Tuesday, May 13, 2014

Recovering Lost Profits In Business Litigation

Today's post features a guest entry by James T. Hunt, Jr., a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A.


Business lawsuits involving the claim of “lost profits” as damages can present unique challenges, especially if your business cannot identify specific transactions or deals that were lost due to the defendant’s wrongful conduct or breach of a contract. Some states have strict guidelines governing the ability to recover lost profits, while others actually prohibit lost profit recovery in certain circumstances.

A Tale Of Two States: New York vs. New Jersey

Despite their proximity and the similarity in contract caselaw, New York and New Jersey have somewhat different standards regarding recovery of lost profits. In New York, any business can recover its lost profits in a lawsuit, regardless of how long the company has been operating.  In fact, lost profits are somewhat treated the same way as any other type of damages.  New Jersey courts, however, have steadfastly refused to permit recovery of lost profits in cases involving a new business, which known as the “new business rule.”  Only an established business with a history of revenue and profits can recover lost profits.

New York

New York courts require a plaintiff to prove its lost profits in the same manner as any other damages. Lost profits, therefore, must be proven with a “reasonable certainty.”  This does not mean that absolute precise mathematical accuracy is required. Rather, courts are mindful that a prediction of future profit is inevitably speculative to some degree. 

In essence, there must be some rational basis on which to support an award of lost profits.  But a request based on pure speculation will most certainly be rejected.  Generally, three criteria need to be satisfied to obtain an award of lost profits: (1) the damages were actually caused by the breach, (2) the particular damages were fairly within the contemplation of the parties to the contract at the time it was made, (in other words, the damages were foreseeable), and (3) that the alleged loss is capable of proof with reasonable certainty.  New York falls in the majority of states that permit recovery of lost profits even if it is a new business with no track record of profitability.  A new business endeavor is held to the same standard – it must prove lost profits with reasonable certainty.  At the same time, however, a New York court will not allow an award to be based on pure conjecture or speculation. While the standard is the same for an existing business or new business, in the case of a new business a stricter standard is imposed because there is no experience from which lost profits may be estimated with reasonable certainty and other methods of evaluation may be too speculative. The more risky and speculative the industry, the less likely a new business could prove lost profits with such certainty. 

What constitutes “reasonable certainty” can be nebulous and difficult to pin down. For example, in a leading New York case, the court rejected a claim for lost profits arising from a domed stadium that was never constructed. The court concluded that the multitude of assumptions required to quantify the lost profits award contained an impermissible level of “speculation and conjecture.”  Some of these questionable assumptions included that the facility would be completed, available for use, and operating profitably for over 20 years. In another federal New York case, the court rejected as speculative a lost profit calculation that assumed the occurrence of numerous successive hypothetical transactions. The court found this constituted precisely the sort of conjecture that the reasonable certainty standard prohibits.

In a Second Circuit Court of Appeals case, Trademark Research Corp. v. Maxwell Online, Inc.,  a trademark search service brought suit against a software design firm for alleged breach of a contract that required the defendant to create for the plaintiff a trademark database and search system. The Second Circuit held that plaintiff's claim for future profits from in-house trademark searches and sales of disks providing direct access to plaintiff's database should not have been presented to the jury because it was incapable of proof with reasonable certainty as a matter of law.  For example, the plaintiff's accounting expert had assumed an abrupt expansion of the market for trademark search services, assumed that plaintiff would reverse the long decline in its market share, assumed that plaintiff's historically aggressive competitors would take no measures to counter plaintiff's ascendancy, and predicted which choices customers would make among a variety of new and old search technologies. To cap it off, all of these assumptions were reduced to speculative exact dollar amounts and spun out to the year 1998. Even though there was a significant amount of evidence submitted, the court found that it consisted of a “network of conjecture.”

By contrast, an established business often is in a good position to offer evidence of past experience as a reasonable basis from which a jury may determine lost profits with the requisite degree of certainty. For example, in a case involving a sidewalk cafĂ© seeking lost profits for breach of contract, the New York Court of Appeals upheld a jury award for lost profits. The Court of Appeals held that the evidence of the past experience and profits of the established restaurant to which the cafe would be attached was sufficient “to remove plaintiff's lost profit claim from the realm of impermissible speculation.”  In a federal New York case, a company in the business of selling costume jewelry through the mail brought suit for breach of contract to distribute 8,000,000 advertising supplements in newspapers. The company had been in business for over forty years.  The company offered statistical evidence of its past performance in a remarkably similar advertising program. The court found this evidence was sufficient to prove its lost profits with reasonable certainty.

New Jersey

Just across the river, New Jersey courts allow recovery of lost profits but not if the business is new and has no history of generating revenue.  This rule is called the “new business rule,” and is the law in a minority of states. Generally, profits lost by reason of breach of contract may be recovered if there are any criteria by which probable profits can be estimated with reasonable certainty. Indeed, New Jersey courts do permit considerable speculation by the trier of fact as to damages. As one court has stated, “[t]he rule relating to the uncertainty of damages applies to the uncertainty as to the fact of damage and not as to its amount, and where it is certain that damage has resulted, mere uncertainty as to the amount will not preclude the right of recovery.”  Courts have pointed out that the mere fact a plaintiff cannot pinpoint its damages with laser preciseness should not get a breaching party off the hook, since the breaching party caused the problem in the first place.  Accordingly,  the  fact that a plaintiff may not be able to fix its damages with precision will not preclude recovery of damages. But a request for damages that is based on pure speculation and on mere opinion evidence without factual support will not succeed. Again, “reasonable certainty” is the touchstone.

A lack of past performance is why New Jersey continues to apply the New Business Rule, which prohibits a new business from recovering lost profits. The reasoning behind the new business rule is that lost profits cannot be determined with a reasonable degree of certainty because there is not an established history of revenue and profits. Under the New Business Rule,  prospective profits of a new business are considered per se too remote and speculative to meet the legal standard of reasonable certainty.  The short existence of the entity makes a determination of lost profits too speculative. A New Jersey appellate court acknowledged it is in the minority of states that preclude lost profits in new business cases, and conceded that it was without any power to award such damages unless the New Jersey Supreme Court changed the law.

So what constitutes a “new business”?   The answer is decided upon a case-by-case analysis of the individual factual circumstances involved and the type of industry in which the business operates. For example, in one case an appellate court deemed a 2 ½ year old business to be “new.” The business offered educational, recreational and entertainment services for children, teens, and adults in one modern community center.  In so doing, the court deemed the business “new and unproved.” Under other circumstances, courts have permitted an award of lost profits where the business had operated only two years (from 1996 to 1998). In fact, the Third Circuit Court of Appeals has permitted lost profits for a business operating for only 1 ½ years. Obviously, the more risky and speculative the industry, the less likely a newer business could prove lost profits.

Past Is Prologue

So how important is it to demonstrate past performance? In fact it is the key to recovering lost profits. Past experience of an ongoing, successful business can provide a reasonable basis for the computation of lost profits with a satisfactory degree of definiteness.   Past profit experience on other projects is widely accepted as relevant to a determination of damages based on lost profits.  Courts have held that evidence of such a past performance may form the basis for a reasonable prediction as to the future.  In addition, courts have accepted other evidence of the profitability of a business, such as industry-wide information and projections and even revenue data of a competitor. While a newer business with no track record may ultimately be able to recover lost profits, it will be a much more difficult task than a business with a solid, several-years record of profitable performance.

Proving Your Damages: The Battle of the Experts
Proving a company’s lost profits to a reasonable degree of certainty will most likely require expert testimony. In most cases, if the stakes are high, a battle of the experts will ensue, where both parties retain experts who submit differing and contradictory expert opinions.  Victory will then hinge on which side retained the most convincing expert.  While it is possible to use the owner of the business as a sort of “expert” given his or her deep knowledge of the business and the industry, it is far too risky to go it alone without a qualified expert. Experts will have to analyze the company’s operating and revenue history, its costs and expenses, and forecast a lost profit figure that can pass muster. Retaining a highly competent, qualified, and trial-experienced accountant as your expert is a necessity. 

Jurisdiction is Important

If you have the option to file a lawsuit in several different jurisdictions, it is always important to confer with an experienced business law attorney to determine which jurisdiction will be most beneficial to you. This is especially true if you have a new business that intends to claim lost profits as part of the damages suffered. Certain factors may dictate where you can sue and what state law applies to the case. For example, if the matter involves an inter-state transaction across jurisdictional lines, determining “where” the transactions occurred as a legal matter will impact your case. Further, your contract may contain a choice of law provision that requires application of the law of a particular state.  You need an experienced business lawyer to assess the ramifications of such a provision and the hurdles the applicable state’s law would raise in your case.


About the author: James Hunt is a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A., a commercial and business litigation firm with offices in NY and NJ. To learn more about claiming lost profits, contact Slater, Tenaglia, Fritz & Hunt, P.A., to schedule a free initial consultation

Friday, March 28, 2014

My Biz Lawyer: Due Diligence and the Business Transaction: Making...

My Biz Lawyer: Due Diligence and the Business Transaction: Making...: Even fledgling entrepreneurs are aware of the importance of conducting due diligence in a business transaction, but possessing a true und...

Due Diligence and the Business Transaction: Making the Examination Fit the Deal


Even fledgling entrepreneurs are aware of the importance of conducting due diligence in a business transaction, but possessing a true understanding of the process is another story.   A simple dictionary definition of the meaning will generally focus on analyzing a company in the context of corporate mergers or a stock purchase.  However, as with any simple definition, reducing an understanding of a due diligence investigation to a few words paints a woefully incomplete picture of its significance in a business transaction. If there is any one concept that should be emphasized before entering into any business transaction, it is this:  Do not engage in any important business transaction until a due diligence investigation that is tailored to the the nature, scope, and terms of the transaction has been completed. 

We conduct due diligence all of the time in our daily lives.  We make decisions about purchasing goods or engaging someone's services based on certain considerations with or without consciously realizing that what we are actually doing is a form of due diligence. It is common for us to conduct due diligence and make decisions about familiar and not-so-familiar transactions—such as trying a new restaurant, downloading a smartphone application, buying the latest high-definition television, hiring a lawyer, and so on— and although we might not realize it, we routinely engage in legal, financial, technology, personal, and other forms of due diligence depending on the product or service we are considering buying.  the legwork required to be a well-informed consumer and to ensure you are getting the right product or service at the right price is simply a less structured and less detailed form of the due diligence an entrepreneur should perform before entering into a business transaction.

Before purchasing a product or engaging a service, diligent consumers research the company/service provider, research the product or the services, try to determine the value of the product or services being offered, and, sometimes, conduct a background check or investigation of potential hires. Parties to a potential business transaction apply due diligence criteria similar to those precautions consumers perform before buying products or hiring professional services:  they will investigate the company and its business operations, research the products or services offered by the company, determine the appropriate valuation of the target business, examine management capabilities and perform background checks and investigations of founders and key personnel.  Due diligence therefore involves the process of examining and developing the necessary level of understanding of (i) the company and (ii) its business operations (in other words, its products, assets, and/or services and how the company functions); (iii) determining an appropriate valuation of a business and the transaction; and (iv) vetting personnel (management capabilities, key personnel and employment matters) before entering into a business transaction with, investing in, licensing assets or services of, or purchasing all or part of a business or its assets. I call these four aspects of any business the business cornerstones.

Whether you are buying or investing in a business, entering into a joint venture or partnership, considering making a business loan, or entering into a variety of other business transactions, you should focus on these business cornerstones before entering into any type of transaction.  While the amount of focus given to each of these areas varies greatly depending on the nature of the transaction and the goals of the parties, these four aspects of any business should comprise the basis for the due diligence investigation. What should you learn from your examination of the cornerstones? The goals of a due diligence examination corresponding to each of the four business cornerstones are shown in the Table below:

Table:  Due Diligence Goals
The Business Cornerstone
The Due Diligence Goal
The Company
To understand the legal and financial structure of the company and identify potential organizational or structural risks
The Business Operations

To understand the nature of the business and its products, assets, and services; the operational aspect of the business, and to identify potential legal, financial, and business risks
Valuation

To determine an appropriate valuation of the company and/or the transaction and identify potential financial risks
Personnel

To identify the key personnel and ascertain whether they are capable of operating the business, executing business plans, and/or fulfilling post-closing obligations

The common denominator of these four goals is that the due diligence process impart to you a level of understanding of the company, its business and operations that is sufficient to enable you to decide whether to engage in the contemplated transaction. To achieve this appreciation, the due diligence investigation necessarily involves, not only examining materials and data provided by the company or your potential business partner but also information obtained from various sources, including public and private information and the advice of professional consultants. 

Simply put, think of due diligence as a process of first hearing the company’s business story—as it may have been provided in an investment presentation or business plan—and then conducting an investigation to corroborate the story. A proper due diligence examination will focus on the four business cornerstones, and includes not only broad-based legal and financial questions, but also requires that you identify the critical areas of the business and thereby gear your inquiries to the specific business and the nature of the transaction involved. It is not enough rely on the standard due diligence set of questions; instead, tailoring the due diligence to the target company’s business operations and the underlying facts of the transaction is essential to conducting a productive due diligence examination. 


For a a comprehensive discussion of the role of due diligence in a wide variety of business transactions, please see Due Diligence and the Business Transaction:  Getting a Deal Done, by Jeffrey W. Berkman (Apress 2013) (available on Amazon and Barnes & Noble) 


Disclaimer:  The above is for informational purposes only and does not constitute legal advice.  You are advised to consult an experienced business lawyer before entering into any business transaction.


Thursday, December 5, 2013

Due Diligence is Important in a Variety of Business Transactions.

The due diligence process should not be limited to buying or investing in a business. It should be conducted in a variety of business transactions, including if you are becoming a partner in a new or existing business, licensing intellectual property, or a taking on a new business partner. And, if you are considering selling your business or taking on new investors, conduct due diligence on your business first so that potential issues can be resolved before they are discovered by a potential purchaser or investor.

Due Diligence and the Business Transaction: Getting a Deal Done (Apress 2013) is a practical guide to due diligence for anyone buying or selling a privately held business or entering into a major agreement with another company or business partner. The book will help you understand when to conduct due diligence, whom to include, and how to spot the red flags that signal danger. In addition, you will learn:

· How to conduct due diligence when contemplating a variety of business transactions, including a business loan, purchase of a business, investment, commercial real estate transaction, franchise opportunity, or licensing deal

· How to calibrate the correct scope and breadth of the due diligence investigation depending on your situation

· How the results of due diligence may and often will change the elements of the final deal

· How to draft due diligence documents so they protect your interests.

The book is available at http://www.apress.com/9781430250869 or on Amazon.

Friday, February 15, 2013

Crowdfunding: When Will the SEC Finally Enact the Implementing Rules?

The below was released in conjunction with Sequel Technology & IP Law (SequelTech), which is Of Counsel to The Berkman Law Firm, PLLC




                                                                                                Media Contact:
                                                                                                Dan Shafer, Shafer Media
                                                                                                831-531-4679
                                                                                                dan@shafermedia.com

Crowdfunding: A Hot Potato

on Which the SEC Must Make Decisions Soon


WASHINGTON, D.C., Feb. 13, 2013 -- Attorneys at Sequel Technology & IP Law, PLLC (Sequeltech), a well-known intellectual property firm based in Washington, D.C., are calling for the Securities and Exchange Commission (SEC) to move the process of regulating so-called “crowdfunding” Web sites closer to its front burner.
When President Obama signed into law the Jump Start Our Business Startups (JOBS) legislation in April, 2012, he and Congress took official notice of the existence for the preceding few years of a fund-raising technique for small and startup businesses called “crowdfunding.” The law established a broad framework for crowdfunding Web services like Project Kickstarter (http://www.kickstarter.com), Indiegogo (http://www.indiegogo.com) and EquityNet (https://www.equitynet.com/), which actually pioneered the field.
“Up to now, crowdfunding services have been acting as mostly passive intermediaries between companies seeking funding for projects and products and large numbers of individuals who are interested in providing small-dollar donations to help them along,” says Jeffrey W. Berkman, Of Counsel to SequelTech.
Companies who use crowdfunding sites to raise capital do not offer securities in return. Rather, they provide themed give-aways, credits on a movie, a chance to get a pre-release or free copy of the product, and the like.
From the start, crowdfunding sites have been viewed with suspicion and wariness by traditional securities brokers and salespeople. They clearly operate outside any framework of SEC regulations. However, in the current economic climate, many government officials see these sites as providing a much-needed service for companies that need to raise capital but can’t afford the sometimes staggering fees associated with registering a stock offering with the government or raising funds through the current framework of a private placement.
With the passage of the JOBS Act, the SEC was given authority over these unconventional funding services. A few broad guidelines were included in the legislation:
        Businesses wishing to avail themselves of crowdfunding must not raise more than $1 million per year through the mechanism.
        Crowdfunding sites will be required to be registered with a self-regulatory organization and regulated by the SEC.
        There will be some sort of means test to insure investors are qualified in the sense that investors in other, more traditional, private placement offerings are qualified, albeit with perhaps fewer restrictions.
        The firm behind the crowdfunding site must be a broker or can be a non-broker but it still must be registered with the SEC.
        Significantly, crowdfunding will allow general advertising and solicitation to accredited investors in a non-registered offering, which is prohibited under securities law.
But the passage of the JOBS Act didn’t have the immediate effect of clarifying the rules and regulations which would govern crowdfunding. Rather, the JOBS Act placed the obligation on the SEC to adopt the required rules and regulations for implementation.
“Unfortunately, up to now the SEC has failed to enact the implementing rules and regulations governing crowdfunding,” SequelTech Founder and Managing Partner Melise Blakeslee points out.  There is speculation as to why the outgoing SEC Chairman failed to act by the January 31, 2013 deadline.  However, with the appointment of Mary Jo White as SEC Chairman, Berkman sees the dawning of a new era at the SEC. “Chairman White,” he says, “has a reputation for being tough and getting things done, so many observers who want to see crowdfunding clarified and properly regulated are expressing hope that the time may now come soon.”
It will soon be a year since the JOBS Act was signed into law. The crowdfunding industry has continued to grow and prosper. Thousands of companies, projects and non-profit organizations have received funding. But so long as the SEC fails to issue the needed regulations spelling out in detail the restrictions it will impose on these Websites, crowdfunding, which is hailed by many start-ups and emerging companies as a game-changing opportunity to raise funds, remains unavailable.
What does this mean if you’re interested in funding a product or project via a crowdfunding site? It means you’ll want your attorneys to keep a close eye on the SEC regulatory process so that you can make timely adjustments to your plans and fund-raising tactics as needed without losing out on the enormous potential of crowdfunding. “And if you’re thinking about starting a new business to get in on the ground floor of crowdfunding, you should pay close attention to the news about the forthcoming SEC regulations,” warns Blakeslee.

ABOUT SEQUEL TECHNOLOGY & IP LAW PLLC
            Sequel Technology & IP Law (SequelTech) is a Washington, D.C.-based law firm specializing in intellectual property and high-technology law. Founded in 2009, the firm is headed by Managing Partner Melise Blakeslee.  Melise Blakeslee and Jeffrey W. Berkman work together as "of counsel" on various business law, IP and high-technology law matters for clients in a variety of industries.  


Disclaimer:  The discussions in this Blog do not constitute legal advice nor create an attorney-client relationship.  You are urged to seek the advise of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.

Tuesday, December 18, 2012

Why You Need a Shareholders Agreement (Part I)

If you are forming a corporation with a partner, regardless of whether it is with your best friend that you have known since birth or a new business relationship, executing a well-crafted Shareholders Agreement is essential.  Too often, partners mistakenly believe that the corporate By Laws answer all the questions and will adequately set the parameters for the relationship between shareholders.  While the By-laws address day-to-day operations of the corporation, the Shareholder Agreement is where a number of specific rights and obligations of the shareholders are set forth.  Common provisions of a Shareholders Agreement will address such issues as voting rights, restrictions on voluntary and involuntary transfers of stock, buy-out clause, non-competition obligations, death, incapacity or divorce of a shareholder, and limitations on Board of Directors powers.  The next several posts will address the importance of the Shareholders Agreement, some of the common provisions, as well as several issues that are often overlooked in drafting the Agreement.

1.  Do Not Confuse the Articles, By-laws and Shareholders Agreement.

Entrepreneurs forming a corporation for the first time may find that they are unclear as to the differences between the Certificate of Incorporation (or Articles of Incorporation), By-laws and the Shareholders Agreement:

    A. Certificate of Incorporation:  This document (which often have a different name outside of New York, such as Articles of Incorporation), is the only document that must be filed in New York to form a corporation.  As with many states, New York provides a simple form requiring only limited information to be included in the Certificate (name of the entity, purpose, county where located, number of authorized shares, and name of registered agent).  While you may draft your own form, the simple New York form is all that is required to incorporate.  There are siutations where you might draft your own Certificate of Incorporation, as where there are different classes stock, and the Certificate of Incorporation will be more complex.  However, the basic Certificate of Incorporation is a bare-bones document that does not address any issues relating to corporate governance, authority of the Board of Directors, or the rights and obligations of the shareholders.

  B.  By-laws of a Corporation.  The By-laws serve the purpose of setting forth important terms relating to the governance of the corporation.  Thus, the By-laws establish important aspects for day-to-day operation of the corporation:

            (i) Board of Directors:  the number of members of the Board of Directors, meetings of the Board, voting, removal, vacancies, and powers of the Board of Directors;
 
            (ii) Shareholders:  Annual and Special Meetings of Shareholders, including notice, voting, and general procedures;

           (iii)  Officers:   election/appointment and removal procedures and authority of officers;

           (iv)  Indemnification:  indemnification of Directors, officers, employees of the corporation; and
   
          (v)   Miscellaneous:  Stock, Maintaining Books and Records, Seal of the Corporation, Amendments to the By Laws.        

    C.  The Shareholders Agreement.  The Shareholders Agreement  is the document among the Shareholders and the Corporation where a number of specific rights and obligations of the shareholders and the corporation are detailed.  The Shareholder Agreement is a contract, and can include essentially any terms that do not violate the New York Business Corporation Law (or any other applicable law).  Typical provisions can include voting agreements or rights among the shareholders, restrictions on voluntary transfers of stock (i.e., selling stock to a third-party) and involuntary transfers (death, bankruptcy or divorce of a shareholder), a buy-out clause, non-competition obligations, information rights of shareholders, and limitations on authority of the Board of Directors and dispute mechanisms.

2.  Why the Shareholder Agreement is Essential.

The Shareholder Agreement is essential as it clarifies the rights and obligations of the Shareholders between each other as well as certain obligations of the corporation to the shareholders that are not otherwise included in the By-laws.  Too often entrepreneurs, to their peril, are willing to rely on the relationship with their friend (now business partner) or believe they lack the negotiating position to ask for certain rights as a condition of an investment or becoming a minority partner in a business.  A well-drafted Shareholders Agreement not only helps delineate the rights of the business partners, but it will in most cases resolve any disputes before they arise because the issue will have been addressed in the Agreement.

Below are some typical disputes that will be alleviated with a Shareholders Agreement:

  • Deadlock in a 50/50 corporation
  • The sale of shares by your business partner to his undesirable friend
  • The transfer of shares to the free-loading son of your deceased business partner
  • The transfer of shares to your business partner's spouse in a divorce
  • A decision by the Board to hire an employee at a ridiculously high salary         
If the business partners have a Shareholders Agreement, all of the above can be dealt with before they become issues.
 
3.  What are some of the Key Provisions to Include in a Shareholders Agreement?

Important provisions in a Shareholder Agreement will, at a minimum, include:

    A.  Restrictions on voluntary and involuntary transfers of a shareholder's stock;

            (i) Right of First Refusal
            (ii) Co-Sale (Tag Along) Rights
                                               
    B.   Resolution mechanism/buy-out clause in case of a deadlock;
   
    C.   Voting rights and obligations among shareholders;
   
    D.   Limitations on Board of Directors powers; and
   
    E.   Several Miscellaneous Rights

           (i) Restrictive Covenants
           (ii) Drag-Along Obligations in the event of sale of the company
           (iii) Information Rights

The next several posts will discuss the above typical clauses of a Shareholders Agreement, including important drafting tips.



Disclaimer:  The discussions in this Blog do not constitute legal advice nor create an attorney-client relationship.  You are urged to seek the advise of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.

Tuesday, November 27, 2012

Private Placements: The Friends and Family Exemption and Other Misconceptions

There is a common misconception among start-ups and emerging companies seeking to raise capital that the securities laws don't apply to them simply because the company is small, or they are not raising millions of dollars or the purchasers are "friends and family".  While all of these may seem logical reasons not to incur the expenses and involve the resources that are required to prepare for a private placement, the fact remains that these are not valid legal excuses for avoiding the application of the securities laws. 

Notwithstanding the desire of the small, private company to avoid the expense and time of complying with the securities laws, if you are considering raising even a small amount, the following principles apply:

1.  Securities Laws Apply to Private Companies.  The fact that a company is private, or is not seeking to do an initial public offering (IPO) to become public, does not mean the securities laws don't apply.  The simple rule to follow is that if you are raising capital through an equity (i.e., stock, LLC interests, partnership interests) or debt (loan, convertible notes) offering, assume that the securities laws apply even for private, closely held companies.

2. An Offering Must Be Registered with the SEC Absent an Exemption.  If you are a small or emerging private company, don't assume that an offering need not be registered with the Securities Exchange Commission (SEC).  The law is actually the opposite:  an offering of securities must be registered unless there is an exemption available under the securities rules.

3. The Securities Laws Apply to More than Stock Offerings.   Don't fall into the trap that the securities laws only apply to stock offerings.   The definition of a "security" is very broad under the securities rules, meaning that not only stock, but LLC, partnership interests, debt, notes and other forms of raising capital will generally fall under the definition.  You should start with the assumption that registration is required and look for an exemption rather than believing the securities laws are inapplicable because your company is only selling a small amount of LLC interests in your private company.

4. The "Friends and Family" Round is Still an Offering.  The fact that your investors are friends or relatives is not a valid exemption from application of the securities laws.  While there are a number of exemptions from registration of an offering (as opposed to application of the securities laws), you won't find a "friends and family" exemption.  If an exemption applies to the offering (such as sales to accredited investors, under Rule 506 of Regulation D), you can substantially reduce the expenses and time associated with the private placement, but you cannot avoid application of the securities laws.   

5. An Exemption from Registration Is Not the Same as Ignoring the Securities Laws.  Even if an exemption from registration is applicable, the securities laws still must be followed when doing the offering otherwise the exemption will be lost and the offering will be in violation of the securities laws.  One common exemption from registering the offering is the right to sell securities to an unlimited number of "accredited investors" and 35 non-accredited investors who must have sufficient financial knowledge and experience to understand the risks relating to the investment.  However, the sale of securities to even one person who does not meet these investor criteria will result in a loss of the exemption, and render the offering in violation of the securities laws.  The lesson is that while there are several types of exemptions, if a company is relying on one of them, they need to be sure to comply or risk substantial legal exposure.

6. A Private Placement Memorandum (PPM) is Advisable Even for Rule 506 Offerings. Under Rule 506 of Regulation D, securities can be offered in an exemption from registration to "accredited investors".  These investors must meet certain annual income (in excess of $200,000, or $300,000 with a spouse) or net worth (in excess of $1,000,000) thresholds before they are deemed "accredited".  The good news is that an offering to an accredited investor means no information has to be provided to the investor, but the reality is that while a full-blown PPM can be avoided, it is prudent to provide at least an investment letter or scaled-down PPM detailing the risks associated with the investment.  This document will go a long way to defending any claims by a disgruntled investor if the company later has financial or operational difficulties.

7. The PPM is Not a Shield from All Liability.  Even if you find an exemption from the registration requirements, and even if you provide a PPM, the anti-fraud rules still apply.  The offering materials cannot mislead investors with false or insufficient information.  The PPM can be a significant tool for defending against claims that may be asserted later by a dissatisfied investor, but it needs to be properly drafted, and include sufficient disclosures regarding the risks of the investment as well as warnings about the suitability of the investment.  
          
8. Blue Sky (State) Laws Apply.  Even if the offering qualifies for an exemption from registration, state Blue Sky laws still apply.  For many states, the availability of a federal exemption from registration is sufficient, requiring only a notice filing (and, of course, payment of a fee) within a prescribed period after the offering.  However, New York, for example, requires the filing of a Form 99 and the payment of a significant fee prior to the first sale.  So, don't ignore the state laws simply because the offering is exempt under the federal securities laws.

9.  The JOBS Act Eliminates Ban on Solicitation Only as to Accredited Investors.  The Jumpstart Our Business Startups Act ("JOBS Act") will eliminate the previous ban on general advertising or solicitation for offerings under Rule 506 of Reg. D, but only if the purchasers are accredited investors.  The issuer will need to take reasonable steps to verify the purchaser is an accredited investor, and what satisfies this "reasonableness" requirement is unclear.  The main point is that companies should not misunderstand the JOBS Act as allowing general advertising and solicitation to anyone unless the issuer can reasonably verify the accredited investor status. 

10. Violations of the Securities Laws Can Result in Substantial Liability.  If you take the risk of avoiding compliance with securities laws on the theory that offering is small or the investors are friends (for example), be aware that a disgruntled investor could lead to liability in the form of rescission of the sale, civil and criminal liability.


The Take Away:  If Your Company is Raising Money, You Will Need to Ensure Compliance with the Securities Laws Regardless of the Size of the Offering or Nature of the Investors. 
             



Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters