Although it’s a little dry and boring (to anyone but us lawyers!), we thought some of you might find it helpful to get a brief overview of the securities law hurdles you face in raising funds for your business. We’ll try to keep it as painless as possible.
First, the general rule is that any offering of equity or debt in a business is a security and must be registered with the federal Securities and Exchange Commission (SEC) and the securities law agency of all states where securities are being offered. This process of registration is what is known as an Initial Public Offering (IPO) and is extremely expensive, so most growing businesses try to qualify for an exemption from registration (although, as we will see, even that can be difficult or expensive or greatly limit your ability to market the offering).
This is the first post in a series about basic securities law. This post summarizes some of the most commonly used exemptions under federal law, i.e. the SEC (state law exemptions will be covered in a future post).
To understand the exemptions from federal registration of a securities offering, it is first necessary to understand the concept of an “accredited investor.”
An accredited investor is defined by the SEC as follows:
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a natural person with a net worth of at least $1 million; or
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year
(note there are some other ways to qualify as accredited, such as being a bank, but we have not listed those here – for the full definition of an accredited investor, click here).
The following are some of the most commonly used exemptions from the federal registration requirement:
1. The statutory private placement exemption (contained in Section 4(2) of the federal Securities Act) – may only be offered privately to a limited number of affluent/sophisticated investors, who must be provided with all material information about the company. This exemption is typically only used for company insiders/founders because these people are most likely to have access to information about the company.
2. Reg D (short for SEC “Regulation D”) – this is actually 3 separate exemptions:
- Rule 504 is for offerings that do not exceed $1,000,000. A Rule 504 offering can be made to an unlimited number of accredited and non-accredited investors.
- Rule 505 is for offerings that do not exceed $5,000,000. A Rule 505 offering may be made to an unlimited number of accredited investors and up to 35 non-accredited investors. If the investment is offered to even one non-accredited investor, a lengthy document called a prospectus or private placement memorandum must be prepared to provide relevant information about the business and the offering to prospective investors.
- There is no limit on the offering amount under Rule 506. A Rule 506 offering may be made to an unlimited number of accredited investors and up to 35 non-accredited investors. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated – that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
The following rules apply to all Reg D offerings:
- The offering cannot be advertised to the general public – the offering can only be made to potential investors that have an existing relationship with the company (there is an exception to this rule – a 504 offering can be advertised to the public if state registration is completed).
- The securities offered under a Reg D offering cannot be re-sold without additional compliance requirements being met.
- A form must be filed with the SEC (Form D).
3. Reg A – this is similar to a full registration but was created by the SEC for small offerings – up to $5 million. It somewhat easier to complete than a full registration but still can cost upwards of $20,000 – $30,000 in legal and accounting fees.
4. Intrastate exemption – this exemption is based on the premise that an offering that stays within a single state does not require federal regulation (it will be regulated by the relevant state). The business must be incorporated and do a significant portion of its business in the same state where the offering takes place (for example, if you are incorporated in Delaware but located in California, you cannot use this exemption). You must also take stringent measures to make sure all investors reside in your home state and do not sell their stock to anyone living outside that state. Because the statute is somewhat vague about how to qualify for this exemption, the SEC created a “safe harbor” for compliance. A safe harbor is a set of conditions that, if you comply with them, you can be assured that you will meet the requirements of an exemption. However, it is not necessary to comply with the safe harbor conditions to comply with the exemption. The conditions required to meet the safe harbor are as follows:
- 80% of the company’s assets are located in the state in which the offering is made;
- 80% of the company’s revenue comes from the state in which the offering is made; and
- 80% of the proceeds from the offering will be used within the state in which the offering is made.
Note that even if you qualify for one of the above exemptions, you must still qualify for an exemption from registration with the securities law agency of every state in which you offer the securities. State exemptions will be covered in a future post.