Just about every day I seem to get a call from someone with an intriguing Internet or technology concept. They have their business plan just about finished, and now they are ready to go out and raise some money from friends and family, or even outside “angel” investors. Their big question for me is: “How do I go about getting this money without violating the securities laws?”
While there is no easy answer to this question, there are some general guidelines that apply to just about all private offerings of this type. Most of the rules that apply are contained in “Regulation D” under the Securities Act of 1933, which sets forth the requirements that must be met for a limited private offering to qualify for an exemption from the registration requirements of the federal securities laws. Each state also has its own set of securities laws, typically called “Blue Sky” laws, that need to be complied with if any securities are sold, and sometimes even offered for sale, in that state.
The first rule is that the offering must be “private” as opposed to “public.” This means that neither the company nor anyone acting on its behalf may offer or sell the securities by any form of general solicitation or general advertising. This includes any ad, article or notice published in any newspaper or magazine or broadcast on television or radio. This prohibition also includes any announcement over the Internet, including statements on the company’s home page. While there are some exceptions to this rule, they are quite specific and beyond the scope of this article.
The next issue that must be addressed is what information must be given to investors. As you might expect from a lawyer, the answer is “it depends.” More specifically, it depends on the type of investors you will be offering securities to and the total amount of cash you are trying to raise.
The general rule is that if you are planning to sell only to “accredited investors,” you don’t need to provide them with any information. Accredited investors are considered sophisticated and able to protect their own interests, so the government has determined that they do not need to be told what information to review. They are deemed capable of making their owns decisions as to what information to request and review in order to make an investment decision.
An “accredited investor” includes any of the following:
A natural person with individual income of more than $200,000 in each of the last two years or joint income with his or her spouse of more than $300,000 in each of those years and who reasonably expects to have more than $200,000 of individual income or more than $300,000 of joint income for the current year. For this purpose, joint income means adjusted gross income, as reported for federal income tax purposes, including any income of a spouse or from property owned by a spouse, (a) increased by (i) the amount of any tax exempt interest income received, (ii) any deduction claimed for depletions, (iii) amounts contributed to an IRA or Keogh retirement plan, (iv) alimony paid, (v) amounts claimed as losses as a limited partner in a limited partnership and (vi) the excluded portion of any long-term capital gains, and (b) as adjusted, either increased or decreased by any non-cash loss or gain reported for federal income tax purposes; or
Any natural person whose individual net worth, or joint net worth with his or her spouse, is more than $1,000,000. For this purpose, “net worth” means the excess of total assets at fair market value, including home and personal property, over total liabilities. In addition, a person’s principal residence is valued either (a) at cost, including the cost of improvements, net of current encumbrances upon the property, or (b) based upon its appraised value as determined by a written appraisal used by an institutional lender making a loan secured by the property, including the costs of subsequent improvements, net of current encumbrances upon the property; or
Any trust not formed for the specific purpose of making the current investment, with more than $5,000,000 in total assets, provided the purchase is directed by a sophisticated person who either alone or with a purchaser representative has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the investment; or
Any entity in which all of the equity owners are accredited investors; or
Any director, executive officer or general partner of the issuer of the securities being sold.
Even if your investors don’t all qualify as accredited, you still won’t need to provide them with any information unless you plan on selling more than $1,000,000 worth of securities. However, this rule is somewhat misleading. The securities regulations may cause several smaller offerings to be integrated into one larger offering based on a number of factors, including whether the sales are part of a single plan of financing, whether the sales involve the same class of securities and whether the sales have been made at or about the same time. If, however, more than six months pass from the end of one offering until the start of the next offering, they will not be considered part of the same offering and will not be integrated.
For offerings over $1,000,000, you will be required to provide all unaccredited investors with substantial information about the company, including financial statement information, in the form of a prospectus-like, private placement memorandum. For offerings up to $2,000,000, this will include an audited balance sheet, with additional audited financial statements required for offerings over $2,000,000.
Since most people just starting out don’t have the capital available to prepare the disclosures required to sell securities to unaccredited investors, we generally recommend limiting the offering only to accredited investors. We also recommend making offerings of under $1,000,000 only to accredited investors, as most new companies need additional capital within six months after the initial financing and might not be able to avoid integrating two otherwise separate offerings. If the original offering includes any unaccredited investors, a company might have to wait until the six months have passed before they do another offering.
Regulation D also contains a limit on the number of investors you can have in your offering. There is a 35-purchaser limit for offerings over $1,000,000, as well as for offerings not qualifying under the rule applicable to offerings of $1,000,000 or less. However, accredited investors do not count towards the limit on the number of investors permitted to purchase securities in an offering. This is yet another advantage of selling only to accredited investors.
Although selling only to accredited investors means that you will not legally be required to provide them with any information, it is sound business practice to give investors some information about the company in which they are investing. This includes information describing the terms of the offering itself and, more importantly, information identifying the risks associated with the investment and the planned use of the proceeds from the offering. The offering document also should state clearly that only the information included in the offering document can be relied upon by investors, and that any other information, even if given to them in writing, should be disregarded. Investors also should be required to sign a subscription agreement acknowledging that they are aware of the potential risks of the investment and attesting to their status as accredited investors. The offering document and the subscription agreement can later help you defend against claims that investors were misled about the nature of the investment or the proposed plans of the company. Of course, no offering document can take the place of a good idea or a good business plan, but it can help the company look more professional and answer many typical investor questions.
In addition to the offering document and subscription agreement, investors must be provided with all information relating to the company that they reasonably request, including any additional documents needed to confirm the information provided by the company or its management. Investors also should be provided with a reasonable opportunity to ask questions of the management of the company, or someone acting on behalf of the company, about the company and its proposed business.
Many states, including California, have their own special rules that must be followed in order to qualify for the appropriate exemption. In California, for example, the proposed investment may not exceed 10% of the investor’s net worth, or joint net worth with the investor’s spouse. In other states, investors are given a right to rescind their investment within a specified period of time, and the company must clearly advise investors of this right before the investment is made. Almost all states require that a notice filing be made, and of course a fee be paid, with respect to the offering, sometimes even before any offers are made in that state.
As you might expect, the federal and state securities laws that may apply to an offering can be quite complex and are constantly changing. Companies are cautioned to consult with experienced securities counsel before going out to raise any money from outside investors.
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