This is general information, not legal advice
Sooner or later, many entrepreneurs decide to raise outside money in order to take their businesses to the next level. It is therefore helpful to have a general understanding of the securities law framework that governs the offering and sale of securities. Some basic principles and important “do’s” and “don’ts” are covered below. Of course, this can be a complex area of the law, and each situation requires careful consideration of the surrounding circumstances with capable counsel.
Public or private?
The Securities Act of 1933 requires all offerings and sales of securities to be registered with the Securities and Exchange Commission (SEC). Registration is no small matter. The requirements are substantial, and the process is intensive and expensive.
The only way to avoid registration requirements is to come within an applicable exemption, of which there are several. The main exemption, set forth in Section 4(2) of the Securities Act, is for a private placement of securities. If you move forward without a valid exemption, the risk is that the SEC brings an action against you and your company under the Securities Act for offering unregistered securities.
Thus, the fundamental question boils down to whether your offering is public or private.
How do you know whether the SEC will consider your offering public or private? One way to know is to keep your offering within the “safe harbors” established in 1982 by the SEC in order to provide some certainly to issuers of securities, which are codified in Regulation D (“Reg D” for short).
There are several safe harbors, each with different requirements. The variables at play include the size of the offering, the wealth or sophistication of the investors, the number of unsophisticated investors that may participate, and the nature of the information that must be disclosed. For example, Rule 504, the safe harbor with the least stringent information and participation requirements, limits the amount to be raised to $1 million within a 12-month period. Rule 506, which has no cap on the dollar amount of the offering, has stricter criteria as to who may purchase securities and the information that must be provided to them.
It is wise to take advantage of one of the safe harbors if they are available, and given the typical sources of early-stage funding, it is quite often possible to do so.
Leaving the harbor
Reg D is non-exclusive. That is, even if an offering falls outside of Reg D’s specific requirements, an offering may nevertheless be viewed as a private placement under Section 4(2). Not surprisingly, the general criteria that have emerged over the years for 4(2) resemble those found in Reg D: the number of offerees, the relationship of the offerees to the issuer, the information available to the offerees, the sophistication of the investors, the size and manner of the offering, and the like. Still, the problem is that the lines here are not clear. It all depends on the particular facts and how the SEC views them, and so it is not possible to know with certainty up front whether an offering might be later characterized as public by the SEC, with all of the consequences that flow from that.
The good news is that it is difficult to come up with many scenarios of truly private placements that cannot fit within one of the Reg. D safe harbors (though with some creativity, one can come up with them).
When dealing with private placements, there are some clear things that you want to do – and several that you should avoid.
- General solicitations – This is the crown jewel of the “avoid” category. General solicitations or advertising are, almost without exception, prohibited in private placements. Thinking of sending out mass e-mails about your offering or putting a section on your website for people who might want to invest? You should reconsider. Consequences of making a general solicitation include loss of the statutory exemption being relied upon for your offering or even a mandatory six-month cooling-off period during which you may be prohibited from making any offering of securities
- “Integration” – Successive, similar exempt offerings might be viewed by the SEC as, in actuality, a single offering that does not qualify as an exempt offering. So when you consider which Reg. D safe harbor to rely on, you and your counsel should consider the nature and timing of anticipated future offerings.
- To thine investors be true – Section 10(b)(5) of the Securities Act prohibits manipulative or deceptive practices, ranging from fraud to making “any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” Thus, whether your offering is public or private, whether you qualify for a Reg D safe harbor or not, your statements have to be factually accurate.
- Overlooking the States – Everything discussed above deals with federal securities law. However, the states also regulate securities offerings within their boundaries. The good news is that most state laws have been harmonized with the federal standards (e.g., have parallel versions of Reg D) and at most, require the filing of a form and payment of small fees. But there are exceptions, and this area needs to be evaluated before your offering commences.
- Forgetting to file the paperwork – Regulation D (and its state equivalents) have filing requirements. Failure to file typically does not necessarily mean that you lose the safe harbor, but it can have adverse consequences.
The good news is that it is usually possible to raise money privately without having to register the offering. If the amount of money being raised is small, and the offerees are all people with whom you have close relationships, this activity seems unlikely either to attract the attention or scrutiny of the SEC. The risk grows with the dollar amount and breadth of the offering, and for any most fundraising efforts, it will be worth your while to obtain legal advice.
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