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.


When is it Necessary to Amend Your Form D?

If a startup materially changes the structure of its financing, it might need to give its Form D a touch-up.

If a startup materially changes the structure of its financing, it might need to give its Form D a touch-up.

This post outlines what situations might require an “Issuer” of securities (e.g., a startup raising capital) to amend its Form D filing.  Failing to amend a Form D when required can jeopardize the startup’s ability to use an important safe harbor to securities registration requirements. This can result in costly public registration of the offering and potential securities laws violations.  The post also provides a brief reminder of the fraud liability exposure associated with any SEC filing (including Form D) or public statement made regarding an Issuer.

What is Form D?

When a start-up begins fundraising, the company typically offers for sale its securities (becoming an “Issuer” of the securities). In the world of start-ups, the Issuer primarily relies on the private placement exemptions to federal securities laws to avoid public registration of the offering of securities.  The Issuer typically structures its offering through the SEC’s private placement safe harbor, Regulation D.  Regulation D provides several options to structure an offering based on the specific nature of the offering.  Even though each type of Regulation D offering has specific requirements, there are also universal obligations imposed on every company that relies on the safe harbor.

One of the universal requirements is for the Issuer to file a “Form D” with the SEC at the start of the offering through its EDGAR database.  The Issuer’s Form D contains certain information about the company and the plans for the capital raised.  And, because offerings can last for an extended period of time, the Issuer must generally keep its Form D up to date through the close of the offering.

 Form D Amendments

After the Issuer files an initial Form D, an amendment may be filed at any time through EDGAR. The new filing should be marked as an “Amendment” under Section 7 of Form D: “Type of Filing.”

There are certain situations that require an amendment, and there are other scenarios where an amendment is optional (the latter referred to herein as the “Amendment Safe Harbor”). The easiest way to think about amendment filing obligations is as an umbrella requirement with several carve-outs, through the Amendment Safe Harbor.

Umbrella Requirement— Form D Amendments Must be Filed

1) Annually – on the 12-month anniversary of the most recently filed notice (if the offering is continuing).

2) Material Mistake – When a material mistake of fact or error has been discovered in the earlier filing and needs to be corrected, as soon as practicable.

  • Under federal securities laws, “material” information typically refers to a fact, that, had an investor been aware of that fact, there would have been a substantial likelihood that its disclosure would have been viewed by a reasonable investor as having significantly altered the “total mix” of information made available. (TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976))
  • Determining materiality is a factual analysis considered on a case-by-case basis.  There is no bright line rule for when an issue becomes “material.”  However, the SEC has provided some examples of circumstances that typically cross the materiality threshold.
  • In the context of an early stage venture, there is little guidance as to what the SEC considers material and therefore requiring an amendment to a Form D filing. When determining if an update is necessary, it is important to think critically about how a “reasonable investor” would assess the information.

3) Other Changes – There has been a change in the information previously provided filing that needs to be corrected, as soon as practicable and subject to the Amendment Safe Harbor.

Amendment Safe Harbor—A change to the information contained in the previous filing does not require an amendment when it only refers to a change to:

  • The company’s revenue or aggregate net asset value;
  • Investment amount:
    • An increase to the minimum investment amount;
    • Any change to the minimum investment amount, that, together with all other changes to the amount since the previous filing, does not result in an decrease of more than 10%;
  • Total offering amount:
    • A decrease to the total offering amount;
    • Any change to the total offering amount, that, together with all other changes in that amount since the previous filing, does not result in an increase greater than 10%;
  • Securities:
    • The amount of securities sold in the offering;
    • The amount of securities remaining to be sold;
  • Investors:
    • The total number of investors who have invested in the offering;
    • The number of non-accredited investors, so long as the change does not increase the total number to more than 35 total non-accredited investors;
  • Payment Information:
    • A decrease in the amount of sales commissions or finders’ fees;
    • The amount of sales commissions or finders’ fees, if the change, together with all other changes in that amount since the previously filed notice, does not result in an increase of more than 10%;
    • A decrease in the amount of proceeds from the offering used for payments to executive officers, directors or promoters;
    • The amount of proceeds from the offering used for payments to executive officers, directors or promoters, if the change, together with all other changes in that amount since the previously filed notice, does not result in an increase of more than 10%;
  • Affiliates:
    • A sales person’s (that is, someone receiving sales compensation) address or states of solicitation; or
    • A related person’s (as identified on the earlier Form D) address or relationship to the Issuer.

No Amendment Requirement—There is no requirement to file a Form D amendment to reflect a change that occurred after the offering ends.

Changes Outside the Safe Harbor While the Amendment Safe Harbor is expansive, there are still some critical updates that do trigger an obligation to file an amendment.  Notably, this includes:

1) When there are more than 35 non-accredited investors in an offering; and

2) When a greater than 10% increase in the amount of the offering proceeds are used to pay executive officers of the Issuer.

It would be good practice to check the Amendment Safe Harbor for a specific exemption in each instance rather than rely on the broad nature of the exemptions.

 Fraud Liability in Connection to SEC Disclosures:

It is also important to remember that any information published or announced about the company is subject to the antifraud provisions of the securities laws (especially Exchange Act §10(b) and Exchange Act Rule 10b-5).  This includes information included in SEC disclosures (like a Form D) or a public statement, whether written, verbal, or electronically transmitted.

Simply, to be in compliance, there should be no incorrect, incomplete, or omitted facts that would mislead an investor in any statement about the company (such as a fact included in a Form D Amendment). Suspicion of deception, manipulation, or fraud in connection with the sale of securities (both private and public offerings) can lead to private litigation and SEC enforcement actions.


Failing to amend Form D when required can create exposure to securities laws liability on two fronts:

  1. Through not adhering to Regulation D’s requirements for use of the private placement safe harbor; and
  2. By outdated/untrue information deceiving any investors in violation of the antifraud provisions.

These claims can be costly to defend and can also result in considerable penalties. As a result, ensuring that all information in the Issuer’s Form D is up to date and accurate is critical to remain in compliance and avoid crippling defense costs.

Especially in the context of private securities offerings, the obligations required to comply with securities laws can be complex and convoluted.  As a rule of thumb, if you are confused about the application of the securities law in a certain scenario, you are not the only person who has posed this question. The best practice is to always check the written statutes, regulations, and other guidelines on the SEC’s website or consult with a securities law attorney.

The information in this memo was primarily taken and condensed from, “Filing and Amending a Form D Notice, A Compliance Guide for Small Entities and Others.”  The SEC’s staff created this page as a guide. The guide summarizes and explains rules adopted by the SEC, but is not a substitute for any rule itself. Only the rules can provide complete and definitive information regarding its requirements.


WhatsApp: What We Know About the Incorporation History of a $19B Company

Incorporated in California in 2009, WhatsApp, Inc. later converted to a Delaware corporation.

Incorporated in California in 2009, WhatsApp, Inc. later converted to a Delaware corporation.

As has now been widely reported, Facebook is acquiring cross-platform messaging app WhatsApp for a reported $19B.  The Wall Street Journal reports that this will be the largest acquisition of a venture-backed company in history.  While much has been written about this deal, it might be interesting to examine the corporate history of WhatsApp, Inc.  According to California’s records, WhatsApp originally incorporated in California on February 24, 2009.  While most startups seeking venture capital will incorporate as a C Corporation in Delaware, some startups will elect to form as an LLC or Corporation in their home state in order to avoid the extra fees associated with having to register as a foreign entity in the home state where they are transacting their business.  Because WhatsApp is based in California, WhatsApp likely benefited from incorporating in its home state because it did not have to register as a foreign entity in California and pay the associated fees on top of its Delaware fees.

As shown below, WhatsApp eventually converted from a California Corporation to a Delaware Corporation.

California records show that WhatsApp, Inc. incorporated in California in 2009 but later "merged out" into a Delaware corporation.

California records show that WhatsApp, Inc. incorporated in California in 2009 but later “merged out” into a Delaware corporation.

As described in this prior post, it is common for a startup to convert from an entity in its home state to a Delaware corporation if it seeks to raise capital from institutional investors.  Most venture capital firms can only invest in C corporations because of the negative tax and paperwork consequences to their limited partners of investing in a flow-through entity (such as an LLC or S corp).  Investors will prefer Delaware for a number of reasons, including that they are familiar with the protections provided to directors (which is relevant to venture capitalists because they will typically take a board seat) provided under Delaware law.

Delaware records show that WhatsApp became a Delaware corporation on July 16, 2013.

Delaware record show WhatsApp becoming a Delaware corporation in 2013.

Delaware record show WhatsApp becoming a Delaware corporation in 2013.

It’s been known that WhatsApp raised a Series A round of $8M from Sequoia Capital in April 2011. TechCrunch is now reporting that Sequoia also led multiple other major rounds in WhatsApp that had been previously unreported.

It is possible that WhatsApp’s conversion from a California corporation to a Delaware corporation was in connection with one of these rounds.  It’s also possible that WhatsApp’s conversion was part of preparations for a potential merger or other exit.  Rumors have swirled that in April 2013, Google and WhatsApp were in acquisition talks.

It is also interesting that no EDGAR results appear for Form D filings made by an entity named “WhatsApp.” Jason Mendelson and others have blogged about (and cautioned against) the perceived rationale for not filing a Form D, and the implications for a startup’s SEC exemption under Regulation D.

Perhaps we will learn more in the coming months about some of WhatsApp’s early legal decisions.  It appears to have worked out historically well for those involved.


Financing a Startup Company Series: Friends & Family

A founder's friends and family are a common source of early capital -- but, be careful.

A founder’s friends and family are a common source of early capital — but, be careful.

We continue our Financing a Startup Company Series with the topic of raising money by issuing stock or promissory notes to friends and family.  Raising money from friends and family is often one of the easiest sources of funding for entrepreneurs to tap.  Many startup companies, including Apple Inc. in its early days, turn to friends and family to raise their first round of funding.  Friends and family are also often willing to invest without receiving much control over the company’s operation and they will not demand the same high rate of return that more sophisticated investors will insist upon.

What types of investments do friends and family make?  Friends and family investors can take equity in a company, however, as discussed in the post on Bootstrapping, to avoid adverse tax consequences, it is usually advisable to issue convertible debt.  A further advantage of using convertible debt with friends and family is that you postpone the tricky decision about how much equity they will receive for their investment until a later date.  Offering the friend or family member a discount of around 20% on the next round of financing is standard.

How much will friends and family invest?  While the amount that can be raised from friends and family ranges widely depending on who your friends and family are, in the aggregate, the average amount invested by friends and family is in the 20-25K range.

Is there a securities law exemption for friends and family?  A very important note is that, contrary to popular belief, there is NO “friends and family” exemption to the Federal securities laws.  When issuing stock to anyone, a company must comply with one of the exemptions from the registration requirements.  For more information, check out our earlier post on the perils of non-accredited investors.  

What are the costs and potential disadvantages to accepting investments from friends and family?  There are many ways that mixing personal relationships with business can lead to problems with both.  Founders must be careful to manage the expectations of friends and family.  Inexperienced investors, such as friends and family, must be made aware that they are likely to lose their entire investment.  Even if the company doesn’t fail, founders need to be very careful about managing the expectations of their inexperienced investors when discussing valuation, risk, exit strategy, and the duration and illiquidity of the investment.  As an aside, many VCs will not invest in companies that have friends and family investors.  Founders considering investments from friends and family should consider the potential downstream consequences of accepting money from early investors who later, more sophisticated investors may deem as “too risky.”


Is the risk of a non-accredited investor worth it?

Using non-accredited investors is possible but may add risk and decrease flexibility in raising capital.

Using non-accredited investors is possible but may add risk and decrease flexibility in raising capital.

A company offering to sell equity to investors in order to raise funds must comply with securities laws.  Generally, companies are required to register any sale of securities with the Securities and Exchange Commission, unless the sale fits into one of the registration exemptions. This posts examines the exemptions most relevant when selling securities to non-accredited investors as well as the associated risks.

Accredited Investors

The most common exemption used by startup companies is Rule 506, which permits, among other things, sale of an unlimited number of unregistered securities to an unlimited number of accredited investors. An individual accredited investor is someone who either has:

• net worth of more than $1 million (excluding residence); or

• an individual income exceeding $200,000, or a joint income with a spouse exceeding $300,000, in each of the last two years and a reasonable expectation of that income continuing.

A problem that some startups face in their early financings, however, is that the investors willing to purchase their securities are not accredited.

The Risks of Non-accredited Investors

While it is possible to sell securities to non-accredited investors, many experienced lawyers in this field counsel against it. The primary reasons for this strong preference for accredited investors are the increased amount of risk and decreased amount of flexibility that accompany investment by non-accredited investors, including:

      Limited Flexibility Under Federal and State Exemptions:  Depending on which securities law exemption the company relies on, there are either limits on the amount of money that may be accepted over time or regulations regarding the level of sophistication of the non-accredited investor. None of these limits or regulations is very clearly defined, so the company takes on some amount of risk in trying to comply with them.  In addition, the relevant federal exemptions for non-accredited investors typically do not pre-empt state securities laws.  So, startups raising capital from such investors will also need to comply with the relevant state exemptions.

     Potential Chilling Effect on Future Investors: In addition, venture capitalists and future acquirers tend to proceed with caution when non-accredited investors or shareholders are involved. Indeed, some investors or acquirers may decline to invest or purchase a startup merely because that startup has sold securities to a non-accredited investor.

     Investor Suitability:  Finally, investment in a seed round is very risky because even if a company succeeds (which it is not likely to do) an investor may lose their most of their investment through dilution. It may be harder to create reasonable expectations of return on investment with non-accredited investors. Therefore, a non-accredited investor who had unreasonable expectations when purchasing the securities may be more likely to bring a claim against a company for a variety of reasons. That claim could be viable even if a company complies with all of the reporting and disclosure requirements of federal and state securities laws.

Specific Exemptions for Non-accredited Investors

If a company chooses to proceed with a non-accredited investor there are two provisions it is likely to rely on to avoid federal securities registration requirements: Rule 504 and Section 4(a) (2).

     Rule 504: Rule 504 allows a company to raise a maximum of $1 million over 12 months from an unlimited number of non-accredited investors without any information disclosure requirements. This exception is problematic because the 12 month clock may be restarted if the SEC decides to integrate later sales of securities it deems related to the original offering. As a result, a company may have unexpected funding needs it cannot satisfy or the opportunity to receive a large sum of money which it cannot seize.

     Section 4(a)(2): The second provision is Section 4(a)(2), which allows a company to raise an unlimited amount of money from an unlimited amount of “sophisticated” non-accredited investors but those investors must be presented with the type of information normally provided in a prospectus used in a public offering. This exemption does not make sense if a company plans to have more than three or four investors in its seed round and carries some risk because what constitutes a “sophisticated” non-accredited investor is not clearly defined. The advantage of Section 4(a)(2) is that there is no limit on the amount of money raised and the Company does not have to file a Form D with the SEC, which it does under Rule 504. The information requirement of Section 4(a)(2) does not exist under Rule 504, but it is wise to provide non-accredited investors with enough information to assess the risk of their investment even when a company relies on Rule 504.   It is also important to note that the federal exemptions are not mutually exclusive.  A startup raising capital from non-accredited investors can attempt to fit under both Rule 504 and Section 4(a)(2).

     State Securities Laws: Regardless of whether a company relies on Rule 504 or Section 4(a)(2) as its exemption under federal securities law, it also must look into state securities laws. Each state may or may not have an exemption that fits the particular circumstances of the offering. As a result, it is necessary to research each state’s laws and it may not be possible to present an offering in certain states.

Benefits of Accredited Investors and Rule 506

Much of this decreased flexibility and increased risk can be avoided through the use of accredited investors. According to Rule 506, securities may be exempt from registration when sold to accredited investors and there are no limits on the number of investors or the amount of capital raised, and there are no information disclosure requirements. In addition, the definition of an accredited investor is provided clearly in the securities laws. Every state also exempts Rule 506 offerings under their own securities laws, so a company only has to make a filing similar to the one made with the SEC and pay a fine to engage in an offering in any given state. Finally, venture capitalists and potential acquirers are happy to work with a company that has prior accredited investors.

Despite the downsides to accepting funds from non-accredited investors, it is possible to use them and if there are no other investment opportunities available and if funding needs are dire that may be the best course of action for a company. In the event that a company elects to use non-accredited investors, it should consult with its lawyers early in the process to ensure that all requirements are satisfied throughout the offering such that the offering is properly exempt from registration under the securities laws.


Securities Laws for Startups Raising Capital

Federal and state securities laws cover startups raising money through sales of equity.

Federal and state securities laws cover startups raising money through sales of equity.

People often associate securities laws as relating only to large public companies.  Securities laws, however, cover even the most basic of equity transactions in small startups.  The following is an overview of securities laws for startups raising capital.

Purpose – As explained on the SEC website: “[t]he main purpose of [securities] laws can be reduced to two common-sense notions: (i) Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing. (ii) People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors’ interests first.”

What is a “Security”? – Section 2(a)(1) of the 1933 Act defines “security”  broadly and includes preferred stock, convertible debt, LLC membership interests, etc.

Complying with Securities Laws Generally speaking, when selling securities, one must (1) either register the securities prior to selling them; or (2) fall under an exemption to the securities laws.

Common Startup Exemptions –There are generally 4 federal exemptions to which startups look when issuing securities to investors:

1.         Section 4(2) – Nonpublic offerings under Section 4(2), which exempts “transactions by an issuer not involving any public offering.”  There is limited guidance on what constitutes a “public offering” and therefore startups typically rely on Section 4(2) as an exemption for only small offerings to a very limited number of investors.

2.         Regulation D –  Regulation D contains three primary exemptions that provide safe harbors:

Reg D Chart

No General Solicitation or Advertising – None of the above exemptions permit the general solicitation or advertising of securities.  While “general solicitation” is not defined in the securities laws, SEC no-action letters have broadly construed it to prohibit mail, email, or other forms of mass communication to anyone unless a substantive pre-existing relationship exists between the issuer and the prospective investor.

Form DIssuers relying on Regulation D must file a Form D with the SEC within 15 days of their first sale. The SEC provides a guide to filing the Form D.  In order to file a From D, the issuer must first successfully apply for EDGAR access.  Startup counsel should start this process well before the Form D filing deadline because the EDGAR application requires a notarized signature of an officer or director and the application approval is not immediate.

State Securities Laws (Blue Sky Laws)Issuers also need to register or find exemptions for their offerings under state securities laws.  The advantage of Rule 506 is that it preempts state securities laws (although issuers still must make certain filings in the states where investors reside, e.g., often a copy of the Form D, a payment, and in some states a consent to service of process).  For example, for a Rule 506 offering to an investor residing in Michigan, the issuer must:

 • File a copy of Form D, manually signed.

• Include a cover letter stating the date of the first sale in Michigan (or advising that sales have not yet occurred in Michigan) and the name of the salesperson.

• Pay a $100 filing fee payable to “State of Michigan.”

• Mail the above to:

Michigan Department of Licensing & Regulatory Affairs

Office of Financial and Insurance Regulation

Securities Division

Constitution Hall, 1st Floor North

525 West Allegan Street

Lansing, MI 48933-1502