Strictly Business

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure:

The Reopening American Capital Markets to Emerging Growth Companies Act (H.R. 3606; the rest of the bills were added to this one).  This bill is also known as the “IPO On Ramp” and it creates a new category of company called an “emerging growth company,” which is defined roughly as a public company with less than $1 Billion in revenue.  An issuer that is an emerging growth company as of the first day of a fiscal year will continue to be one until the earliest of (i) the last day of the fiscal year during which the issuer had $1 billion in annual gross revenues or more; (ii) the last day of the fiscal year following the fifth anniversary of the issuer’s IPO date; or (iii) the date in which the issuer is deemed to be a large accelerated filer, defined by the SEC as an issuer with more than $700 million in public float. In addition, a company would not be considered an emerging growth company if it has issued more than $1 billion in non-convertible debt over the prior three years.  An emerging growth company would enjoy more lax regulation by the SEC.  For instance, the bill would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company.  Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that carries high compliance costs. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to their IPO rather than three years. The bill also exempts emerging growth companies from new corporate governance requirements within the Dodd-Frank Act, namely the so-called “say on pay” requirement and the requirement that public companies calculate and disclose the median compensation of all employees compared to the CEO.  The bill would remove restrictions prohibiting investment banks that underwrite a company’s IPO from publishing research on emerging growth companies and would  expand the range of permissible pre-filing communications to “qualified institutional buyers” or “accredited investors.”

The Access to Capital for Job Creators Act (formerly H.R. 2940).  As discussed in a previous post, this bill essentially removes the general solicitation prohibition on offerings made under Rule 506 of Regulation D.

The Entrepreneur Access to Capital Act (formerly H. R. 2930).  This is the “crowdfunding” bill, which I’ve discussed at length in the following posts: Is action forthcoming on a crowdfunding exemption to Federal securities laws?; Bill Creating Crowdfunding Exemption from Securities Registration Passes U.S. House of Representatives; What does the future hold for crowdfunding legislation?; Implications of the Pending Startup Crowdfunding Bill.

The Small Company Formation Act (formerly H. R. 1070).  This bill would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. It would also preempt state blue sky laws with regards to such offerings if they are traded on a national exchange.   Regulation A is a little used exemption from registration that permits an exempt public offering using a type of “short form” registration.  It is rarely used for two reasons: (i) it has a limit of $5 million and (ii) there is no preemption and so the offerings are subject to blue sky laws.  This bill would eliminate both of these obstacles.

The Private Company Flexibility and Growth Act (formerly H.R. 2167).  This bill raises the number of shareholders a company can have before it is forced to go public from 500 to 1,000.  In addition, it also excludes employees from counting against this limit.  More details can be found on a previous post on this topic: Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer.

The Capital Expansion Act (formerly H.R. 4088).  This bill raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.  The issue here is that community banks are often forced to engage in expensive Exchange Act reporting because they have over 499 shareholders.  This bill would remove this expense for many of them.

The vote was lopsided and the White House has indicated that it is supportive, so the bill has a decent chance of become law.  That said, don’t let the lopsidedness of the vote fool you.  There is genuine opposition to these bills in the Senate that has been building for some time.  There are some significant concern that the legislation will increase the incidence of securities fraud, particularly for senior citizens.  Therefore, stay tuned.

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© 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.

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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.

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.

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.

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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.

I am frequently asked by entrepreneurs whether I think a startup should ask potential investors to sign a non-disclosure agreement (NDA).  While the answer depends largely on the situation, my view is that in most cases an NDA is unnecessary if the only information being conveyed to potential investors is their company’s general business plan or overall market strategy.

Entrepreneurs generally tend to overestimate the need for an NDA in these situations.  They will often seek to obtain NDAs from others, including potential investors, just to hear their business plan.  This is often a waste of time and energy and can be a turnoff to potential investors.  Many professional investors like VCs or even angels hear numerous business plans and will simply not sign an NDA to hear each one.  If they did, they would be putting themselves at risk, because each time they sign a new NDA, they create the potential to be sued for an alleged breach of that NDA (whether they actually breached it or not).  Given that there are so many businesses out there seeking their capital, it’s easier just to forgo hearing the pitch from a business that insists on the investor signing an NDA.

That said, an NDA can be very useful and highly necessary when there are genuine trade secrets or technical details that need to be protected (i.e. some kind of “secret sauce”).  This could be in the form of a chemical formula, programming code, technical plans, or some other hard information where there is a genuine risk of misappropriation.  Therefore, NDAs should generally only be used when conveying actual proprietary information that goes beyond mere discussions of overall business plans.

To get an investor’s perspective, I recommend that you read the following article by Aristos Peters, who raises funds for early stage startups: Why I don’t sign NDAs (usually).

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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.

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?

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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.

Form D is a document that the SEC requires a company to file when it issues securities in a private placement under Regulation D.  It must be filed with the SEC within 15 days of the first sale of a security in a private placement.  In addition, for offerings made under Rule 506 (the most frequently used part of Regulation D), an issuer must also file a copy of Form D (along with a filing fee) with the securities administrator of each state in which purchasers of the securities reside within 15 days of the first sale within each state.  Overall, Form D is a relatively simple document to complete and file; however, it’s very easy for a small company to overlook filing one, especially if it doesn’t use qualified legal counsel for its securities offering.  I frequently get asked about what happens when an issuer fails to file Form D or if the issuer files it late.  This post describes what consequences can and cannot occur.

The first consequence an issuer might be concerned about is losing the federal private placement exemption and consequently be in violation of securities laws by improperly selling unregistered securities.  Thankfully, a failure to file a Form D does not result in the loss of the federal registration exemption.  The SEC has issued guidance on this in Question 257.07 of the Securities Act Rules Questions and Answers of General Applicability.  While filing Form D is a requirement for using a registration exemption under Regulation D, it is not a condition to qualifying for the exemption.  Instead, the only potential consequence on the federal level is that the SEC could take action against the issuer and seek to have the issuer enjoined from future use of Regulation D under Rule 507.  If the violation is willful, it could also constitute a felony.[1] Despite the fact that Form D is not a condition to being exempt under Regulation D, I would caution issuers to not take their responsibility to file Form D lightly.  Often when an issuer is sued in court, the plaintiff will accuse the issuer of violating the federal registration requirements of the Securities Act.  In such instance, the issuer will bear the burden of proof to prove that the securities offering met an exemption under Regulation D.  While courts have explicitly stated that failing to file Form D does not create a private right of action, an issuer may be assisted in meeting its burden of proof that the securities were issued pursuant to an exemption under Regulation D by producing a properly filed Form D.[2]  Therefore, while failing to file Form D may not result in the SEC seeking penalties against an issuer for selling unregistered securities, it could put an issuer at a disadvantage in civil litigation by eliminating one piece of evidence that an issuer can use to build their case that they substantially complied with Regulation D.  In addition, the SEC may seek substantial penalties against an issuer who has failed to properly file Form D.

The other question an issuer may be concerned about is what are the consequences for failing to file Form D at the state level.  Most Regulation D offerings are conducted through Rule 506.  When an issuer makes use of Rule 506 to issue securities, those securities are considered “covered securities,” and state registration requirements are preempted.  However, states are permitted to require that the issuer file a copy of the Form D (along with a filing fee) with the state securities administrator if the issuer has sold its securities to the state’s residents.  Is the preemption of state securities registration requirements in a Rule 506 offering lost if the issuer fails to file with a state?  The SEC’s position is that it is not.  Under Question 257.08 of the Securities Act Rules Questions and Answers of General Applicability, the preemption is not conditioned on properly making a notice Form D filing with a state.  One word of caution: some states take the opposite position.  The Wisconsin Department of Financial Institutions for instance takes the position that if a Form D is filed late in Wisconsin, the issuer must find another exemption or register the security.[2]  My personal opinion is that if the Wisconsin Department of Financial Institutions ever took the case to court and claimed that a Rule 506 offering needed to be registered because a Form D was late, Wisconsin would lose that case, as courts have repeatedly held that failure to make a notice filing does not strip the offering of the status of a “covered security.”[3]  But taking such a case to court would be expensive.  In addition, there can still be significant consequences on the state level beyond losing a registration exemption for an issuer who fails to make required notice filings.  States can issue fines or even stop orders, preventing further sales of securities by an issuer.  Arkansas, for example, is one state that has been particularly aggressive in issuing fines for late Form D filings.

The good news here is that if an issuer accidentally fails to file a required Form D when conducting an offering or files it late, that will not invalidate the private placement registration exemption, which would potentially be a catastrophic event for an issuer.  However, the SEC and state securities administrators can still issue fines and prevent an issuer from engaging in future private placements, so issuers still need to be diligent in making all required securities filings when conducting private placements.

Footnotes

[1] See Hamby v. Clearwater Consulting Concepts, Lllp, 428 F.Supp.2d 915, 920 (E.D. Ark., 2006).

[2] In a court trial, the issuer would have to produce additional evidence to show substantial compliance with Regulation D, such as subscription documents that evidenced an inquiry into whether the investors were accredited or sophisticated.

[2] See http://www.wdfi.org/fi/securities/regexemp/exemptions/23_19_506.htm

[3] See for example Chanana’s Corp. v. Gilmore, 539 F.Supp.2d 1299 (W.D. Wash., 2003) for an example of a case where a court concludes that a late filing does not cause a security to lose its status as a “covered security.”

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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.

Recently, I came across an online petition proposing a new “Startup Exemption” to federal securities registration requirements.  You can find the petition at this website:  www.startupexemption.com.  Like many other similar proposals, its goal is to ease the regulatory burden on small businesses trying to raise capital.   Some of the highlights of the proposed exemption are:

• There would be a $1 million limit on the amount of capital raised.
• It would only be available to “small businesses,” defined as a business with average annual gross revenue of less than $5 million during each of the last three years or since incorporation if the business has existed for less than three years
• Unaccredited investors could invest a maximum of $10,000.  I like this idea, though it is certainly possible that $10,000 could wipe out the life savings of some lower-income investors.
• It’s somewhat unclear as to the suitability requirements.  It’s clear that unaccredited investors would be permitted to invest, but investment should be limited to investors who understand “the risks inherent in this type of investment.”  I’m not sure what that means.  In general, ambiguity in registration exemptions is a bad idea and leads to them not being used, because people want the safe harbor that a clear exemption provides.  Another part of the site mentions some kind of questionnaire that would be used to determine sophistication.  I’m somewhat skeptical about the effectiveness of something like that.
• The 500 investor limit in the Securities Exchange Act would be lifted.  It’s not clear whether this would be for all companies or just small businesses.  Nor is it clear what would happen when these small businesses are no longer “small.”
• Securities issued under this exemption would be a covered security similar to Rule 506 offerings, so it would preempt state registration requirements.
• General solicitation would be permitted on certain” registered platforms.”
• There would also be “standardized forms (generic term sheets & subscription agreements) based on industry best practices” used for the offerings and regular reporting on the registered platforms.  This sounds a lot like a simplified version of Exchange Act reporting.  The problem is, as soon as you attach anti-fraud liability to reporting, the stakes become too high to do the reporting without sophisticated legal help, which of course is the expense that the proponents of this proposal are trying to avoid.
• There would be some kind of exemption from the requirement to use a broker/dealer in facilitation of these transactions.  I’m not sure if they are proposing that finders fees could be paid to non-broker/dealers or if they mean something else.

So those are the highlights.  As you can see, many of the points described need some further thought.  I like the basic idea and even Mary Shapiro, Chair of the SEC has spoken of the need to relax the regulatory burden on startups.  Actually accomplishing that without increasing the likelihood for fraud is the hard part.

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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.

Representative David Schweikert (R-AZ) recently introduced a bill called the “Private Company Flexibility and Growth Act,” which promises to allow private companies to remain private for a longer period of time.  Currently, if on the last day of a company’s fiscal year, any class of securities of the company is held of record by 500 or more shareholders and the company has total assets of more than $10 million, then it must register under the Securities Exchange Act of 1934.  This brings upon it a multitude of responsibilities and obligations including filing annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and meeting proxy regulation requirements.  With these added obligations, most companies will simply choose to go public (i.e. engage in an IPO), since they might as well gain the advantages of the public markets given that they will now be dealing with all of the compliance expenses that come along with them.  An example of a company that is likely dealing with this issue now is Facebook.  It has been widely reported that it is either past the 500 shareholder limit or soon will be, since its shares are held by many employees, some of which may have sold their shares to other parties.  Many people believe that Facebook has no desire to go public, but will likely be forced to do so early next year.  Is that fair?

Certainly Rep. Schweikert doesn’t think so.  His bill would make a couple of changes.  First, it would increase the shareholder limit to 999 from the existing 499.  Second, accredited investors and persons who received shares pursuant to an employee compensation plan would no longer count towards the limit.  The second change is the far more important one, since it will allow private companies to grow to almost a limitless size without ever being required to go public.  A vast majority of the shares of private companies are issued in one of two ways: (1) private offerings made only to accredited investors and (2) shares issued to employees as compensation.[1]  Since the two largest categories of shareholders in a private company would no longer be counted towards the limit, this bill would effectively do away with the requirement of companies to go public as they expand.

Since I also write a lot on private investment funds, I would also point out that this bill would be of significant benefit to some of the larger hedge funds and private equity funds.  Large private funds tend to be so-called “(3)(c)(7)” funds.  3(c)(7) funds are offered only to qualified purchasers, which general speaking are individual investors with investment assets over $5 million or companies with investment assets over $25 million.  Because of the Exchange Act’s 499 investor limit, these funds cannot have more than 499 investors under current law.  If this bill were passed, there would be no limit to the amount of investors that a 3(c)(7) fund could have, since any qualified purchaser would easily qualify as an accredited investor.  Many people often incorrectly believe that the 3(c)(7) exception itself contains the 499 investor limitation. It does not; the limitation is in the Exchange Act.  Thus this bill would allow the largest private hedge funds, private equity funds, and venture capital funds to get even larger.

I agree with the overall premise of this bill.  I do think that companies should have more control over when and if they go public.  I also think that the bill is unlikely to pass in its current form for a couple of reasons.  First, regulators are likely to lobby against it rather aggressively.  Since accredited investors and employee shareholders will no longer count towards the limit, the limit would be effectively eliminated.  For a lot of people in the securities regulation field, that would be a step too far, potentially undermining the investor protection policy goals of the Exchange Act.  Second, I’ve already pointed out that large hedge funds will be unintended significant beneficiaries of the bill, and it will be too easy to paint this bill as something favored by “Wall Street.” (And we would never want to do anything like that!)

That said, this bill is part of a conversation that is has begun over the last year.  Even Mary Shapiro, chair of the SEC has written about the possibility of loosening the 499 investor limit on private companies.  I think that if some of the concerns mentioned above are addressed, the introduction of this bill moves us closer to the possibility of reforming the Exchange Act’s limits on private companies.

Footnotes

[1] Some may point to Rule 12h-1(f), which exempts employee stock option holders from the 499 investor limit, if certain conditions are met.  But this rule does not exempt actual employee stock holders from counting towards the limit, so the exemption on employee shareholders in this bill is a significant loosening of restrictions.

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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.