Today’s topic surprises and shocks most of my start-up and entrepreneur clients when they consult me about a potential capital raise. Under the Securities Act of 1933 (Securities Act), any offer or sale of securities must either be registered with the SEC or qualify for an exemption from the Securities Act’s registration requirements. That is the legalese. What it means in plain English is: whenever you raise money in exchange for securities (including convertible notes and SAFEs), you will have to make sure that you fall within an exemption spelled out in the securities laws. An experienced securities attorney can help you with the analysis. The alternative, i.e., a registered offering, is quite frankly in most cases not realistic. And yes, this applies to EVERY issuance, including to founders and friends and family. The consequences if you don’t comply can be very damaging: they may involve criminal charges and civil penalties, rescission rights on the part of the investors and a potentially chilling effect on future investors.
The exemption most frequently relied upon is Regulation D under the Securities Act, which contains three main rules that provide safe harbors from those registration requirements: Rule 504, Rule 505, and Rule 506.
Rule 504 and Rule 505 are available for certain offerings with an aggregate offering price of up to $1 million and $5 million. These safe harbors were established to help small businesses raise capital.
Rule 506 under Regulation D does not place any limit on the amount of money an issuer can raise. Rule 506 is the most frequently used and one of the most important means of raising capital in the US.
Just to give you an idea of the magnitude: According to an October 2015 SEC report:
- In 2014, Regulation D offerings were used to raise $1.33 trillion, compared to $1.35 trillion raised through SEC-registered offerings.
- Since 2009, Rule 506 offerings accounted for more than 99% of reported capital raised through Regulation D offerings (with the remaining 1% raised in offerings under Rule 504 and Rule 505).
While a company relying on a Regulation D safe harbor can avoid Securities Act registration, it must file a Form D with the SEC within 15 days after the first sale of securities. Form D must also be filed at the state level, in accordance with the state’s “blue sky” laws, if the offering is conducted under Rule 506. Form D is a brief notice setting out specified information about the offering, including the amount and value sold, whether broker-dealers were used, and the states where the securities were offered and sold. In New York, the blue-sky filing is a bit more involved (on Form 99), and most importantly, must be done before the transaction is completed. Based on my own experience, it may also take a while to get the okay from the New York state regulators, so plan accordingly.
It is important to point out that while technically Regulation D offerings may be made to accredited and non-accredited investors where there is no general solicitation or advertising, I would recommend, if possible, limiting the group to accredited investors only for a number of reasons. Most importantly, if non-accredited investors are involved, the information requirements are much more extensive. There is also a 35 non-accredited person limit.
Historically, the use of general solicitation and general advertising in any private placement was prohibited. In September 2013, Rule 506 was amended to add a new subsection (c) that permits general solicitation in offerings made under that subsection as long as the securities are sold only to accredited investors and other specified conditions are met. Note that the steps you need to take to verify the accredited investor status in Rule 506(c) are more onerous, and you should make sure that they are palatable to your target investor group.
A cautionary note: this is a bird’s eye summary of a very complex area of the law. You definitely should consult with an attorney with securities law experience to discuss your specifics. I will also post follow-up articles on what it means to be an “accredited investor” and what constitutes “general solicitation” and “general advertising,” among other things. Stay tuned.
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