Strictly Business

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.

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© 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.

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© 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.

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© 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.