCA and SBA-OA also

provided written comments and generally commended the information in

the report.

SBA estimated that there are about 25.5 million small businesses operating

in the United States today that differ widely in size, industry, and rates of

growth. They also differ in their needs for external financing, including

equity capital financing. In the early years of most companies, capital tends

to come from the entrepreneur; friends; family members; and cash from

operations, if any. A business’ opportunities for external capital in the form

of a business loan will depend on its ability to meet commercial lenders’

requirements for collateral or personal guarantees. For many companies,

including “mom and pop” businesses, debt financing can be a viable

external financing business option. Moreover, we were told that many

owners of small businesses prefer debt financing because they want to

retain total control of the business.

Background
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The cash needs of a rapidly growing small business might exceed funds

from the entrepreneur and his or her family and friends as well as the

business’ borrowing capacity. For example, small businesses might have

difficulty qualifying for substantial bank loans because they may lack the

necessary collateral. When this occurs, the business may seek to sell

shares of ownership, or securities convertible into shares of ownership, in

the business to raise needed cash to be used in operations. Equity capital

investors may be willing to take on such risk if they expect relatively larger

returns on their investment than on less risky investments. By bolstering a

business’ overall capital, equity capital financing can also help facilitate

future bank loans as a source of financing.

SBA-OA undertakes research, conducts and participates in conferences,

and engages in other activities to promote the role of small businesses in

the U.S. economy. While SBA-OA is part of SBA, its actions and positions

are independent of the Administrator of SBA.

SBA operates the SBIC program. SBICs are privately organized and

managed for-profit investment businesses that are licensed and supported

by SBA. SBICs provide equity capital and management assistance to

qualifying small businesses. Most SBICs differ from private venture capital

firms in that they supplement their investment capital with funds raised by

issuing SBA-guaranteed debt or equity securities. This “leverage” allows

them to invest in businesses with more modest growth targets and still

generate competitive financial returns for their private investors.

The Securities Act of 1933 (Securities Act) requires companies that are

publicly offering securities for investment to register the securities with

SEC and to provide investors with all material information relating to the

purchase of a business’ securities. The Securities Exchange Act of 1934

(Exchange Act) contains antifraud provisions that provide civil recovery

rights to investors who purchase or sell securities on the basis of

materially inaccurate information. All states also have established

securities registration and review requirements to protect purchasers of

securities.

To provide an overview of major sources of external equity capital

financing for small businesses and to describe the perceived needs in such

financing for U.S. small businesses, we interviewed knowledgeable

governmental and private sector officials and academicians and reviewed

relevant studies.

Scope and

Methodology
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To determine trends in equity capital for the 1994-99 period, we analyzed

cost and industry data for domestic companies regarding venture capital,

SBIC, IPO, and private placement financing.4

We obtained data on IPO,

private placement, and venture capital financing from databases

maintained by Thomson Financial Securities Data (TFSD) and data on

SBIC financing from SBA’s Investment Division. Difficulties in obtaining

data about business angel investments prevented us from including these

in our analysis. SBIC financing data that we gathered relates solely to small

businesses. From available data, we treated venture capital financing as

small business financing. We excluded later stage and buyout investments

because, according to the NVCA’s Director of Research, these investments

are not made in small businesses.

Information on the size of the business receiving financing was not

available on each of the IPO and private placement data records we

obtained. Therefore, we had to estimate the total dollar amount raised for

small business IPOs and private placements.5 To do this, we compared the

ratios of total dollar financing among businesses known to be small with

the total dollar financing among all of those businesses, large or small, in

which size was known, and we applied that ratio to the total dollar

financing among records in which size was unknown. The validity of this

estimate depends upon the assumption that the distribution of total

financing for small and large firm IPOs and private placements among the

businesses with missing size information was similar to the distribution

among businesses whose size was known. Many of the IPO and private

placement records were missing size information, so our estimate has

some unknown amount of error. We did not verify the reliability of these

data.

To describe how market practices and securities law regulations could

affect small businesses and to describe differences in the potential effects

of these practices and regulations on small businesses, we obtained both

qualitative and quantitative information on investment volume and costs

for both small and large businesses, for the 1994-99 period, from a variety

of public and private sources. Specifically, to identify market practices and

costs for IPOs, private placements, and venture capital financing, we

obtained the views of officials from the SEC’s Division of Corporation

4

We excluded from our trend analysis foreign companies and domestic companies in foreign countries.

5

The TFSD IPO database had 3,292 records, of which 1,511 had business size information. These 1,511

businesses comprised 1,053 small businesses and 458 large businesses. The TFSD private placement

database had 1,969 records, of which 257 had business size information. These 257 businesses

comprised 160 small businesses and 97 large businesses.
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Finance—Office of Small Business Policy; the National Association of

Securities Dealers Regulation, Inc. (NASDR); and SBA’s Office of

Advocacy and Investment Division. We also obtained the views of officials

from NVCA; the National Association of Small Business Investment

Companies; and NASAA. In addition, we interviewed officials from various

industry participants, including investment bankers, securities lawyers,

venture capital firms, business angels, business incubators,6

and small

businesses. Lastly, we reviewed information from various Internet Web

sites.

To determine the respective authorities of federal and state securities

regulators and to investigate the effect of that division on small businesses,

we interviewed federal securities regulators at SEC and NASDR; state

securities regulators for Washington and Maryland; officials at NASAA; and

securities lawyers. We also reviewed federal and state securities statutes,

rules, and regulations and assessed their effects on small and large

businesses’ capital formation. In addition, we attended several conferences

on small business financing and reviewed available literature on Web sites

and in print, including reports, studies, articles, and published

proceedings.

To describe the efforts undertaken by federal and state agencies to

facilitate small businesses’ access to equity capital, we interviewed

officials of SBA-OA, SEC’s Division of Corporation Finance—Office of

Small Business Policy, NASAA, and Maryland and Washington securities

divisions. We also interviewed securities lawyers and the President of the

National Association of State Seed and Venture Funds and reviewed

material on relevant Web sites.

We conducted our work mostly in Washington, D.C., and San Francisco,

CA, between August 1999 and September 2000 in accordance with

generally accepted government auditing standards. We requested

comments on a draft of this report from the heads, or their designees, of

SEC, NVCA, SBA, and NASAA. All four entities provided technical

comments, which were incorporated in this report where appropriate.

NVCA and SBA-OA also provided written comments that are discussed at

the end of this letter and reprinted in appendixes V and VI.

6

Business incubators are entities that help young businesses to survive and grow during their first few

years of existence by providing them with aids such as hands-on management assistance, access to

financing, and exposure to critical business or technical support services (e.g., office space and

telephones).
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Small businesses have four major sources of external equity capital:

wealthy individuals, known as business angels; venture capital funds;

private placement of securities; and public offerings of securities. These

sources of external equity capital tend to be relevant at different stages of

a business’ growth. The need for, and the availability of, external equity

capital can change with economic conditions that affect such factors as

the number and wealth of investors in capital markets and the number and

type of start-up companies.

In 1996, SBA-OA sponsored a study to estimate small businesses’ need for

equity capital.7

According to SBA-OA officials, the results of this study

indicated that the businesses needing equity capital included about 10

percent of the business start-ups each year and about 25 percent of the

mostly small businesses growing faster than 20 percent annually.

Therefore, in 1996, SBA-OA estimated that about 50,000 start-ups and

about 75,000 fast-growing businesses, which was a total of about 125,000

businesses needed equity capital financing. In addition, partly on the basis

of the results of several focus groups that it conducted in 1996, SBA-OA

identified the greatest equity capital financing need of small businesses as

financing in the amounts of $250,000 to $5 million.8 SBA-OA estimated the

total unmet need for early-stage equity financing for small businesses to be

about $60 billion annually.

Small businesses have the following four major sources of external equity

capital financing: business angel investors, venture capital funds, private

placement of securities, and public offerings of securities. These sources

tend to be relevant at different stages of a business’ growth, as illustrated

in figure 1.

7

Cognetics, Inc., which is a New Jersey consulting firm, conducted the study, according to an SBA-OA

official. Also, see the June 1996 SBA-OA-sponsored study entitled Creating New Capital Markets for

Emerging Ventures, which was done by the Center for Venture Research at the University of New

Hampshire.

8

The Process and Analysis Behind ACE-Net, SBA-OA, October 1996.

Small Businesses Have

Four Major Sources of

External Equity Capital

and Are Perceived to

Mostly Need $250,000

to $5 Million in Equity

Capital

Small Businesses Have Four

Major Sources of External

Equity Capital Financing
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Up to $250,000

$250,000 to $5 million

Seed stage

Capital to prove a

concept or develop a

product

Start-up stage

Financing for product

development and

initial marketing

First stage

Investment to initiate

commercial 

manufacturing and

shipping

Second stage

Investment for initial

expansion of production

Third stage

Investment for plant

expansion, marketing, 

product improvement or

working capital

Bridge stage

Financing to sustain 

major growth in a 

company expecting to

go public in 6-12 months

Exit/Liquidity stage

Via IPO, merger, or

acquisition

$1 to $5 million

Up to $10 million

Up to $10 million

Up to $20 million

$30 million or greater Public markets

Private markets

Private placements

Venture capital funds

Venture capital funds

Leverage buyout funds

Venture capital funds

Corporate venture funds

Venture leasing companies

Strategic partnerships

Business angels

Small Business Investment Company

Venture capital funds

Research and development partnerships

Leasing companies

Strategic partnerships

Private placements

Business angels

Early-stage venture capital

Small Business Investment Company

Foundation grants

Government funds

Private placements

Entrepreneur's assets

Friends

Family

Stages Capital needed Financing sources

A

Note: This illustration shows stages of growth and financing sources relevant to many, but not all,

small businesses.

Source: GAO analysis of SBA, NVCA, and California Bureau of Research data and available articles.

Figure 1: Possible Stages of Business Growth and Sources of Financing
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Business angels are important participants in the informal, unregulated

market for small business equity capital. Entrepreneurs typically first seek

early-stage, external equity financing from business angels. Business

angels

• invest their own funds in small businesses;

• provide incremental financing to small businesses on the basis of the

business’ achievement of specific financial and nonfinancial milestones;

• typically provide early-stage funds, which may range from $25,000 to

several million dollars per deal;

• generally seek high-growth, high-return investment opportunities, although

some invest more for social good, with high returns being of secondary

importance;

• take 10 percent or more of a firm’s ownership and generally look for the

ability to liquidate the investment in about 5 to 10 years through a merger,

acquisition, or IPO;

• advise and may manage the firm or be passive investors; and

• may act independently, but increasingly are organizing to share

information about possible investments and pool resources with other

business angels.

According to an industry representative, venture capital funds, which are

private partnerships that provide private equity financing, generally consist

of about 6 to 12 general partners and associates. These funds generally are

structured as 10-year limited partnerships with venture capitalists acting as

the general partners and outside investors serving as limited partners.9

Venture capital funds generally

• invest the money of others, including pension funds, university

endowments, insurance companies, and wealthy investors;

• provide incremental financing to small businesses on the basis of the

business’ achievement of specific financial and nonfinancial milestones;

• tend to fund high-growth, high-return deals at later stages and in larger

amounts than business angels;

• take about 20 to 40 percent ownership of a firm, depending on the amount

of capital provided and their valuation of the firm;

• look for the ability to liquidate the investment in about 3 to 5 years through

a merger, sale, or IPO;

9

A limited partnership is a form of business organization that is made up of a general partner—who

manages a project—and limited partners—who invest money but have limited liability, are not involved

in the day-to-day management, and usually cannot lose more than their capital contribution. The

limited partnership structure is the dominant structure used by venture capital businesses to raise

money.

Business Angels

Venture Capital Financing
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• advise and manage the firm by taking seats on the firm’s Board of

Directors; and

• may invest in a business with other venture capital funds to reduce risks

through diversification.

NVCA, which is a trade association for the venture capital industry,

reported that 620 venture capital firms in the United States were managing

1,237 funds in 1999. In its technical comments to our draft report, NVCA

noted that although most venture investments are $20 million or less (in

1999, 86 percent of venture deals), in recent quarters, venture capital funds

have made increasingly large investments, ranging from $30 million (e.g.,

Internet-related companies needing capital to establish national brand

awareness) to $200 million or more (which often involves huge

infrastructure investment, such as communication satellites or extensive

wiring).

SBICs, a further source of venture capital financing for small businesses,10

generally

• provide equity financing in amounts of $250,000 to $5 million and

management assistance to a wide variety of companies and

• include Specialized SBICs, which are to provide financing and

management assistance to economically or socially disadvantaged

persons.

Specialized SBICs typically make smaller investments than SBICs. The

average equity amount that Specialized SBICs invested per deal in 1999

was $350,554; while for SBICs, the average equity amount was $2.05

million. As of December 31, 1999, the number of licensed SBICs was 295,

and the number of licensed Specialized SBICs was 61.

A small business can raise equity capital in the regulated securities

markets through a private placement of equity securities. Private

placements—an offering of securities that are exempt from federal

registration requirements and limited in distribution to certain types of

investors—can provide financing to sustain rapid growth of a business and

may be a lower-cost alternative to an IPO. Private placements are generally

less expensive than public offerings because they (1) must be offered in a

limited manner to a limited audience of participants, (2) are exempt from

10In 1999, SBA proposed the creation of the New Markets Venture Capital Program to stimulate

economic development in low- and moderate-income communities. SBA expects equity investments

made by the new venture capital companies to range from $50,000 to $300,000.

Private Placements of Securities
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SEC registration requirements, and (3) are usually sold without the

assistance of an underwriter. However, private placements may not be

exempt from state registration requirements.

Small businesses also can raise capital in the regulated securities markets

through the public offerings of securities. For the purposes of this report, a

public offering can be

• an IPO—a private business’ first offering and sale of securities to the

general public (i.e., going public) or

• a DPO—in which the issuer attempts to raise capital in the public markets

without the aid of a securities underwriter.

IPOs are subject to federal and state securities laws designed to protect

investors and the integrity of securities markets, and an underwriter

usually assists in IPOs. Underwriters play an important role throughout the

IPO process by helping companies in their efforts to market and sell the

IPO to the investment community.

DPOs can be a lower-cost alternative to underwritten public offerings

because DPOs are not assisted by an underwriter and, therefore, have no

underwriting expense. However, DPOs do entail costs, such as regulatory

filing, accounting, printing, legal, and marketing costs, since DPOs have to

be registered with SEC and go through its traditional registration review

process. According to NASAA officials, DPOs stand little chance of

success without an existing client base or other affinity group. See

appendix I for the chronology of a small business’ attempt to raise capital

via a DPO.

At the 1995 White House Conference on Small Business, small businesses’

need for equity capital was identified by participants as a high-priority

issue. As a follow-up to that concern, SBA-OA sponsored a study in 1996 to

estimate small businesses’ need for equity capital. According to SBA-OA

officials, the results of this study indicated that businesses in need of

equity capital include about 10 percent of business start-ups each year and

about 25 percent of the small businesses growing faster than 20 percent

annually. Therefore, in 1996, SBA-OA estimated that about 50,000 start-ups

and about 75,000 fast-growing businesses, or a total of 125,000 businesses

needed equity capital financing. In addition, partly on the basis of the

results of several focus groups that it conducted, SBA-OA identified that

the greatest equity capital financing need of small businesses was

financing in the amounts of $250,000 to $5 million. SBA-OA estimated for

1996 that the total unmet need for early-stage equity financing for small

Public Offerings of Securities

Small Businesses’ Greatest

Perceived Need for Equity

Capital Is for Financing in

the Range of $250,000 to $5

Million
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businesses was about $60 billion annually. Although acknowledging that

these numbers were soft, an SBA-OA official told us that he considered all

of these findings valid today.

Several business officials and academicians that we interviewed were

familiar with SBA’s effort to define the perceived need of small businesses

for equity capital. Although they recognized the difficulty associated with

defining the need of small businesses for equity capital, several of them

stated that many small companies face difficulties raising equity capital in

amounts from $250,000 to $5 million. Part of this difficulty was perceived

as arising from upward movement in the average minimum amount that

venture capital funds were investing per deal.

Several business officials we interviewed also said that the cost of

conducting an IPO of securities could limit small businesses’ access to the

equity capital market. In addition, some market participants we

interviewed acknowledged that equity-financing difficulties exist for

companies in industries that are not the current “favorite” of the

investment community. For example, some said that companies in such

technologies as renewable energy, have difficulty attracting venture capital

financing because these companies are perceived as offering lower

investment returns than some other investment opportunities (most

recently, Internet-related companies) and also as having a relatively long

investment horizon of 20 to 25 years.

To better understand the current environment and recent trends in small

business equity capital financing, we analyzed available industry data for

domestic companies receiving equity capital financing during 1994-99 from

venture capital funds, SBICs, IPOs, and private placements of securities.

We found a dramatic increase in the estimated overall level of small

business equity financing in the study period and also since 1996, which

was the year of SBA-OA’s effort to estimate small businesses’ needs for

equity capital financing. While the estimated level of small business equity

capital financing increased, so did the number of start-up companies. In

the study period, high-tech companies had the widest use of venture

capital, IPO, and private placement financing. We also observed that recent

increases in the average amount of equity capital invested in small

businesses by venture capital funds could make these funds a less likely

source of financing for amounts of less than $5 million than they had been

previously.

Small Business Equity

Capital Financing

Increased In 1994-99
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The estimated level of financing for small businesses from venture capital

funds, SBICs, private placements of securities, and IPOs increased almost

six-fold in the 1994-99 period, from about $18 billion in 1994 to about $107

billion in 1999. Of the sources we analyzed, venture capital funds provided

the greatest amount of small business equity capital financing; also, the

greatest annual increase in financing was from that source in 1999. The

$107 billion estimate of small business equity capital financing from those

sources in 1999 represents an increase of about 270 percent over the

estimated amount from those sources in 1996 ($29 billion).

We did not attempt to account for financing from business angels because

of difficulties in obtaining industry data. According to SBA-OA and others,

approximately 30,000 companies a year receive about $20 billion in equity

capital from about 250,000 business angel investors. Many industry

representatives we interviewed told us that the business angels often

provide financing in the $250,000 to $5 million range.

During the 1994-99 period, estimated venture capital, IPO, SBIC, and

private placement equity financing for small businesses increased, as

shown in figure 2. Venture capital financing of small businesses

dramatically increased in 1998 and 1999. IPO financing also had significant

growth in 1999. SBIC equity financing increased from approximately $1

billion in 1994 to $4.6 billion in 1999.

Total Amount of Small

Business Equity Capital

Financing Increased Almost

Six-Fold in 6 Years
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Note: IPO and private placement amounts have been adjusted to account for missing business size

information. See the scope and methodology section of this report for adjustment calculation.

According to SBA’s Associate Administrator for Investment, subordinated debentures with equity

features are the common investment vehicle for many of SBA’s SBICs and are considered by SBA to

be the functional equivalent of convertible preferred stock financing used by venture capital funds.

Therefore, we included such SBIC investments as equity in this report.

Source: GAO analysis of data provided by TFSD and SBA.

The amounts of equity capital financing that venture capital funds, SBICs,

IPOs, and private placements provided to all businesses (large and small)

are shown in figure 3.

Figure 2: Estimated Financing Provided

to Small Businesses by Venture Capital

Funds, SBICs, IPOs, and Private

Placements, 1994-99
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Note: All reported statistics are based on all records of domestic equity financing available from TFSD

and SBA.

According to SBA’s Associate Administrator for Investment, subordinated debentures with equity

features are the common investment vehicle for many of SBA’s SBICs and are considered by SBA to

be the functional equivalent of convertible preferred stock financing used by venture capital funds.

Therefore, we included such SBIC investments as equity in this report.

Source: GAO analysis of data provided by TFSD and SBA.

Because SBICs only fund small businesses, and we generally treat venture

capital financing as small business financing, the amounts for these

sources are identical in figures 2 and 3. Over the stated period, as shown in

figure 3, the amount of equity capital financing provided to large and small

businesses grew significantly for the private placement, IPO, SBIC, and

venture capital markets. In 1999, the private placements and IPO markets

accounted for the majority of financing to large and small businesses from

these equity sources. Venture capital financing showed the greatest

percentage increase for 1998 and 1999.

Figure 4 shows the number of businesses (large and small) receiving equity

capital financing from venture capital funds, SBICs, IPOs, and private

Figure 3: Equity Capital Financing

Provided to All Businesses by Venture

Capital Funds, SBICs, IPOs, and Private

Placements, 1994-99
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placements in the study period. The figure also shows that during 1994-99,

the number of businesses financed by venture capital increased steadily

and that venture capital financed the greatest number of businesses.

Venture capital funds financed 1,178 businesses in 1994 and 3,638

businesses in 1999. SBICs financed 534 businesses in 1994 and 1,426

businesses in 1999. The number of businesses financed by IPOs and

private placements remained relatively constant over the period.

Note: All reported statistics are based on all records of domestic equity financing available from TFSD

and SBA. Also, the number of businesses receiving private placement financing may be overstated

because it represents the number of financings and a business may have received more than one

financing.

Source: GAO analysis of data provided by TFSD and SBA.

Results from our review of trends in the equity capital financing for small

and large businesses during 1994-99 indicate that high-tech companies in

particular states had the widest use of venture capital, IPO, and private

placement financing. California, Massachusetts, New York, and Texas

were the four states with the largest amounts of venture capital financing

Figure 4: Number of Businesses

Receiving Equity Capital Financing

From Venture Capital Funds, SBICs,

Private Placements, and IPOs, 1994-99

High-Tech Companies in

Specific States Had Widest

Use of Venture Capital

Financing
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from 1994-99. In 1999, California businesses received $16.87 billion in

venture capital investments—nearly 3 times the amount they received in

1998. Additional industry data show that of the total amount invested in

the computer software, computer networking/equipment, and

telecommunications industries in 1999, Silicon Valley businesses received

46.0 percent, 45.5 percent, and 31.0 percent, respectively.

As shown in table 1, the average amount of investment in small business

by venture capital funds more than doubled in 1999 to $13.3 million, up

from $6.6 million in 1998. Although overall financing has increased, this

suggests that, in general, venture capital funds may have become a less

likely source of equity capital financing in the $250,000 to $5 million range.

Based on the increase in the average investment to $13.3 million, SBA-OA

officials believe that, the increased level of venture capital financing will

be less likely to serve the unmet needs of small businesses.

Dollars in millions

Calendar year

Average amount of equity

capital disbursed

1994 $4.32

1995 4.36

1996 5.38

1997 5.75

1998 6.61

1999 13.34

Source: GAO analysis of data provided by TFSD.

For large and small businesses, equity capital formation is affected by (1)

market practices of private equity capital providers, which reflect their

efforts to maximize returns and manage risks, and (2) costs associated

with federal and state securities market regulations, which are designed to

protect investors and the integrity of securities markets. Private equity

capital providers generally view small businesses as high-risk investments

because small businesses have a high, historical rate of failure and

information that is often helpful in assessing risks and returns is typically

limited. Therefore, to manage risks in small business investing, private

equity capital providers have strict criteria for the selection of businesses

in which they will invest.

In the formal, regulated securities market, regulations that protect

investors and help to ensure the integrity of equity capital markets can

facilitate information disclosures that can improve investor confidence.

However, the costs of compliance with these regulations can be a limiting

Venture Capital Firms May

Be Less Likely to Provide

Financing in the $250,000 to

$5 Million Range

Table 1: Average Dollar Amount of

Equity Capital Disbursed to Small

Businesses by Venture Capital Firms,

1994-99

Market Practices of

Private Equity

Providers and

Regulatory

Requirements Affect

Small Business Equity

Capital Formation
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factor for small businesses. Certain regulatory costs for small issues of

securities tend to be higher per-dollar-raised compared with costs for large

issues, partly because certain costs are not proportionate to the size of the

offering. Small businesses may also be subject to potentially costly state

requirements in their capital-raising activities, while large businesses often

are not. This is because large issues, such as nationally traded securities,

are exempt from state registration and review requirements, while small

issues are not.

Because state registration requirements differ, a small business making a

multistate offering can find complying with the varying state laws

complex, costly, and time-consuming. Federal and state securities

regulators have adopted several reforms to streamline the capital

formation process for small businesses and reduce their regulatory

burden. Some market participants we interviewed believed that more

could be done to reduce regulatory burden to small businesses. For

example, some suggestions were aimed at attracting more investors to

small business investment, increasing the dollar limits on securities

offerings allowed under certain exemptions, and encouraging greater

commonality in certain federal and state registration requirements.

According to literature we reviewed, equity capital providers view new and

rapidly growing companies generally as high-risk investments because

such companies have a high, historical failure rate. In addition, these

companies often lack a record of performance that investors can use to

evaluate potential risk and returns.11 Some research indicates that

approximately 80 percent of new businesses will either fail or no longer

exist within 5 to 7 years of formation due to a lack of financial depth, a

lack of management expertise, an unworkable business idea, or some

combination of these factors. The perceived high risk associated with new

and rapidly growing companies is also borne out by the past performance

of venture capital investments in the informal, unregulated equity capital

market. According to a recent study by the National Association of Seed

and Venture Funds, only about 10 percent of venture capital investments

meet their expected rate of return.12 This statistic is particularly striking in

light of venture capital funds’ strict processes for selecting investments

and their active monitoring of the companies in which they invest.

11By way of contrast, information about the performance of companies whose stocks are publicly

traded is available from a variety of sources, such as Standard & Poors.

12Growing New Businesses with Seed and Venture Capital: State Experiences and Options, Robert G.

Heard and John Sibert, National Association of State Seed and Venture Funds, Year 2000.

Investment in New, Rapidly

Growing Businesses Is

Viewed as High Risk by

Equity Capital Providers
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According to market participants we interviewed and literature we

reviewed, to maximize returns and help manage risk, providers of equity

capital in the informal, unregulated equity capital market require small

businesses in which they invest to meet highly selective financing criteria.

Venture capital funds, for instance, typically look for businesses with

• a marketable business idea with widespread appeal;

• an estimated minimum annual internal rate of return13 in the range of 30 to

50 percent;

• an experienced management team; and

• an opportunity to liquidate the investment in about 3 to 5 years through a

merger, a sale, or an IPO.

These and other criteria limit the companies deemed eligible for financing.

Although venture capital investments have increased dramatically, only

about 1 percent of all business plans14 submitted to venture capital funds

typically has received financing in recent years and historically, according

to an NVCA official and the venture capitalists that we interviewed.

Providers of private equity capital may also impose investment selection

criteria that serve to minimize the high cost of obtaining information to

evaluate potential risk and return. For example, those providers may

consider only businesses that are located in a specific geographical area or

only businesses of a specific type in which they have expertise. Regarding

location, providers of private equity capital often prefer to make their

investments within a reasonable commuting distance due to their need for

firsthand information about the small businesses they fund and to

participate in management tasks.15

The type of business may play a role in the selection process of venture

capital funds because some providers prefer to specialize in a particular

industry to achieve economy in their research efforts. The costs of due

13Internal rate of return is the discount rate (i.e., interest rate) at which the “present value” of the future

cash flows of an investment equals the cost of the investment. Present value is the value today of a

future payment, or stream of payments, discounted at some appropriate interest rate.

14A business plan is generally supposed to be a concise, complete, and easy to understand document

that describes the company, its products, business methods, financial condition, and financing needs.

Business plans, usually prepared by a firm’s management, are written to clarify company purposes,

plan new directions, and raise capital from private investors.

15According to some industry participants we interviewed, some geographic areas may also be

attractive to investors—and start-up companies—because they offer a supportive infrastructure that

includes ready access to patent and securities attorneys; a workforce willing to work for limited

salaries in exchange for stock options, warrants, and the like; research and development activity;

investment bankers; and accountants.

Stringent Investment

Selection Criteria Designed

to Maximize Returns and

Manage Risks

Some Criteria Designed to

Minimize the High Cost of

Obtaining Information
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diligence16 efforts of private providers of equity capital can be substantial.

According to a business angel investor group we interviewed, the

investigation of a finalist company alone can cost up to $25,000.

The size and developmental stage of a business can also play a role in the

investment selection process. Small businesses seeking larger amounts of

capital (most often at later stages) may be at an advantage since venture

capital funds are increasingly less likely to make early-stage investments of

less than $5 million, according to industry officials. According to NVCA, in

1999, about 55 percent of venture capital investments in companies were

for expansion financing, compared with 22 percent for early-stage

financing, 18 percent for later-stage financing, and 5 percent for buyouts or

acquisitions. Market participants noted that venture capitalists are limited

in the number of investments they can actively oversee, and that managing

a small investment takes as much time and effort as managing a larger one.

They also stated that given that larger sums of money invested in venture

capital have been available, venture capitalists have been leaning toward

larger investments.

According to venture capital literature and the market participants that we

interviewed, once investment decisions are made, venture capital funds

typically impose further requirements that help protect the investment.

Such requirements can include

• incremental financing from the venture capital fund on the basis of the

business’ achievement of specific financial and nonfinancial milestones;

• the business’ adoption of incentive-related compensation schemes, such as

smaller cash salaries, which are offset by issuance of stock options;

• involvement of venture capitalists in a wide range of the business’

activities; and

• preferences in stock liquidation for the venture capital fund or priority in

receiving proceeds from a liquidation of assets.

As in the informal, unregulated equity markets, practices in the regulated

equity securities markets can be restrictive for small businesses in need of

equity capital. Market requirements in regulated securities markets are

imposed partly by securities underwriters to compensate them for risks

involved in the marketing of the offering. According to an investment

banker we interviewed and literature reviewed, large underwriters

generally like IPO candidates to have, at a minimum,

16Due diligence examinations usually include a review of books and records, discussions with members

of the management team, and an in-depth financial analysis of the company.

IPO Market Has Strict

Criteria for Selecting

Investments
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• annual revenues of $20 million,

• net income of $1 million, and

• the potential to achieve and sustain significant annual growth rates (i.e., 20

percent or greater in revenues) for the next 5 to 10 years.

However, in recent times, astronomical growth expectations have enabled

some Internet and Internet-related companies to go public with minimal

revenues and no profits. Also, according to investment bankers we

interviewed, businesses doing IPOs of less than $50 million generally are

having a difficult time attracting large investment banking firms (e.g.,

Merrill Lynch and Goldman Sachs) to underwrite their public offerings.

The investment bankers said this is the case partly because of high, fixed

costs, including high, after-market monitoring costs and the need to make

large-size investments. Therefore, these IPOs are commonly distributed by

third- and fourth-tier investment banks rather than prestigious first-tier

investment banks. Investors are less inclined to invest in small offerings

placed with lower-tier investment banks because such firms often do not

have the same market recognition that the large firms command. Further,

we were told that another problem for these small issues is finding a

securities analyst to cover the stock. In addition, investment bankers said

that economies of scale typically make IPOs under $50 million

uneconomical for larger investment banking firms.17

Securities laws and regulations to protect investors and help ensure the

integrity of equity markets facilitate information disclosures that can

improve investor confidence. Unless subject to a specific exemption, a

business selling its securities is required by the Securities Act to file a

registration statement with SEC that includes a prospectus, that describes

the business’ operations, financial condition, security offering, risk factors,

and management. A company cannot sell its securities until SEC declares

the registration statement effective.

The Securities Act requires that all information provided to investors in

connection with the offer or sale of the company’s securities is to be

materially complete and accurate. NASAA officials representing state

securities’ regulators told us that small businesses issuing securities may

be especially vulnerable to loss of investor confidence if some issuers

“poisoned the well” with material misstatements.

17Economies of scale occur when cost per dollar of issuance declines as issuance volume increases.

Securities Laws and

Regulations Facilitate

Information Disclosure
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In analyzing estimates of IPO costs, we found that the estimated average

total cost needed to conduct a small business IPO during 1994-99 was

about 10 percent of the total offering proceeds, while the average total cost

for a large business IPO was about 8 percent.18 Implementation of

securities law regulations results in costs that are greater per dollar raised

for smaller issues compared with larger issues subject to the same

requirements because certain costs are not proportional to the size of the

offering. Examples of these costs include legal and accounting expenses.

Table 2 presents the estimated average costs for an IPO that raised $25

million.

Cost categorya

Estimated average costs for a

$25 million underwritten IPO

Securities and Exchange Commission registration fee $9,914

National Association of Securities Dealers, Inc., filing fee 3,375

State (Blue Sky) filing fees and expenses 15,000

Accounting fees and expenses 160,000

Legal fees and expenses 200,000

Printing and engraving expenses 100,000

Transfer agent and registrar fees 5,000

Miscellaneous expenses 34,200

Nasdaq entry listing fees 63,725

Nasdaq annual fees 11,960

Underwriting discounts and commissions 1,750,000

Total $2,353,174

a

The figures presented in this table were calculated by Nasdaq and are based on the mean value of

each cost category from a number of illustrative examples of IPOs of about $25 million. It should be

noted that all aspects of business relationships involved in an IPO, including underwriting, can be

negotiated.

Source: Nasdaq’s Going Public, 4th Edition, 1999.

As represented in table 2, underwriting expenses represents the largest

single cost of an IPO, partly due to the complexity of the federal and state

securities laws and risks of the offering. According to a SEC official we

interviewed and literature we reviewed, because of the complexity of these

laws and liability issues, companies typically use underwriters, along with

securities lawyers and certified public accountants, to assist them in

registering and processing IPOs with SEC, NASDR, and state securities

regulators. According to the securities professionals we interviewed,

underwriting expenses consist of a discount or commission19 of about 6 to

18The average cost is for businesses where the size was known.

19The underwriting discount or commission is the fee paid by the company to the underwriter for

purchasing or selling the company’s securities.

Regulatory Costs Per Dollar

of a Public Offering Tend to

Be Higher for Small Issues

Than Large Issues

Table 2: Estimated Initial Costs of Becoming a Public Company
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10 percent of an offering’s value for small issues (typically 7 percent)

compared with 4 to 6 percent for large issues. According to investment

bankers and securities attorneys we interviewed, underwriting expenses

are generally lower for large issues than for small issues because large

issues involve less risk and work per dollar of offering. We found this

difference in underwriting expense for our subset of small and large IPO

offerings: the average cost of the underwriting discount or commission for

small offerings was 7.5 percent and, for large offerings, 6.7 percent.

According to the securities professionals we interviewed and literature we

reviewed, underwriters typically determine their fee on the basis of several

factors, including the size, quality, and underwriting type of the offering.20

We also received average cost figures calculated by NASDR from several

IPOs of about $5 million and $10 million. According to a NASDR official,

the methodology used by NASDR was consistent with that used by Nasdaq.

For a $5 million IPO, the average total cost was 14.4 percent of the total

offering proceeds, with 9.4 percent of the proceeds representing

underwriting discounts and commissions. For a $10 million IPO, the

respective figures were 9.8 and 7.3 percent.

Other expenses of the underwriter can include

• an expense allowance to cover the underwriter’s legal, due diligence,

travel, and other expenses;

• warrants to purchase stock in the business for the underwriter’s own

account;

• right of first refusal on subsequent offerings; and

• financial consulting fees.

In addition to the underwriting compensation, the business usually incurs

legal, accounting, printing, and other marketing costs; also incurred are

filing fees for SEC, NASDR, stock exchange, and state registration, as

shown in table 2. The amounts of these costs can vary, depending on

several factors, including the size of the offering. Offering expenses

generally are paid out of proceeds at the closing of the offering.

20The underwriting types are firm commitment and best-efforts basis. In a firm commitment offering,

the underwriter can purchase some or all of the newly issued shares to resell to other investors,

thereby assuming financial risk for the issuance of the shares. In a best-efforts offering, the

underwriter acts as an agent for the company and assumes no financial risk for the sale of the new

shares since the company retains ownership of the shares.
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Although most small securities offerings are subject to state registration

requirements, large, nationally traded issues are not. The National

Securities Markets Improvement Act of 1996 (NSMIA) preempts state

registration and review requirements of nationally traded securities.21

Unless exempt by state statute, securities not preempted by NSMIA are

subject to state registration requirements.

The three methods of registration at the state level are notification,

qualification, and coordination. As described more fully in appendix II,

notification is a method of registration that requires a notice filing with the

state. Registering a nonexempt security at the state level is known as

registration by qualification. The registration requirements under this

option are similar to a registration at the federal level in which the issuer

must file a registration statement satisfying requests for approximately 16

categories of information.

Registration by qualification frequently includes a merit review by state

securities regulators of the securities being offered. A merit review is an

analysis of the offering using substantive standards (e.g., the disparity in

the price paid by promoters for their shares and the price paid by public

investors). According to NASAA officials, the purpose of merit review is to

align the interests of the issuer with those of the public investors. Although

this process can improve investor confidence in small, locally sold

securities, it can be costly and time-consuming for businesses seeking to

raise capital.

Registration by coordination is a method of registration that is available to

issuers who have registered their offering with SEC. Although the content

of the registration and the procedure by which it becomes effective is

streamlined, it is still subject to merit review and according to NASAA

officials, is the registration method most often used for equity offerings.

Appendix II shows state registration-filing fees, which vary by state.

Balancing the need to assist small businesses in capital formation with the

need to protect investors, Congress and securities regulators have

simplified the registration process and provided small businesses with

exemptions from federal registration requirements on the basis of the

dollar size of the offering, location of the offering, and number and type of

investors. However, offerings exempt from federal registration

requirements are not always exempt from state registration requirements.

21As discussed in a later section of this report, NSMIA also preempts state registration and review

requirements of offerings under SEC rule 506 of Regulation D.

Large, Nationally Traded

Issues Are Exempt From

State Registration

Requirements, Although

Small Issues Generally Are

Not

Congress and Securities

Regulators Have Sought to

Ease Regulatory

Requirements for Small

Businesses
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For this reason, businesses offering such securities may have to register

their securities offerings in each state in which they are sold. In addition,

certain offerings by small businesses subject to federal registration

requirements must register with state regulators. Several market

participants we interviewed supported further efforts by federal and state

regulators to reduce the regulation of securities offerings by small

businesses, including increasing dollar limits on securities offerings

allowed under certain federal and state exemptions. Several market

participants also suggested encouraging greater commonality in certain

federal and state registration requirements.

To minimize the regulatory costs of raising equity capital, SEC allows

small business issuers (those with less than $25 million in revenues in the

last fiscal year and outstanding stock of $25 million or less) to use

simplified small business forms (SB-1 and SB-2) in filing registration

statements (see table 3 below).

Requirement Form S-1 Form SB-1 Form SB-2

Type of disclosure Extensive narrative

discussion of disclosure

Disclosure can be presented

in a question-and-answer

format

Less extensive narrative

disclosure than S-1

Audited financial statements required Yes, for last 3 fiscal

years

Yes, for last 2 fiscal years Yes, for last 2 fiscal years

Capital that can be raised Unlimited amount $10 million every 12 months Unlimited amount

Source: GAO analysis of SEC regulations and forms.

The SB-1 and SB-2 forms require audited financial statements for 2 fiscal

years. In contrast, the regular registration form available to all issuers (S-1)

requires more detailed audited financial statements for 3 fiscal years.

According to a securities law article, forms SB-1 and SB-2 are estimated to

save an issuer up to approximately $125,000 for an average offering.

However, regardless of which form is used, according to an investment

banker we interviewed, small business issues are viewed unfavorably by

many investment bankers because they are too small in size to be

profitable. He further noted that small offerings are commonly distributed

by smaller investment banks that lack market recognition, which can be a

hindrance to attracting investors.

Table 3: Simplification of SEC Registration Requirements for Securities Offerings for Small Businesses
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In response to concern that the expense of SEC registration restricts small

businesses’ access to equity capital markets, federal securities laws

provide certain securities offerings with exemptions from federal

registration requirements. (The registration requirements and exemptions

summarized in this section, and others, are discussed in greater detail in

app. III.) Generally, such exemptions apply when issues are relatively

small in dollar size or purchasers of the securities are wholly or largely

restricted to investors’ meeting certain standards of wealth or business

sophistication.

Regulation D is designed to (1) eliminate any unnecessary restrictions that

SEC rules place on small business issuers and (2) achieve uniformity

between state and federal exemptions to facilitate capital formation

consistent with protecting investors. Regulation D establishes three

separate but interrelated exemptions—rules 504, 505, and 506—as

summarized in table 4. The exemptions differ regarding the size of the

offerings to which they apply and/or the number and type of investors to

which offerings may be made. These exemptions were a focus of interest

for several market participants that we interviewed, who are affected by

these exemptions, and they had suggestions for streamlining these

exemptions. These suggestions could thereby increase small businesses’

access to equity capital.

Exemptions From Federal

Registration Requirements

Reflect Efforts to Balance Small

Businesses’ Needs With

Protections for Investors and

Market Integrity
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Characteristic Rule 504 exemption Rule 505 exemption Rule 506 exemption

Number and type of investors

who may invest

Unlimited number of any type

of investors

An unlimited number of

accredited investorsaand up

to 35 nonaccredited investors

An unlimited number of

accredited investors and

up to 35 nonaccredited,

sophisticated investors

Maximum dollar size of

securities offering

Up to $1 million in any

12-month period

Up to $5 million in any

12-month period

Unlimited dollar amount may

be sold

Restricted securities resales Yes, unless certain

conditions are metb

Yes Yes

Disclosure documents

required to be delivered to

investors

Under state law

requirements pursuant to

certain conditionsb

Yes Yes

Restrictions on general

solicitation and advertising

for investors

Yes, unless certain

conditions are metb

Yes Yes

Subject to federal and state

antifraud provisions

Yes Yes Yes

Preexisting relationship

requirement

Yes, unless certain conditions

are metb

Yes Yes

SEC form D filing required Yes Yes Yes

State registration required Yes, unless there is a state

exemption

Yes, but most states have state

exemptions, such as the Uniform

Limited Offering Exemption

No, preempted from state

registration by NSMIA

Type of issuers that cannot use

exemption

Blank check companies,c

investment companies,

or SEC reporting companies

Investment companies None

a

Accredited investors include, among others, individuals whose net worth is more than $1 million and

whose individual income exceeds at least $200,000 for the most recent 2 years and certain

institutional investors, such as insurance companies, banks, and endowments.

b

To deter micro-cap stock fraud, rule 504 of Regulation was amended in April 1999 by SEC to restrict

the resale of securities and prohibit general solicitation and advertising unless specified conditions

permitting a public offering are met. These conditions are that (1) the transactions are registered

under a state securities law requiring public filing and delivery of a substantive disclosure document to

investors before sales; (2) for sales to occur in a state without this sort of provision, the transactions

must be registered in another state with such a provision, and the disclosure document filed in the

state must be delivered to all purchasers before sale in both states; or (3) the securities are issued

under a state law exemption that permits general solicitation and advertising, so long as sales are

made only to accredited investors, as that term is defined in Regulation D.

c

A blank check company is a development stage company that has no specific business plan or

purpose or its business plan is to merge with an unidentified company.

Source: GAO analysis of SEC Regulation D.

Rule 504 provides an exemption from the federal registration

requirements for small offerings (up to $1 million in any 12-month period)

that would be state regulated because of the small amount of the offering

and the likelihood that sales would occur in a limited geographic area. The

purpose of rule 504 is to provide small companies attempting to raise seed

capital through the sale of securities with the ability to do so without being

hampered by the expense of federal registration. According to statistics

Table 4: Summary Characteristics of SEC Regulation D Exemptions
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provided to us by SEC’s Office of Small Business, rule 504 offerings have

steadily increased, rising from 2,357 in 1994 to 3,407 in 1999.

Issuers relying on the rule 504 exemption must register in every state in

which the securities are offered, absent a state exemption. Since most

states do not have exemptions for 504 offerings, an issuer with a multistate

offering will likely have to comply with differing individual state filing

requirements. Some industry participants suggest that rule 504 filings be

exempt from state registration requirements to avoid the burden of stateby-state registration. However, NASAA officials believe that because these

offerings are local in nature and have been exempt at the federal level,

states have an interest in regulating these securities offerings. Others

suggest that the state securities laws (also known as blue-sky laws) be

simplified and made uniform. One registration form used at the state level

to ease this burden is the Small Company Offering Registration (SCOR)

form. SCOR is a simplified question-and-answer registration form accepted

by 49 states, which also can be used as the disclosure document for

investors in rule 504 offerings. A NASAA official believes that the use of

the SCOR form makes registration at the state level more uniform.

Rule 505 allows an exemption for private offerings up to $5 million in a

12-month period. Its purpose is to unify the state and federal exemption for

offerings up to $5 million that meet certain criteria. As such, a parallel

initiative to rule 505 was adopted at the state level of NASAA’s Uniform

Limited Offering Exemption (ULOE), which contemplates a uniform rule

exempting offers and sales if offered or sold in compliance with rule 505.

More disclosure is required for rule 505 offerings than for rule 504

offerings because of the increased dollar amount of the offering. Rule 505

allows an issuer to sell its securities to an unlimited number of “accredited

investors” and up to 35 other persons who need not satisfy a business

sophistication or wealth standard. Investors cannot resell the issued

securities unless the issuer registers the securities or an exemption exists

at both the federal and state level. The issuer may not use general

solicitation or advertising to sell the securities, and SEC has stated that the

demonstration of a preexisting relationship with any offeree to whom the

issuer sells is evidence of freedom from general solicitation. Furthermore,

unless there is a state law exemption, rule 505 offerings must be registered

at the state level.

Since the passage of NSMIA, rule 505 offerings have declined. According to

SEC statistics, rule 505 offerings have decreased since 1994, dropping from

2,163 offerings that year to 1,016 offerings in 1999. Industry participants we
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interviewed told us that because offerings must be registered at the state

level and because of the prohibition of general solicitation and advertising,

rule 505 offerings are rarely used. Thus, it has been suggested by such

participants that SEC eliminate the restriction on advertising and general

solicitation for rule 505 offerings. In addition, industry participants suggest

that rule 505 offerings be preempted from state registration requirements.

According to an SEC official, SEC takes a posture of neutrality regarding

the preemption of the state securities laws. As discussed in the next

paragraphs, SEC is not inclined to eliminate the general solicitation and

advertising restrictions on rule 505 offerings because the restrictions on

solicitation are among the attributes that distinguish a private placement

offering from a public offering. According to an SEC official, SEC

supports the general solicitation restrictions in part as a demonstration of

the limited nature of the offering, which is a reason not to require

registration under the Securities Act.

Rule 506 allows a business of any size to raise an unlimited amount of

capital through offerings to an unlimited number of accredited investors

and up to 35 other financially sophisticated purchasers without having to

register with SEC. Rule 506 offerings have been preempted by NSMIA from

state registration requirements. According to SEC statistics, rule 506

offerings have increased dramatically since 1994, growing from 5,414 in

that year to 13,112 in 1999.

Industry participants believe that the restriction on general solicitation and

advertising impedes small businesses’ ability to search for investors. Some

securities attorneys have suggested that rule 506 be amended to permit

general solicitation and advertising. In June 1995, SEC solicited comments

on an amendment to Regulation D that would eliminate the prohibition

against general solicitation for rules 505 and 506 offerings. Although SEC

deferred action on the general solicitation question, it indicated that it

would consider comments in connection with a future initiative. According

to an SEC official, one rationale for the prohibition on general solicitation

and advertising is to distinguish a rule 506 offering, which is a private

offering with no federal or state oversight, from a public offering, which

requires significant oversight due to its wide distribution. The prohibition

on general solicitation and advertising is what keeps the offering “private”

and helps minimize the risks of widespread fraud. Another SEC concern

regarding lifting the general solicitation ban is the potential for

participation of unsophisticated investors who may need the protection

provided by registration under the Securities Act.
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Regulation A provides further exemption for offerings under $5 million.

Although Regulation A is termed an “exemption,” it actually provides a

simplified SEC registration form, which does not require audited financial

statements for public offerings of securities not exceeding $5 million. SEC

has stated that its primary purpose in adopting Regulation A was to

provide a simple and relatively inexpensive procedure for small business

use in raising limited amounts of needed capital. A business that relies on

Regulation A must (1) file with SEC for review an offering circular, which

may be in a question-and-answer format, that contains unaudited financial

statements and (2) provide the offering circular to investors. Like

registered offerings, the securities can be offered publicly and are freely

tradable in the secondary market. According to SEC statistics, on average,

83 Regulation A offerings have been filed each year since 1994. Some of

the reasons given for Regulation A’s limited use is that it is rare for an

issuer to attract an underwriter for an offering under $5 million. In

addition, although Regulation A does not require audited financial

statements at the federal level, most states require audited financial

statements for a Regulation A offering. Notwithstanding the benefits

provided by the SEC exemption, because most states do not offer the same

regulatory relief, the issuer receives little benefit from a Regulation A

exemption.

Unlike traditional public offerings, Regulation A offerings enable

companies to “test the waters”—that is, to determine if adequate investor

interest in the securities exists before incurring the expense of filing with

SEC. Thus, if certain conditions are met, a business may issue written or

oral statements asking whether investors would be interested in

purchasing its securities. If there is insufficient interest, the business is

spared the expenses associated with filing with SEC. Another advantage of

Regulation A is that issuers can use SCOR and regional reviews in the

states where they are available.22 (SCOR and regional reviews are

discussed in detail in the next section of this report.) Also, like certain

Regulation D offerings, Regulation A offerings can be made over the

Internet.

Market participants we interviewed stated that the requirement to register

issues under $5 million with both SEC and the states is burdensome for

small businesses. One state regulatory official told us that one of the

problems in coordination between state regulators and SEC is

inconsistency in time periods for comments and eligibility requirements

22Regional review is a program in which several states from a given region coordinate their regulatory

review of a filing and issue one comment letter to the issuer within a standard agreed-upon time frame.
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for testing the waters. Another problem with Regulation A offerings that

were identified by several interviewees is that the under $5 million offering

size is often too small to attract broker-dealers who can distribute the

securities to investors. Some interviewees recommended that the

Regulation A threshold be increased from $5 to $10 million. A securities

lawyer we interviewed suggested that Regulation A offerings be exempt

from SEC and state registration requirements.

In addition to the various exemptions from federal registration

requirements, the states and others have taken steps to reduce the

regulatory complexity and cost that small businesses face in multistate

offerings of securities. The states have also made efforts to increase the

availability of information about small businesses seeking to raise equity

capital. Various state-level programs coordinated by NASAA focus on

simplifying the preparation of state-required disclosure documents and

streamlining state-level reviews of multistate securities offerings. In

addition, SBA-OA has established an Internet-based service to increase the

availability of information about small companies seeking equity capital

from business angels and venture capital funds. Appendix IV presents

additional efforts of state and federal agencies to increase small

businesses’ access to equity capital markets.

Through NASAA, state securities regulators have developed model

regulations and legislation that states can adopt to simplify state

registration requirements for small issuers planning to raise capital in

more than one state. Virtually all states have adopted SCOR, an initiative

developed by NASAA in conjunction with the American Bar Association.

SCOR is designed to simplify and reduce the costs of registration of

securities for small businesses seeking to raise seed capital and is available

to issuers relying on exemptions found in Regulation A, rule 504, or the

intrastate offering exemption. SCOR offers a simplified question-andanswer registration form (form U-7) that also can be used as the disclosure

document for investors in rule 504 offerings.

According to a 1999 NASAA written statement, SCOR has been used by

more than 1,000 companies to raise capital since its 1989 inception. SCOR

appears to work best for companies that have an existing client base or a

well-defined affinity group for marketing purposes. According to an

industry source, the success rate (i.e., raised minimum offering dollar

amount) of raising money via SCOR offerings varies widely by state but

averages about 35 percent for the businesses that initiate the process. The

estimated average cost of a SCOR offering is about $30,000, according to

an industry source. However, some market participants we interviewed

Steps Taken to Reduce

Regulatory Burden and

Increase the

Availability of Small

Business Information

State Programs Are

Designed to Simplify and

Streamline Processes in

Multistate Securities

Offerings by Small Issuers
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thought that raising capital via SCOR had limited credibility among

brokers and investors. A NASAA official said that it is not the SCOR form

on which the offering is registered that limits the credibility of the offering

but the size of the offering, which cannot attract investment bankers to

distribute the securities.

Many states use the Regional Review Program, established in 1996, in their

review of state registrations using the SCOR form. A regional review of a

security offering streamlines the review process, thereby potentially saving

issuers time and money. Under the Regional Review Program,

• the issuer files a registration application in the states in which it intends to

sell securities and requests a coordinated review;

• participating states forward comments on the initial application to the

designated lead state, and the designated lead state forwards one comment

letter to the issuer, generally within 3 to 4 weeks of application receipt;

• the issuer responds and the response is communicated to the designated

lead state; and

• by prior agreement, all participating states clear the comments when the

designated lead state clears comments, generally within 5 business days of

receiving issuer’s response.

Each state participating in the Regional Review Program agrees to apply

uniform standards regarding such matters as the time frame for issuing

comments and the type of comments to be issued in reviewing registration

applications.23 According to NASAA officials, 5 regional review programs

have been established in which 36 states are participating, and a 6th

program is being established to cover the southeastern part of the country.

Also, 75 offerings have been attempted under the Regional Review

Program to date.

The Coordinated Equity Review (CER) Program, initiated in 1997, is

designed by NASAA to lower the cost associated with equity offerings by

providing for a coordinated state review process for offerings of equity

securities registered at the federal level and in multiple states. Under the

CER Program, as under the Regional Review Program, the participating

states coordinate to produce one comment letter to an issuer that

addresses both substantive, “merit,” and disclosure matters. Pennsylvania

is the administrator for the CER Program. According to NASAA officials,

under the CER Program’s protocol, the comment letter must be issued no

23Participating states in the Regional Review Program follow NASAA’s Statements of Policy, which are

uniformity guidelines for state securities regulators to follow in the review of registrations.

The Regional Review Program

Streamlines State Review of

SCOR Forms

CER Program Coordinates

Multistate Review for Offerings

Over $5 Million
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Page 34 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

later than 19 days after the filing is received in Pennsylvania. NASAA

officials note that 39 of the 42 states that review offerings registered at the

federal level are participants in the CER Program, and 54 offerings have

been filed, with 24 becoming effective under CER.24 According to a state

regulator, 54 does not appear to be a large number of filings in comparison

to the number of offerings that are eligible to use the CER Program.25

However, he said that NASAA is continuously trying to educate issuers,

underwriters, and securities attorneys about the availability of the program

and its potential benefits.

According to market participants we interviewed and feedback that SEC

and NASAA have received from issuers and securities attorneys, the

coordinated review programs are steps in the right direction for promoting

greater uniformity in and streamlining the state securities registration

process. Market participants we interviewed would like to see more states

participating in the programs and greater coordination among regional

review programs regarding the time frames for issuing comments.

SBA-OA created ACE-Net in 1996 in response to the perceived needs of

small businesses for equity capital in amounts of $250,000 to $5 million.

ACE-Net (Access to Capital Electronic Network) is a secure, password

protected, Internet-based listing service that is designed to link

institutional and individual accredited investors with fast-growing

businesses seeking equity capital. As of July 2000, about 40 states had

agreed to a uniform set of disclosure documents and to a model accredited

investor exemption. Investors in those states can use ACE-Net to

electronically access information about deals nationwide.

SBA-OA has recruited over 60 state- or university-based network operators

to work with entrepreneurs and business angel investors as a means of

increasing the amount of equity capital to the underserved areas of the

country. SBA-OA officials and a director of an ACE-Net site we

interviewed told us that ACE-Net operators administer the management of

the program by providing mentoring and counseling to entrepreneurs and

business angel investors on various issues relating to running a small

24Eight states (Colorado, Florida, Georgia, Hawaii, Illinois, Louisiana, New York, and Wyoming) and the

District of Columbia do not require state-level review of this type of filing and, therefore, are not

included in the CER Program.

25An average of 430 registration statements, using the form SB-2, have been filed with SEC annually

between 1994 and 1999. According to an SEC official, most issuers that file their registration

statements on form SB-2 must also register their offerings at the state level and, therefore, would be

eligible for the CER Program if the states where they expect to sell the securities also participate in

CER.

Market Participants Support

Coordination Programs

SBA’s ACE-Net Program Is

Designed to Increase the

Availability of Information

for Investors in Unregulated

Equity Capital Markets
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Page 35 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

business and seeking equity capital. As of 1999, ACE-Net had listed 162

businesses in a variety of industries and was processing another 150

applications for listing. However, the number of companies listed falls

short of the critical mass of about 500 companies that the SBA’s Chief

Counsel for Advocacy says the program needs to be recognized by

investors as a viable service. Negotiations are under way to privatize ACENet.

Investors we interviewed stated that they were concerned about the

investment quality of the companies listed on ACE-Net and believed that

SBA should do a better job of screening companies. Entrepreneurs we

interviewed expressed concerns regarding the lack of information about

ACE-Net’s financing successes. However, according to the Chief Counsel

for Advocacy, the “no-action” letter granted by SEC—which allows ACENet to operate without being registered as an exchange, broker-dealer, or

investment advisor—does not allow SBA-OA to analyze, advertise, or

release information about the merits of particular investment

opportunities and is not permitted to screen companies.

State governments have also initiated a variety of efforts to encourage

small business capital formation. These efforts include, among others,

training business angels in how to make investments and organize

themselves; training entrepreneurs how to obtain equity financing for their

ventures; and underwriting visibility events, such as venture fairs or

venture networks, to link entrepreneurs to investors. For example, Iowa

sponsored an 1-day event in Des Moines in which a selected group of

business angels from around the state gathered to learn how to evaluate

and make investments and organize themselves. The participants were

expected to share this knowledge with other angel investors.

In 1996, SBA-OA sponsored a study, which was based in part on the results

of several focus groups that it conducted, to estimate the equity capital

need of small businesses. The study identified unmet needs for equity

capital. Estimates from our analysis of available industry data indicated

that the total of small business equity capital financing provided in 1999 by

venture capital funds, SBICs, IPOs, and private placements of securities

was about $107 billion. This amount represents almost a six-fold increase

from the amount in 1994 (about $18 billion) and an increase of about 270

percent over the total estimated amount from those sources in 1996 (about

$29 billion). However, the extent to which the recent increases in equity

financing have helped to fill the unmet need identified by SBA-OA’s 1996

estimate is not clear. The average amount of a venture capital fund

investment has increased suggesting that, in general, venture capital funds

State Governments Have

Made Efforts to Encourage

Small Business Investment

Conclusions
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Page 36 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

may have become a less likely source of equity financing in the $250,000 to

$5 million range.

In addition, venture capital fund investments tend to be concentrated in

certain geographical areas and certain industries, raising questions about

whether unmet needs in different parts of the country and industries are

being addressed. Furthermore, business start-ups have also increased.

Finally, business angel investors, for whom financing data are not

available, are considered an important source of equity capital funds for

small businesses. SBA-OA officials we interviewed continued to believe

that, despite the growth in the total dollar volume of venture capital fund

investments, available evidence supports their assessment that a major

equity financing shortage persists for small businesses needing amounts of

$250,000 to $5 million.

The extent to which equity capital is well suited to meet the needs of small

businesses is associated with several interrelated factors. First, many small

business owners do not want to issue external equity capital because they

want to retain control of the business. Second, market practices, which

reflect the efforts of investors and other market participants to maximize

returns and manage risk on investments, serve to limit equity investments

in small businesses. For example, investors perceive small business

investment to be high risk and so require high potential returns to

compensate for that risk. In addition, the cost of obtaining information on

small businesses can be high, and investors require some control of the

businesses to help manage the risk of their investment. Third, although

securities laws and regulations facilitate information disclosures that can

improve investor confidence, they impose disproportionate costs on small

businesses because IPOs are more costly for small businesses compared

with large businesses. The results of our analysis of IPO offerings indicate

that the average total cost to conduct a small business IPO during 1994-99

was about 10 percent of total offering proceeds, while the average total

cost for a large business IPO was about 8 percent.

Market participants we interviewed identified perceived obstacles faced by

small businesses in gaining access to equity capital. Federal securities

regulators have simplified federal registration of securities offerings and

exempted certain small business securities offerings from several

requirements in an attempt to reduce the regulatory burden and costs for

small businesses in equity capital formation. State governments have also

taken steps in an attempt to reduce the regulatory burden and costs for

small businesses seeking equity capital financing in the regulated

securities markets. However, some market participants we interviewed
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Page 37 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

believe more can be done, including, for example, increasing dollar limits

on securities offerings allowed under certain exemptions, encouraging

greater commonality in certain federal and state registration requirements,

and encouraging commonality among state registration requirements.

These suggested changes merit future consideration and should be

analyzed within the context of enhancing small business access to equity

capital while ensuring that securities laws foster investor protection and

confidence.

We requested comments on a draft of this report from the heads, or their

designees, of SEC, NVCA, SBA, and NASAA. All four entities provided

technical comments, which we have incorporated where appropriate.

NVCA and SBA-OA provided written comments that are reprinted in

appendixes V and VI, respectively.

NVCA generally commended our work and expressed its views on several

related topics including the need to increase the number of small

businesses eligible to use forms SB-1 and SB-2 registration; governmental

and non-governmental actions that have increased the barriers to

accessing capital markets or increased the cost of capital for small

businesses; and the effect that the elimination of pooling of interests

accounting would have on venture capital financing.

SBA-OA complimented our draft report as providing valuable information

for policymakers on what is occurring in the equity markets. SBA-OA also

expressed views on 1) the difficulty of documenting the equity capital

needs of small businesses due to a lack of precise data; 2) market barriers

and regulatory requirements that hinder small business access to equity

capital; 3) the limited number of small businesses receiving equity

financing; and 4) the need to further study small businesses’ ability to

access the equity capital markets.

As agreed with your office, unless you announce the contents of this report

earlier, we plan no further distribution until 30 days from the date of this

letter. At that time, we will send copies of this report to Senator John F.

Kerry, Ranking Minority Member, Senate Committee on Small Business;

Senator Phil Gramm, Chairman, and Senator Paul S. Sarbanes, Ranking

Minority Member, Senate Committee on Banking, Housing and Urban

Affairs; Representative Jim Leach, Chairman, and Representative John J.

LaFalce, Ranking Minority Member, House Committee on Banking &

Financial Services; Representative James M. Talent, Chairman, and

Representative Nydia M. Velazquez, Ranking Minority Member, House

Committee on Small Business; the Honorable Aida Alvarez, Administrator,

Agency Comments
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Page 38 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

SBA; the Honorable Arthur Levitt, Chairman, SEC; Mr. Mark G. Heesen,

President of NVCA; Mr. Marc Beauchamp, Executive Director of NASAA;

and other interested parties. Copies will also be made available to others

upon request.

The major contributors to this report are acknowledged in appendix VII. If

you have any questions about this report, please call me or William Shear

at (202) 512-8678.

Sincerely yours,

Richard J. Hillman

Associate Director, Financial

Institutions and Markets Issues
Page 39 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Page 40 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Contents

1 Letter

44

Birth of Hahnemann Laboratories, Inc. 44

Search for Financing 44

Satisfying SEC Requirements 45

First Financing: Hahnemann Laboratories, Inc., Goes

Public

45

Appendix I

A Small Business Goes

Public Via a Direct

Public Offering

Appendix II 46

Methods and Fees for

Registering Offerings

of Securities Under

State Blue-Sky Laws

51

Federal Securities Laws Protect Investors by Requiring

Disclosure of Material Information

51

Federal Exemptions and SEC Initiatives Expand Small

Business Access to Equity Capital

52

Companies Must Register Securities in Each State in

Which Their Securities Are Offered for Sale

63

Appendix III

Federal and State

Agencies Have Taken

Some Actions to Help

Small Businesses Raise

Capital While

Protecting Investors

Appendix IV 67

Special SEC, SBA, and

NASAA Activities to

Facilitate Small

Business Access to

Equity Capital
Contents

Page 41 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Appendix V

Comments From the

National Venture

Capital Association

69

Appendix VI 71

Comments From the

Small Business

Administration’s Office

of Advocacy

Appendix VII 73

GAO Contacts and

Staff

Acknowledgments

Glossary 74

Table 1: Average Dollar Amount of Equity Capital

Disbursed to Small Businesses by Venture Capital

Firms, 1994-99

18

Table 2: Estimated Initial Costs of Becoming a Public

Company

23

Table 3: Simplification of SEC Registration Requirements

for Securities Offerings for Small Businesses

26

Table 4: Summary Characteristics of SEC Regulation D

Exemptions

28

Table II.1: Fees for Registration of Initial Offerings Under

State Blue-Sky Laws

47

Table IV.1: Activities by SEC, SBA, and NASAA to Help

Small Businesses Raise Equity Capital

67

Tables

Figures Figure 1: Possible Stages of Business Growth and

Sources of Financing

9
Contents

Page 42 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Figure 2: Estimated Financing Provided to Small

Businesses by Venture Capital Funds, SBICs, IPOs, and

Private Placements, 1994-99

15

Figure 3: Equity Capital Financing Provided to All

Businesses by Venture Capital Funds, SBICs, IPOs, and

Private Placements, 1994-99

16

Figure 4: Number of Businesses Receiving Equity Capital

Financing From Venture Capital Funds, SBICs, Private

Placements, and IPOs, 1994-99

17

Abbreviations

ACE-Net Access to Capital Electronic Network

Amex American Stock Exchange, Inc.

CER Coordinated Equity Review

DPO direct public offering

HL Hahnemann Laboratories, Inc.

IPO initial public offering

MAIE model accredited investor exemption

NASAA North American Securities Administrators Association, Inc.

NASDR National Association of Securities Dealers Regulation, Inc.

NSMIA National Securities Markets Improvement Act

NVCA National Venture Capital Assocation

NYSE New York Stock Exchange, Inc.

SBA Small Business Administration

SBA-OA SBA-Office of Advocacy

SBIC Small Business Investment Company

SCOR Small Company Offering Registration

SEC Securities and Exchange Commission

TFSD Thomson Financial Securities Data

ULOE uniform limited offering exemption
Page 43 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Appendix I

A Small Business Goes Public Via a Direct

Public Offering

Page 44 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

This appendix presents a chronology discussion of a small business

attempting to raise equity capital by directly selling securities to investors

without the assistance of an investment banker. Hahnemann Laboratories,

Inc. (HL), provided this information.

The company, a retail pharmacy, was founded in 1985 in conjunction with

a medical clinic (a separate corporation), which was formed by

homeopathic physicians as a teaching clinic for promoting classic

homeopathic medicine. Homeopathy is a 200-year-old natural system of

using nontoxic medicines to relieve symptoms and cure disease. In 1986,

Mr. Quinn, the company’s founder, undertook a separate effort to

compound homeopathic medicines. The new company was incorporated in

1992 as Hahnemann Medical Clinic Pharmacy, Inc. This name was changed

to Hahnemann Laboratories, Inc., in 1994. Mr. Quinn, HL’s President, Chief

Executive Officer, and Chief Financial Officer, is a pharmacist.

HL packages medicines in kits that supply a range of commonly requested

homeopathic medicines. In the spring of 1993, the company developed the

Quinn Dispensing Kit Program. Each kit contains 240 homeopathic

medicines. Later, Mr. Quinn established a goal of marketing 100 kits to

homeopathic practitioners and these kits were to be produced at a cost of

$2,500 each. To expand, HL estimated that it would need about $400,000 to

cover the costs of U.S. Food and Drug Administration registration,

accounting, printing, construction of a manufacturing laboratory, initial

production, marketing, and working capital.

HL entered into merger discussions with other homeopathic firms but

could not reach an agreement on the direction of the companies. Merging

with another company would have given HL access to more sales

representatives and additional funds.

HL applied for a loan from the Small Business Administration but was

denied due to a lack of collateral.

Birth of Hahnemann

Laboratories, Inc.

January 1985 to April 1994

Search for Financing

April 1992 to September

1992

May 1993
Appendix I

A Small Business Goes Public Via a Direct Public Offering

Page 45 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Two business angel investors, one in August and the other in December,

rejected HL.

Mr. Quinn contacted a lawyer and a consultant who were engaged in (1)

assisting small businesses to identify investors interested in particular

products and (2) providing advice on making initial direct public offerings

(DPO).

Mr. Quinn prepared the prospectus on HL and documents necessary to

make a Regulation A offering1

on HL. Mr. Quinn submitted the documents

to the Securities and Exchange Commission (SEC), including pro forma

financial estimates for the next 5 years, and to the California Department

of Corporations.

HL converted its accounting system to meet SEC requirements. The DPO

consultant gave Mr. Quinn guidance on converting the system. HL hired a

certified public accountant to perform the conversion.

SEC approved HL’s Regulation A offering.

HL updated financial statements for SEC to obtain an extension to raise

funds.

HL mailed letters to potential investors that HL had targeted as having an

interest in its products. HL made contact with potential investors.

HL made an initial public offering of 50,000 shares of common stock at $10

per share. From this offering, HL raised about $470,000. Twenty percent

($94,000) of the funds were used to pay fees and costs of printing and

mailings. The remainder was spent on building a laboratory, equipment,

production costs, staffing, materials, and outside consultants.

1

A Regulation A offering allows a company to raise up to $5 million annually.

December 1993

August 1994

September 1994 to

December 1994

Satisfying SEC

Requirements

July 1994 to December 1994

March 1995

First Financing:

Hahnemann

Laboratories, Inc.,

Goes Public

January 1995 to August

1995

June 1995 to October

1995
Appendix II

Methods and Fees for Registering Offerings of

Securities Under State Blue-Sky Laws

Page 46 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Each state regulates the sale of securities within its borders. These

regulations, generally referred to as the blue-sky laws, prescribe three

methods of registering securities offered for sale within the state. These

registration methods are notification, qualification, and coordination.

The notification method requires a notice filing1with the state and is

reserved for mature issuers that satisfy a certain net earnings test. The

qualification method is used for any security not exempt from the state

registration requirements. Registration by qualification, like registration at

the federal level, requires the issuer to file a registration statement

satisfying requests for approximately 16 categories of information, and the

state administrator is given a wide range of authority to deny the

effectiveness of a registration statement. This method frequently includes

merit review of the securities being offered. According to NASAA officials,

the coordination method is most often used in equity offerings and is

available to issuers who have registered their offerings with SEC. These

issuers can file copies of the SEC registration statement and any

amendments with the state administrator. The registration typically

becomes effective at the state level the moment it becomes effective at the

federal level. Registration by coordination streamlines the content of the

registration statement and the procedure by which it becomes effective,

but not the substantive standards governing its effectiveness. Thus,

registration by coordination is subject to merit review.

Table II.1 describes the fees charged by state for each method of

registration (see table note). Fees paid by small business issuers vary,

depending on the state where the issuer registered the securities. As

shown in this table, under the qualification method, a small business issuer

seeking to secure $3 million would pay a minimum of $2,500 to qualify in

California, $1,500 in Georgia, $300 in Idaho, and $500 in Virginia.

1

The notification filing contains a description of the security being offered, the offering price, any

underwriter’s discounts or commissions, finder’s fees, selling expenses, a copy of the underwriting

agreement, a description of stock options to be offered, a copy of the prospectus, and any other

information circulated in connection with the offering.
Appendix II

Methods and Fees for Registering Offerings of Securities Under State Blue-Sky Laws

Page 47 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Method of registration

State Notification Coordination Qualification

Alabama $40 and 1/10 of 1% of AOP,

$1,000 maximum

$40 and 1/10 of 1% of AOP,

$1,000 maximum

$40 and 1/10 of 1% of AOP,

$1,000 maximum

Alaska $100 nonrefundable fee and

$500 refundable if for 1 year; or

$100 nonrefundable and $1,100

refundable, if automatic

extension for 1 year

$100 nonrefundable fee and $500

refundable if for 1 year, or $1,100

refundable if automatic extension

for 1 year

$100 nonrefundable fee and $500

refundable if for 1 year or $1,100

refundable if automatic extension

for 1 year

Arizona 1/10 of 1% of AOP, $200

minimum, $2,000 maximum

N/A 1/10 of 1% of AOP, $200

minimum, $2,000 maximum

Arkansas 1/10 of 1 % of maximum AOP,

$150 minimum, $2,000

maximum; sales over 105% of

AOP, $200 penalty

1/10 of 1% of maximum AOP,

$150 minimum, $2,000 maximum;

sales over 105% of AOP, $200

penalty

1/10 of 1% of maximum AOP,

$150 minimum, $2,000 maximum;

sales over 105% of AOP, $200

penalty

California $200 and 1/5 of 1% of aggregate

value of securities proposed to

be sold, $2,500 maximum

$200 and 1/5 of 1% of aggregate

value of securities proposed to be

sold, $2,500 maximum

Small company qualification by

permit: $2,500 and additional fee

in certain circumstances, not to

exceed $1,000.

Colorado N/A $200 $100 qualification fee; $200 for

amendment

Connecticut N/A 1/10 of 1% of maximum AOP,

$300 minimum, $1,500 maximum

1/10 of 1% of maximum AOP,

$300 minimum, $1,500 maximum

Delaware N/A 1⁄2 of 1% of maximum AOP, $200

minimum , $1,000 maximum for

small company offering

1⁄2 of 1% of maximum AOP, $200

minimum, $1,000 maximum for

small company offering

Florida $1,000 nonrefundable application

fee

$1,000 nonrefundable application

fee

$1,000 nonrefundable application

fee

Georgia 1/20 of 1% of maximum AOP,

$250 minimum

N/A 1/20 of 1% of maximum AOP,

$250 minimum

Guam 5/100 of 1/5 of maximum AOP,

$25 minimum, $500 maximum

5/100 of 1/5 of maximum AOP,

$25 minimum, $500 maximum

5/100 of 1/5 of maximum AOP,

$25 minimum, $500 maximum

Hawaii 1/20 of 1% of AOP, $500

maximum

N/A 1/10 of 1% of AOP, $250

minimum, $2,500 maximum

Idaho $300 flat fee $300 flat fee $300 flat fee

Illinois N/A 1/20 of 1% of defined maximum

AOP, $500 minimum, $2,500

maximum

If registered under the Securities

Act of 1933, 1/20 of 1% of defined

maximum AOP, minimum $500,

maximum $2,500 + $300

examination fee; If not registered

with SEC, $250 filing fee, $150

examination fee, and $25

amendment examination fee

Indiana N/A 1/20 of 1% of maximum AOP,

$250 minimum, $1,000 maximum;

$25 amendment fee

1/20 of 1% of maximum AOP,

$250 minimum, $1,000 maximum;

$25 amendment fee

Iowa N/A 1/10 of 1% maximum AOP, $50

minimum, $1,000 maximum

1/10 of 1% maximum AOP, $50

minimum, $1,000 maximum

Table II.1: Fees for Registration of Initial Offerings Under State Blue-Sky Laws
Appendix II

Methods and Fees for Registering Offerings of Securities Under State Blue-Sky Laws

Page 48 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Method of registration

State Notification Coordination Qualification

Kansas .05% of AOP, $100 minimum

each statement, $1,500

maximum; $100 application fee

for amendment

.05% of AOP, $100 minimum

each statement, $1,500

maximum; $100 application fee

for amendment

.05% of AOP, $100 minimum

each statement, $1,500

maximum; $100 application fee

for amendment

Kentucky $125 exam fee and 3/50 of 1% of

AOP, $60 minimum, $1,200

maximum

$125 examination fee and 3/50 of

1% of AOP, $60 minimum, $1,200

maximum

$125 examination fee and 3/50 of

1% of AOP, $60 minimum, $1,200

maximum

Louisiana 1/10 of 1% of AOP; $100

minimum, $1,000 maximum, and

$250 expense charge

N/A 1/10 of 1% of AOP, $100

minimum, $1,000 maximum and

$250 expense charge

Maine $500 for registration statement

for each class of security

registered

$500 for registration statement for

each class of security registered

$500 for registration statement for

each class of security registered

and $300 where total raised does

not exceed $1 million

Maryland 1/10 of 1% of maximum AOP,

$500 minimum, $1,500 maximum

1/10 of 1% of maximum AOP,

$500 minimum, $1,500 maximum

1/10 of 1% of maximum AOP,

$500 minimum, $1,500 maximum

Massachusetts N/A 1/20 of 1% of aggregate amount

of offering, $300 annual minimum,

$1,500 annual maximum

1/20 of 1% of aggregate amount

of offering, $300 annual minimum,

$1,500 annual maximum

Michigan 1/10 of 1% of maximum AOP;

$100 minimum, $1,250

maximum; $10 certificate of

existence and status of issuer

1/10 of 1% of maximum AOP,

$100 minimum, $1,250 maximum;

$10 certificate of existence and

status of issuer

1/10 of 1% of maximum AOP,

$100 minimum, $1,250 maximum;

$10 for certificate of existence and

status of issuer

Minnesota $100 and 1/10 of 1% of

maximum AOP, combined $300

maximum; $25 amendment; if

increase in selling price,

additional fee

$100 and 1/10 of 1% of maximum

AOP, $300 combined maximum;

$25 amendment, additional fee if

increase in selling price

$100 and 1/10 of 1% of maximum

AOP, $300 combined maximum;

$25 amendment, additional fee if

increase in selling price

Mississippi $300 1/10 of 1% of amount registered,

$150 minimum, $1,000 maximum

1/10 of 1% of amount registered,

$150 minimum, $1,000 maximum

Missouri $100 for up to $100,000; over

$100,000, 1/20 of 1% of amount

by which maximum AOP

registered securities offered in

state exceeds $100,000; $900

maximum and $100 filing fee

$100 for up to $100,000, over

$100,000, 1/20 of 1% of amount

by which maximum AOP

registered securities offered in

state exceeds $100,000, $900

maximum, $100 filing fee

$100 for up to $100,000; over

$100,000, 1/20 of 1% of amount

by which maximum AOP

registered securities offered in

state exceeds $100,000; $900

maximum and $100 filing fee

Montana $200 for first $100,000 or portion

and 1/10 of 1% for excess over

$100,000, $1,000 maximum;

excess sales where amendment

is not filed requires payment of 3

times the normal fee

$200 for first $100,000 or portion

and 1/10 of 1% for excess over

$100,000, $1,000 maximum;

excess sales where amendment

not filed require payment of 3

times normal fee

$200 for first $100,000 or portion;

1/10 of 1% for excess over

$100,000; $1,000 maximum;

excess sales where amendment

not filed requires payment of 3

times normal fee

Nebraska 1/10 of 1% of AOP, $100

minimum

1/10 of 1% of AOP, $100

minimum

1/10 of 1% of AOP, $100

minimum

Nevada 1/10 of 1% of AOP, $350

minimum, $2,500 maximum

1/10 of 1% of AOP, $350

minimum, $2,500 maximum

1/10 of 1% of AOP, $350

minimum, $2,500 maximum

New Hampshire 2/10 of 1% of offering value,

$1,050 maximum and $200

examination to qualify

2/10 of 1% of offering value,

$1,050 maximum and $200

examination fee to qualify

2/10 of 1% of offering value,

$1,050 maximum and $200

examination fee to qualify

New Jersey $1,000 nonrefundable fee $1,000 nonrefundable fee $1,000 nonrefundable fee
Appendix II

Methods and Fees for Registering Offerings of Securities Under State Blue-Sky Laws

Page 49 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Method of registration

State Notification Coordination Qualification

New Mexico 1/10 of 1% of AOP, $525

minimum, $2,500 maximum

1/10 of 1% of AOP, $525

minimum, $2,500 maximum

1/10 of 1% of AOP, $525

minimum, $2,500 maximum

New York $75 state notice; $75 for further

state notices; intrastate offerings:

1/2 of 1% of maximum AOP, $25

minimum, $1,500 maximum

N/A N/A

North Carolina $2,000 initial and renewal fees;

$50 additional securities filing fee

$2,000 initial and renewal fees;

$50 additional securities filing fee

$2,000 initial and renewal fees;

$50 additional securities filing fee

North Dakota 1/20 of 1% of AOP, $100

minimum, $500 maximum

N/A 1/10 of 1% of AOP on first

$750,000; 1/20 of 1% of amount

over $750,000; $100 minimum for

each class of securities

Ohio 1/10 of 1% of AOP, $100

minimum, $1,000 maximum; for

certain securities, flat fees as

prescribed

$100 and 1/10 of 1% of AOP,

$100 minimum, $1,000 maximum

$100 and 1/10 of 1% of AOP,

$100 minimum, $1,000 maximum

Oklahoma $200 examination fee and 1/10 of

1% of AOP, $200 minimum,

$2,500 maximum; Oklahoma

issuers: $200 and 1/20 of 1% of

amount registered; $100

minimum, $2,500 maximum

$200 examination fee and 1/10 of

1% of AOP, $200 minimum,

$2,500 maximum; Oklahoma

issuers: $200 and 1/20 of 1% of

amount registered; $100

minimum, $2,500 maximum

$200 examination fee and 1/10 of

1% of AOP, $200 minimum,

$2,500 maximum; Oklahoma

issuers: $200 and 1/20 of 1% of

amount registered; $100

minimum, $2,500 maximum

Oregon N/A Examination: $1 per $1,000 of

AOP on first $100,000 or fraction;

$.50 per $1,000 on next $200,000

or fraction; $25 for each additional

$100,000 or fraction; $25

minimum, $500 maximum; sales

in excess of quantity registered

$25 minimum

Examination: $1 per $1,000 of

AOP on first $100,000 or fraction;

$.50 per $1,000 on next $200,000

or fraction; $25 for each additional

$100,000 or fraction; $25

minimum, $500 maximum; sales

in excess of quantity registered

$25 minimum

Pennsylvania N/A $500 based on maximum AOP

less than $10 million; $750 for $10

million or more

$350 and 1/20 of 1% of maximum

AOP, $2,150 maximum

Rhode Island 1/10 of 1% of max AOP, $300

minimum, $1,000 maximum

1/10 of 1% of maximum AOP,

$300 minimum, $1,000 maximum

1/10 of 1% of maximum AOP,

$300 minimum, $1,000 maximum

South Carolina $500 fee; $25 fee for prospectus

or offering circular accompanying

registration application

$500 fee; $25 fee for prospectus

or offering circular accompanying

registration application

$500 fee; $25 fee for prospectus

or offering circular accompanying

registration application; $50 fee

for review of prospectus or

offering circular to determine

eligibility of securities for

registration

South Dakota N/A $1 per $1,000 on first $500,000 of

sale price; $500 and $.75 per

$1,000 of excess over $500,000;

$100 minimum; $25 amendment

fee plus fees described above

$1 per $1,000 on first $500,000 of

sale price; $500 and $.75 per

$1,000 of excess over $500,000;

$100 minimum; $25 amendment

fee, plus fees described above
Appendix II

Methods and Fees for Registering Offerings of Securities Under State Blue-Sky Laws

Page 50 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Method of registration

State Notification Coordination Qualification

Tennessee N/A 1/10 of 1% of offering price, $300

minimum, $1,000 maximum; $300

for limited offering; $25 late

registration fee

1/10 of 1% of offering price, $300

minimum, $1,000 maximum; $300

for limited offering; $25 late

registration fee

Texas Examination, 1/10 of 1% offering

price of securities sold in state

and $10 filing for original

application fee; sales in excess of

registration 3 times difference in

fees, plus $10

Examination: 1/10 of 1% offering

price of securities sold in state

and $10 filing for original

application; sales in excess of

registration 3 times difference in

fees, plus $10

Examination: 1/10 of 1% offering

price of securities sold in state

and $10 filing for original

application; sales in excess of

registration 3 times difference in

fees, plus $10

Utah $300 $750 $300

Vermont .50% on each $1,000 par value

stock (no-par stock, or par less

than $100, offering price), $20

minimum, $200 maximum

N/A 1/10 of 1% ($1 each $1,000 of

AOP), $400 minimum (covers up

to $400,000), $125 maximum

Virginia 1/20 of 1% of maximum AOP,

$100 minimum, $250 maximum

1/20 of 1% of maximum AOP,

$200 minimum, $700 maximum

1/10 of 1% of maximum AOP,

$250 minimum, $500 maximum

Washington N/A $100 on first $100,000 and 1/40 of

1% for excess for 12-month

period; $100 for each additional

12 months

$100 on first $100,000 of offering

price and 1/20 of 1% for excess.

West Virginia 1/20 of 1% of maximum AOP,

$50 minimum, $1,500 maximum

1/20 of 1% of maximum AOP, $50

minimum, $1,500 maximum

1/20 of 1% of maximum AOP, $50

minimum, $1,500 maximum

Wisconsin N/A $750 $750

Wyoming 1/50 of 1% of total offering

amount in Wyoming, $200

minimum, $600 maximum

1/50 of 1% of total offering

amount in Wyoming, $200

minimum, $600 maximum

1/50 of 1% of total offering

amount in Wyoming, $200

minimum, $600 maximum

Note: These registration fees are only one of several types of fees that states can charge business

issuers. This table does not include a description of the other types of fees since the focus is to

describe the initial fees that can be charged to small business issuers.

Legend: AOP aggregate offering price

N/A not applicable

Source: Blue Sky Law Reporter, CCH Paragraph 6501, October 1999. Reproduced with permission

from BLUE SKY LAW REPORTER published and copyrighted by CCH INCORPORATED 2700 Lake

Cook Road, Riverwoods, Illinois 60015.
Appendix III

Federal and State Agencies Have Taken Some

Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 51 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Companies intending to raise capital by selling securities to the public

generally are required to file a registration statement with SEC and state

regulators and to supply investors with an offering document. Federal and

state securities laws aimed at protecting investors prohibit false and

misleading statements in connection with the offer or sale of securities.

Such statements include communications and documents supplied to

investors and documents filed with SEC and state regulators. In an attempt

to assist small businesses in capital formation while balancing the need to

protect investors, Congress and the securities regulators have simplified

the registration process and provided small businesses with exemptions

from federal registration requirements on the basis of the dollar size of the

offering, location of the offering, and number and type of investors.

However, offerings exempt from federal registration requirements are not

always exempt from state registration requirements. If no state

exemptions exist, a company may have to register its securities offerings

in each state where they are sold and must register some offerings with

both federal and state regulators.

Companies selling securities to the public must comply with the Securities

Act of 1933 (Securities Act) and the Securities Exchange Act of 1934

(Exchange Act). The Securities Act requires companies to provide

investors with the information that an investor would find important in

deciding whether to purchase a company’s securities, and it prohibits

material misrepresentations in the sale of securities. The Securities Act

also requires companies to file a registration statement with SEC, which

includes an offering document or prospectus to be supplied to investors. In

a process known as disclosure review, SEC is to review the registration

statement to determine whether it contains the required information. SEC

does not evaluate whether the offering is fair to investors or whether

statements in the offering documents are accurate. The purpose of these

requirements is to ensure that investors have access to certain basic facts

about securities before buying them. Furthermore, the antifraud provisions

of the Exchange Act provide civil recovery rights to investors who

purchase or sell securities on the basis of inaccurate public filings and

suffer losses. The purpose of the antifraud provisions is to ensure that

information provided to investors is accurate.

Before offering securities for sale to the public, issuers are required to file

a registration statement with SEC. A company cannot sell its securities

until SEC declares the registration statement effective. Registration

statements must contain a prospectus that describes, among other things,

the company’s business operations; financial condition; and management.

Companies must give the prospectus to all investors that purchase its

Federal Securities

Laws Protect Investors

by Requiring

Disclosure of Material

Information

Federal Securities Laws

Specify Registration

Requirements
Appendix III

Federal and State Agencies Have Taken Some Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 52 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

securities. Companies registering securities are required to use certain

forms specified by SEC. If a company is a small business issuer (as

described below), it can file its registration statement using a simpler, less

costly form than the ones larger issuers can use.

Companies selling securities to the public to raise capital are also subject

to sanctions outlined in the securities laws for fraudulent conduct in

connection with securities sales. Material misstatements and omissions

may result in SEC civil suits or administrative proceedings under the

general antifraud provisions of the Securities Act and the Exchange Act.

Private investors can also sue a seller of securities for material

misstatements or omissions in connection with securities sales, and

purchasers of securities can bring action when a registration statement

contains material misstatements or omissions. The Exchange Act’s

antifraud provisions prohibit misstatements and omissions of material

facts in connection with the purchase or sale of a security, even if the

security is exempt from registration requirements. Under provisions of the

Exchange Act, an investor may bring a claim against a company for

material misstatements or omissions in any of its public filings for any

losses incurred as a result of securities purchases or sales that are based

on such misrepresentations or omissions.

To facilitate small businesses’ access to equity capital, SEC allows small

businesses to use a simplified registration form. The securities laws and

SEC rules also contain several exemptions from SEC’s registration

requirements for small business issues. In addition, SEC allows issuers to

save significant underwriting costs by issuing securities directly over the

Internet.

To minimize the costs of raising equity capital, SEC makes available

streamlined registration processes for small business issuers with less than

$25 million of revenues in the previous fiscal year and that also have

outstanding stock of less than $25 million in value. SEC allows such small

business issuers to file their registration statements using one of the two

simplified small business forms. Small business issuers offering up to $10

million worth of securities in any 12-month period can use the form SB-1,

which allows issuers to provide information in a question-and-answer

format. Form SB-1 also requires audited financial statements for only the

preceding 2 fiscal years, rather than for the 3 previous years, which is

otherwise required by the regular S-1 registration form that applies to all

issuers. Form SB-1 is used infrequently, according to SEC staff members.

Issuers have used an average of 12 form SB-1s each year between 1994 and

1999, according to SEC data.

Antifraud Provisions

Provide Legal Remedies for

SEC and Private Investors

Federal Exemptions

and SEC Initiatives

Expand Small Business

Access to Equity

Capital

Special Forms for Small

Business Issuers Are

Available
Appendix III

Federal and State Agencies Have Taken Some Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 53 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Another simple form available to small business issuers (form SB-2) allows

an issuer to register an unlimited dollar amount of securities using a less

extensive narrative than the regular form S-1. Form SB-2 also lets issuers

provide audited financial statements for only 2 fiscal years. Issuers use

form SB-2 more frequently than form SB-1. According to data provided by

SEC staff, an average of 430 registration statements have been filed

annually using the form SB-2 between 1994 and 1999.

The forms SB-1 and SB-2 have been estimated to save an issuer as much as

$125,000 for an average offering. However, although these forms make it

easier for small business issuers to register securities, an investment

banker we interviewed told us that small business issues are viewed

unfavorably because they are too small in size to be profitable to many

investment banks. He further stated that such offerings are commonly

distributed by third- and fourth-tier investment banks that lack market

recognition, which can hurt in attracting investors.

The Internet provides an alternative to the traditional method of offering

stock to the public that can eliminate some underwriting costs for

companies of all sizes. The Internet especially enables smaller companies

to raise capital through self-managed initial public offerings known as

DPOs, which are generally not distributed by an underwriter and,

therefore, are much less expensive. Underwriter fees, which are normally

the largest cost involved in conducting a public offering, can range from 6

to 10 percent of the total dollar amount being raised. These fees can

commonly total $300,000 to $500,000 for a typical public offering seeking

to raise $5 million. The same securities laws govern securities offerings

made over the Internet as traditional offerings distributed by underwriters,

and the registration process is the same as the ones used for traditional

securities offerings.

In an offering, during the period when a company decides to file a

registration statement, a company is prohibited from making any

communication that “conditions the market” for the securities it intends to

offer. In an Internet offering during this period, for instance, hyperlinks to

analyst reports and financial forecasts; projections; or other indications of

the company’s value contained on a company’s Web page may be

considered an impermissible communication.1

During the date between the

filing of the registration statement and the date that it becomes effective,

only certain types of written offers are permitted and electronic

communications must conform to SEC rules governing written offers.

1

Such a communication, which is called “gun-jumping,” violates section 5(c) of the Securities Act.

The Internet Can Be Used

for Initial Public Offerings

by Small Businesses
Appendix III

Federal and State Agencies Have Taken Some Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 54 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Once the registration statement becomes effective, an issuer may deliver

the final prospectus and any additional sales literature electronically only

if the investor has consented to its delivery in electronic form. SEC has

also stated that there is adequate delivery of the prospectus electronically

if the investor has access to both the prospectus and the sales literature in

close proximity to each other and, if the investor is able to view the sales

literature, the investor must also able to view the final prospectus.

Concerns have been and continue to be expressed by industry participants

that the expense of registering with SEC for certain small business

offerings impedes small businesses’ ability to use the public capital

markets for financing. In an attempt to ease this potential impediment,

federal securities laws exempt certain securities offerings from registering

with SEC, which saves certain issuers the expense of federal registration

as well as other associated costs, such as certain accounting and legal fees.

Regulation D was one of the results of SEC’s evaluation of the impact of its

rules and regulations on the ability of small business to raise capital, which

revealed a concern that the registration requirements of the Securities Act

imposed disproportionate restraints on small business issuers. Regulation

D is designed to eliminate unnecessary restrictions that SEC rules place on

small business issuers. While preserving protections for investors,

Regulation D also was intended to promote uniformity between state and

federal exemptions to facilitate capital formation for small businesses.

Regulation D establishes three separate but interrelated exemptions, rules

504, 505, and 506.2

Rule 504. The first exemption, rule 504, provides an alternative to SEC

registration for public or private offerings of up to $1 million. Rule 504

provides that a company offering up to $1 million of securities in a 12-

month period does not have to file a registration statement with SEC. Rule

504 was designed to provide an exemption from federal registration

requirements for small offerings by small issuers that are presumed to be

regulated by the states because of the modest amount of the offering and

the likelihood that sales will occur in a limited geographic area.

Like the other Regulation D exemptions, an issuer may not use public

solicitation or advertising to market the securities, and purchasers receive

“restricted” securities, meaning that they may not sell the securities

without registration or an applicable exemption. However, unlike the other

2

A notice of exempt sales (i.e., form D) is required to be filed with SEC within 15 days of the first sale

of Regulation D securities.

SEC Registration

Exemptions Are Intended to

Assist Small Businesses

Regulation D Represents an

Attempt to Reduce Burdens

Imposed by Federal Securities

Laws
Appendix III

Federal and State Agencies Have Taken Some Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 55 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Regulation D exemptions, under rule 504, (1) the company can issue its

securities publicly using general solicitation3

and advertising to market the

securities and (2) purchasers can resell their securities, if the following

conditions are met:

• the company registers its offering in a state that requires it to file a

registration statement and to deliver a prospectus to investors before sale;

• the company registers and sells its securities in a state that requires

registration and disclosure delivery and also sells its securities in a state

without those requirements, as long as the company provides investors

with the prospectus that is required by the state where the securities are

registered; or

• the company can sell its securities according to state law exemptions that

permit general solicitation and advertising, as long as it sells only to

certain financially sophisticated investors known as “accredited

investors.”4

Rule 504 benefits small businesses because it allows them to avoid the

significant costs they would otherwise incur in registering their securities

with SEC. Another benefit is that an issuer can sell rule 504 securities to an

unlimited number of investors. Other rule 504 benefits are the lack of a

sophisticated investor requirement, which is required for certain other

Regulation D exemptions, and the lack of a prohibition on general

solicitations and advertising if the previously listed conditions are met.

However, issuers using the rule 504 exemption must register in every state

in which the issuer offers the securities, unless there is an available state

exemption. Since the majority of the states do not have exemptions for

rule 504 offerings, an issuer choosing to sell securities in more than one

state has to comply with each state’s filing requirements. Additionally,

states often have different filing and disclosure requirements for rule 504

offerings.

3

“General solicitation” refers to the public dissemination of information regarding an anticipated or

pending private offering. A series of SEC no-action letters indicates that a preexisting relationship

between an offeror and the investor is an indication that general solicitation did not occur.

4

An “accredited investor” is defined as: a bank, insurance company, registered investment company,

business development company, or small business investment company; an employee benefit plan; a

charitable organization, corporation, or partnership with assets exceeding $5 million; a director,

executive officer, or general partner of the company selling the securities; a business in which all of the

equity owners are accredited investors; a natural person with a net worth of at least $1 million; a

natural person with income exceeding $200,000 in each of the 2 most recent years or joint income with

a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in

the current year; or a trust with assets of at least $5 million that is not formed to acquire the securities

offered and whose purchase is directed by a sophisticated person.
Appendix III

Federal and State Agencies Have Taken Some Actions to Help Small Businesses Raise

Capital While Protecting Investors

Page 56 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Rule 504 offerings have steadily increased since 1994, when 2,357 offerings

were made, through 1999, when 3,407 offerings were made, according to

SEC data. Corporate attorneys and industry participants expressed a

variety of views about rule 504 offerings. Some industry participants

suggested that rule 504 offerings should be altogether exempted from state

registration requirements to allow issuers to avoid the burden of having to

register in each state. Others suggested that state blue-sky laws need to be

simplified and made uniform to enable small businesses to access capital

more readily.

The North American Securities Administrators Association, Inc. (NASAA)

officials have stated that the development of the Small Company Offering

Registration (SCOR) initiative eases the burdens created by state

registration requirements for rule 504 offerings. NASAA, in conjunction

with the American Bar Association, developed the SCOR initiative in 1988,

which allows issuers to use a simplified “question-and-answer” registration

form that also can be used as the disclosure document for investors for

rule 504 offerings. According to NASAA officials, it costs an average of

about $30,000 to do a SCOR offering. Further, many of the 49 states that

recognize SCOR filings coordinate such filings through the Regional

Review Program, which provides a uniform state registration procedure

for coordinating and expediting the registration process in all states in the

region in which the issuer seeks to sell its securities. According to one

state regulatory official, an important feature of SCOR and regional review

is that states involved in the programs have agreed to uniform registration

standards in the review and issuance of comments.

Rule 505. A second Regulation D exemption, rule 505, is an option for

issuers who wish to make private offerings of securities of up to $5 million

in a 12-month period. The purpose of this exemption is to provide a

uniform federal and state exemption as Congress directed in section 19(c)

of the Securities Act. Indeed, in 1983, a parallel initiative to rule 505 was

the adoption at the state level of NASAA’s Uniform Limited Offering

Exemption (ULOE). According to NASAA officials, ULOE is available in

approximately 45 states.

Under rule 505, an issuer may sell to an unlimited number of accredited

investors5

and up to 35 other persons who do not need to satisfy a

sophistication or wealth standard. The issued securities are restricted and

cannot be resold by investors unless the issuer registers the securities or

5

Regulation D provides that regarding the purchaser’s qualifications, all that is required is that the

issuer reasonably believes that the purchaser’s qualifications and limitations have been met.
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there is an available exemption. In addition, the company may not use

general solicitation or advertising to sell the securities. An indication that

an offer is free from general solicitation is that an offeror has a preexisting

relationship with the offeree that it solicits. Unlike rule 504, regarding the

unaccredited investors, the company must provide an offering document

similar to the document that is required in a registered offering, which

includes financial statements that are certified by an independent public

accountant.

One commentator noted that rule 505’s more extensive disclosure

requirement (as compared with rule 504) is appropriate because of the

increased size of the transaction, which would necessitate more investor

protection.6 Like rule 504, rule 505 exempts offerings from federal

registration. However, such securities are required to be registered in each

state in which they are offered, unless a state exemption is available.

Although ULOE is available in 45 states, the requirements are not

necessarily uniform among the states. According to SEC data, rule 505

offerings have dramatically decreased from 2,163 offerings in 1994 to 1,016

offerings in 1999.

Industry participants complain that the prohibition against general

solicitations and advertising further lessens the appeal of rule 505 offerings

to issuers. For that reason, some participants have suggested that SEC

eliminate the restriction on advertising and general solicitation for rule 505

offerings, and other industry participants have suggested that rule 505

offerings be exempt from state registration requirements. However,

according to an SEC official, SEC is not inclined to eliminate the general

solicitation restrictions on rule 505 offerings, because such restrictions are

among the attributes of a private placement that distinguishes it from a

public offering.

Rule 506. A third Regulation D exemption, rule 506, tends to be used more

frequently than the other exemptions. Issuers, especially those raising

more than $5 million in a private offering, find the rule 506 exemption

particularly attractive because it allows a company to raise an unlimited

amount of capital from an unlimited number of accredited investors and

up to 35 other sophisticated purchasers. Issuers also view the rule 506

exemption favorably because rule 506 offerings are exempt from state

6

In a rule 505 offering, the issuer and its officers and directors must not be disqualified under certain

“bad person” provisions (i.e., a pending indictment; a criminal conviction within the last 10 years; an

injunction; stop order and suspension proceedings; postal fraud; and disciplinary orders issued by SEC,

a securities exchange, or other securities organization, in each case, resulting from some aspect of the

securities business).
Appendix III

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registration requirements. According to SEC data, rule 506 offerings have

increased dramatically from 5,414 offerings in 1994 to 13,112 rule 506

offerings in 1999.

As with rule 505, rule 506 prohibits companies from using general

solicitation or advertising to market the securities. Moreover, with both

rules 505 and 506, the offeror generally has a preexisting relationship with

any offeree that it solicits. Differences between rules 505 and 506,

however, are that under rule 506, all nonaccredited investors must be

sophisticated and they must have sufficient knowledge and experience in

financial and business matters as well as access to sufficient information

to be capable of evaluating the investment. The company must also give

nonaccredited investors disclosure documents that generally are the same

as those used in registered offerings. Rule 506 financial statement

requirements are the same as those for rule 505. In addition, purchasers

under rule 506, as with rule 505 offerings, receive restricted securities,

which means that unless the issuer registers the securities or the investor

obtains an exemption at the federal and state level, the investor may not

freely sell the securities.

Unlike offerings made under rule 504 and 505 exemptions, offerings made

pursuant to the requirements of rule 506 are automatically excluded from

state registration requirements because of the National Securities Markets

Improvement Act (NSMIA). However, industry participants complain that

the restriction on general solicitation and advertising impedes small

businesses that need to search for investors through solicitation or

advertising. Some securities attorneys have suggested that rule 506 be

amended so that general solicitation and advertising are permitted. In June

1995, SEC sought comments on an amendment to Regulation D that would

eliminate the prohibition against general solicitation for rules 505 and 506

offerings. Although SEC deferred taking action on the general solicitation

question, it indicated that it would consider comments regarding the

question in connection with a future initiative.7

Another complaint by industry participants is that rule 506 is only available

for issuer transactions and that it cannot be invoked for subsequent sales

by accredited investors. Thus, an investor must find an exemption from the

federal and state registration requirements or the issuer must register the

securities. Regarding exemptions, at the federal level, SEC rule 144 permits

the resale of unregistered securities by individuals if certain requirements

7

Furthermore, NASAA officials believe that the bad person provisions should be extended to rule 506

offerings so that violators of the securities laws do not have an avenue to commit fraud again.
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are met. Rule 144 requires that adequate information concerning the issuer

must be available, that the individual must have held the securities for at

least 1 year, and that only a limited number of shares may be sold. Industry

participants also cited as a problem the lack of uniformity at the state level

in exemptions for the resale of unregistered securities. They said that a

small business’ ability to raise capital is ultimately affected since it is

difficult to sell securities initially when a secondary market for the

securities is lacking.

Other exemptions that are available for offerings under $5 million are the

Regulation A offering exemption, the accredited investor exemption, the

California Limited Offering Exemption,8

the employee benefit plans, and

the intrastate offering exemption. Each is described below.

Regulation A. Although Regulation A is termed an “exemption,” it actually

provides a simplified registration form with SEC for public offerings of

securities not exceeding $5 million. SEC has stated that the primary

purpose of Regulation A is to provide a simple and relatively inexpensive

procedure by which small businesses could raise limited amounts of

needed capital. SEC has also stated that Regulation A can be an effective

tool for a developing company, which may not be able to justify the

significant costs of registration. Unlike the companies that use Regulation

D exemptions, a company that relies on Regulation A for an exemption

must file an offering circular with SEC for review and provide the circular

to investors.9

However, the company can use a simplified question-andanswer format. Like registered offerings, the securities can be offered

publicly and are freely tradable in the secondary market. Among the

principal advantages of Regulation A offerings, as opposed to full

registration, are that the financial statements are simpler and do not need

to be audited. This difference can cut an issuer’s costs because the issuer

can avoid hiring an outside accounting firm in connection with the

offering. According to SEC data, an average of 83 Regulation A offerings

have been filed each year since 1994.

Unlike traditional public offerings, in Regulation A offerings, companies

may “test the waters” to determine if there is adequate interest in the

securities before going through the expense of filing with SEC. Thus, if

certain conditions are met, a company may issue written or oral

statements asking whether investors would be interested in purchasing its

8

The California Limited Offering Exemption can be found in SEC rule 1001.

9

Regulation A offerings also have a bad person provision that prevents an issuer who has violated the

securities laws in the past 10 years from conducting a Regulation A offering.

Exemptions Are Available for

Offerings Under $5 Million in an

Effort to Reduce Costs for Small

Offerings
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securities. If insufficient interest is indicated, the company can avoid the

cost of preparing an offering statement, filing it with SEC, and delivering it

to investors. The ability to test the marketplace before incurring the costs

of an offering can be a tremendous advantage for small businesses.

However, a drawback of Regulation A filings is their lack of exemption

from state law registration filing requirements. This lack of an exemption

makes them more expensive than Regulation D offerings since an offering

statement must be prepared, filed, and reviewed by SEC before any

securities can be sold. Market participants complain that it is a burden for

them to have to register with SEC and each state where they offer their

securities for sale. A state regulatory official told us that one problem

encountered in trying to coordinate the filing process between state

regulators and SEC is that periods for comments are not consistent

between the states and SEC. For example, in many states, the turnaround

period for initial comments is about 15 business days, while the SEC

turnaround period is about 30 calendar days. Like rule 504 offerings, in

Regulation A offerings, issuers can (1) use SCOR and regional review in

the states where they are available and (2) make offerings over the

Internet.

A solution suggested by one securities lawyer that we talked to for

lessening the burden of requiring registration at the state and federal level

for Regulation A offerings is to eliminate the requirement that Regulation A

offerings be filed and reviewed by SEC. Another suggested solution is to

preempt states from regulating Regulation A offerings so that only SEC

would prescribe the requirements with which an issuer must comply to

qualify for the ability to test the waters.

Another problem with Regulation A offerings cited by a state securities

regulator official is that the offering size of under $5 million is often too

small to attract broker-dealers, who can distribute the securities to

investors. This official recommended that the Regulation A threshold be

increased from $5 to $10 million.

The accredited investor exemption. Under the accredited investor

exemption,10 sales of securities to accredited investors11 with an offering

10Section 4(6) of the Securities Act.

11The definition of accredited investors is the same as that used in Regulation D. However, unlike the

Regulation D exemptions, the exemption is lost if any investor is not accredited. Whereas, with the

other Regulation D exemptions, the issuer need only have a reasonable belief that the investors are

accredited.
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price under $5 million are exempt from Securities Act registration

requirements. Like the exemptions in rules 505 and 506, this exemption

does not permit any form of advertising or public solicitation, and the

resales of securities are restricted. The issuer is not required to provide

investors with an offering document, and the offering is required to be

registered in each state where the securities are being sold. Commentators

have suggested that the accredited investor exemption is rarely used since

the exemptions offered under Regulation D are easier to use and offer the

same relief.

The California Limited Offering Exemption. Another exemption available

for offerings that total less than $5 million, is known as the California

Limited Offering Exemption, which provides an exemption from the

registration requirements of the Securities Act for offers and sales of

securities that satisfy the conditions of section 25102(n) of the California

Corporations Code. This exemption was designed to facilitate the ability of

small companies to raise capital to finance their growth. By wrapping a

federal exemption around a state’s exemption, SEC believed that other

states might follow suit for the benefit of small issuers. According to

NASAA officials, the states followed suit when in 1997, NASAA drafted and

many states thereafter adopted the Model Accredited Investor Exemption

(MAIE). NASAA adopted MAIE with the expectation that SEC would adopt

a corresponding exemption similar to SEC rule 1001. To date, no such

federal exemption has been adopted.

The California law provides an exemption from California state law for

registration offerings made by California companies to “qualified

purchasers” who are defined as similar to accredited investors. Unlike

Regulation D offerings, this exemption allows some methods of general

solicitation before sales, such as general announcements of the proposed

offering to be widely published and circulated, so long as they contain only

specified information. Like Regulation D offerings, the securities are

restricted and cannot be resold unless there is an available exemption for

the resale.

Employee benefit plans. Small businesses have available to them an

exemption for offerings pursuant to certain compensatory benefit plans or

compensation contracts. In addition to obtaining financing through

securities issuances, small businesses may also use their securities to

compensate employees and other personnel. Securities-based plans or

arrangements often constitute an essential part of the compensation

structure of nonpublic companies, especially start-up ventures in which

the ability to share in equity appreciation is often a powerful inducement
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available to attract employees. Offering securities to employees in

compliance with the federal securities laws, however, is very costly for

nonpublic companies because of the costs associated with SEC filings.

Thus, in an effort to enable small businesses to provide securities to

employees as an incentive in a cost-effective manner, SEC promulgated

rule 701, which exempts the sale of securities that were made to

compensate employees by companies meeting certain requirements. The

company can sell at least $1 million of securities under this exemption and

can sell more securities if it satisfies certain formulas that are based on its

assets or on the number of its outstanding securities. If the company sells

more than $5 million in securities in a 12-month period, it must provide

limited disclosure documents to its employees. Like the securities in rules

505 and 506, under rule 701, employees receive “restricted securities.”

The Intrastate offering exemption. The intrastate offering exemption

allows a company to sell its securities to the public within a single state

without registering with SEC.12 The purpose of this exemption is to

facilitate the financing of local businesses by local sales. The rationale is

that if the offering is local, the federal government can appropriately rely

on the states to regulate such securities sales. To qualify for the intrastate

offering exemption, a company must be incorporated in and conduct a

significant amount of its business in the state in which it is offering the

securities. There is no fixed limit on the size of the offering or the number

of purchasers. However, the company only can sell its securities to the

residents of the state in which it is incorporated. Although exempt from

federal registration, a company obtaining the intrastate offering exemption

must register its securities pursuant to state law. According to officials

from NASAA and a securities attorney, the intrastate offering exemption is

viewed unfavorably by issuers concerned that this exemption can be easily

lost due to the inadvertent noncompliance with the residency requirement

of investors that purchase the securities. For this reason, this exemption is

rarely used.13

To assist issuers in conducting such offerings over the Internet, the Small

Business Administration’s Office of Advocacy (SBA-OA) established ACENet (Access to Capital Electronic Network), which is an Internet site

where small companies may list their rule 504 and Regulation A offerings.

Several industry participants told us that ACE-Net does not have a great

reputation in the investment community because companies listed on

12Section 3(a)(11) of the Securities Act; 17 C.F.R. 230.147 (1999).

13Under this exemption, even one offer to, or securities transfer to a nonresident within 9 months from

the sale may make the entire intrastate offering subject to registration.

Certain Exempt Offerings Can

Be Made Over the Internet
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ACE-Net are considered low-quality companies that could not otherwise

get funding. Industry participants suggested that as a solution to this

problem, SBA should better screen the quality of the companies that are

listed on ACE-Net to ensure better quality investment opportunities for

investors. However, according to a SEC no-action letter, ACE-Net is not

legally permitted to screen the quality of the companies that are listed on

its site.

States require securities to be registered before they can be offered for

sale within the state unless a state law exemption is available or federal

law preempts state registration requirements. As discussed in appendix II,

these requirements prescribe three methods of registering securities—

notification, qualification, and coordination.

Like SEC, some states perform a disclosure review of small businesses’

securities offerings to ensure that companies disclose to investors all

information needed to make an informed investment decision. NSMIA

preempts state registration and review requirements of nationally traded

securities and offerings under SEC rule 506 of Regulation D. Unless

exempt by state statute, securities that are not preempted by NSMIA are

subject to state registration requirements. Certain initiatives have been

developed to assist companies that are exempt from SEC registration, but

these companies must register in all states in which their securities are

offered.

The state blue-sky laws are aimed primarily at new and unproven concerns

and speculative ventures that often have local or regional impact. States

require securities to be registered before they can be sold, unless a state

law exemption is available or, as discussed below, state registration

requirements are preempted by federal law. The primary purpose of state

securities laws is to protect purchasers of securities. Omissions of material

facts and fraud or deception regarding both the purchase and the sale of

securities are prohibited.

Historically, most state legislatures have followed one of two approaches

in regulating public securities offerings, or a combination of the two

approaches. Some states review small businesses’ securities offerings to

ensure that companies disclose all information investors need to make an

informed investment decision. This is known as disclosure review. Other

states also analyze public offerings using substantive standards to ensure

that the terms and structure of the offerings are fair to investors, in

addition to the focus on disclosure. This analysis is known as merit review.

One of the concerns voiced by securities attorneys and market participants

Companies Must

Register Securities in

Each State in Which

Their Securities Are

Offered for Sale

State Securities Regulators

Conduct Merit Reviews and

Focus on Unproven Entities

With Local or Regional

Impact
Appendix III

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is that merit review standards are not uniform among the states. Different

states look at different factors to determine if a registration statement

contains sufficient information and if the offering terms and structure are

fair to investors. Although difficult to implement, one securities attorney

proposed that merit review standards be consistent among the states or

that states conduct disclosure reviews such as SEC does at the federal

level. However, NASAA officials note that under the Coordinated Equity

Review (CER) Program, 39 of the 42 states that review offerings registered

at the federal level have agreed to apply a uniform set of merit standards in

the form that is described in NASAA’s Statements of Policy.

NSMIA14 preempts state registration and review requirements of securities

offerings known as “covered securities.” These securities are defined by

NSMIA to include “nationally traded,” —that is, securities traded on the

New York Stock Exchange, Inc. (NYSE); the American Stock Exchange,

Inc. (Amex); the NASDAQ National Market System; Tier I of the Pacific

Exchange, Inc.; Tier I of the Philadelphia Stock Exchange, Inc.; or the

Chicago Board Options Exchange, Inc.—as well as securities that are

offered under rule 506 of Regulation D.15 Securities that are not within the

definition of covered securities, remain subject to state registration

requirements. These securities include those quoted on the NASDAQ

SmallCap market, securities traded on the over-the-counter Bulletin Board;

securities quoted on the over-the-counter “pink sheets,” and securities

listed on securities exchanges other than those exchanges listed above

under covered securities. Unless subject to an exemption, securities that

are covered securities must be registered with SEC and with each state in

which they are offered for sale.

Even though NSMIA exempts covered securities from state registration

requirements, NSMIA preserves the authority of state securities regulators

to enforce actions that arise out of fraud regarding securities sold in their

states. The purpose of NSMIA is to enhance capital formation and the

competitiveness of the economy by eliminating regulatory overlap

14Securities Act 18(a)(3), 15 U.S.C. 77r(a)(3).

15Section 18(b) defines covered security to include:

a. A security listed, or authorized for listing, on the New York Stock Exchange or the American Stock

Exchange, or listed, or authorized for listing, on the National Market System of the NASDAQ Stock

Market;

b. A security listed, or authorized for listing, on a national securities exchange that has listing

standards that the Commission determines by rule (on its own initiative or on the basis of a petition)

are substantially similar to the listing standards applicable to securities described in item a. above.

NSMIA Preempts State

Registration and Review

Requirements for Covered

Securities
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between the states and the federal government, thus simplifying the way

that securities are regulated.

The state blue-sky laws set forth numerous exemptions from their

registration requirements. The exemptions under state acts often contain

significant variations. As is true with federal law, state blue-sky laws

provide for types of securities and transactions that are exempt from state

registration requirements, such as securities issued by certain charitable,

educational, or religious organizations.

Most state statutes also exempt certain types of transactions from state

registration requirements. For instance, most states have adopted some

form of an exemption for transactions that involve an offer to sell

securities to not more than 10 persons within the state in any 12-month

period. The purchasers usually must be buying for investment and not

resale. Another common state law registration exemption covers offerings

made only to institutional investors16 that acquire the security for

investment only and not resale.

The Uniform Securities Act of 1956 and the Revised Uniform Securities Act

of 1985 represent key efforts to make the states’ registration and

exemption processes more uniform. Specifically, both acts incorporated

model rules developed by the American Law Institute to increase

uniformity among the states’ registration and exemption processes.

Although certain provisions of the Uniform Acts have been adopted by

certain states, there are significant departures in many states. In 1983, a

parallel initiative to SEC’s Regulation D led to the adoption at the state

level of NASAA’s ULOE, which contemplates a uniform rule exempting

offers or sales if offered or sold in compliance with Regulation D’s rules

505 and 506 that satisfy certain conditions. However, regarding rule 506,

NSMIA preempts the states from requiring anything more than a notice

filing and, although the rule 505 counterpart exemption remains relevant, it

seldom comes into play because rule 505 is used infrequently.

In April 1997, NASAA approved the Model Accredited Investor Exemption

(MAIE), which provides an exemption from state securities registration

requirements to small businesses offering securities to accredited

investors. This exemption is based on the premise that accredited

investors, which are wealthy individuals or institutional investors, can do

their own due diligence and risk assessment. According to NASAA, 33

16Although the statutes define institutional investor differently, they generally include insurance

companies, banks, and savings institutions.

Exemptions Are Also

Available at the State Level

Model Acts Have Been

Proposed in an Effort to

Coordinate State

Registration and

Exemptions
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states, Puerto Rico, and the District of Columbia have adopted a form of

this exemption, and 7 more states have bills providing for such exemptions

pending in their legislatures.

NASAA has addressed the issue of conducting initial public offerings (IPO)

and DPOs over the Internet to provide a uniform standard after which each

state could model its own regulations. NASAA’s resolution, which was

adopted on January 7, 1996, encourages states to exempt Internet offers

from their state registration requirements if certain conditions are met.

States that follow the NASAA resolution exempt Internet offerings in

which the Internet offer specifies that (1) the securities are not being

offered to residents of a particular state and (2) the offer is not specifically

directed to any person in a state. According to NASAA, 32 states have

adopted the NASAA Internet Resolution.

To assist companies conducting IPOs that are not sold on a national

securities exchange but that are required to be registered with both SEC

and all of the states in which the company offers securities, a coordinated

review procedure (i.e., the CER Program) has been developed. The CER

program streamlines the process for such firms by providing a uniform

state registration procedure designed to coordinate the blue-sky

registration process in all of the states in which the issuer seeks to sell its

equity securities. NASAA notes that 39 states are participants in the CER

Program.

The CER Program offers issuers registration efficiencies by creating a

uniform scheme of review. The program also simplifies the blue-sky

registration process for issuers by simplifying the process for resolution of

comments. The CER Program Protocol establishes compulsory periods for

review and generation of comments.

Exemptions From State

Registration for IPOs and

DPOs Conducted Over the

Internet

A Uniform State

Registration Process Assists

Issuers in Coordinating

State Registration
Appendix IV

Special SEC, SBA, and NASAA Activities to

Facilitate Small Business Access to Equity

Capital

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SEC, the Small Business Administration (SBA), and NASAA have activities

to help small businesses raise equity capital. Table IV.1 highlights some of

these small business activities. To aid the small business capital formation

process, all three of these entities have Internet Web sites dedicated to

small business issues; have toll-free telephone numbers; provide a small

business ombudsman; and provide outreach efforts through forums,

conferences, and Web sites.

Organization Activity Activity description

U.S. Securities

and Exchange

Commission (SEC)

Annual Conference on

Uniformity of FederalState Securities

Regulation

SEC and the North American Securities Administrators Association, Inc.,

(NASAA) conduct an annual conference designed to increase uniformity and

cooperation between the federal and state regulatory systems so that capital

formation can be made easier and at less cost while at the same time

maintaining investor protections. This conference was first held in 1984.

Small Business

Regulations

Simplified registration regulation to reduce costs and regulatory burden on

small business issuers by requiring less extensive registration and disclosure

requirements for small issuers.

Annual SEC

Government-Business

Forum on Small

Business Capital

Formation

The conference focuses on the capital formation concerns of small

businesses. It provides a platform for those involved in raising small business

capital (e.g., small business owners, venture capitalists, and small business

advocates) to highlight perceived unnecessary impediments to the process of

raising capital. Recommendations are developed and voted on by participants

as to importance. This conference was first held in 1982.

Town Hall Meetings Since 1996, SEC has periodically held town hall meetings with small

businesses. These meeting allow small businesses owners to learn about the

basic federal securities law requirements for selling securities in the public

markets. They also allow SEC staff to learn about small business concerns in

raising capital so that initiatives and programs can be designed to meet these

concerns. Town hall meetings are conducted throughout the United States.

Plain English

Disclosure

To improve the readability of disclosure documents, it is required that they be

written simply and in plain English. According to a SEC official, the small

business disclosure area was the first area to which plain English was applied.

Office of Small

Business, Division of

Corporation Finance

A centrally located headquarters unit that specializes in small business filings

and the needs of small business issuers.

Public and Private

Placement Exemptions

These exemptions at the federal level ease the regulatory cost and burden on

small business capital formation by providing exemptions from federal

securities registration requirements for securities offerings up to $5 million if

certain conditions are met.

U.S. Small Business

Administration (SBA)

Office of Advocacy This office was created as an independent entity within SBA in 1976. It acts as

the advocate for small business in the federal government.

Small Business

Investment Company

(SBIC) Program

Licensed and regulated by SBA, SBICs are privately owned and managed

firms that provide venture capital and start-up financing to small businesses.

Access to Capital

Electronic Network

(ACE-Net)

Created in 1996, ACE-Net is a secured Internet service where small

companies may list their equity offering for review by accredited investors that

are looking to invest $250,000 to $5 million.

Table IV.1: Activities by SEC, SBA, and NASAA to Help Small Businesses Raise Equity Capital
Appendix IV

Special SEC, SBA, and NASAA Activities to Facilitate Small Business Access to Equity

Capital

Page 68 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Organization Activity Activity description

North American Securities

Administrators

Association (NASAA)

Coordinated Review

Programs

The two registration and review programs are Coordinated Equity Review

(CER) and Regional Review. The CER program provides for a coordinated

state review process for offerings of equity securities registered with SEC.

Thirty-eight states participate in the program. The Regional Review program

provides for a coordinated regional state review process for offerings in certain

regions of the country. State registrations under this program use the Small

Company Offering Registration form, which is a simplified question-andanswer-offering document that is provided to investors. Thirty-six states

located in 5 regions participate in the program. The participating states in both

programs coordinate with each other to produce one comment letter to an

issuer that addresses both merit and disclosure matters.a These programs

came into existence only a few years ago and are intended to create

uniformity in and expedite the registration and review process and thus save

small business issuers time and money.

Model Accredited

Investor Exemption

(MAIE)

Approved by NASAA in 1997, the MAIE exempts offers and sales of securities

from state registration requirements if the securities are sold only to persons

who are accredited investors. MAIE is based on the premise that accredited

investors, defined by SEC as wealthy individuals or institutional investors, are

capable of undertaking their own due diligence and gauging the risks involved

before making an investment.

Model Internet

Exemption

Adopted in 1996, the model rule exempts offers and sales of securities over

the Internet from state registration requirements if certain conditions are met.

a

Merit (or Substantive) review is a review of issuers and their securities offerings to prevent promotion

of fraudulent or inequitable issues. According to NASAA officials, merit review of securities offerings

generally addresses (1) disparity in the price paid by promoters for their shares and the price paid by

the public investors, (2) whether the issuer has provided for an impound of proceeds in a best efforts

offering until sufficient funds have been raised to implement a bare bones business plan, and (3) the

terms of material transactions affiliates have entered into with the company. NASAA officials told us

that the purpose of merit review is to align the interest of the issuer with those of the investing public.

According to NASAA officials, about 27 states follow the merit review approach to registration review

of securities offerings. Disclosure review is a review of securities offerings to ensure that adequate

disclosure of all material information is made to potential investors.

Source: GAO review of agencies’ Web sites and interviews of agency officials.
Appendix V

Comments From the National Venture Capital

Association

Page 69 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Appendix V

Comments From the National Venture Capital Association

Page 70 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Appendix VI

Comments From the Small Business

Administration’s Office of Advocacy

Page 71 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Appendix VI

Comments From the Small Business Administration’s Office of Advocacy

Page 72 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
Appendix VII

GAO Contacts and Staff Acknowledgments

Page 73 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Richard J. Hillman, (202) 512-8678

William B. Shear, (202) 512-8678

In addition to those named above, Joe E. Hunter, Sindy R. Udell, Desiree

W. Whipple, Janet Fong, Gerhard Brostrom, Jerry T. Sandau, Carl M.

Ramirez, Elizabeth A. Olivarez, May M. Lee, and Christopher C. Henderson

made key contributions to this report.

GAO Contacts

Acknowledgments
Glossary

Page 74 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

As defined in rule 501 of Regulation D, an accredited investor means any

person who comes within any of the following categories, or who the

issuer reasonably believes comes within the following categories at the

time of the sale of securities to that person: a bank, insurance company,

registered investment company, business development company, or small

business investment company; an employee benefit plan; a charitable

organization, corporation, or partnership with assets exceeding $5 million;

a director, executive officer, or general partner of the company selling the

securities; a business in which all of the equity owners are accredited

investors; a natural person with a net worth of at least $1 million; a natural

person with income exceeding $200,000 in each of the 2 most recent years

or joint income with a spouse exceeding $300,000 for those years and a

reasonable expectation of the same income level in the current year; or a

trust with assets of at least $5 million not formed to acquire the securities

offered, and whose purchases are directed by a sophisticated person.

A business angel investor is a high net worth individual with an interest

and knowledge in a particular business sector, often because that is where

he or she gained personal wealth. Business angels can help a start-up

company with their considerable experience. They can also cause

considerable harm if they are naïve about the needs of the business. An

angel will frequently become an active advisor to the company and often

take a seat on the board.

Each state has statutory laws governing the distribution and sale of

securities. These state statutes, which vary widely in their terms and

scope, are commonly referred to as blue-sky laws, an appellation with

several suggested origins.

Financing that is usually provided by private investors or venture capital

firms to a company that is expecting to go public usually within 6 months

to 1 year or is initiating its next stage of financing. It is often structured so

that it can be repaid from proceeds of a public underwriting.

A direct public offering is the offering of new securities to the public

directly by an issuer without the assistance of an investment banking firm.

Firms that have a substantial risk of failure, because the technology behind

their production method or the logic behind their marketing approach has

yet to be proven. The objective of an early-stage venture is to grow fast

enough so that it will be able to go public or be sold to another company.

Accredited investor

Business angel investor

Blue-sky laws

Bridge financing

Direct public offering

Early-stage venture
Glossary

Page 75 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

Ownership interest in a company or corporation that is represented by the

shares of common or preferred stock held by the investors.

An equity ownership position in the company that is provided to a funding

source, usually a venture capital firm, but also lenders or other investors,

as compensation for providing management consulting, financing, or

miscellaneous services.

A stage of development in which the company has expended its initial

capital and requires funds, often to initiate commercial manufacturing and

sales.

A subsequent investment made by an investor who has made a previous

investment in the company, generally a later-stage investment in

comparison to the initial investment.

The most comprehensive registration statement to be filed with SEC by

companies that do not qualify for any of the abbreviated registration

statement forms. It requires complete registration and transaction

information to be provided in the prospectus.

A relatively small amount of capital provided to an investor or

entrepreneur, usually to prove a concept. It may involve product

development, but rarely involves initial marketing.

A company’s first offering of stock for sale to the public (i.e., going public).

Selling stock to the public is a way for the company to raise money.

An offering of the sale of securities within the borders of a state in which

the company is registered.

An internal rate of return is the discount rate (or interest rate) at which the

present value of the future cash flows of an investment equals the cost of

the investment. Present value is the value today of a future payment, or

stream of payments, discounted at some appropriate interest rate.

An investment banking firm acting as underwriter sells securities from the

issuing corporation to the public. A group of firms may form a syndicate to

pool the risk and ensure successful distribution of the issue. There are two

types of underwriting arrangements—best efforts and firm commitment.

With best efforts, the underwriters agree to purchase only as many new

securities as they can either successfully resell or serve only as brokers

and assist in the search for investors. This arrangement is more common

Equity

Equity stake

First stage

Follow-on/Later stage

Form S-1

Initial seed

Initial public offering

Intra-state offering

Internal rate of return

Investment bank
Glossary

Page 76 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

with speculative securities and with new companies. With a firm

commitment, the underwriters purchase outright the securities being

offered by the issuer.

A fund investment strategy for financing the expansion of a company that

is producing, shipping, and increasing its sales volume.

Firms with a proven technology behind their product and a proven market

for it. Their risk is based on a myriad of uncertainties that affect small

business, including the feasibility of their business concept. They have a

proven technology and a proven market for their product, are growing fast

and generating profits, and need private equity financing to add capacity or

to update their equipment to sustain their fast growth. As with early-stage

ventures, their objective is to grow fast enough that they will ultimately be

able to go public or be sold to another company.

A form of business organization that offers limited liability to the investors

who become limited partners and, in certain cases, also offers tax benefits.

Limited partnerships are often used for certain types of investments, such

as those in research and development and real estate. Limited partners

enjoy limited liability for the debts of the firm and this liability is limited to

the amount of the limited partner’s investment in the business. Limited

partners have no voice in the management of the partnership. They merely

invest money and receive a certain share of the profits. There must be one

or more general partners who manage the business and remain liable for

all of its debts. A limited partnership is organized under state statutes,

usually by filing a certificate and publishing a notice in the newspaper. The

statutes, codified in many states as the Uniform Limited Partnership Law,

must be strictly observed. As in a general partnership, the death,

adjudication of insanity, or bankruptcy of any one of the general partners

dissolves the limited partnership.

An offering of securities that is exempt from federal registration and

limited in distribution to certain types of investors.

A disclosure document prepared to provide potential investors with

detailed information regarding the purchase of securities, including debt or

equity offerings, or limited partnership offerings. As it pertains to a

registered offering, the prospectus is part 1 of the registration statement.

The prospectus must be delivered before the consummation of any sale

pursuant to a registered offering.

Later-stage investment

Later-stage venture

Limited partnership

Private placement

Prospectus
Glossary

Page 77 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

The disclosure document filed with SEC in accordance with the

registration requirements of the federal securities laws. The registration

statement is divided in two parts. The first part is the prospectus, which

describes the business and how the proceeds of the offering will be used

and includes some background on the principal executives, audited

financial statements, and other pertinent data. The second part consists of

additional information that is not sent out in the prospectus but is

available in the SEC files for inspection.

Shares of a company’s stock generally obtained in a private placement that

cannot be sold to the public without registration of the shares or an

applicable exemption.

A second stage of development in which working capital is provided for

the initial expansion of a company that is producing and shipping and has

growing accounts receivable and inventories. Although the company has

clearly made progress, it may not yet be showing a profit.

An act passed by Congress, which has been amended, that has two

objectives to (1) require that investors receive financial and other

significant information concerning securities being offered for public sale

and (2) prohibit deceit, misrepresentations, and other fraud in the sale of

securities.

The U.S. governmental agency that regulates the securities industry and

that is responsible for the administration of U.S. securities laws, including

the 1933 Act and the 1934 Act. The primary mission of SEC is to protect

investors and maintain the integrity of the securities markets.

An act passed by Congress, which has been amended, that empowers the

SEC with broad authority over all aspects of the securities industry. This

includes the power to register, regulate, and oversee brokerage firms,

transfer agents, and clearing agencies as well as the nation’s securities self

regulatory organizations. The act also identifies and prohibits certain types

of conduct in the markets and provides SEC with disciplinary powers over

regulated entities and persons associated with them and empowers SEC to

require periodic reporting of information by companies with publicly

traded securities.

Companies at the seed stage have not yet fully established commercial

operations, and may involve continued research and product development.

Registration statement

Restricted shares

Second stage

Securities Act of 1933

Securities and Exchange

Commission

Securities and Exchange Act of

1934

Seed stage
Glossary

Page 78 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation

A small business issuer is a company incorporated in the United States or

Canada that had less than $25 million in revenues in its last fiscal year, and

whose outstanding publicly held stock is worth no more than $25 million.

The stage of business development in which funding is provided for the

major growth of a company whose sales volume is increasing and that is

beginning to break even or turn profitable. These funds are typically for

plant expansion, marketing, working capital, or development of an

improved product.

An underwriter is a brokerage firm, securities dealer, or investment

banking firm that sells company securities to investors, other brokerage

firms, securities dealers, and investment banking firms. The selling of

securities can occur either through a private placement offering or public

offering.

Venture capital is money invested or available for investment at

considerable risk of loss in small businesses with exceptional growth

potential and potential of high return on investments. Managerial and

technical expertise are often also provided.

Venture capital firms are venture capital and private equity firms organized

into a limited partnership which pools capital for the purpose of investing

in companies that represent an opportunity for a high rate of return within

5 to 7 years. Venture capital firms foster growth in companies through

their involvement in the management, strategic marketing, and planning of

their portfolio companies.

Small business issuer

Third stage

Underwriter

Venture capital

Venture capital firm
Page 79 GAO/GGD-00-190 Efforts to Facilitate Equity Capital Formation
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