Back in January, I wrote about securities laws and how business owners need to be careful not to violate them when raising capital. I also suggested some ways to raise capital that are exempt from extensive compliance paperwork. The reality is that it is almost impossible to raise a significant amount of capital for your business without having to deal with securities laws. Yet this does not mean it is not worth the effort. Using the “private offering” exemption from securities registration requirements and armed with an understanding of the legal framework, it is possible to raise capital from people you know.
The general rule of securities law is that any offering of equity or debt in a business must be registered with the federal Securities and Exchange Commission and the securities regulators of all states in which the securities are being offered. The most commonly used exemption from this requirement is the so-called private offering exemption. A private offering, also known as a private placement, is one in which the investment opportunity is not advertised to the general public, but only made known to potential investors who have an existing relationship with the company or its founders. The private placement exemption is based on the premise that potential investors who have a pre-existing relationship with the company need less protection from being duped into making a bad investment.
This does not mean that you are in the clear as long as you only talk to potential investors you already know. It is necessary to understand the various ways of doing a private placement within the law and to select the way that fits your circumstances.
The first question to ask is who do you want to invite to invest in your company? If you are only seeking investment from so-called accredited investors — organizations with more than $5 million in assets, or people with a net worth of at least $1 million or income exceeding $200,000 in each of the two most recent years — you are in luck. In that case, all that is required is a few hundred dollars in fees and a couple of simple filings with state and federal regulators.
But if you are like most of us, you may not know that many rich potential investors. So you will want to be able to solicit some unaccredited investors. Securities laws assume that unaccredited investors need much more protection than accredited investors from unscrupulous promoters of investment opportunities. The minute you solicit even one such investor, the legal requirements become more complicated.
If you do choose to solicit unaccredited investors, the next question to ask yourself is whether you qualify for the intrastate exemption from federal securities law. If you can answer yes to the following questions, you can use this exemption:
Is the state in which your business is incorporated the same state where you do business? Do all your potential investors live in that state? Are most of your company’s assets located there? Does most of your revenue come from there? Finally, will you use most of the money you raise in that state?
The intrastate exemption is based on the premise that an offering that stays within a single state does not require federal regulation since it will be regulated by the relevant state. If you qualify for this exemption, you need only worry about state securities regulations and not federal. In California there is a useful exemption from the registration requirement called the 25102(f) exemption. Under this exemption, you can offer securities to an unlimited number of accredited investors and up to 35 unaccredited investors who either have a preexisting personal or business relationship with the company or its principals or have the ability to protect their interests due to their financial experience or the fact that they have experienced professional advisors.
The term “preexisting personal or business relationship” includes any relationship consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen, and general business and financial circumstances of the person with whom such relationship exists.
What if you can’t use the intrastate exemption? Under federal securities law, if you plan to offer securities to unaccredited investors, you are required to prepare a “private placement memorandum” that describes in great detail your business, your financial projections and current condition, the potential risks of the investment being offered, etc. It is best to consult with an expert to help you prepare this. The good news is that you can fill in a lot of the information yourself. And, as under the California 25102(f) exemption, you can only sell securities to a maximum of 35 unaccredited investors under the federal private placement exemption.
No matter what type of private placement you do, the rule for all of them is that you cannot solicit the general public. What does this mean exactly? Advertisements on the radio, the Internet, or other media are strictly prohibited, as are seminars advertised to the public. There are, however, some less-obvious prohibitions. For example, the US Supreme Court ruled that when Ralston Purina made a stock offering to its employees, the offering did not qualify for the private-offering exemption. The court said “employees are just as much members of the investing ‘public’ as any of their neighbors in the community.” Unfortunately, it is sometimes hard to figure out what would be considered advertising by the courts. It is important to keep records of all of the contacts you make with potential investors and document your relationship with each one.
The law of private placements is complicated. It is essential to have a complete understanding before attempting to solicit investors. But the big take home lesson is to establish “pre-existing relationships” with as many people as possible before you need capital.