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

Issues Overlooked by Start-Ups: A Live Blog Chat

I was recently the featured guest on Image Talk, a blog talk radio interview presented by YPI Consultants (http://www.ypiconsultants.com/), discussing some of the legal issues that small businesses and start-ups often overlook. 

You can listen to the interview at:

http://www.blogtalkradio.com/ypiconsultants/2012/07/24/image-talk

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


 

Ten Legal Mistakes Made by Start-Ups: Violating Securities Laws (#9)

If you have the opportunity to raise financing for your start-up by issuing securities in your corporation/ membership interests in your limited liability company, don't make the mistake of believing the securities laws don't apply because it is a private company or you are not raising a lot of capital.

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.

        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.