In my blog post on May 10, 2016, I described the U.S. Securities and Exchange Commission’s (SEC) new rules for equity crowdfunding which became effective May 16, 2016 and noted that that type of funding might not be the right type of funding for many startups. Startups have been raising capital via non-crowdfunded equity offerings for decades and that still remains a great way to raise funds for many companies who are willing and able to comply with applicable federal and state securities laws. As I explained in my prior post, the basic premise of the SEC’s regulations is that an offer or sale of securities must be registered with the SEC unless the particular security or transaction is exempt from registration under the SEC’s rules. States have similar rules for raising equity. This post describes some of the exemptions historically relied upon by startups and other private companies.
Founders and others who will be actively involved in starting and running a new business and who contribute capital to the business typically rely on an exemption from registration contained in Section 4(a)(2) of the Securities Act of 1933, as amended (Securities Act), which exempts transactions by an issuer not involving any public offering. These investors must be able to evaluate the risks and merits of the investment and must have access to the type of information normally provided in a prospectus for a registered offering. The company will also need to check state securities laws for similar exemptions and comply with any filing requirements of the applicable states.
Angels, VCs and Others.
Rule 506(b) of SEC Regulation D is the exemption most often relied upon by companies raising funds from outside investors. Under this exemption, a company may raise an unlimited amount from an unlimited number of “accredited investors” (generally, institutions and high net worth individuals, excluding the value of a primary residence). A company may also include up to 35 non-accredited investors in an offering; however, the company must provide each of these prospective investors with a disclosure document that contains the information required by Regulation D and each of these investors 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.” An offering under Rule 506(b) cannot be made over the Internet, via newspapers or by any other form of general solicitation.
Rule 506(c), which became effective September 23, 2013, provides a similar exemption for offerings made ONLY to accredited investors and allows a company to use general solicitation (that is, a company may advertise its offering on its website or social media). The catch with this type of equity raise is that the company will be required to verify that each investor is an accredited investor, which will mean undertaking and documenting a fairly extensive financial background investigation on each investor.
Securities offered using Rule 506(b) or (c) are “covered securities” for purposes of state law, which means that states cannot regulate these offerings. States can (and do), however, require filings with their state securities regulators in connection with offerings of covered securities in their states, so you will still need to check the requirements of the states in which you are offering securities using these exemptions.
Friends and Family.
A “friends and family” round can be accomplished in reliance on Rule 504 of SEC Regulation D, which allows a company to raise up to $1 million in a 12-month period from accredited AND non-accredited investors with whom the company has a pre-existing relationship. Under this exemption, no formal disclosure document is required, but the company must provide enough information to prospective investors so that they may make informed investment decisions. The company may NOT use general solicitation to advertise this type of offering. A company would also need to check applicable state laws for similar exemptions.
If a company is conducting an offering that is limited to investors residing in the state in which the company is located and conducts most of its business, state securities laws may provide an exemption for this type of intra-state offering. Section 3(a)(11) of the Securities Act provides a federal exemption for this type of offering, with no limit on the size of the offering or the number of investors. Note that including even one out-of-state investor could result in violation of the Securities Act.
Prior to raising capital, it is a good idea to do a self-check of the company’s organizational documents to ensure that it is structured in way that would allow for issuance of equity and possibly multiple classes of equity. Founders will also need to consider the impact of having to answer to outside investors, including friends and family. Shareholders have certain information rights under state law – managing communications with tens or hundreds of shareholders can be time-consuming and expensive. And raising money from friends and family could put a strain on your relationships with them if your next great idea turns out to be not so great after all, so think carefully about whether you want to add that risk to your mix.
DISCLAIMER: No attorney-client relationship is intended to be established with any person or entity by the distribution of the information in this blog post and no such relationship may be inferred. Readers should consult counsel and other advisors when considering an offering of securities.