Small Business: Efforts to Facilitate Equity Capital Formation (Letter
Report, 09/29/2000, GAO/GGD-00-190).

Pursuant to a congressional request, GAO provided information on the
U.S. small businesses' access to equity capital financing, focusing on:
(1) the major sources of external equity capital for U.S. small
businesses and the Small Business Administration's (SBA) Office of
Advocacy (OA) estimate of its perceived needs for equity capital
financing; (2) trends for the period of 1994-1999 in small business
equity capital financing; (3) how market practices and securities law
regulations for equity capital-raising activities could affect small
business; and (4) any efforts undertaken by federal and state agencies
to facilitate small businesses' access to equity capital.

GAO noted that: (1) markets that provide equity capital financing to
U.S. small businesses include informal, unregulated markets and
regulated securities markets; (2) the primary providers of private
equity capital in informal, unregulated markets are "business angel"
investors and venture capital funds; (3) small businesses that raise
equity capital in regulated securities markets do so through private
placement of securities and public offering of securities; (4) in 1996,
SBA-OA sponsored a study to estimate the need of small businesses for
equity capital; (5) from the results of this study, SBA-OA estimated
that about 10 percent of the businesses started in a year would need
equity capital, as well as about 25 percent of faster growing small
businesses; (6) available data are insufficient for updating the
estimate of small businesses' equity capital needs, but indicate for the
1994-1999 period that the level of small business equity financing
increased dramatically; (7) 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; (8) in the 1994-1999
period, high-tech companies had the widest use of venture capital,
initial public offering (IPO), and private placement financing; (9)
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; (10) the results of GAO's analysis of IPO offerings
indicate that the average total cost to conduct a small business IPO
during 1994-1999 was bout 10 percent of total offering proceeds, while
the average total cost for a large business IPO was about 8 percent; and
(11) 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.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-00-190
     TITLE:  Small Business: Efforts to Facilitate Equity Capital
	     Formation
      DATE:  09/29/2000
   SUBJECT:  Small business
	     Capital
	     Economic growth
	     Small business assistance
	     Securities regulation

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GAO/GGD-00-190

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

B- 283890 Page 2 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

ï¿½ “business angel” investors- wealthy individuals who provide
private equity financing to early- stage, high- growth small businesses and

ï¿½ 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

ï¿½ Private placement of securities- an offering of securities exempt from
federal registration, which is limited in distribution to certain types of
investors.

ï¿½ 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.

B- 283890 Page 3 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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.

B- 283890 Page 4 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

B- 283890 Page 5 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

B- 283890 Page 6 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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.

B- 283890 Page 7 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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).

B- 283890 Page 8 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

B- 283890 Page 9 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

Financing sources Capital needed Stages 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

B- 283890 Page 10 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

ï¿½ invest their own funds in small businesses;

ï¿½ provide incremental financing to small businesses on the basis of the
business' achievement of specific financial and nonfinancial milestones;

ï¿½ typically provide early- stage funds, which may range from $25,000 to
several million dollars per deal;

ï¿½ generally seek high- growth, high- return investment opportunities,
although some invest more for social good, with high returns being of
secondary importance;

ï¿½ 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;

ï¿½ advise and may manage the firm or be passive investors; and

ï¿½ 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

ï¿½ invest the money of others, including pension funds, university
endowments, insurance companies, and wealthy investors;

ï¿½ provide incremental financing to small businesses on the basis of the
business' achievement of specific financial and nonfinancial milestones;

ï¿½ tend to fund high- growth, high- return deals at later stages and in
larger amounts than business angels;

ï¿½ take about 20 to 40 percent ownership of a firm, depending on the amount
of capital provided and their valuation of the firm;

ï¿½ 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

B- 283890 Page 11 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

ï¿½ advise and manage the firm by taking seats on the firm's Board of
Directors; and

ï¿½ 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

ï¿½ provide equity financing in amounts of $250,000 to $5 million and
management assistance to a wide variety of companies and

ï¿½ 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

10 In 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

B- 283890 Page 12 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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

ï¿½ an IPO- a private business' first offering and sale of securities to the
general public (i. e., going public) or

ï¿½ 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

B- 283890 Page 13 GAO/ GGD- 00- 190 Efforts to Facilitate Equity Capital
Formation

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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Formation

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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Formation

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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Formation

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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Formation

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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Formation

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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Formation

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.

11 By 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. 12 Growing 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

ï¿½ a marketable business idea with widespread appeal;

ï¿½ an estimated minimum annual internal rate of return 13 in the range of 30
to 50 percent;

ï¿½ an experienced management team; and

ï¿½ 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 plans 14 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

13 Internal 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.

14 A 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.

15 According 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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Formation

diligence 16 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

ï¿½ incremental financing from the venture capital fund on the basis of the
business' achievement of specific financial and nonfinancial milestones;

ï¿½ the business' adoption of incentive- related compensation schemes, such as
smaller cash salaries, which are offset by issuance of stock options;

ï¿½ involvement of venture capitalists in a wide range of the business'
activities; and

ï¿½ 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,

16 Due 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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Formation

ï¿½ annual revenues of $20 million,

ï¿½ net income of $1 million, and

ï¿½ 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.

17 Economies 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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Formation

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 category a 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 commission 19 of about 6 to

18 The average cost is for businesses where the size was known. 19 The
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

ï¿½ an expense allowance to cover the underwriter's legal, due diligence,
travel, and other expenses;

ï¿½ warrants to purchase stock in the business for the underwriter's own
account;

ï¿½ right of first refusal on subsequent offerings; and

ï¿½ 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.

20 The 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.

21 As 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 investors a and 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 met b Yes Yes Disclosure documents

required to be delivered to investors

Under state law requirements pursuant to certain conditions b

Yes Yes Restrictions on general

solicitation and advertising for investors

Yes, unless certain conditions are met b Yes Yes

Subject to federal and state antifraud provisions Yes Yes Yes Preexisting
relationship requirement

Yes, unless certain conditions are met b 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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Formation

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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Formation

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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Formation 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

22 Regional 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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Formation

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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Formation

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,

ï¿½ the issuer files a registration application in the states in which it
intends to sell securities and requests a coordinated review;

ï¿½ 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;

ï¿½ the issuer responds and the response is communicated to the designated
lead state; and

ï¿½ 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

23 Participating 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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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

24 Eight 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.

25 An 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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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

B- 283890 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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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

B- 283890 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

46 Appendix II 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

67 Appendix IV 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 71 Appendix VI Comments From the Small Business Administration's Office
of Advocacy

73 Appendix VII GAO Contacts and Staff Acknowledgments

74 Glossary 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 offering 1 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 filing 1 with 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 ï¿½ of 1% of maximum AOP, $200

minimum , $1,000 maximum for small company offering

ï¿½ 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 12month
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 solicitation 3 and advertising to market
the securities and (2) purchasers can resell their securities, if the
following conditions are met:

ï¿½ 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;

ï¿½ 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

ï¿½ 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
investors 5 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).

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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

Appendix III Federal and State Agencies Have Taken Some Actions to Help
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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 investors 11 with an offering

10 Section 4( 6) of the Securities Act. 11 The 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

12 Section 3( a)( 11) of the Securities Act; 17 C. F. R. 230. 147 (1999). 13
Under 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 Federal and State Agencies Have Taken Some Actions to Help
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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.

NSMIA 14 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

14 Securities Act 18( a)( 3), 15 U. S. C. 77r( a)( 3). 15 Section 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 investors 16 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

16 Although 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- and answer- 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 naï¿½ve 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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