Myth #9: "The Securities Laws do not apply to private companies raising money from friends and family."
Many founders fall into the trap of believing that the state and federal securities laws do not apply to their business because they are only raise a small amount of money in the context of a non-public company. One common example is raising funds from “friends and family” who, as you later discover, do not fall within any exemption to the application of the securities laws. You will not find any protection in arguments such as, "these were my close friends and they knew all about my company" or "we did not think the securities laws applied because we are a small, private company." Worse yet, the failure to comply can result in severe liability, including returning the funds to the investors, plus interest, injunctive relief, fines and penalties – and possible criminal exposure.
Does this mean you cannot raise money? Of course not, but it does mean you need a clear understanding of how raising fiancning can be done in compliance with state and federal securities laws. If there is only one take away from this posting, it is that any decision to raise funds from outside investors should be done in consultation with corporate counsel.
1. You Need to Generally Understand When the Securities Laws Apply. The rule is that if you are offering securities (including stock in a corporation or LLC interests) the securities laws always apply, but there may be an exemption from the need to register the offering. Simply put, you must register the offering or preferrably find an exemption to the registration requirement. The reality, however, is that registering an offering is an arduous, time consuming and expensive process that start-ups generally cannot undertake so really what you want to do is be able to make the offering without the registration because of an applicable exemption. Also, a security is not just common or preferred shares in a corporation or membership interests in an LLC, but includes warrants, options, and convertible notes.
2. The Exemption Must Apply to the Offer and each Sale of the Securities. What this means is while you might find an exemption to registering the offering, even one sale that does not qualify for an exemption will result in a violation of the securities laws. So, each sale/purchase must be exempt.
3. What are the Exemptions and Which One Applies to Our Company's Offering. There are several exemptions, but a full discussion of each is for another posting and absolutely requires that the company work through the exemptions in consultation with experienced corporate counsel. Remember, securities are subject to federal and state law ("Blue Sky Laws"), and therefore even if there is a federal exemption you will also need a state exemption for each state in which any of your purchasers resides. Also remember that even one non-exempt offer/purchase will destroy the application of any exemption to the offering. Further, rules prohibiting public solicitation and advertising must be observed, as applicable, and the restricted securities will affect the purchasers right of resale.
a. Intrastate Offering (Section 3(a)(11) of the Securities Act: the offer and sale is made only to residents of the state where the business is incorporated
b. Private Offering (Section 4(2) of the Securities Act): applies to transactions by an issuer not involving a public offering. The focus of the exemption is on the type of offeree/purchaser and the nature of the offering.
The Offeree :
(i) must be a "sophisticated investor," meaning the investor has sufficient knowledge and experience to evaluate the risks and merits of the investment, or be able to bear the investment's economic risk;
(ii) have access to the type of information normally provided in a prospectus; and
(iii) agree not to resell or distribute the securities to the public.
The parameters of the Private Offering exemption are hard to delineate, and thus the SEC adopted Rule 506 of Regulation D as a "safe harbor" that sets forth standards for meeting the exemption.
c. Regulation D: This regulation sets forth a number of exemptions to the registration requirement through Rules 504 through 506 based. A quick snapshot of the Rules:
(i) Rule 504: offer and sale of up to $1million of restricted securities in a 12-month period
(ii) Rule 505: offer and sale up to $5million of restricted securities in a 12-month period to an unlimited number of accredited investors and 35 others
(iii) Rule 506: is the "safe harbor" for the private offering under 4(2), and does not have a limitation on the amount of the raise or number of accredited investors and is limited to 35 others who must be sophisticated investors
d. Accredited Investor (Section 4(6): offering up to $5million to accredited investors (as defined in Regulation D)
e. Regulation A (Section 3(b) of the Securities Act): Exempts small securities offerings, not exceeding $5 million in any 12-month period. But, the company must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review
f. Employment Benefit Plan (Rule 701): applies to certain employee benefit plan offerings.
4. We Found an Exemption So Can the Company Just Proceed with the Offer? Understand that determining that an exemption applies does not mean the company can just proceed with the offering or sale of the securities; there are are still certain regulatory filings you will need to make and the company likely will need to prepare and provide potential investors with a private placement memorandum (PPM). The PPM is a key document in the private placement and needs to be properly drafted to include certain information and disclosures.
5. Even Exempt Transactions are Subject to Antifraud Rules. All securities transactions, even exempt transactions, are subject to the antifraud provisions of the securities laws. This means that the company, its directors and officers will be responsible for false or misleading statements, whether oral or written.
6. What Happens if the Company Violates the Securities Laws? There are significant penalties for violating federal and/or state securities laws. It is very important to understand that a violation of the registration requirements under the securities laws arises regardless of the company's lack of intent to violate the law or attempt to argue good faith. Determining liability in the context of any securities offering is an issue of whether the company complied with the registration requirements or was excused from registering the offering under one of the exemptions to registration. In the event of a violation, the company and its officers and directors could be subject to both civil and criminal sanctions under federal and state law.
a. Recission: In the event of recission, the company essentially must contact all purchasers and offer to repay them.
b. Fines/Sanctions: Fines and sanctions can be imposed on the company, and this can include precluding the company from making further offerings.
b. Fines/Sanctions: Fines and sanctions can be imposed on the company, and this can include precluding the company from making further offerings.
c. Founder/Officer Liability: Fines and sactions can be imposed on officers and directors, including the possibility of liability for the recission.
Translation: founders can be exposed to personal liability.
d. As noted above, even an exempt offering does not shiled the company and its officers/directors from civil and criminal liability if they violate the antifraud provisions of the securities laws.
BOTTOM LINE: DO NOT OFFER OR SELL SECURITIES IN YOUR COMPANY WITHOUT PROPER LEGAL ADVICE, AND DO NOT THINK YOU CAN FIGURE THIS OUT FROM THE INTERNET. LASTLY, MAKE SURE YOUR COUNSEL HAS THE REQUISITE EXPERIENCE AS A MISTAKE CAN DESTROY THE COMPANY AND EXPOSE YOU TO PERSONAL LIABILITY.
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