It seems like all of a sudden clients are asking questions about selling securities. This could be one sign that the economy is picking up or it could be serendipity. Either way, it seems to me that there are certain things entrepreneurs ought to understand about the regulatory structure when they are out raising money. You don’t need (or want) to know what SEC lawyers know, but knowing the lay of the land is probably not a bad idea.
So here is my attempt at giving you a basic sense of orientation in the world of securities laws. [Here are the caveats: This is not legal advice. The descriptions below are way too big picture to substitute for discussing the particulars of your situation with a competent attorney.]
Where to begin? Think about it this way: In the mind of the Securities Exchange Commission (“SEC”), the entire universe of transactions in securities can be divided into two (well not quite – but OK for my purposes) categories: First, transactions that are registered with the SEC (like initial public offerings a/k/a IPOs), and, second, transactions that are exempt from registration for one reason or another (like trades on the New York Stock Exchange or investments in technology companies by venture capital firms).
With certain exceptions that I am not going into here, transactions in securities that are neither registered nor exempt from registration are illegal. Bad things can happen if you engage in transactions that are neither registered nor exempt.
Now I am going to take a metaphorical step back and talk about “registered securities.” Actually “registered securities” is a lay term that is confusing. You don’t register securities with the SEC; you register “transactions” that involve securities. You can also register “classes” of securities such as common stock.
So, under the Securities Act of 1933 you register “transactions” that involve securities. An IPO would be a classic example of a transaction in securities that is registered under the Securities Act of 1933. In essence, an IPO is the sale of securities by a company to the public (actually to an underwriter who in turn sells to the public, but that is a nuance). Just to be clear, a sale of preferred stock to a VC is a transaction that involves securities. It just happens to be exempt, as we will see later.
Under the Exchange Act of 1934, you register “classes” of securities. For example, IBM has a class of securities (common stock) registered under the Exchange Act of 1934. These shares are also listed for trading on the New York Stock Exchange. When you register a class of securities under the Exchange Act of 1934, you become required to make all those dreadful quarterly filings that public companies are always complaining about.
If you are a privately held company (meaning you don’t have a class of securities registered under the Exchange Act of 1934) looking for venture financing, you don’t, as a general matter, need to worry about the Exchange Act of 1934. You don’t have a class of securities registered under that statute and you are not proposing to register one.
You do, however, need to worry about the Securities Act of 1933. Why? Because you are proposing to engage in a transaction involving securities and to be legal, such a transaction must either (1) be registered or (2) be exempt.
Before we dive into exempt transactions, which is what you really care about, a few (very few) words about registration. It is expensive, really expensive, and time consuming, really time consuming. A company going public could easily chalk up $750,000 in legal fees alone not to mention accounting fees and amounts paid to underwriters. These types of transactions are the provenance of companies that are already public or are raising very large amounts of money. Microcap public offerings do exist, but that is a story for another day.
So, at long last, exempt transactions. There are lots of exempt transactions. One example is trades on the New York Stock Exchange. These transactions are exempt from registration under Section 4(1) of the Securities Act of 1933.
Venture capital investments are also exempt. These transactions are exempt because they are so-called private placements. The “classic” form of private placement is exempt under Section 4(2) of the Securities Act of 1933 – a limited offering, not involving a general solicitation of the public, to persons who are sophisticated buyers of this type of investment, and who are able to bear the risk of the complete loss of their investment (if it comes to that).
The issue with this type of exemption is determining where the line is between a private placement and a public offering. Clearly, an IPO is a public offering. The underwriters broadly solicit offers to buy and they sell to many thousands of people. A placement of preferred stock to a couple or three venture funds (which is done with no publicity) is clearly a private placement. But the issue is, where is the line? What happens if there is an offering to, say, 100 people (or 1000)? What if the investors are solicited through telemarketing or mass mailing? What if the offering is made to all graduates of Harvard University?
Anyway, you get the point. It is not always clear what is private and what is public. In an effort to make the distinction clear, the SEC adopted something called Regulation D in the early 1980s. Regulation D is a so-called safe harbor from the registration requirements of the Securities Act of 1933. By safe harbor, the SEC means that if you comply with all the requirements of this regulation, your transaction will be deemed to be exempt from the registration requirements. (In addition, compliance with Rule 506 of Regulation D limits the application of state securities laws in private placement transactions. That’s really beyond what I am trying to cover here, but it turns out to be important.)
Regulation D has quite a number of requirements, some of them depend upon the amount raised and the nature of the offerees. A detailed explanation of Regulation D is way beyond the scope of this post, so I want to focus on who can be an offeree, what disclosures must be made to offerees, how they can be solicited and the amount raised, but keep in mind that there are other requirements so you need to get advice around them.
Who can be an offeree?
Note that I am talking in terms of offers not purchases. The safe harbor is structured in terms of the persons to whom you can make offers (not in terms of the persons who end up buying). If you make offers to persons who are not appropriate offerees for your offering, even if only compliant persons end up buying, you have failed to comply with the requirements of Regulation D and the safe harbor is not available to you. Note, you may (or may not, depending on the facts) have a good private placement (i.e. a transaction that is exempt from registration because it is a private placement) but you won’t have the certainty associated with meeting the requirements of the safe harbor.
So, assuming compliance with other requirements of Regulation D, including the requirement that there be no general solicitation, you can sell to an unlimited number of persons who are “accredited investors” and, again assuming compliance with other requirements, up to 35 (in some instances more, but these are for small offerings under $1,000,00 – more below under the discussion Section 504 of Regulation D) persons who are not accredited investors.
Here is a link to the definition of “accredited investor.” I am not going to recreate the whole definition, but described below are the four categories of accredited investor that are most relevant to technology companies seeking angel or other private financing.
· corporations and certain other entities, not formed for the specific purpose of acquiring the securities offered, with a net worth in excess of $5,000,000,
· any director, officer, or general partner of the issuer of the securities being offer or sold
· any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000
· any natural person who had an individual income in excess of $200,000 (or joint income with such person's spouse in excess of $300,000) in each of two most recent years and has a reasonable expectation of the reaching the same income level in the current year
In the mind of the SEC, people and entities that meet the definition of accredited investor, are able to fend for themselves and therefore, generally, require less protection through disclosure and other requirements than people who do not meet these requirements.
What disclosures must be made to offerees?
That last paragraph makes a nice segue into this section. With respect to offers made solely to accredited investors, Regulation D does not impose any particular disclosure requirements. (Please note, common law fraud applies. If the offer is such that the disclosures amount to fraud the fact that the offer was made solely to accredited investors and was otherwise compliant with Regulation D, does not protect you from liability.)
But with respect to offers made to persons who are not accredited investors, Regulation D (with a modest exception) requires that extensive disclosures be made to all persons to whom securities are being offered. So, if you include non-accredited investors in your offering, not only do you have to make extensive disclosures to them, but you have to make the same disclosures to all offerees.
The disclosures are extensive. They basically track the requirements for a public offering. Complying with these requirements is way too time consuming and expensive for most (but not all) early stage companies.
You may have run across formal offering memoranda prepared by investment bankers or brokers seeking to offer securities to individual investors. These documents typically include many pages of descriptions of the company, its business, its management, its financial condition, the risks of investing, financial statements and the like. These offering memos are often designed to comply with the disclosure requirements of Regulation D that are applicable to offers to not accredited investors. There is a significant cost both in dollars and time associated with preparing these documents (often many tens of thousands of dollars).
Now there are circumstances in which these types of offerings make a lot of sense, but for most technology companies seeking angel or VC funding, this is not a practical (or frankly in terms of the investor’s expectation sensible) way to go.
In order to minimize the time, cost and distraction of preparing the relevant disclosures, most attorneys will advise technology start-ups seeking angel or VC financing to exclude any non-accredited investors from the offering.
How may you solicit investors?
The big thing here is that you are not allowed to engage in “general solicitation” that is the hallmark of a public offering. A public offering is made to the public. A private placement is made privately to a select group. In essence, you can only make offers (that comply with Reg D) to people with whom you have some connection and whom you have some reasonable basis think are accredited investors.
Here is a classic example of something you can’t do. You can’t get a hold of the directory of alums of the Harvard Business School and mail your offering materials to them. Why? This amounts to an indiscriminate offer to a large number of people with whom you have no connection. It is general solicitation. You may think you have a reasonable basis to think they are all accredited and you may intend to sell only to those who later on establish that they are in fact accredited, but that is not enough. If you engage in general solicitation, you are not engaged in a private placement and you must either register the transaction or find another exemption.
Here is another classic example of something you cannot do. You cannot post on your web site that you are seeking investors for your new round of financing – not even if you also state that you will only accept accredited investors. Why? This amounts to an indiscriminate offer to a large number of people with whom you have no connection. It is general solicitation. If you engage in general solicitation, you are not engaged in a private placement and you must either register the transaction or find another exemption
What can you do? Lots of stuff.
You may approach individuals with whom you have a personal connection. If you know Bill Gates, call him up. (Ditto your mother-in-law, if you dare.)
You may approach individuals to whom you are referred by your advisors (accountants, lawyers, bankers, etc.). If your accountant says, “I know Bill Gates. Here is his cell number. Give him a call and feel free to use my name.” You can call up Bill. This is true for angel investors generally. If you are a client and I make an introduction, you can call.
You can approach organized angel groups. This approach is typically done by contacting a member of the group who vets your business plan and then recommends you (or not) for a presentation to the group. This is OK because you have established a connection to the group and it is not an indiscriminate offering to a large number of unknown persons.
You can approach venture funds. They are accredited investors. They hold themselves out as making investments. Even if you mail to a lot of them, you are not making an indiscriminate mailing.
You can retain a “placement agent” (usually an investment banker or broker) who prepares a placement memo and sends it to persons with whom he or she has a connection.
How much can you raise?
Section 506 of Regulation D does not limit the amount that you can raise. If you offer only to accredited investors (or if you meet the relevant disclosure requirements and make offers to 35 or fewer not accredited investors) and meet the other requirements of Regulation D (some of which I have described) you can raise any amount of money in a private placement thing to note here is that in a 506 offering non-accredited investors must demonstrate such knowledge and sophistication in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment or the issuer must reasonably believe that immediately prior to the closing they meet this standard. To meet this standard, issuers typically insist upon obtaining the certification of a financial advisor to the effect that the proposed investment has been appropriately explained to the not accredited investor.
Section 505 of Regulation D has somewhat less stringent requirements’ than Section 506 (that is when it comes to offers to not accredited investors), but it is only available for offerings of up to $5,000,000, less the aggregate offering price of all securities sold under Section 505 in the trailing 12 months.
Section 504 eliminates the limitation on the number of not accredited investors and the information disclosure requirements of applicable to 505 and 506, but it is only available for offerings of up to $1 million less the aggregate offering price of all securities sold under Section 504 in the trailing 12 months.
Although Regulation D is not the exclusive route to an exemption from registration for raising VC or angel money, it is a very popular route because of the certainty it provides around compliance with SEC rules. If you are out raising money, you should have a basic understanding of the landscape. Unfortunately, the securities laws are second only to the tax code in length, complexity and potential for mischief (by which I mean opportunities for entrepreneurs to mess up). For this reason, you need competent advice when you are raising money.
