Strictly Business

This last week, the Senate passed the “JOBS Act,” leaving it one step away from final passage by Congress and Signature by President Obama.  The JOBS Act contains a number of provisions which are aimed at reducing the securities compliance burdens of small companies and startups.  One of the major provisions within the JOBS Act is the so-called “crowdfunding” provision.

Crowdfunding has an enthusiastic following online and within the entrepreneurial community.  Obviously, that following is very excited about the bill’s Senate passage.  Unfortunately, I don’t think they should be popping the champagne corks anytime soon.  Before passing the bill, the Senate passed an amendment to the bill substituting a new version of the crowdfunding law by Senators Merkley, Bennet, and Brown in place of the one written by Rep. Patrick McHenry.  All signs point to the Republican leadership in the House conceding to the Senate’s amendment this week in order to get the bill to the president’s desk for signature as soon as possible.

And I believe the Senate’s amendment kills crowdfunding.  The replacement crowdfunding bill is significantly more complex and fraught with liability for issuers.  While even the McHenry approach had some degree of complexity, the Merkley version makes it look simple and straightforward in comparison.  Here are just a few examples of some of the differences that I think will sink the new crowdfunding law and prevent it from being of any practical use:

• In the new version, the exemption from registration only applies if the aggregate amount sold to any investor by an issuer (that is, ANY issuer) does not exceed certain caps, which vary depending on the investor’s income.  That’s right, if you use the crowdfunding exemption, it may not apply depending on whether your investors have invested in OTHER startups using the exemption — something you have no control over.  Hopefully, the SEC, in regulations, will provide a safe harbor for issuers to make this determination (both as to income and the amounts invested in other crowdfunding offerings), but you can never count on the SEC making anything simple. [Update 4/19/12: see comments below.  One commenter had pointed out that from first blush the limits may not apply in the aggregate.  However, a separate portion of the bill does confirm that the limits apply in the aggregate, but the funding portal will have the obligation to enforce this.  That said, there still may be significant consequences to the issuer if the funding portal fails fulfill their responsibilities.]
• In the new version, the offering can only be made through a registered broker-dealer or a new “funding portal” which also must be registered with the SEC and, apparently FINRA.  In the McHenry version, an issuer could use an unregistered “intermediary” but was not required to.  This additional requirement will greatly increase the costs of conducting a crowdfunding offering.
• The new version requires that the issuer of any crowdfunding offering of over $500,000 have audited financials, again significantly increasing the compliance costs on issuers.  It also prohibits any advertising to promote the offering.
• The Merkley amendment creates a new cause of action against a crowdfunding issuer, and its directors and officers.  Traditionally, in Federal securities fraud suits (at least those involving non-public securities), the plaintiff has to prove that the defendant acted knowingly or recklessly.  In any suit involving a crowdfunded company, the burden of proof will be on the defendants and they will need to prove they didn’t know about any misstatements nor in the exercise of reasonable care could not have known about the misstatements.  Good luck finding competent directors for your crowdfunded company.

In all, the statute that provides for the crowdfunding exemption expanded from 12 pages to 24 after the substitution of the Merkley version.  For a crowdfunding exemption to work, it must be simple.  Small companies cannot afford the significant compliance burdens placed upon them by the crowdfunding exemption that was passed.  Therefore, my prediction is that entrepreneurs will quickly find that the new exemption is too expensive to utilize and is more trouble than it is worth and that it will rarely be used.  As I’ve stated in the past, there are some significant practical obstacles to crowdfunding even with the McHenry bill.  The Senate’s solution certainly didn’t help.   Therefore, I believe the Senate may have just effectively killed crowdfunding.  I may be wrong; the SEC may implement the bill well through regulation and save crowdfunding.  Anyone want to take a bet that this happens?

———————————–

© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Recycling is generally considered a good thing when it comes to trash.  It helps the environment and conserves resources.  However, in the context of legal work, it is not such a good thing.  Of course, when I use the word “recycle,” I don’t mean recycling the paper that the legal documents are on.  I’m talking about recycling the actual words on the page.  When a client “recycles” their lawyer’s work which was performed on a previous deal and uses it in a new deal, the client is asking for trouble.

Let’s look at a hypothetical example: The founder of a startup has some friends and family invest in the seed round of the company, issuing stock to the investors.  He hires a lawyer to draft the documents and offering materials.  The work is done correctly and the offering of stock is completed without a hitch, and rather importantly, carried out in compliance with securities laws.  The lawyer’s bill came in at $5,000 and the founder is not exactly happy about it (it’s just for “paperwork” after all!), but he begrudgingly pays it.

A year later, the company is running out of money and needs to raise more capital, perhaps this time from a few angel investors.  The founder thinks to himself: “I’m in luck, since I have the documents from our last stock offering, I have what I need and I can simply recycle the old documents.  That way I won’t have to pay the bloodsucking (or some other expletive) lawyers to charge me more exorbitant fees for more paperwork.  It’s just changing the date on the form for heaven’s sake.”

So that’s what he does.  He takes the old documents, changes the dates and the names of the investors and takes in the new investment.  Unfortunately for him and the company, the capital raise is not done in compliance with securities law, causing the offering to be considered an unlawful sale of an unregistered security.  In addition, because the disclosure is a year old, certain events from the past year which would be considered material information are omitted, resulting in a potential securities fraud claim against the company and the founder.  Finally, because provisions in a previous buy-sell agreement or subscription agreement relating to rights of first refusal and preemptive rights are not complied with, there is a dispute as to whether the stock was validly issued.

These kinds of defects have real world consequences.  When securities laws are violated, investors essentially have a “put” option against the founder; that is, if the company fails and the stock is worthless, they can sell it back to the founder and go to court to force him to pay them.  In addition, the SEC and state securities regulators can bring an enforcement action against the founder.  The confusion over whether the stock was validly issued could result in expensive litigation for the company at a later stage, as competing groups of shareholders dispute the ownership of the company.  Even if none of these things happen, and the company continues to grow, if the company were to later seek VC or institutional funding or engage in an IPO, the due diligence will reveal the problems.   At this point, the VC fund or underwriter will either (a) force the founder to pay the VC fund’s lawyers (at high NY rates like $1,000 per hour) to painstakingly clean up the violations or (b) pass on the deal altogether.

The above story is hypothetical, but similar real life examples happen all of the time.  A startup may save some money upfront by doing its own legal work, but the costs down the line will usually end up much higher.  Therefore, trying to draft your own legal documents based on prior work by an attorney ends up being penny-wise and pound-foolish.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The U.S. House of Representatives recently passed the Entrepreneur Access to Capital Act (H.R. 2930), which creates an exemption from the registration requirements of the Securities Act of 1933, allowing startups to engage in crowdfunding (i.e. raising capital from a large number of investors over the Internet).  Action is still pending in the U.S. Senate.  While the actual usefulness of this new exemption will depend largely on how the SEC interprets it in implementing regulations, it’s worth thinking ahead about how such an exemption would actually work (assuming of course that the bill passes).  Here are some of my thoughts:

• The bill may (or may not) reduce the amount of legal fees a company would pay for its seed round.  It creates a new type of capital markets participant called an intermediary, which would typically handle the offering for a startup.  The intermediary itself would be subject to considerable regulatory oversight and would also carry a large amount of risk of lawsuits brought under the anti-fraud provisions of securities laws.  Therefore, the intermediary’s need for legal counsel will be considerable (as will the need for some form of E&O insurance).  These costs will be passed along to the startups who use the intermediaries.  Ultimately, it remains to be seen whether the intermediaries will be able to obtain economies of scale for these costs, or whether startups will be better off engaging in the offering themselves.  And of course, even when a startup does use an intermediary, not hiring legal counsel is a risky move, given that the intermediaries will likely try to shift as much of the legal risk to the startup companies as possible through contract.
• With numerous shareholders comes the potential for class action securities lawsuits, derivative claims, requests for books and records inspections, and other actions shareholders can take against management.  These actions are much rarer when a company is funded through a small number of sophisticated investors.
• Having numerous shareholders also increases administrative burdens on a company.  The company will need to administer shareholder voting, transfers of stock, and communications with investors.  For large companies with significant resources, this is not a problem, but for a small startup that raises $1 Million, the administrative costs associated with having many shareholders could start to hurt the company’s bottom line. One possibility is that the intermediaries themselves may step in and provide this service to crowdfunded startups on their electronic platform, permitting them to take advantage of economies of scale.
• We have no way of gauging how VCs will regard the attractiveness of investing in a company that previously used a crowdfunding offering.  Crowdfunding can be used for seed rounds, but eventually, many companies need to turn to VCs or other institutional or sophisticated investors for further funding.  Assessing a startup’s capital structure is an essential part of any sophisticated investor’s due diligence.  When they find that they’ll be investing in a company that has numerous unsophisticated investors as its existing shareholders, they may balk at going ahead with the transaction.
• Finally, we have no idea how undertaking a crowdfunding offering will affect the price of a company’s D&O policy.  A sophisticated investor will usually want some form of board representation, which means they will also want the company to purchase D&O insurance for their board members (if they haven’t already).  D&O insurance providers may regard a company that has used the crowdfunding exemption as a higher risk, and price the premium accordingly.

As you can see, there are some downsides to using crowdfunding as your source of seed capital (as opposed to an angel investor or some other form of accredited investor).  If this bill passes, it will be interesting to see how this plays out.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previous, I summarized the Entrepreneur Access to Capital Act (H.R. 2930), a bill which provides for a crowdfunding exemption to the registration requirements of federal and state securities laws.  The bill was recently passed by the U.S. House of Representatives, and now awaits U.S. Senate action.  In this post, I’ll provide some of my thoughts on what is to come.

Will it pass?

Predicting the future is usually a futile effort, but I do believe that this bill (or something like it) has a good chance of becoming law.  If you had asked me this same question a year ago, or even six months ago, I would have told you that it has no chance.  The political climate over the last few years has favored the tightening of securities laws, not their deregulation, due in no small part to the perceived excesses of the securities industry in the events leading up to the financial crash in 2008.  What I hadn’t counted on was the cumulative effect of three years of high unemployment on the political process.  Politicians are desperate for a solution to reduce unemployment and consequently legislation that promises to reinvigorate the entrepreneurial sector has found rare bipartisan support.  Of course, the Republican gains in the Congress in 2010 helped significantly as well, given that the need for business deregulation is an article of faith within the Republican party.  As a result of these factors, the House passed the bill overwhelmingly in a rare bipartisan vote.  The White House has also signaled that it supports the effort.  The only remaining piece to the puzzle is Senate passage.

The U.S. Senate could choose to take up H.R. 2930 itself, or proceed with its own version, the Democratizing Access to Capital Act of 2011 (S. 1791), which is sponsored by Sen. Scott Brown (R – MA).  S. 1791 is remarkably similar to the House bill.  Given the bipartisan support for the concept, I think it is highly likely that a crowdfunding bill will pass the Senate, though it will likely differ in small or major ways from the House legislation.  These differences will need to be reconciled in conference committee, and then the reconciled bill will need to be passed again by each house.  However, neither political party has drawn a line in the sand about any of the particular differences and most of them are rather technical.  Therefore, there currently aren’t any major impediments to a final bill being passed before the end of 2012.  My prediction, therefore, is that we will see a crowdfunding exemption passed into law by the end of next year.

How will its implementation affect its usefulness?

Assuming the bill passes, it must also be implemented by SEC regulations.  It is crucial to understand that the SEC has significant power to determine how useful a crowdfunding exemption could be.  If the SEC’s regulations make it difficult to use, then no one will use it and the effort will be for naught.  If the SEC issues regulations that are friendlier to issuers, then the exemption could be highly useful.  For instance, here are some open issues that will need to be addressed and could drastically affect the ability of companies to use the exemption effectively:

• How will income be measured?  The bill requires that investors invest no more than the lesser of $10,000 or 10% of their annual income.  It further provides that an issuer or intermediary may rely on a certification of annual income provided by an investor.  This leaves several unanswered questions: (1) How will income be measured?  By the previous calendar year?  By an average of several of the previous calendar years? (2) Will the investor’s spouse’s income be included? (3) Is the limit subject to each of the spouses separately or are the amounts invested by each spouse considered in aggregate towards the limit?  (4) Will the certification ask for any kind of documentation to establish the income of the investor or does the investor merely provide a number which the issuer or intermediary can accept without question?  If so, is it reasonable for an issuer to accept that someone in a low paying field claims he or she makes $150,000 a year?  All of these questions will need to be addressed by SEC regulations, and the more specifically it does so, the more beneficial it is for issuers and intermediaries because bright-line tests remove business uncertainty.
• What will be the permissible activity of intermediaries?  The bill establishes a new category of participant in the capital markets called an “intermediary.” No definition of an “intermediary” is provided in the legislation, but presumably an intermediary would operate a website which administers the crowdfunding offering.  The  bill specifically exempts intermediaries from the broker-dealer registration requirements under the Securities Exchange Act of 1934.  There are a number of unresolved questions: (1) What activities may an intermediary engage in?  Are they simply passive participants, or may they engage in active sales efforts?  (2) How may they be compensated?  Are their fees limited to flat fees to use their platform or can compensation be varied depending on the success of the offering (i.e. a success fee or a fee in proportion to the amount of securities actually sold)? (3) Finally, how will state broker-dealer registration requirements apply?  Will they be required to register as broker-dealers and their employees as broker-dealer agents with the states they operate within?[1]
• Will issuers also be permitted to conduct a simultaneous offering under Rule 506 of Regulation D to accredited investors?  The bill itself says that use of the crowdfunding exemption does not prevent an issuer from raising capital through other methods.  Therefore, a simultaneous Rule 506 offering will not preclude the use of a crowdfunding offering.  Unfortunately, the use of a crowdfunding offering may preclude the use of Rule 506.  Regulation D provides that other offerings conducted near in time to a Regulation D offering are considered part of the Regulation D offering (i.e. they are integrated).  Since a crowdfunding offering would not be in compliance with Rule 506 (because it was conducted via a general solicitation and the securities were offered to non-accredited investors), the Rule 506 exemption relied upon for the offering would be invalidated.  Unless the SEC alters the integration provisions of Regulation D, companies may be unable to conduct an angel financing round near the same time as a crowdfunding offering.
• The bill requires issuers or intermediaries to “take reasonable measures to reduce the risk of fraud.”  It will be up to the SEC to spell out what those reasonable measures are.  The SEC could leave it with a relatively subjective standard, or they could provide a safe harbor which contains a number of measures an issuer or intermediary can take that will assure it that it has complied with this requirement.  A safe harbor would be far more preferable to an open-ended standard, since certainty is required for any securities registration exemption to be truly useful.  The bill also requires that the issuer or intermediary require potential investors to answer questions demonstrating their understanding of the level of risk involved with investing in a startup.  It also requires an intermediary to conduct a background check on the issuer’s principals.  Both of these requirements could also jeopardize the usefulness of the exemption if the SEC does not provide a safe harbor or otherwise objective criteria for meeting these obligations.

As you can see, even if the crowdfunding exemption bill passes as is, there will still be any number of issues unresolved until the SEC fills in the gaps in the legislation through interpretive regulations.  These regulations could greatly facilitate the usefulness of this new exemption, or could eviscerate its usefulness, causing it to be used as often as Rules 504 and 505 of Regulation D.[2]

Footnotes

[1] This issue of whether state registration requirements apply to intermediaries is very complex and merits its own post.  This issue has been around for some time, because there is an analogous situation pertaining to Rule 506 offerings.  Some states require the officers who conduct a Reg. D offering to register as “issuer agents,” but such requirements may be preempted by federal law.

[2] Rules 504 and 505 are other exemptions contained within Regulation D.  They tend not to be used very often because, unlike Rule 506, there is no federal preemption of state registration requirements, subjecting offerings conducted under this rule to numerous state regulations.

On November 3, 2011, the U.S. House of Representatives voted overwhelmingly to pass the Entrepreneur Access to Capital Act (H.R. 2930). The bill creates an exemption from the registration requirements of the Securities Act of 1933, adding a new Section 4(6).[1]  This section provides that an offering of securities is exempt if it meets the following criteria:

• The aggregate amount sold within the previous 12-month period is $1,000,000 or less. This limit is increased to $2,000,000 if the issuer provides potential investors with audited financial statements. Both limits are indexed to inflation.
• The aggregate amount sold to any investor in reliance on the exemption in any 12-month period is the lesser of (a) $10,000 (indexed to inflation) or (b) 10% of the investor’s annual income. No definition is given for annual income, so presumably fleshing this out will be handled by SEC interpretive regulations.
• The offering must also meet the requirements of the new Section 4A, which I’ll discuss shortly.

The bill also creates a new category of participant in the capital markets called an “intermediary.” There is not much detail provided as to what role an intermediary can play in an offering, but the bill explicitly exempts them from the broker-dealer registration requirements of the Securities Exchange Act of 1934. So presumably, an intermediary could act as a compensated finder and be paid a fee to find investors, though none of this is spelled out, and much will turn on the SEC’s interpretive regulations.

The new Section 4A sets out an additional set of criteria that must be met in order for an offering to qualify under the new Section 4(6) exemption. Such criteria include: warning investors of the risks involved in an investment in a start-up, reporting certain information to the SEC, ensuring that potential investors demonstrate an understanding of the risks involved, stating a target offering amount and a deadline to reach such amount, carrying out background checks on the issuer’s principals, and refraining from offering investment advice. If the offering is carried out by an intermediary, then the burden of complying with Section 4A lies with the intermediary.

The bill also provides that:

• Much of the information collected by the SEC will be shared with the States’ securities divisions.
• The securities sold will be subject to a holding period of one year, unless the securities are sold back to the issuer or to an accredited investor.
• Use of Section 4(6) does not preclude an issuer from raising capital through other means, though in practice, the integration provisions of Regulation D would probably prevent a simultaneous Reg. D offering from taking place, unless the SEC provides otherwise in its regulations.

The bill instructs the SEC to issue interpretive regulations for Section 4A and to issue regulations precluding the use of the Section 4(6) exemption by issuers, intermediaries, or affiliated persons with a poor disciplinary history. Presumably these rules will mirror the new “bad actor” exclusions for Rule 506.

Investors who purchase securities under the crowdfunding exemption would not count towards the 499 investor limit under the Securities Exchange Act.[2] In addition, securities issued under Section 4(6) will qualify as federally covered securities, which means they will be exempt from state registration requirements.[3]

The new exemption is complex and will no doubt keep securities lawyers busy. In a future post, I’ll discuss some of the implications and unanswered questions revolving around the new crowdfunding exemption.

Footnotes

[1] For those of you who might ask “what happened to the old Section 4(6),” the Dodd Fank Act had already moved the old Section 4(6) to Section 4(5), and the old Section 4(5) was eliminated.

[2] Under the Securities Exchange Act of 1934, a company with more than 499 investors held of record and more than $10 million in assets must register their securities with the SEC and become a publicly reporting company.

[3] Via federal preemption of state law.

———————————–

© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

As I’ve mentioned before, it’s very important for growing companies to comply with securities laws, even during the initial seed and friends and family rounds of financing.  The possibility of lawsuits and even fines and other criminal penalties give founders a strong incentive to comply with the law.  But there’s another consequence that could result from non-compliant sales of securities: loss of the company’s IP.

Often, co-founders are issued stock or other ownership interest in exchange for a contribution of intellectual property.  That issuance of stock is a securities transaction.  If it is not done in compliance with the law, the purchaser of the security (in this case the co-founder who contributed the IP) has a right of rescission, which means that he can sue in court to have the deal unwound.  In most securities transactions, where stock was issued in exchange for cash, this would simply result in a monetary award of damages.  However, if the stock was issued in exchange for intellectual property rights, then a successful lawsuit by a the founder who contributed the IP could result in the company losing its rights to its intellectual property, potentially crippling the company.

When could this arise?  Certainly a partnership dispute could cause a departing co-founder to institute such a lawsuit to gain additional leverage in his or her departure.  If a company is doing very well, then normally, even if the departing partner alleges a securities law violation, the company can simply pay him cash for his shares.  But if a rescission action for the securities law violation would result in the loss of mission-critical IP, then the departing shareholder will have an enormous amount of leverage in negotiating his departure.  He could extract significantly larger concessions than he otherwise would have been able to if his remedy had simply been to have the cash he put into the company returned.  In addition, even if there are no disputes, potential investors doing due diligence on the company may be scared away because of the potential cloud hanging over the company’s most important assets.

Therefore, once again it is important to emphasize that start-ups should not ignore securities laws in their early rounds of financing, or even in transactions with their co-founders.  Failing to comply with the law creates a ticking time bomb for a company that can threaten its business in the future.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Representative Kevin McCarthy (R-CA and House Majority Whip) recently introduced the Access to Capital for Job Creators Act (H.R. 2940), which would remove the ban on general solicitation for securities offering conducted under Rule 506 of Regulation D.  Rule 506 is a safe harbor regulation which sets forth some conditions that if met, will assure an issuer that its securities offering is exempt from registration under Section 4(2) of the Securities Act of 1933.  The rule permits the sale of securities to up to 35 non-accredited but sophisticated investors and an unlimited number of accredited investors.  However, the issuer must also avoid engaging in a “general solicitation,” which prohibits the issuer from conducting any public advertising of the offering.  Rep. McCarthy’s bill would remove this prohibition on any offering conducted exclusively to accredited investors.

Rep. McCarthy has advocated for the bill by arguing that it will increase access to capital for small businesses.  This is certainly true.  Under current law, issuers of securities may only offer their private placements to pre-existing contacts, which significantly limits a small business’s pool of potential investors.  However, while it may be true that lifting the ban on general solicitation will help many small issuers get a wider audience for their investment pitches, regulators have concerns that removing this requirement will increase the likelihood of fraud.  The North American Securities Administrators Association (NASAA) articulated these concerns in testimony before the House Capital Markets Subcommittee.

In the NASAA’s testimony, Heath Abshure, Chairman of the NASAA’s Corporation Finance Section Committee, expressed concern that Rule 506 offerings are often used to defraud investors.  Since an offering conducted under Rule 506 is considered a “federally covered security,” states are preempted from regulated them in any meaningful way (apart from prohibiting outright fraud).  As a result, state securities regulators have become increasingly alarmed at the widespead use of this exemption, which they believe has led to increased incidents of securities fraud.  If this exemption permitted publicly advertised offerings, they argue that these instances of fraud would become even more prevalent.

The outlook on this legislation is mixed.  The state regulators’ concerns are certainly valid, though the reality is that most perpetrators of securities fraud routinely violate the registration requirements anyway.  Perhaps increased enforcement of anti-fraud provisions is the answer to dealing with fraud rather than retaining the general solicitation ban.  That said, I don’t think Rep. McCarthy’s bill is particularly well thought-out.  He simply eliminates the ban on general solicitation without considering the effects on other parts of Rule 506.  With no ban on general solicitation, Rule 506 would allow a company to raise unlimited amounts of money from an unlimited amount of investors using public advertising.  This would pretty much be a public offering and allowing it to qualify as an exempt unregistered offering would essentially negate the registration requirements of the Securities Act and of the securities laws of all of the states.  As a result, the only real limit placed on a company that does not register its securities would be that all of the investors must be accredited.  But even that would not be much of a limitation, since an investor’s status as an accredited investor is determined by a questionnaire.  Investors can and frequently do misrepresent themselves on investor questionnaires, especially if they are convinced that they are being given access to a great “investment opportunity.”

I do agree that the ban on general solicitation is an outdated idea.  However, simply removing it from Rule 506 without considering the impact on the rest of the Securities regulatory system is probably not the answer.  In it’s testimony, the NASAA itself advocated for the adoption of a different exemption called the Model Accredited Investor Exemption (which I’ll explore in a future post), so the NASAA is not completely unsympathetic to business owners.  Overall though, I’m pleased that legislators and regulators are now beginning to look to find ways to update securities laws for the 21st century.

———————————–

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previously, I highlighted a proposed Startup Exemption to Federal securities laws, which would allow small companies to “crowdfund” (i.e. raise small amounts of money as startup capital from a large number of participants over the internet).  At the time, I thought that it was highly unlikely that anything significant would come of it.  In today’s climate, where investment losses from 2008 are still fresh in the minds of policymakers, I thought it was unlikely that there would be any significant support for the loosening of financial regulations.  I might have been wrong.

I saw the following statement on the White House’s web site: “As part of the President’s Startup America initiative, the Administration will work with the SEC to conduct a comprehensive review of securities regulations from the perspective of these small companies to reduce the regulatory burdens on small business capital formation in ways that are consistent with investor protection, including expanding “crowdfunding” opportunities and increasing mini-offerings.”

In addition, Republicans (unsurprisingly) are also getting on the bandwagon.  Perhaps we may have a genuine area of bipartisan agreement here?

———————————–

© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Raising money for your company can be an exciting, challenging, and stressful time.  There are always plenty of other businesses and ideas out there competing for scarce funds.  When you find a venture capital fund willing to potentially invest in your company, you will probably feel like you’ve struck gold.  However, receiving a proposed term sheet from a VC should be seen as the beginning of a process, not the end of one.  If possible, it’s always best to have interest from more than one VC, to ensure that you receive the best deal possible and don’t get pressured into a bad deal.  The terms of an investment in your company from an outsider do matter, and can make a big difference down the road.

Some VCs may try to pressure you into accepting their terms before you are able to shop around for a better deal.  What should you do?  Fellow blogger Mark Suster wrote a piece a few years ago on this topic, and I think it’s still relevant today.  If you’re in the process of raising money from venture capitalists, I recommend that you read it.  To sum up his post: don’t cave into pressure tactics.

Article Referenced: Beware of Gym Salesman VC

———————————–

© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The so-called “friends and family” round is often the first capital raise a new startup will engage in.  Many entrepreneurs often go into it without any knowledge of securities laws and as a result, end up violating them, sometimes with real and significant consequences later.  However, plenty of entrepreneurs do take the time and effort to comply with securities laws and make use of an exemption from the registration requirements under the Securities Act of 1933.  Regulation D covers the most often used exemptions (at least by smaller companies).  The most common form of a Regulation D offering is one conducted under Rule 506, which essentially requires that the issuer offer the securities only to preexisting contacts (no advertising or widespread communication of the offering) who are accredited investors.  An accredited investor is someone who either: (i) has an individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeding $1,000,000, excluding the value of the primary residence of such person or (ii) 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.[1]  However, it is often the case that an entrepreneur’s friends and family are not accredited and so if he limits his capital raise to accredited investors, the capital raise will go nowhere.  Not everyone has a rich uncle.  So, if you are an entrepreneur in this situation, can you raise money from investors without those investors being accredited?  Yes, you can, but proceed with caution.

Regulation D offers a number of ways to accept investments from non-accredited investors.  Rule 506 itself allows a company to include up to 35 non-accredited investors in the offering.  However, this is impractical for two reasons.  First, any non-accredited investor must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”  This is a very subjective standard and unfortunately the only way to get a final determination if an investor meets this qualification is in the courtroom.  By relying on this subjective standard in the offering, the issuer is taking a huge risk of litigation later.  In addition, Rule 506 presents an even more significant obstacle to including non-accredited investors.  If a Rule 506 offering includes non-accredited investors, then it must provide investors with much of the same information as is provided in a registered offering, which largely defeats the purpose behind conducting an exempt offering and is likely to drive up costs of the offering to the point where it is not economical to conduct a small friends and family capital raise.  In contrast, when a Rule 506 offering is conducted without non-accredited investors, there is no information requirement, which means that there is no specific information that is mandated by securities regulations to be given to investors.[2]

So is there a way to include non-accredited investors in an exempt unregistered offering and still retain the “no information requirement?”  Yes, through Rule 504.  Rule 504 allows a company to raise up to $1 million over a 12 month period.  There is no requirement that the investors be accredited and, as in the case of a Rule 506 offering made exclusively to accredited investors, there is no information requirement.[3]  The one major limitation placed on a Rule 504 offering is that, like a Rule 506 offering, there must be no general solicitation.  All investors must be preexisting contacts of the issuer and its principals and no advertising or widespread promotion of the offering is permitted.

Rule 504 does have one major disadvantage as compared to a Rule 506 offering.  Rule 506 preempts state registration requirements whereas Rule 504 does not.  So, when conducting a Rule 506 offering, as long as the correct notice filings are made, issuers need not worry about finding an exemption from state securities registration requirements. However, if an issuer relies on Rule 504 in its capital raise, the issuer’s counsel will need to research the state law of every single state in which the company will be soliciting investors in order to find a separate exemption from registration in each state.  In some states there are exemptions allow for residents to take part in a Rule 504 offering.  For instance, in Tennessee, offering up to 15 investors in a 12 month period are exempt.  Other states may or may not have similar provisions and it may be possible that you might not be able to accept investments from residents in certain states.

The next question that needs to be asked is should you include non-accredited investors in your capital raise as a matters of morals and good business sense.  The law may permit it (subject to restrictions), but is it a good idea?  Recall the proverb: “Before borrowing money from a friend, decide which you need more.”  With any entrepreneurial venture there is a substantially high chance of failure.  You may think that you have the best idea in the world and it’s a sure thing, but chances are there are unforeseen forces that could derail your efforts.  Therefore, for both moral and legal reasons, it’s a good idea to only take investments from people who can bear the risk of loss of the investment.  Therefore, you should never accept investor money from a friend or family member when that money constitutes a significant portion of that person’s life savings or if losing that money could substantially harm them or those that depend on them.  In any event, before taking an investment from a friend or family member, ask yourself this: if he or she lost all of the money invested because the business failed after you did your very best to make it succeed, would this cause hard feelings?  If there answer is yes or maybe yes, then either don’t take the money from this person at all, or reduce the amount of the investment to something that this person would consider to be insignificant. If you don’t, the hard feelings you create can cause you to lose the relationship and may land you in court.

Conducting a first capital raise can be an exciting time for any company.  It can also be fraught with pitfalls.  You should consult an attorney who is familiar with securities laws to help you navigate this exciting but high stakes stage in the growth of your company.

Footnotes

[1] It is also possible for business entities to qualify as accredited investors if they meet certain net worth or other requirements.  In addition, directors and officers of the issuer also qualify.

[2] “No information requirement” does not mean that no information is given to investors; rather it means that the issuer is free to choose the overall format, degree, and composition of information given to investors, as long as that information does not violate the anti-fraud provisions of securities laws.  Frequently, the compiled information in a Rule 506 offering is called a “private placement memorandum.”

[3] Again, as a matter of clarification, “no information requirement” means no specific mandated information is required to be given to investors.  However, if the information that is given is misleading, the offering could violate the anti-fraud provisions.

———————————–

© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.  In addition, the laws regulations discussed in this piece are complex.  In the interests of summarizing them, I have presented a simplified description some of the requirements of conducting a Regulation D offering.  Therefore, this post should not be viewed as comprehensive instructions on conducting such an offering.