From Advising the Small Business
- Learn what you need to be aware of.
- Discover what an accredited investor is.
- Find out what to do if your client violates the law.
Which Laws Should a Small Business Be Aware of When Raising Money?
Even when a client already has a group of friends and family lined up for a seed round of financing, they need to be aware of their securities law obligations because there are a number of legal issues and requirements to be concerned about. The applicable requirements will be determined in part by the number of investors, which state (or states) they are in, and whether they are all “accredited investors.”
Whenever a company raises funds by selling common stock, membership interests, limited partnerships, convertible debentures, or some other form of equity, it is selling securities and must comply with applicable securities laws. This basic rule applies regardless of the consideration received—services, cash, notes, or other property such as stock in another company. Generally, whenever an “issuer” (i.e., the company selling its equity) wishes to sell any securities, it must register those securities with the Securities and Exchange Commission (SEC) and appropriate state regulators, unless one of the many exemptions from registration applies to the proposed sale. For offerings that qualify for an exemption from registration, rules must be observed governing the way in which the offering is conducted, the filing of notices, payment of fees, consents to service, and in some cases submission of offering documents.
Companies often rely on the so-called private placement exemptions from the securities registration requirements. Typically, an issuer can sell stock to any number of accredited investors and to a limited number of investors who don’t meet the accredited investor standard in a private (i.e., nonpublic) offering. Reasonable disclosure about the business must always be made to prospective investors; and if the company is selling stock to investors who are not accredited, specific written information about the business must be provided. When a company relies on these exemptions, it will be required to make certain notice filings with the Securities and Exchange Commission (SEC) and with state securities regulators in states in which offers or sales are made. Failure to comply with the securities laws can subject a company or its principals to investors’ claims for their money back (“rescission” claims) and other penalties.
Whenever a company is dealing with securities law issues, a lawyer should be consulted. Problems with early stage fund-raising may subject the company to rescission claims and could dissuade venture capitalists, institutional investors, and fund-raisers from working with the company later.
Rule 506 of Regulation D is a “safe harbor” for the private offering exemption, assuring issuers that they are within the Section 4(2) exemption if they satisfy the standards within the rule. The criteria for reliance upon the Rule 506 exemption from registration are that the offering be made without any means of “general solicitation”; that the offering be made to no more than thirty-five persons who are not “accredited investors”; that each nonaccredited investor be financially sophisticated (that is, has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the investment); and that if the offering is made to any nonaccredited investors, the same detailed disclosures required in comparable public offerings be made to them.
Blue-sky compliance (meaning the securities law compliance in each state where the securities are offered or sold) for Rule 506 offerings was simplified by the National Securities Markets Improvement Act of 1996 (NSMIA), Section 18(b)(4)(D) of the Securities Act of 1933, which preempts a state’s registration requirements with respect to securities being offered and sold under Rule 506 of Regulation D. States are permitted only to (i) require a notice filing from the issuer, (ii) impose a filing fee, and (iii) require the issuer to consent to service of process in the state. In accordance with NSMIA, each state generally requires an issuer that offers and sells securities in its state pursuant to Rule 506 to submit the following materials within fifteen days after the first sale of securities in that state in order to qualify for an exemption from registration: (a) an executed copy of Form D Notice of Sale of Securities, (b) an executed copy of Form U-2 Uniform Consent to Service of Process, and (c) a filing fee. A Form D must also be filed with the SEC.
The Securities Lawyer’s Deskbook, a website maintained by University of Cincinnati College of Law, is a great resource for accessing the federal securities laws (at http://www.law.uc.edu/CCL/index.html). The Securities and Exchange Commission website is also a great resource at http://www.sec.gov.
What Is an Accredited Investor?
Regulation D, Rule 501, of the Securities Act of 1933 defines an “Accredited Investor” as any person who falls within any of the following categories, or who an issuer (the company selling securities) reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:
1. Any bank as defined in Section 3(a)(2) of the act, or any savings and loan association or other institution as defined in Section 3(a)(5)(A) of the act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934; any insurance company as defined in Section 2(a)(13) of the act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in Section 2(a)(48) of that act; any small business investment company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in Section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
2. Any private business development company as defined in Section 202(a)(22) of the Investment Advisers Act of 1940;
3. Any organization described in Section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts, or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;
6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and 8. Any entity in which all of the equity owners are accredited investors.
Does It Matter Where the Investors Reside?
The state or country of residence of each investor dictates which securities laws govern the offering. For example, an offering solely to investors residing in a single state is exempt from federal regulation, whereas an offering to investors in several states is governed by federal law and by the laws of each state in which an investor resides.
As discussed more fully in the sample blue-sky memorandum (included as Form 10 D in section 10.11), in accordance with NSMIA, each state generally requires an issuer that offers and sells securities in the state pursuant to Rule 506 to file the following materials in order to qualify for an exemption from registration: (i) an executed copy of Form D; (ii) an executed copy of Form U-2, uniform consent to service of process; and (iii) pay a filing fee at the time of filing. These materials, in addition to supplemental materials required by Alabama, Connecticut, Louisiana, Massachusetts, New Hampshire, and Tennessee, generally must be filed with each state within fifteen days after the first sale of securities in that state. However, New York requires filings before an offering, Florida requires the delivery of disclosure information to an investor before a sale, and Louisiana and Oklahoma require filings before, or within a prescribed time period of, the receipt of money or a subscription agreement from an investor.
New York and Florida have different filing requirements for offerings under Rule 506. New York requires a notification filing on its own Form 99 in addition to the filing of a federal Form D. Florida requires an issuer to register as a “dealer” in addition to making a notice filing pursuant to NSMIA because the securities laws of Florida include an issuer of securities in its definition of a “dealer.” Therefore, to avoid having the principals of an issuer register as dealers in the State of Florida, the issuer should conduct its offering of securities in Florida pursuant to Florida’s limited offering exemption. The eligibility and disclosure requirements of this exemption are set forth in Form 10 A, Outline for Private Placement Memorandum. The issuer’s private placement memorandum (or PPM), if one has been prepared, should contain the information required to be disclosed to the Florida investors under this exemption. Note, however, that the private placement memorandum is required to contain the legend set forth in Form 10 A, and the purchasers in Florida must also be provided with an unaudited balance sheet and statement of profit and loss of the issuer as of a date not earlier than the end of the issuer’s last fiscal year. This exemption is self-executing and, provided requirements of Florida’s limited offering exemption are met, no filing is required to be made with the Florida Division of Securities.
The specific requirements of each state in which your client intends to make offers and/or sales of securities should be checked prior to commencement of the offering. The Internet has made this task much less time consuming and expensive than it once was. While the information contained in the Blue-Sky Law Requirements and Rule 506 of Regulation D (Form 10 D) at the end of this chapter is believed to be accurate, more current and complete information is typically available on each state’s securities division website, and should be reviewed for updates and best practices before any offering is accepted. For example, the Colorado Securities Act contains three registration exemptions that are often used with private offerings: Section 11-51-308(1)(i), Section 11-51-308(1)(j), and Section 11-51-308(1)(p):
• Section 11-51-308(1)(i) has no Colorado filing requirement and may be used by issuers who are relying on Section 4(2) under the Securities Act of 1933, but usually not Regulation D; and commissions may not be paid to anyone other than a licensed broker-dealer.
• Section 11-51-308(1)(j) has no Colorado filing requirement and may be used by issuers who are making offers to no more than 20 persons in Colorado and selling to no more than 10 purchasers in this state, but commissions may not be paid to anyone other than a licensed broker-dealer and the issuer must reasonably believe that the investors are purchasing for investment only.
• Section 11-51-308(1)(p), outlined in Form 10 D (Blue-Sky Law Requirements and Rule 506 of Regulation D), is a safe-harbor type of exemption and does not have offeree/investor numbers limitations. Other than Regulation A offerings, these securities are restricted from resale by federal law and are purchased for investment purposes only. Commissions may not be paid to anyone other than a licensed broker-dealer. Section 11-51-308(1)(p) requires the issuer to submit a fee of $75 made out to the “Colorado State Treasurer” along with one copy of whatever documents are submitted to the SEC (usually the Form D). A Consent to Service of Process and a cover letter with a brief description of the applicable state and federal citations and a contact person for the filing should be included. The filing should be submitted concurrently at the time of the federal filing, no later than fifteen days after the first Colorado sale. Submit this filing to Colorado Division of Securities, 1560 Broadway, Suite 900, Denver, CO 80202. See the Colorado Division of Securities website at http://www.dora.state.co.us/securities/privoff.htm.
Under the federal regulatory regime, pursuant to Rule 503 of Regulation D, an issuer will be required to file with the Securities and Exchange Commission a federal Form D within fifteen days after the first sale of security.
Copies of the forms and notices discussed in this chapter are available online at the Internet addresses listed here.
State Notice/ Further State Notice: http://www.dos.state.ny.us/corp/miscfae.html
What If Investors Provide Goods and Services Rather Than Cash?
A fact that is sometimes hard for clients to accept is that if they issue securities in exchange for goods and services, it is a “sale”—the same as if it had received cash. In such cases, the securities laws apply.
Is It Okay to Put Fund-Raising Information on a Website?
No general solicitation is permitted in connection with a private offering of securities, thus the designation of the offering as “private.” Don’t let your client put fund-raising information on its website, or it will likely be deemed to have made a general solicitation in connection with its sale of securities.
A problem that often arises in meeting the criteria of the Rule 506 safe harbor is that either the company’s officers and directors or the selling agent inadvertently engages in an act that is deemed to constitute a general solicitation, or at least cannot be affirmatively shown not to involve a general solicitation (the burden of proof being upon the person seeking to rely upon the exemption). Often the problem arises indirectly, and the company’s management or the soliciting agent are not aware of the issue until it is too late.
A typical action that raises a general solicitation issue is a mass mailing to potential investors, even if the mailing is confined to accredited investors. To preclude these issues from arising, the company’s management and the selling agent should review carefully in advance the strategies for solicitation of investors in the offering. Form letters, particularly to strangers, should be avoided, as should mailings with similar contents to a large number of persons. An appropriate procedure is to forward the offering materials or an executive summary to persons with whom management or the selling agent has an existing, established relationship (such as, for example, an existing securities customer of the selling agent) to determine if the recipient has any interest in the offering. The contact should be direct and personal, not general and to a number of persons, and particularly not to a number of strangers. A mass mailing by a selling agent in an attempt to solicit for itself, through advertising, newsletter, or otherwise, new accredited customers (especially strangers) can be deemed a general solicitation if the company’s offering is then in progress—unless steps are taken to preclude any person so solicited from becoming an investor in that pending offering.
One common occurrence that creates general solicitation issues is the appearance of a company’s management before a meeting of an investment forum consisting of potential investors, even if confined to accredited investors. The nature of these gatherings and how they are assembled will determine whether they are deemed to involve a general solicitation. Some of these groups have sought and obtained no-action letters from the Securities and Exchange Commission assuring that the Commission will not take any administrative action if their methods of operation are confined to certain stated circumstances. Companies that desire to appear before such groups should inquire before appearing as to whether the group has obtained such a no-action or interpretive letter and whether the circumstances recited in these letters are being observed. Otherwise, the ability to proceed with funding may be impaired or precluded.
Another common occurrence that creates general solicitation issues is media coverage at or near the time of the offering. If the company becomes the object of media reporting, even if not sought out by the company, a general solicitation may be deemed to be involved. Particularly problematic are news reports or articles that mention the company’s possible financial success or the fact that it is or may be seeking financing. Unless the company is then actually engaged in product or service marketing efforts, reports by the media should generally be avoided. If product or service marketing efforts are then actually in progress, media coverage should be confined to information concerning the company’s products or services, and then only to the extent that it might be of interest to potential customers.
It goes without saying that no solicitation of investors should be entered into directly or indirectly by any form of paid advertising, whether in newspapers or on radio or television. Such activity is usually inconsistent with the concept of a “private” offering and in any event is expressly prohibited by Regulation D.
The foregoing are examples of typical ways in which a “general solicitation” issue can arise. There are many other possibilities, of course. It is thus important for those persons involved in a private offering to be alert to the general solicitation prohibition and the ways that it may be violated, and to ask securities counsel for guidance when doubts arise before irreversible action has been taken.
What Is Restricted Stock?
Restricted stock is stock that is held outright, but subject to a right of repurchase as to unvested portions, or subject to other restrictions or limitations. The term “restricted stock” is also used to refer to shares sold in private placements and subject to securities law restrictions on resale. Restricted stock may be preferable over nonqualified stock options to the recipient because, if the recipient makes an election under Internal Revenue Code (IRC) Section 83(b) upon receiving the stock, any appreciation in the value of the stock after receipt is taxable at long-term capital gain rates when the stock is sold if the recipient has held the stock for more than one year. Thus, the tax issues generally associated with options are avoided. Restricted stock also entitles the holder to voting rights, a benefit that may make a key employee feel more involved in the ownership of the company.
What Is a Private Placement Memorandum?
The mandatory disclosures for an offering in which up to thirty-five of the investors are not “accredited” (a Reg. D Rule 506 offering) are typically organized into a private placement memorandum (or PPM).
The disclosure requirements for a PPM are essentially the same as would be required under Part II of Form 1-A for a Reg. A offering, which is available online at http://www.sec.gov/about/forms/form1-a.pdf. Part II of Form 1-A is set forth in a questionnaire/fill-in-the-blank format and can be used to help gather or identify the necessary information to be included in your PPM. This chapter includes a skeleton PPM (Part II of Form 1-A) that can be used to draft a PPM; see Form 10 A.
The financial disclosure requirements depend on the amount being raised, with the minimum level (offerings up to $2 million) being the information required under Item 310 of Reg. S-B—with the exception that only the balance sheet must be audited. The full text of Reg. S-B (and lots of other tantalizing information) is available on the SEC website (http://www.sec.gov).
It is a good idea to have each of the principals of the company complete a questionnaire to identify whether there are any other mandatory disclosure items. A standard Directors’ and Officers’ Questionnaire can be used for that purpose (see Form 10 B).
In early stage offerings—where the company is raising funds through the sale of its securities to a limited number of investors, all of whom are accredited investors and all of whom have some preexisting relationship with the issuer—it is impractical and inefficient to prepare a complete private placement memorandum.
Instead, the company might decide to provide certain abbreviated disclosure materials to the prospective investors in the form of an executive summary, or along with an executive summary or business plan. The company would then document the investment transactions through individual stock purchase agreements or detailed subscription agreements containing extensive investor representations. These include acknowledgments in which subscribers represent and warrant that that they have conducted due diligence, have had the opportunity to ask questions, and have received information from the company to their satisfaction. The company usually will consult with counsel to make a final determination of the appropriate form of these documents and/or whether and to what extent the company should prepare a private placement memorandum.
Before making a final determination about the form of documentation your offering will require, you should consider and decide upon the structure of the proposed offering. In sum, you should begin to assemble the following information to prepare for the private placement.
1. Names, Permanent Residence Addresses, and Economic Status of All Prospective Investors
It is important to anticipate the jurisdictions in which the securities will be offered and sold. The issuer needs to anticipate blue-sky filing requirements in all jurisdictions. Are the prospective investors accredited investors?
2. Proposed Offering Amount/Targeted Aggregate Offering Proceeds
How much will the company seek in the private placement? Will the company pay any commissions or other fees to securities professionals, consultants, or others in connection with the private placement? What expenses, if any, are estimated to be attributed to the private placement? Is the company seeking to raise a minimum amount (before which it will use funds raised from prospective investors), or will it accept and use any and all offering proceeds as soon as they are received?
3. Proposed Statement of Use of Proceeds
How does the company propose using the proceeds to be raised by the private placement? All private placement memoranda and similar disclosure documents contain some statement or analysis of how the company plans to use the proceeds raised in the offering.
Even if the issuer does not prepare and disseminate a complete private placement memorandum, investors may inquire about use of proceeds. This information will also be required for the notices filed with the SEC and state securities regulators.
4. Proposed Structure of the Security to Be Offered
Will the investors receive common stock, nonvoting common stock, preferred stock, or some other form of equity? If preferred stock, what will be the liquidation rights, voting rights, and other rights, preferences, and privileges?
Most venture capital funds and organized angel groups or angel funds expect to receive preferred stock in a private placement offering, which will have a set of fairly standard rights, preferences, and privileges. In larger or later offerings, certain rights or privileges pertaining to the preferred stock placed with an institutional investor or investors may be heavily negotiated by the investors (or a lead investor) and the issuer.
If a new class of security will be created and offered in the private placement, the issuer will need to amend its charter (its articles or certificate of incorporation) to designate the new class of securities. This may require the approval of existing equity security holders.
5. Current and Projected Financial Information
While the issuer is not required to have audited financial statements, it is generally expected that the issuer will have current, internally prepared or externally prepared—but unaudited—financial statements for prospective investors. Financial statements will consist, at a minimum, of a current balance sheet and a statement of income or profit and loss statement. Most issuers will also provide prospective investors with either a private placement memorandum or business plan, executive summary, or other document that includes projected income/loss information.
Can My Client Pay Finder’s Fees?
The idea that “finders” are exempt from the requirement of broker-dealer registration is a common misconception. Companies should be discouraged from paying “finder’s fees” that may be illegal and/or jeopardize their ability to rely on an exemption from registration. Unfortunately, it is rare that a company has sufficient contacts to meet its capital needs without assistance from an intermediary, such as a finder or professional placement agents. The typical compensation arrangement for such an intermediary is to pay a “transaction-based fee” (i.e., a fee based on the amount of capital they successfully identify for the company). However, federal securities law requires that a person “engaged in the business of raising capital” for others must be registered as a broker-dealer and become a member of the National Association of Securities Dealers (NASD). If any intermediary accepts a transaction-based fee more than once, that person or agency may be deemed to be “engaged in the business” and operating illegally, if not appropriately registered. Most state securities laws have similar requirements.
Are There Any Record-Keeping Requirements?
The burden of proving the availability of an exemption from registration is on the company asserting it, and companies selling securities have an affirmative obligation to make full and fair disclosures in connection with any offering of securities. It is therefore wise to prepare and preserve a written record of the offering, during the ordinary course of the offering, to make it admissible as evidence if required.
The following records should be maintained and preserved in connection with a private placement securities offering:
• A list of investors, with addresses, telephone numbers, who they are, and how contact was developed (which cannot be by means of general solicitation)
• A list of persons who received copies of the private placement memorandum, business plan, or other offering materials, and the control number for each copy (which is typically entered on the cover page of the document for identification and tracking)
• Copies of all term sheets, business plans, private placement memoranda, and supplements used in the offering, identified by date
• A file of source materials for factual disclosures in the offering materials
• All original subscription agreements (with representations of investment intent and other information critical to qualification for exemption)
• The agreement engaging the selling agent, if any, and related correspondence
• A certificate signed by the officers of the company to certify that the offering has been terminated, that the records of the offering are accurate and complete, and that there was no general solicitation in connection with the offering
• A certificate signed by the selling agent, if any, stating that the offering has been terminated, that each investor was furnished a copy of the offering materials, and that there was no general solicitation in connection with the offering
• Copies of the certificates for the securities, with appropriate legends. These records should be kept secure for at least the period of the applicable statutes of limitations. It is also a good idea for the company to maintain a D&O policy covering securities law claims for private offerings.
What If Your Client Violates Securities Laws?
If your client violates the securities laws, the company, its officers, directors and principal shareholders, and others involved in selling the securities may be held liable for the full amount raised, plus interest and lawyer’s fees in one or more individual lawsuits or a class action on behalf of all investors. If applicable disclosure requirements are violated (technically “securities fraud”), the liability may not be dischargeable in personal bankruptcy.
Issues regarding securities law compliance are often raised by regulators, often at the instigation of investors or competitors. Such actions can hinder a company’s ability to raise additional capital or to go public in a timely and orderly fashion. Securities law violations will likely preclude a company from obtaining an opinion that an exemption was available for a past offering when such an opinion is required in connection with a subsequent private or public offering. Underwriters may refuse to work with a company with a questionable compliance record until the applicable statutes of limitations have run (typically three years from the last closing).
Proactive measures can be taken if a company violates securities laws; for example, a carefully orchestrated rescission offer can be presented in which all appropriate disclosures are made and all other applicable rules are observed. However, a successful rescission offer is an option only for companies that are capable of returning investor funds to investors who request it.