This blog discusses the legal aspects of raising money for your startup / early stage business in relation to the Securities Act of 1933 (the “33 Act”). My objective is to educate you enough so that a) you will avoid time in the poky as a result of SEC violations, b) you’ll understand the legal babble your securities attorney will throw at you and c) save you money.
Before you start telling the world you’re raising money and before you accept a cent from an investor, make sure you seek sound legal advice from an experienced knowledgeable securities attorney. This blog is not intended to be legal advice in any way.
In the US after the 1930s depression the Securities and Exchange Commission implemented laws (Securities Act of 1933) that required companies to register with the SEC in order to offer and sell securities (equity, shares, stock) in their business or meet certain qualifications to exempt them from registration. These exemptions, which are covered by Regulation D (aka Reg. D), were designed to help the startup and small business raise funds while avoiding SEC registration which is prohibitively expensive for small companies. Reg. D contains rules (501 through 508) that must be followed or you could find yourself in very hot water.
Rules 504, 505 and 506 define from whom you can raise money, how much and over what period of time. There are also Blue Sky Laws which refer to laws at the state level that can also come into play. The basic objectives of these rules are to protect the innocent from scam artists selling shares of non-existent businesses and require the issuer to proclaim the extreme risk of the investment.
In order to legally raise money you have to file Form D with the SEC under one of these rules. Form D is a short electronic form that identifies the issuer and any promoters, beneficial owners, officers and directors, and partners. Also, it provides information about the exemption claimed (Rule 504, 505, or 506) and information on the type and amount of the securities offered and the use of proceeds.
Below I have vastly simplified the requirements of the rules to help you to understand the basic differences. These rules talk about limiting sales of securities to “accredited” and “sophisticated” investors, which is very important for you to understand.
An “accredited investor” is an individual with a net worth of at least one million US dollars, not including the value of one's primary residence or have made at least $200,000 each year for the last two years (or $300,000 together with his or her spouse if married) and have the expectation to make the same amount this year. An “accredited investor” is also a bank, insurance company, registered investment company, business development company, or small business investment company. See http://www.sec.gov/answers/accred.htm for additional entity qualifications
A “sophisticated investor” is someone with sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment
Rule 504 of Reg. D
You can raise up to $1,000,000 in any 12 month period. General offerings and solicitations are permitted as long as they are restricted to “accredited investors”. The issuer is not required to restrict the purchaser’s right to resell securities. Blue sky laws apply.
Rule 505 of Reg. D
You can raise up to $5,000,000 in any 12 month period. Securities can be sold to an unlimited number of “accredited investors” and up to 35 “unaccredited investors”, i.e., non-sophisticated investors. Issuers are required to impose predefined restrictions on the resale of securities. General solicitation or advertising to sell the securities is not allowed. There are also provisions regarding financial statement requirements.
Rule 506 of Reg. D
Under this rule there is no limit to the amount that can be raised. Securities can be sold to an unlimited number of “accredited investors” and up to 35 “unaccredited investors”, but must be sophisticated investors. General solicitation or advertising to sell the securities is not allowed.
For all three rules, it’s important to be aware that the sales of securities must occur within 6 months of each other. If they do not, you have to resubmit Form D.
Disclosure - Private Placement Memorandum (PPM)
A company should take care to provide sufficient information to investors to avoid violating the anti-fraud provisions of the securities laws. This means that any information a company provides to investors must be free from false or misleading statements. Similarly, a company should not exclude any information if the omission makes what is provided to investors false or misleading. This information must be provided in the form of the PPM and you must get a signature from the receiver that they received and understood the risks outlined. In a nutshell, the PPM is a modified version of the business plan listing the risks, Blue Sky warnings if applicable and a description of the securities. You can kill two birds with one stone if you create a single document enables the investor to prove their accreditation status and acknowledge the receipt of the PPM
As a startup you are probably not a publically traded company, which means any investments you receive are called Private Placements and you must adhere to rule 504, 505 or 506 of the 33 Act. Which means to sell securities you must verify that you are selling to “accredited investors” only (rule 504) or to “accredited” or “un-sophisticated” investors (rules 505 and 506).
Also, you cannot publically promote your investment opportunity (505 and 506), e.g., you can't setup a website asking for investment or stand up in a public setting such as your local Rotary Club, LeTip, BNI meeting, etc., promoting your company as an investment opportunity; as this would be declared a public offering and put you in violation of the 33 Act.
It’s also important to note that to become compliant with Reg. D can cost in excess of $10,000 in attorney and filing fees.
Catch 22 or What!?
So “Hang on!” you’re saying, “In order to ask people for money for my startup I have to file Form D with the SEC under Rule 504, 505 or 506. But to do this correctly it’s going to cost me over $10,000 in legal fees!? If I had $10,000 to spend on a lawyer I wouldn’t need to raise money in the first place!”
This is also especially confusing because we know thousands of people are investing millions of dollars every year in startups and small companies without anyone going to jail. In these circumstances, from what we can determine, this is the result of “no harm no fowl”, which I don’t believe is a legal defense. What I mean by “no harm no fowl” is that if no one files a complaint with the SEC, then the SEC is not aware of the violation and so is not in a position to pursue the startup.
However, according to Reg. D Rule 503 (Filing of notice of sales rule) the issuer selling securities has 15 business days to file Form D after the initial sale of the security. In other words, as long as your disclosure meets SEC requirements, you can approach prospective investors before filing Form D.
Also, if you, your business and your proposed investor all live in the same state, you may be eligible to accept money under Rule 147 without registering with the SEC. This rule allows you to raise small amounts of money, but your business must have had revenue of at least $5,000 within 12 months of receiving monies from an investor. However, like any of the previous rules mentioned, you must abide by the anti-fraud provisions of the 33 Act.
The Subscription Agreement
Another investment option is through a subscription agreement, whereby the investor becomes a partner. In this scenario the investor doesn’t have to be an accredited investor or require a PPM.
Related Topics / Information:
For more information, visit: http://www.kenovatech.com/blog/how-to-legally-rais-funds-for-your-startup-and-early-stage-business/