Many start-ups need to raise capital to be able to produce the prototype, enter the revenue generating stage, grow their customer base, expand their product offerings etc etc etc. Fundraising is typically a path to profitability for startups — but if you sell your shares or other securities (and Convertible Notes and SAFEs are considered securities), the rules of the Securities Act of 1933 will apply. If this catches you by surprise, you are not alone: almost none of the start-ups who seek my legal advice realize that this applies even when they issue stock to their founders or advisors or raise money from friends and family.
The basic rule is: if you sell securities, you must either register them with the SEC, or fall within one of the exemptions from the registration requirement that the Securities Act and its regulations offer. Non-compliance may subject your company to various types of liability and consequences from regulators or investors.
The regulation most companies rely on for an exemption is Regulation D. Regulation D contains two SEC rules: Rules 504 and 506. Most offerings are done under Rule 506.
Under Rule 506, you may raise an unlimited amount of money. Rule 506 actually contains two possible exemptions—Rule 506(b) and Rule 506(c). An issuer relying on Rule 506(b) may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors. Accredited investor is a defined term in the regulations and means individuals who meet certain net worth and net income requirements. The reason these offerings are limited to accredited investors or a limited number of non-accredited investors who (either alone or with a purchase representative are financially sophisticated) is to ensure that all participating investors have a clear understanding of the risk they are taking with the investment in an early-stage venture.
Any non-accredited investors in the offering must also be financially sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment. To meet this requirement, non-accredited investors may appoint a purchaser representative. In addition, if non-accredited investors are involved, the company must provide certain information about itself, including its financial statements. Non-accredited investors also have the right to ask questions and obtain additional information. If selling only to accredited investors, the issuer has discretion as to what to disclose to investors. Any information provided to accredited investors also must be provided to non-accredited investors. As you see, selling to non-accredited investors is much more cumbersome than only having accredited investors, and that is why most of my clients decide to only approach clients that they have reason to believe are accredited.
Issuers relying on the Rule 506(b) exemption may not generally solicit their offerings (for example sending out mass emails that are not targeted to a specific group of individuals that you think are accredited, putting a notice on your website that you are raising capital, posting on FB and similar advertising directed at the general public). However, the Rule 506(c) exemption permits the issuer to generally solicit or advertise for potential investors. As a result, you may see an investment opportunity advertised through the Internet, social media, seminars, print, or radio or television. Only accredited investors, however, are allowed to purchase in generally solicited offerings under Rule 506(c), and the issuer will have to take reasonable steps to verify your accredited investor status. The SEC has provided guidance as to what steps they deem reasonable, such as obtaining letters from accountants and investment advisors, which many investors find unacceptable. For this reason, more often than not, clients decide not to generally solicit and advertise and instead rely on Rule 506(b). That means they approach potential investors whom they had a prior relationship with or of whom they have a good sense that they meet the net income or net worth requirements.
Rule 504 permits certain issuers to offer and sell up to $10 million of securities in any 12-month period. These securities may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements. Generally, securities issued under Rule 504 will be restricted securities (which means they must be held at least for a certain time period), unless the offering meets certain additional requirements.. You should also make sure that you do not plan a larger capital raise in the year after starting issuing securities in reliance on Rule 504, or you may have to wait until the year has passed. Also, you will have to comply with state securities laws (Blue Sky Laws) of the states in which the securities are offered and sold. This can add significant complexity and costs if investors reside in a number of different states, or you offer in a state that requires extensive documentation and registration. With counsel you would determine whether this is the right choice of exemption considering your specific circumstances.
All issuers relying on a Regulation D exemption are required to file a document called a Form D no later than 15 days after they first sell the securities in the offering. Form D will include brief information about the issuer, its management and promoters, and the offering itself and is fairly easy to file on the SEC’s EDGAR system.
Other Exempt Offerings.
There are other exemptions from registration aside from Regulation D. These include offerings under Section 4(a)(2) of the Securities Act, crowdfunding and Regulation A offerings. Each exemption is governed by one or more rules setting forth specific requirements that the company offering the securities must meet in order to qualify for the exemption. Note though that many people rely on Section 4(a)(2) but it has specific requirements such as non-solicitation, having only a limited group of sophisticated investors and other restrictions. It also does not provide a "safe harbor."
Compliance with the securities laws is critical for the success of your venture. The analysis is very technical, and you should talk with your lawyer to make sure that you understand which exemption you are relying on and then comply with its requirements. It is the ultimate protection for your business and later stage investors will invariably want to know whether you did your homework.