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