Economic Provisions within a Term Sheet

When startups attempt to raise funding for a priced round, founders are often primarily focused on the valuation of a term sheet. This focus is not entirely unfounded. A high valuation comes with an increase in working capital for the company’s growth. The founder is also given third-party confirmation of the value of the business they created. Still, for the long-term health of the company, as well as the entrepreneur’s financial well-being, it is crucial to look beyond the valuation to the terms that come with that dollar amount.

In evaluating a term sheet, entrepreneurs need to examine the other economic provisions that impact their wealth and the wealth distribution of other investors in the event of an exit. This blog post will discuss the impact of liquidation preferences, participation rights, and anti-dilution provisions contained in most VC offers. For a further anecdotal reading on the effects of provisions in term sheets, read: How To Build A Unicorn From Scratch—And Walk Away With Nothing.


Liquidation Preferences

While most associate liquidation to the failure of a company, a liquidation event within the context of a term sheet includes not just bankruptcy or a wind-down of the business, but mergers, acquisitions, or a sale of voting control. The liquidation preference refers to the multiple of the initial investment stockholders are entitled to receive for a liquidation event. For example, if Series A investors invest $2 million with a 2x liquidation preference, they would be entitled to 4 million for any liquidation event. The standard liquidation preference is 1x, so founders should critically examine term sheets with higher liquidation preference multiples.


Participation Rights

Liquidation preferences are combined with participation rights which have a significant impact on the amount founders receive in a liquidation event. Each series of investors have the right to convert to common stock. If the class of stock investors own is nonparticipating, then the investor must choose between their liquidation preference or converting to common stock. If the class grants participation rights, then investors may take their liquidation preference and convert their shares to common stock to receive the remainder of the proceeds on a pro-rata basis.

For a clear picture of how this works, let’s examine the Series A $2 million investment. Let’s say that the post-money valuation of the company is $6 million giving investors a third of the company. If the company is sold for $8 million, then investors with a 1x liquidation preference and no participation could either take the $2 million or convert to common stock. In this instance, they would convert to common stock as the $2.67 million return is higher than their liquidation preference. Now let’s examine a sale under the same fact pattern but with investors that have participation rights in addition to a 1x liquidation preference. Those investors would get their $2 million liquidation and then convert to common stock to get a third of the remainder which would be an additional $2 million. In this scenario, the investors would get half of the proceeds from the sale of the company despite only owning a third of the company. If a founder finds themselves in a position where they must accept a term sheet with participation rights, they should at least negotiate a cap on the multiple investors can receive in return.



Another critical economic term that founders should be cognizant of is anti-dilution. Anti-dilution provisions give investors the ability to protect themselves if a company later issues equity at a lower price than what they paid for in a previous round. There are two types of anti-dilution provisions, full-ratchet and weighted average. A full-ratchet anti-dilution provision can not only negatively impact founders but other classes of investors as well. Using the example of a Series A $2 million investment, if the share price is $5, then the Series A investors would own 400,000 shares. If the next round is a down round at $3/share, then a full-ratchet provision would give Series A investors shares at this lower price. So rather than 400,000 shares, these investors would have 666,666 shares, an increase of over 200,000 shares. Such a harsh term not only impacts payouts among classes of investors but the level of control within the company. This provision may also deter the next round of investors from providing financing in the first place.

A fair and more common solution would be to take the weighted average of the price of all shares outstanding. A weighted-average anti-dilution provision provides investors with the appropriate level of downside protection while also mitigating the dilution impact it would have on the founders and future investors.



Should SAFEs replace Convertible Notes?

You may have heard about the investment instrument Simple Agreement for Future Equity, otherwise known as a SAFE. SAFEs are just one of the many things Y Combinator is famous for. Y Combinator released their form documents for this instrument in late 2013, so they have been around for some time now. However, the startup community remains divided as far as whether this kind of financing is beneficial to entrepreneurs and investors alike.

SAFEs are investment instruments that represent a promise between the company and the investor. The investor hands the company cash in exchange for the promise of the company to issue stock to the investor when some agreed upon triggering event takes place. Typically, this triggering event is when the company experiences a subsequent priced round, but the triggering event can be any one of many events the company believes it will go through. Although this process sounds similar to that of a convertible note, SAFEs are not debt instruments. They do not have a maturity date, they do not collect interest, and they are not subject to some of the regulations imposed on convertible notes. Unlike convertible notes, SAFEs have some unique features.



One of the most attractive things about SAFEs is the range of options available to the investor and entrepreneur in negotiating the terms of the SAFE. Convertible notes come with red tape and many different terms to agree on. However, SAFE negotiations usually center on one term — the valuation cap. Since there is generally only one term to negotiate, it’s “safe” to assume that the amount of time and money the investor and entrepreneur must dedicate and spend on negotiations will be lower than a convertible note. Thus, allowing for some of that precious capital to be spent on what really matters – growing the business.



SAFEs not only can be used as a mechanism for seed capital, but the instrument can also be used, under the right circumstances, to help an early stage company with a significant short-term expense.


Not Debt; Therefore No Interest

Convertible notes come with a string of terms to negotiate such as conversion cap, discount, conversion on maturity, the sale of the company, and much more. SAFEs on the other hand typically only require negotiation of the valuation cap – the cap sets the highest value that may be used to determine the conversion price of the SAFE. Another important distinction is that SAFEs do not have a maturity date like convertible notes. If the company takes years to receive new funding, the SAFE owner still maintains their right to conversion. If the company goes public, has a change in control, or dissolves the SAFE holder still maintains their right to conversion. In each of those scenarios, the SAFE is designed to convert. However, it’s important to keep in mind these conversion terms are all negotiable.

It’s important to remember that SAFEs may not be suitable for all situations and that there are drawbacks to using a SAFE. SAFEs have the potential to dilute the founder’s ownership share in their own company, causing the founder not to be properly incentivized. Having too many SAFEs on the company’s capitalization table may cause future VCs to shy away from investing in the enterprise due to them having to be pressured to a higher valuation than they may want to give. Entrepreneurs often assume the valuation cap on the SAFE will become the floor for the future equity round, as well, which is not always the case.

Overall, the entrepreneur will want to evaluate their company’s particular position when deciding whether to use a SAFE or convertible note during the seed and later rounds. It’s important for the company to assess their situation, analyze the pros and cons of issuing a SAFE versus a convertible note, and to ask if the issuance of a SAFE aligns with the company’s long-term goals.


Beware the Cap Table

So you founded your own company, congratulations! You came up with a great idea, built a team, and built a product. You are going to take over the world! But there is one thing standing in your way: money.

Startups can live and die by financing. The good news is that there are many different ways to raise money. One of the most popular/prestigious is to get an investment from an Angel or Venture Capital investor. Of course, whenever you raise money (even if it is convertible debt) you need to be aware that you are giving up a portion of your company. You may need the money, but equity is valuable, and you should protect it fiercely.

Equity is visualized/kept track of on something called a Capitalization Table (Cap Table for short). They are usually on an Excel spreadsheet, but more and more they are moving to online platforms like eShares.

Numbers and Excel spreadsheets can be super intimidating. But, founders, I encourage you to embrace the challenge and really understand your cap table. You should know it inside and out, and how different types and amounts of financing will change it. How well you understand your cap table will have far reaching consequences for the health of your company and your personal finances.

Unfortunately at the Clinic we see too many startups who take money from inexperienced investors and end up selling too much of their company too soon. While every company is different, here are some ballpark figures you should keep in mind:

  • Accelerators/incubators usually take somewhere between 5-10% of equity their portfolio companies for a combination of cash and services.
  • Angel/Series Seed investors should get somewhere between 15-33% of your company. The exact numbers depend on a number of factors, but if an investor is asking for more than 1/3 of your company at this early stage, that should raise red flags.

One of the best things you can do for your company and yourself is raise as little outside capital as possible. This means that you should bootstrap for as long as possible, and once you do raise money, be very diligent about how you use that cash so you can wait as long as possible before you raise more (if you raise more at all).

Companies that give up too much too early are in danger of scaring off future investors. When founders don’t own enough of their own company investors fear that founders, who are the heart and soul of the company, will no longer have incentives to work hard. We have seen this in several companies.

On the flip side, there are some recent success stories from the Ann Arbor ecosystem. While I won’t give away too many details for confidentiality reasons, there are some common threads. Each company raised a relatively small amount of capital (only a few million dollars, which I know sounds like a lot, but is tiny in this world). In every case the founders kept close track of their cap table and made sure they didn’t give up too much. When these companies sold, the majority of the purchase price went right to the founders, who still owned sizable (sometimes close to half) of the equity in their companies. When you are talking about acquisitions in the tens or hundreds of millions of dollars, every percentage point on the cap table is important. Many of those founders can now go on to be VCs, found another company, or never work again if they so choose.

So founders, don’t skimp on learning the ins and outs of your cap table, it will pay off in the long run!


A Primer on Bank Financing for Small Business

Small businesses may be financed in a variety of ways. Two of the most basic are through the investments of founders and key backers, and through loans provided by banks. Although bank loans are not appropriate for all small businesses, they can be a valuable lifeline for many. In order to receive such bank financing, the borrower will undergo a process called underwriting, which will rely on a few key considerations.


Underwriting A Loan

The primary task of a bank that performs commercial credit functions (loans for business purposes) is the underwriting of loans. Although this process varies from bank to bank, and may sound intimidating, it can be boiled down to a broad description helpful to entrepreneurs and small business owners. At its most basic, underwriting commercial credit is the process by which the bank will determine whether not to extend a loan to any particular party who requests it. What the bank is doing is making the decision of whether or not the requested loan is an appropriate risk for it to take on. This decision reflects a judgment about a few core criteria.

First, a small-business owner seeking bank credit should understand the goals of the bank, or other financial institution, from which they have requested a loan. A bank makes its profits primarily through something called its net interest margin. This metric is a simple calculation that attempts to quantify the difference between what a bank pays out to its depositors as interest on their accounts, and the amount that a bank receives from its borrowers on their loans. As common sense would suggest, a bank will only make money if it is able to charge its borrowers a rate of interest higher than it is paying to its depositors. This is not, however, the end of the story.

In addition to charging borrowers a greater rate of interest than it pays depositors, the bank will also need to account for the possibility that its borrowers do not pay back their loans at all — and therefore reducing the total amount it receives from borrowers as a group. This is the primary consideration a bank undertakes in its underwriting process. Put simply, if the bank does not believe that a small-business will be able to repay the loan, it will not enter into the transaction. This is why it is sometimes difficult for new start-ups and small businesses to get bank financing. Because the risk in a new venture is often hard to quantify, the bank will require extra assurances that it will be paid back, including with interest. These assurances come in a variety of forms, but the two below usuallyrepresent the most important considerations to a lender.


What A Bank Looks For

Cash Flow

A primary consideration in the underwriting process is the cash flow of the proposed borrower. There are a number of ways to calculate this figure, but one of the simplest is a measure called EBITDA (earnings before interest, taxes, depreciation, and amortization). What this accounting figure attempts to reflect is the actual amount of cash coming into and going out of a business. A bank will want this figure to be large enough that when loan payments are taken into account, the business will not struggle to fund its necessary operations.

This presents a challenge for start-ups in particular because they often do not have a history of cash flows at all, let alone a history of positive cash flows. Entrepreneurs often start businesses which will take months or even years to show profitability. Further exacerbating this problem, a bank will often require a borrower to be able to show at least a few years of positive cash flow, to reassure the bank that it will be paid back. Although this is often a disqualifying factor for many small businesses, as will be seen below, it may not foreclose the possibility of funding a business with bank loans.



Collateral means something specific in the context of banking. It refers to some other property the borrower commits to the lender as way of guaranteeing repayment. For example, in a simple transaction a borrower may grant the lender a lien or security interest on the business’s tangible property. Perhaps on the building in which the business operates, or on valuable equipment the borrower uses to create its goods. From the bank’s perspective good collateral is often essential in that it represents a kind of back-stop against possible losses in the event the business is unable to pay back its loan through cash flows.

From this description, it may already be apparent that good collateral may represent another way for a small business to gain bank financing, even in the absence of a history of positive cash flows. If the bank is satisfied that the collateral it holds against a loan will be sufficient to satisfy the debt, they are more likely to lend to a new-and-unproven enterprise. Examples of strong collateral include property whose value greatly exceeds the size of the loan requested, and such property as may be easily sold by the bank. The gold standard would be cash held at the bank financing the loan, because it has a readily-ascertainable value, and can be easily converted to satisfy the borrower’s debt. Therefore, even in the absence of positive cash flows, a small-business may be able to reassure the bank of repayment by committing adequate collateral.



For many new and emerging start-ups, bank financing may not be a realistic goal. However, for a business that has a history of positive cash flows, or one that has access to high-quality collateral, it remains a potentially valuable source of funding. It has the benefit of allowing the entrepreneur to retain ownership of their business (rather than selling part ownership to investors), and can provide a ready source of funds for the entrepreneur to invest back into the business. Through the process of underwriting, a bank will look at a number of factors to determine whether it wants to take the risk of extending a loan. Cash flow and collateral are only two considerations, but are often the most important to the lender.


The Basics of Debt-Based Crowdfunding



Attaining funds is a critical step for many entrepreneurs. Fortunately, innovative concepts like crowdfunding, where funds are collected from a large, dispersed pool of investors, have provided entrepreneurs with alternatives to traditional funding sources like financial institutions and venture capitalists. According to an industry report, in 2015, the global crowdfunding industry surpassed $34 billion in estimated fundraising volume. In conjunction with the increase in crowdfunding transactions, crowdfunding sites have multiplied. These sites come in a variety of different forms and provide entrepreneurs the ability to customize their funding campaigns. Common types of crowdfunding sites, in their simplest form, include:

Equity-Based – investors receive a portion of the company in exchange for funds

Reward-Based – investors receive goods or services in exchange for funds

Donation-Based – individuals provide contributions


While these three types comprise a large sector of the crowdfunding market, entrepreneurs and investors also commonly use debt-based sites, which accounted for $25 billion in estimated fundraising volume in 2015. In a debt-based crowdfunding transaction, rather than receiving equity in exchange for capital, investors receive a debt instrument, often in the form of a note or bond, with a fixed repayment term and a specified rate of interest. Most debt-based sites are free to register and require borrowers to submit financial information before receiving a customized interest rate and credit risk. Entrepreneurs favor these sites because the interest rates are often lower than or competitive with interest rates at traditional financial institutions. It is important to keep in mind that this type of crowdfunding campaign is not for every entrepreneur. Rather, it is particularly advantageous for entrepreneurs who have difficulty meeting market demand for their service or product.

Debt-based crowdfunding has been described as a “win-win” because it provides investors with a relatively low-risk return and entrepreneurs with the ability to retain equity. However, one inherent risk to investors is the fact that these loans are often unsecured and leave little recourse in the event of default. The growth of the crowdfunding industry has alleviated some of these investor concerns, as several debt-based platforms boast impressive track records. Three examples of such sites include:


Lending Club:

  • Founded: 2006
  • Total Amount of Loans (individual loans and business loans): Over $20 billion
  • Interest Rate Range: 5.32–30.99%

Funding Circle:

  • Founded: 2010
  • Total Amount of Loans: Over $2 billion
  • Interest Rate Range: 5.49–27.79%


  • Founded: 2006
  • Total Amount of Loans (individual loans and business loans): Over $6 billion
  • Interest Rate Range: 6.88–31.10%

It is undeniable that debt-based crowdfunding has experienced a dramatic growth over the past decade. Yet, citing a limited pool of investors and an influx of loan applications, critics warn that perhaps the “novelty” of debt-based crowdfunding is coming to an end. It remains to be seen whether this is the case.

For now, because the laws concerning crowdfunding remain in flux, entrepreneurs should stay informed. Visit the following links to learn more about crowdfunding:

CrowdFund Intermediary Regulatory Advocates

Crowdfund Insider


Crowdfund CPA


A Quick Primer on Title III Equity Crowdfunding: Drafting Your Term Sheet (Part 3 of 3)

Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if "market" terms emerge.

Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if “market” terms emerge.

While it remains to be seen how and to what extent crowdfunding will take off, here are a few things to keep in mind as you start thinking about possible deal terms on your first crowdfunding operation. I should note that ultimately, I anticipate that entrepreneurs will gravitate toward terms suggested by the most popular funding portals, and that these terms will become the market standard. Nonetheless, you’ll still have to come up with the economic and control terms of the deal yourself, and I hope this article helps you think critically about such terms as you do.

  • Valuation – Valuation is a function of the amount being raised and the percentage of the company being purchased. Current practices involve a negotiation between the investors and the entrepreneur, whereas crowdfunding will let the entrepreneur set the terms. In Venture Deals, Brad Feld and Jason Mendelson warn of setting your valuation too high due to the risk of not achieving a higher valuation at the time of your next round, causing dilution of your original supporters. While crowdfunding investors might not have the same anti-dilution protections as VC investors, there still might be risks from a subsequent down round due to the investors’ expectations going unmet. The takeaway here is to be reasonable in your valuation and have a solid plan on how you’re going to use your funds to build and create value in the business.
  • Number of Shares – Angel investing in seed rounds typically acquire between 20%-35% of the company—any more than that could hurt your ability to raise future rounds. Of course, with new types of companies entering the mix, common practices may not hold. Consider having your CFO use a <a href=””>pro forma cap table</a> to run through a few hypothetical future financing scenarios, and let where you hope to end up inform where you might start.
  • Protective Provisions – Freedman and Nutting anticipate a future in which funding portals may opt to allow investors to pool their funds into a single entity that could serve as an agent of the “CF class” and possibly negotiate a board seat. Until that becomes a reality in the U.S., you can expect investors to pay special attention to the veto rights they are given.In negotiated transactions, investors almost always have the right to vote when an issuer (1) alters the rights of the issued shares, (2) changes the authorized shares of common or preferred stock, (3) creates a new class of shares having rights, preferences or privileges senior to the issued shares, and (4) wants to merge or be acquired. I can’t imagine many investors signing up to invest without (1)–(3), but we’ll have to see how investors respond in a system in which the terms are set by entrepreneurs.Note that Section 4A(b)(1)(H) requires “a description of how the exercise of the rights held by the principal shareholders of the issuer could negatively impact the purchasers of the securities being offered,” so failing to treat your investors fairly will likely negatively impact the economic terms of your offering.
  • Drag-Along/Tag-Along Rights – Drag-along rights ensure that if you want to sell the company, you can compel other shareholders to sell their shares on the same terms. Tag-along rights provide corresponding rights for investors and ensure that they have the option to sell their shares on the same terms if you sell the company.Drag-alongs tend to be more controversial when they are being requested by investors in a new round, in which case they could force an entrepreneur to sell her company even if she didn’t want to. When being imposed on crowdfunded investors, they simply allow you to capture the full value of your equity in the event of a sale. You’ll almost certainly want them given the large number of shareholders inherent in crowdfunding transactions. It’s tough to think of a reason why you wouldn’t want to offer investors tag-along rights—which is likely why both drag-alongs and tag-alongs appear in the suggested term sheet on UK crowdfunding site Seedrs.

Of course, no deal is the same, and you should always work with an attorney experienced in this field when creating a financial offering.

Part 1 of this series is here and Part 2 of this series is here.


A Quick Primer on Title III Equity Crowdfunding: Is Equity Crowdfunding Right For Your Startup? (Part 2 of 3)

Even though equity-based crowdfunding is now legal, it might not be right for you.

Even though equity-based crowdfunding is now legal, it might not be right for you.

This is part 2 of our series on equity based crowdfunding.  Let’s take a step back from the brave new world of equity crowdfunding and think back to the existing model of getting early stage funding through networks of angels and VC’s. Hasn’t this system worked until now, and will startups be missing out if they stray from the beaten path?

We’d be remiss to forget that angels and VC’s provide more value than just capital. Experienced investors will challenge your assumptions and send you back to the whiteboard a few times before providing capital, which can ultimately improve your business outlook in the long run. Post-financing, these investors also serve as valuable mentors and advisors, providing expertise and a rolodex of people that can help your business blossom. And even though these investors are loathe to sign confidentiality agreements, you’re generally safe to meet with these folks with the understanding that your financials won’t wind up in the hands of a competitor. All this is to suggest that simply because you might no longer need the traditional conduits for seed capital, it doesn’t follow that they won’t be one of your better options.

But rather than compare crowdfunding to the traditional early-stage/seed model on the merits, it may be more accurate to think of it as opening up entrepreneurial finance to businesses that didn’t have much access before. In Equity Crowdfunding for Investors, David Freedman and Matthew Nutting predict that while crowdfunding will eventually attract all types of businesses, early adopters may be limited to certain types, such as consumer products businesses with a devoted fanbase, for-profit businesses supporting a social cause, community-based retailers with investors that have a direct connection to the business, and creative projects such as films, music, and games. Many of these might not quite qualify as a “homerun” to an angel or VC, but could still attract investment for a variety of reasons.

Here are a few questions to ask as you grapple with the question of whether to seek a Reg CF round:

  • How many rounds do you plan on raising in the future? Ideally, your first Reg CF round should be enough to get your project off the ground, and subsequent rounds will also be crowdfunded. I have personally heard one VC state that as of now, he would refuse to invest in a company with a large number of unaccredited investors. That’s not to say that this is a widely-held belief of VC’s or that the industry doesn’t stand to change; but if you anticipate seeking VC funding in the future, a crowdfunding round may be too much of a hindrance in the long term.
  • How competitive is your industry? Are you developing tech that will be the next big thing in virtual reality? The next cure for a heavily-researched disease? If confidentiality, trade secrets or other IP are a major concern, or the industry in which you operate is extremely fast-paced, you may want your investor profile to be as lean as your startup. While drag-along rights (discussed in Part 3) coupled with the founders maintaining control over the company may make receiving stockholder approval for major transactions less of an issue, you’ll want to think about how the disclosures mandated by Reg CF will affect your financing strategy.
  • How big do you plan on getting? Reg CF is overall, less burdensome. But if your company will someday be the size of Facebook (which it will be, of course), then the costs associated with other exemptions may not be a huge concern, all things considered. Of course, if the $1 million cap on Reg CF rounds simply won’t meet your needs, then you should certainly seek alternative exemptions rather than impede your business early on.

You can find Part 1 of this series here.


A Quick Primer on Title III Equity Crowdfunding: Starting-Up as a VC (Part 1 of 3)

The SEC's equity-based crowdfunding rules went into effect on May 16, 2016.

The SEC’s equity-based crowdfunding rules went into effect on May 16, 2016.

In the same way technology empowered anyone to become an entrepreneur, so too will it enable anyone to step into the shoes of a venture capitalist. April 5 marked the 4th anniversary of the JOBS Act’s signing by President Obama, but the final rules which implement Title III, which pertains to equity crowdfunding, went into effect on May 16, 2016.

While the creation of a more legitimate crowdfunding industry can be seen as a major step in the democratization of capital markets, it’s not as if the barriers to entry are being completely leveled—entrepreneurs and investors alike will still have to be conscientious of the investment restrictions, disclosure requirements, and other limitations before determining whether equity crowdfunding is suited to finance their ventures.

In this first part of this three-part series, we clarify some terminology for those completely new to the concept of equity crowdfunding and give a quick overview of the regulations themselves. In Parts 2 and 3, we’ll help you use some of this information to determine whether crowdfunding is right for your business and some things to think about when you raise your first round.


If you’re confused by the foregoing because you’ve been funding new ventures through Kickstarter for years, don’t feel bad; people often speak of “crowdfunding” generally without distinguishing between equity crowdfunding and other types.

Crowdfunding simply refers to the practice of funding a project through a large number of donors. In the past, people have initiated crowdfunding campaigns through platforms like IndieGoGo and Kickstarter in which donors typically receive certain perks or rewards for early presales or donations.

Equity crowdfunding involves the offering of equity securities to investors online. Investors purchase an actual ownership stake in the business entity with an intent to share in its financial returns and profits. It’s a close cousin of debt crowdfunding or peer-to-peer lending, which involves the offering of debt securities to groups of lenders online.  Debt crowdfunding sites like Lending Club and Upstart have already taken off.

In the U.S., the sale of securities implicates federal securities laws, as well as state “blue sky” laws. Issuers must either register their securities with the SEC or find an exemption (…or, face serious penalties).  Until recently, startups nearly always structured early stage offerings to fall under Reg D, a set of three rules—504, 505, and 506—which carve out exemptions to the registration requirements of the Securities Act of 1933, which we described in great detail in an earlier post. Because Reg D fails to provide startups a way to reach larger pools of investors, the SEC created another avenue by amending Regulation A (now referred to as Reg A+), as described in our prior post. Reg A+ allows companies to file a single, less costly registration with the SEC as opposed to one under each state’s blue sky laws, but given the need for audited financials (and a track record of legal, audit, and underwriting fees sometimes exceeding $1M), Reg A+ is not always suited to early/seed stage companies.

Enter Regulation CF

To fill the vacuum of ways for startups to raise seed capital from a large number of investors, Title III added Section 4(a)(6) to the Securities Act to create an exemption from registration for certain crowdfunding transactions.

Amounts Raised

Section 4(a)(6) sets a hard cap of $1M per 12-month period for any entity raising funds. This may seem low, considering that the median convertible note round last year was $1M, on the rise from years prior. However, it’s possible that the sort of crowdfunding enabled by Reg CF will itself change the way startups raise money by eliminating the need to pull together a syndicate of interested accredited investors and gather funding in a single transaction.

Investment Limits

The SEC doesn’t want you to get carried away as you start channeling your inner Mark Cuban. If you make less than $100,000, you can invest the greater of $2,000 or 5 percent of your annual income or net worth in a 12-month period. If you make over $100,000, you can invest up to 10% of your annual income or net worth (but in no cases greater than a total of $100,000) per 12-month period. Transactions must be done through an intermediary registered as a broker-dealer or a funding portal.

Entrepreneurs Who Can Stop Reading Now

Some companies aren’t eligible to use the Reg CF exemptions. These include:

  • Non-U.S. companies
  • Exchange Act reporting companies
  • Certain investment companies
  • Companies that are disqualified under Reg CF’s disqualification events (which include the conviction of crimes, court orders against engaging in the sale of securities, and other regulatory actions against the issuer)
  • Companies that have failed to comply with the annual reporting requirements under Reg CF during the two years immediately preceding the filing of the offering statement, and
  • Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Resale Restrictions

Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year. Investors should consider themselves in it for the long haul.


How will investors know what they’re investing in? Issuers are going to have to disclose in their offering documents information that includes:

  • Information about officers, directors, and owners of 20 percent or more of the issuer
  • A description of the issuer’s business and the use of proceeds from the offering
  • The price to the public of the securities or the method for determining the price
  • The target offering amount
  • The deadline to reach the target offering amount
  • Whether the issuer will accept investments in excess of the target offering amount
  • Certain related-party transactions
  • A discussion of the issuer’s financial condition
  • Financial statements of the issuer that are accompanied by information from the issuer’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.

An issuer relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless they’ve already had their financial statements audited. Issuers are also required to file an annual report with the SEC and provide it to investors.

Check out Part 2 of our series here.


Pitching Investors: Watch for General Solicitation Rules

Securities laws may restrict how you discuss how your startup plans to raise money.

Securities laws may restrict how you discuss how your startup plans to raise money.

Many people think securities laws are only relevant to big companies in their billion dollar public offerings. Securities laws, however, are also relevant to your startup.

The general rule in the Securities Act of 1933 prohibits selling securities other than by means of a registration statement. Fortunately, the statue also provides certain registration exemptions for transactions that are not public offerings.

One critical concept under Regulation D is the general solicitation rule. Failing to comply with the general solicitation rule may cause a start-up to lose the exemption status. Under some circumstances, pitching your company could be deemed a general solicitation. Therefore, it’s critical for founders to pay attention to the Regulation D and the general solicitation requirements before pitching your company.

Safe harbors in Regulation D

Most startups rely on Regulation D, promulgated by the SEC as the exemption from the registration requirements of the securities laws. There are three main safe harbors in Regulation D – Rule 504, 505, and 506. Rule 504 and Rule 505 are less popular because the issuers have to comply with the securities laws in each state where they are selling securities (see previous post for more information of Rule 504 and 505).

The most commonly used exemption is Rule 506, which allows a company to raise an unlimited amount of capital from an unlimited number of accredited investors (see previous post for information of accredited investors). Rule 506 has two separate but related exemptions—Rule 506(b) and Rule 506(c). Rule 506(b) prohibits general solicitation while the new Rule 506(c), subject to a variety of conditions, allows offering through public advertising and general solicitation.

What is General Solicitation?

Regulation D doesn’t define general solicitation, but gives some examples of prohibited solicitations, including any advertisement published in any media (e.g., television, newspapers, magazines, Internet, radio, public seminars, or cold calls), and any meeting whose attendees have been invited by a general advertising.

When is a solicitation not general? The SEC interpreted the prohibition as requiring that the issuer (or a person acting on its behalf) has a “pre-existing relationship” with each offeree. Examples of pre-existing relationship including:

  • Use an outside agent, such as a broker, to serve as an intermediary
  • Use questionnaire to request investors providing self-verification regarding their financial status
  • Use password protection to prevent general public from accessing investment information on the website

The New Rule 506(c) Under the JOBS Act

On July 10, 2013, the SEC revised Regulation D to remove prohibition on general solicitation and general advertising in offerings and sales under Rule 506(c), provided that all purchasers of the securities sold in these offerings are accredited investors. The major differences between Rule 506(b) and Rule 506(c) are summarized in the chart below.

Rule 506(b) Rule 506(c)
Limitation on amount of capital raising Unlimited Unlimited
Type of investors Accredited investors and up to 35 non-accredited sophisticated investors Only accredited investors.
General solicitation Prohibited Allowed
Accreditation process Allow Self-certification Take reasonable steps to verify accredited investor status

Although Rule 506(c) allows general solicitation, which seems to be a huge advantage, there are several reasons an issuer may prefer to rely on Rule 506(b).

First, Rule 506(c) requires an issuer to take “reasonable steps” to verify that all investors in the offering are accredited investors. According to the SEC guidance, self-certification by investors, for instance questionnaires in which investors self-report their income or net worth, does not satisfy Rule 506(c)’s standard. Instead, issuers must generally request investors to provide tax returns, bank statements, or credit reports to demonstrate their income or net worth. Not only will this requirement add an additional administrative burden on an issuer, it may also alienate some investors.

More importantly, Rule 506(b) is a non-exclusive safe harbor. This means that an issuer can still use the general Section 4(a)(2) exemption under the Security Act if the offering fails to satisfy Rule 506(b)’s requirements. However, an issuer using general solicitation in reliance on Rule 506(c) does not have this fall-back option as general solicitation is prohibited by the Section 4(a)(2) exemption.

Finally, the SEC has also proposed to add new disclosure requirements to Rule 506 and Form D, which may offset Rule 506(c)’s Advantages. For example, the proposed rule requires a Rule 506(c) issuer to file an advance Form D at least 15 days before any general solicitation (instead of the current requirement, 15 days after the first sale). The proposed rule also requires an issuer to file the general solicitation materials, which must have specific mandated legends, with the SEC on or before the date of the general solicitation. These requirements may be difficult or impossible to comply with in practice.

If you do decide to rely on Rule 506(b), here are some tips to help avoid running into the general solicitation trap.

  • Limit offers and solicitations to persons with whom you have a “preexisting substantive relationship.”
    • When attending a pitch event, make sure the attendees are limited to persons with whom the event organizer has a pre-existing relationship or who have been contacted through a network that the event organizer can rely upon to create that relationship.
  • Avoid making “offer” to people you do not have a preexisting relationship.
    • To avoid making offer, only provide factual business information and do not include projections.
  • Monitor the activities of any agents or representatives to ensure that they are not performing general solicitations.
  • Prepare a list of likely investor targets as early in the process as possible and stick to it.
  • Be very circumspect in any interactions with the press.
  • Keep strict control over the dissemination of offering materials.
  • Use password protection and online questionnaires to prevent nonaccredited investors from accessing investment information on a website.
  • Review your website content.







Revisiting Regulation A+: A Few Considerations

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flicker. CC By 2.0 License.

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flickr. CC By 2.0 License.

The ability to successfully fundraise is typically a significant factor in an early technology venture’s success. While most seek to raise capital from a small number of wealthy individuals or institutions, such as angel investors or venture capital firms, entrepreneurs are increasingly seeking the ability to raise capital through larger groups of investors, each offering a smaller financial contribution. Until recently, startup financings have typically fallen under Regulation D, a set of three rules – 504, 505, and 506 – which carve out exemptions to the registration requirements of the Securities Act of 1933, as described in this prior post. However, “Reg D offerings” are not without limitations – offerings conducted under Rule 504 are capped at a modest $1M, while offerings under 505 and 506 significantly limit the number of unaccredited investors. Although still a popular option, Reg D offerings often do not give capital-starved ventures the ability to sell to a much larger pool of interested investors, especially one including unaccredited investors..

It is not surprising then that there was significant excitement within the entrepreneurial community when the SEC finalized amendments to Regulation A in June 2015. Similar to Regulation D, the existing Regulation A provided an alternative set of exemptions to the Security Act of 1933, but these exemptions did not include limitations on the number of unaccredited investors. However, prior to this recent amendment, due to the fact that Reg A offerings were capped to $5M per sale and subject to burdensome “blue sky” security laws of individual states where securities would be sold, Reg A offerings have failed to take off. The new amendments to Regulation A, dubbed “Regulation A+,” created buzz by raising the dollar limit from $5M to $20M and $50M for each of the respective Tier 1 and Tier 2 offerings. Combined with a new coordinated review process for Tier 1 offerings and blue sky law exemptions for Tier 2 offerings, Regulation A+ gives entrepreneurs the ability to raise much more per sale while bypassing the time and financial costs associated with blue sky law compliance.

Since June 2015, the SEC has received many filings and have qualified around a dozen sales to date. A few examples of recently qualified offerings include:

  • Sun Dental Holdings, LLC – A traditional dental device manufacturing company that also focuses on digital scanning, cloud-based data management system and 3D printing to produce dental devices.
    • Sun Dental filed and qualified a Tier 2 offering for $20 million (9/3/15 – 12/1/15).
    • Disclosed costs include $330K in legal fees, $380K in audit fees, and $950K in underwriting fees.
  • Groundfloor Finance Inc – An online investment platform designed to source financing for real estate development projects.
    • Groundfloor has had two Tier 1 offerings qualified, the first for $545K (3/23/15 – 8/31/15) and the most recent for $1.5M (10/7/15 – 10/29/15).
    • Disclosed costs for the first offering included $458K in legal fees, $30K in audit fees.
  • Elio Motors – An automobile company planning on manufacturing low-price, compact cars for a fraction of the price.
    • Elio filed and qualified a Tier 2 offering for $25M (8/28/15 – 11/20/15).
    • Disclosed costs include $110K in legal fees, $25K in audit fees.

While Reg A+ offerings have been gaining some traction, there are still significant obstacles in pursuing this financing option. Some issues entrepreneurs should consider before proceeding include:

  1. Cost. The first obstacle to Reg A+ has been the fees associated with completing and filing the application. While not as costly as an actual IPO, Regulation A+ still requires a dedicated team of lawyers and accountants to produce the offering circular and the financial statements (audited, if conducting the more lucrative Tier 2 offering). Recent filings have put legal fees anywhere from the low thousands up to $485K, and auditing fees typically add on another $20K to $30K. Due to the complexity of securities law and filing requirements, experienced counsel and the associated fees are essential to the process.
  2. Administrative Burden. In addition, the venture must be prepared to handle the administrative aspect of filing and selling securities under Regulation A+. Developing the substance of the offering circular will be time consuming, and companies conducting a Tier 2 offering will be on the hook for ongoing reporting requirements. For a leanly staffed team, the administrative burden might be a significant worry.
  3. Liability. Sellers of Regulation A+ securities are liable for any material misleading statement or omission made in an offering circular or oral communications, and anything said in the offering circular could be used in litigation down the road. As such, entrepreneurs must be careful to engage with experienced counsel in developing their circular.
  4. Impact on Future Investors. Experienced attorneys have brought up concerns surrounding the impact of introducing many unaccredited investors into a company’s cap table. There appears to be a consensus that VCs and other institutional investors tend to shy away from companies that have “crowded cap tables” because it can be difficult and risky to invest in a early-stage company with such a composition.
  5. Public Disclosure. Entrepreneurs will need to provide significant disclosures about their business and financials in its offering circular. This can sometimes be an issue for a venture that prefers to keep certain facts about its technology or financials internal until a more appropriate time.

While brimming with potential, Regulation A+ offerings can hardly be considered “easy money.” These very real obstacles are substantial, and should give any prudent entrepreneur pause to entertain other, more traditional financing methods. Those who do decide that they have the appetite to pursue a Regulation A+ offering should do so with ample resources, experience counsel, and a clear understanding of the difficulties involved in the process.