Private markets have contributed significantly to capital formation in the U.S. economy, particularly for small companies that are often considered the engine for creating new jobs and for accelerating economic growth (see, e.g., Zhao, Harris, and Lam, 2019). The amount of capital raised in private markets has, in fact, outpaced that raised in public markets during recent years. In 2017, for example, $2.4 trillion was raised in U.S. private markets and $2.1 trillion raised in public ones. Almost 70 percent of the former amount came from private placements: sales of unregistered securities in private offerings, mostly to accredited investors.
On April 5, 2012, the U.S. adopted the Jumpstart Our Business Startups (JOBS) Act, which allows startups to raise capital from a broader investor pool. Under Title II of the JOBS Act, which became effective September 23, 2013, small businesses can advertise and sell securities in private placements via general solicitations, such as advertising in the newspaper and on the internet, as long as the sales are only to accredited investors, verified using a reasonable process.
Specifically, a firm that needs to raise capital can offer and sell securities without registering the offering with the Securities and Exchange Commission (SEC) under rule 506 of a Regulation D exemption. Under Title II, this exemption provides two ways to structure securities offerings: the newly created rule 506(c) and rule 506(b). Rule 506(c) allows issuers to contact investors through advertising, internet or social media but requires issuers to ensure that the buyers are accredited investors, using an elaborate verification process. An offering under rule 506(b) cannot use general solicitation or advertising to market the securities, but investors can self-certify that they are accredited simply by checking a box on an issuer-provided questionnaire. Moreover, rule 506(b) allows issuers to sell to 35 or fewer unaccredited (but financially sophisticated) investors, while rule 506(c) does not allow sales to any unaccredited investors.
Numerous stories in the business media suggest that brokers’ questionable practices and high commissions place burdens on issuers and regulators. As private placements boom, many problematic brokers sell billions of dollars of these investments annually and often target seniors. In response, regulators have increased their scrutiny of this market. While the market for private placements has grown in size and importance, its full extent and functioning and the role of financial intermediaries in this market have not been systematically investigated. To our knowledge, our large-scale study is the first to analyze these issues for small firms. This topic is also of interest to investors, entrepreneurs seeking capital, registered brokers and dealers who serve as intermediaries for these offerings, and policymakers.
Using a comprehensive set of private placements, our paper investigates the impact of the JOBS Act on firm financing. The analysis yields three sets of results. First, we identify the characteristics of firms that choose general solicitation, i.e., 506(c) offerings. We find that firms that choose these offerings tend to have lower revenue and fewer existing investors. They make offerings of longer duration, open for more than a year, on average. These offerings are more likely to involve debt instead of equity or option-type securities. Moreover, these offerings are typically not the first that a company sells via Regulation D.
Second, we find that payments made to brokers increased dramatically after the JOBS Act. Firms tend to have fewer zero fee filings and substantially larger brokerage fees, consisting of sales commissions and finders’ fees. The brokerage fees after the adoption of the law are substantially larger for 506(c) offerings than for 506(b) offerings. These findings suggest that general solicitation increases payments to financial intermediaries, likely to cover the cost of verifying accredited investors.
Third, we find that firms issuing under rule 506(c) have a 6.3 percent lower funding success rate than those issuing under rule 506(b). Moreover, offerings under 506(c) raise less capital than those under 506(b). These findings conflict with the intent of rule 506(c), which was to allow small businesses to raise more capital by allowing entrepreneurs to solicit from a wider investor pool.
We study small firms’ decision to raise funds by general advertising and the consequences of this decision and study the fundraising mechanism such as fee allocation to financial intermediaries. If the JOBS Act Title II is successful, then we would expect a new set of issuers to take advantage of this new 506(c) exemption to raise capital in private placements. These new issuers may differ from issuers claiming the 506(b) exemption and from issuers raising capital before the JOBS Act. That can create a challenge for empirically testing whether the act broadened access to capital to a new set of firms that could not access this market earlier because of the lack of a counterfactual. This would be especially problematic if there were unobservable characteristics of the firm, issue, or project that are related both to the likelihood of claiming the 506(c) exemption and the likelihood of financing success.
While selection concerns are generally difficult to eliminate completely, we try to reduce them by using two approaches. First, in our baseline tests, we control for a number of measures of firm quality such as firm age, revenue, the number of current investors, offering duration, and the type of security offered. We also include fixed effects for industry, state of firm location, and year. Second, we separately analyze the subsample of firms that raise capital under both exemptions in the same year and include firm fixed effects in these regressions to differentiate project-specific effects within a given firm and to remove any time-invariant firm characteristics that might affect both the choice of 506(c) offering and the success rate of financing. We find that 506(c) offerings have a lower success rate for a given firm, controlling for selection effects and time-invariant firm characteristics. We also find consistent results that securities offered under 506(c) raise less capital.
This is the first study to analyze the effects of Title II of the JOBS Act. Bauguess, Gullapalli, and Ivanov (2018) show overall statistics of private placements. We extend that study by employing systematic and multivariate approaches to identify the effectiveness of Title II of the JOBS Act. Our paper contributes to the literature on entrepreneurial finance (e.g., Agrawal, Catalini, and Goldfarb, 2015; Dambra, Field, and Gustafson, 2015), crowdfunding (e.g., Estrin, Gozman, and Khavul, 2018; Hellmann, and Thiele, 2015; Mochkabadi, Kazem, and Volkmann, 2018), and private placements (e.g., Chakraborty, and Gantchev, 2013).
Our findings cast doubt on the notion that Title II provides greater access to capital markets for small firms that lack prior connections to investors. The paper also points to possible reasons why small businesses still prefer to raise capital through the traditional 506(b) offering, without advertising. This is because Title II places heavy restrictions on who can purchase the securities offered, and brokers charge substantial fees for verifying that investors are accredited. Our results imply the need to craft policies that induce better ways of signaling firm quality or more transparent approaches to reducing information asymmetry.
Agrawal, A., Catalini, C., & Goldfarb, A. (2015). Crowdfunding: Geography, social networks, and the timing of investment decisions. Journal of Economics & Management Strategy 24(2), 253-274.
Bauguess S., R. Gullapalli, & V. Ivanov. 2018. Capital raising in the U.S.: An analysis of the market for unregistered securities offerings 2009‐2017. White Paper, U.S. Securities and Exchange Commission.
Chakraborty, I., & Gantchev, N. (2013). Does shareholder coordination matter? Evidence from private placements. Journal of Financial Economics 108(1), 213-230.
Dambra, M., Field, L. C., & Gustafson, M. T. (2015). The JOBS Act and IPO volume: Evidence that disclosure costs affect the IPO decision. Journal of Financial Economics 116(1), 121-143.
Estrin, S., Gozman, D., & Khavul, S. (2018). The evolution and adoption of equity crowdfunding: entrepreneur and investor entry into a new market. Small Business Economics 51(2), 425-439.
Hellmann, T., & Thiele, V. (2015). Friends or foes? The interrelationship between angel and venture capital markets. Journal of Financial Economics 115(3), 639-653.
Mochkabadi, Kazem, & Christine K. Volkmann. (2018). Equity crowdfunding: a systematic review of the literature. Small Business Economics 54(1), 1-44.
Zhao, Y., Harris, P. & Lam, W. (2019). Crowdfunding industry-History, development, policies, and potential issues. Journal of Public Affairs 19(1), 1921-1930.
 See Eaglesham, J. & Jones, C., The fuel powering corporate America: $2.4 trillion in private fundraising, Wall Street Journal, April 2, 2018.
 Before Title II, rule 506(b) was called rule 506.
 A financially sophisticated investor is one who, alone or with a representative, has the knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment. Investors can self-certify that they are sophisticated simply by checking a box on an issuer-provided questionnaire.
 See Eaglesham, J. & Jones, C., A private-market deal gone bad: Sketchy brokers bilked seniors and a cosmetologist, Wall Street Journal, May 7, 2018.
 Over 1,200 brokerage firms sold approximately $710 billion in private placements in 2017, a nearly threefold increase from 2009. See Eaglesham, J. & Jones, C., Firms with troubled brokers are often behind sales of private stakes, Wall Street Journal, June 24, 2018.
This post comes to us from professors Anup Agrawal at the University of Alabama’s Culverhouse College of Business and Yuree Lim at the University of Wisconsin-La Crosse’s College of Business Administration. It is based on their recent paper, “Does Advertising Improve Access to Capital for Small Businesses? Evidence from the JOBS Act,” available here.