Tip #1: Do Not Advertise or Solicit Investors.  Subject to certain limited exceptions, companies are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities.  These terms have been broadly construed by the U.S. Securities and Exchange Commission (SEC) and, accordingly, many entrepreneurs get trapped in the SEC’s wide net.

Indeed, “advertising” includes not only the traditional definition – e.g., newspaper ads, radio ads, banner ads, etc. – but also blog posts, articles and other publications publicizing the offering of a company’s securities.

Moreover, the term “general solicitation” is even trickier and includes any offer to sell securities via mail, e-mail or other electronic transmission unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor.

A relationship is deemed “substantive” if the company (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication.  In other words, the nature and quality of the relationship must be such that the company (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor.  To be “pre-existing,” the relationship must be in place prior to the offer.

Accordingly, spam emails or solicitations via Twitter, Facebook or LinkedIn are all prohibited by the SEC because the offer would be reaching persons with whom the issuer (or the person acting on behalf of the issuer) does not have a substantive, pre-existing relationship.  (Note: Congress and the SEC are currently weighing a crowdfunding exemption which may permit “general solicitations” in certain limited circumstances.)

Tip #2: File a Form D with the SEC and Applicable State Commissions.  As I discussed in part one of this series, the rule of thumb in connection with private placements is to offer and sell securities only to “accredited investors” under SEC Rule 506 of Regulation D.  What many entrepreneurs forget to do, however, is to file a Form D with the SEC and applicable State securities commissions.

Form D is the SEC’s official notice of an exempt offering of securities in reliance upon Regulation D; it requires certain prescribed information with respect to the issuer and the offering, including (i) the issuer’s identity, (ii) its principal place of business and contact information, (iii) the names and addresses of its executive officers and directors, (iv) the specific exemption claimed under the Securities Act of 1933, and (v) most importantly, the identity (and contact information) of any broker-dealer, finder or other person receiving  “any commission or other similar compensation” relating to the sale of securities in the offering.

An executed Form D must be filed with the SEC and each of the applicable State securities commissions in which the offer originated, the offer was delivered or received, and/or any part of the sale transaction took place.  Certain States may also require the filing of a consent to service and the payment of a filing fee.  (The SEC does not charge a filing fee for a Form D notice or amendment.)

As of March 16, 2009, the SEC requires the electronic filing of Form Ds through the SEC’s Electronic Data Gathering, Analysis and Retrieval System (commonly referred to as “EDGAR”).  There is currently no electronic filing with the States.  Accordingly, an issuer must file a Form D with each applicable State securities commission in hard copy.

Tips #3: Limit the Number of Investors. Finally, it is important that entrepreneurs raise money from as few investors as possible.  Why?  Because the more investors a company has, the more likely that one of them will create problems as a minority stockholder.  Indeed, minority stockholders have certain significant rights, including the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company and certain protections against oppression by the controlling stockholders.

Moreover, as discussed in part two of this series, the ideal investor is an experienced, sophisticated angel who can add substantial value through his or her domain expertise and/or rolodex.  If such an investor makes a significant investment, he or she will be there in the trenches when and if things turn sour.  As experienced entrepreneurs understand, this is very important and one of the reasons you try to find a superstar investor and give him or her a great deal to get them on board.

Having a bunch of small, unsophisticated investors is also a nightmare from a practical standpoint – as founders will typically get inundated with daily or weekly emails and phone calls from such investors inquiring as to the company’s prospects and the status of their investment.  OneWire recently touted the fact that it raised $30 million from 101 angel investors.  They will likely learn the hard way what this means in the real world.

Conclusion.  I hope this series has been helpful.  The securities laws are a potential minefield for the unwary, and it is critical that entrepreneurs understand some of the legal basics to capital-raising.  As I have previously discussed, non-compliance with applicable securities laws could lead to severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

Tip #1: Only Sell Securities to “Friends & Family” as a Last Resort. Many entrepreneurs initially reach-out to friends and family as a source of capital.  This is understandable, but generally a mistake for two significant reasons: first, friends and family investors are often not “accredited investors” under SEC Rule 501, which generally triggers tricky compliance and disclosure issues (as I discussed in detail in part one of this series); and second, they are inappropriate investors from a business perspective.

Indeed, the ideal investor is an experienced, sophisticated angel who can add substantial value through his or her domain expertise and/or rolodex.  A sophisticated angel investor understands how the startup game is played and the role that he plays.  More importantly, he understands that most startups fail and that he may lose his entire investment – which is why sophisticated angels typically have 20 or more investments in different startups (and are merely looking for a few of them to succeed to get a strong return).

This mistake is further magnified by a large number of friends and family investors.  For example, having 15 or more family members, former college classmates and neighbors invest $10,000+ each is a recipe for disaster.  Not only will this scare-away many sophisticated angel and VC investors, but also the founders will likely find themselves constantly peppered with questions about their company and how things are going; not to mention turning holidays, like Thanksgiving, into stockholders’ meetings.  (“Hey Steve, can you pass the salt – and by the way, how’s the company doing?  How much money have you made so far?  When will I get my first dividend check?”, etc.)

Tip #2: If You Don’t Know Any Sophisticated Angels, Hustle and Build Relationships.  If you’re an entrepreneur looking for seed capital, but don’t know any sophisticated angel investors, you need to hustle and build relationships in order to get “warm” introductions.  This is how the game is played.  Entrepreneurs must first determine who would be the ideal investor for their company.  They then must work hard to get an introductory phone call or email from a middleman whom the investor trusts and respects (ideally, another entrepreneur whom that investor has backed).

How is this done?  By banging on doors.  By getting-out and attending conferences and meet-ups; by blogging; by reading and commenting on other blogs; and by engaging on Twitter and other social media sites.  In short, it takes tenacity and resourcefulness – qualities that every great entrepreneur possesses.

David Hornik, a partner at August Capital and a very smart investor, confirms this approach in his interview on Sprouter:

So if you are new to the area or to entrepreneurship, how do you get the right . . . intros? What you need to do is build relationships from the bottom up.  Spend a ton of time meeting people, talking with them about what they are working on, and sharing what you are working on.  Over time you will find people with whom your idea resonates and they will introduce you to folks with whom they are close.

In his book “Mastering the VC Game,” Jeffrey Bussgang, a general partner at Flybridge Capital Partners, explains how he got an introduction to superstar VC John Doerr of Kleiner Perkins when he was a first-time entrepreneur:

[W]hen we started Upromise, Michael Bronner and I knew we wanted to get to John Doerr.  We networked to him through three sources – one of my [Harvard Business School] professors who knew him well, a Silicon Valley CEO friend of Michael’s who knew him, and a Fortune 500 CEO with whom Michael was friendly.  After hearing from us from these trusted sources, even a guy as busy as John Doerr decided it was worth taking a meeting.

Tips #3: Unless You’re Raising $750,000 or More, Issue Convertible Notes. Finally, unless the startup is raising at least approximately $750,000, it generally is not in the company’s interest to issue shares of preferred stock.  Indeed, sophisticated angel investors will generally push hard for shares of preferred stock because they want to receive special rights and preferences for their money and to share in the increase in the company’s value that they arguably helped create; however, preferred stock financings are complicated, time-consuming and expensive (despite the “Series Seed” documents and other stripped-down forms).

Moreover, the company would need to be valued at the time of the investment, which is obviously difficult at an early stage and could be extremely dilutive to the founders.  Accordingly, entrepreneurs are usually better served by issuing convertible notes to angel investors, which would automatically convert into shares of preferred stock in the Series A round.  This approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round.

What about issuing shares of common stock?  Sophisticated angel investors will rarely accept shares of common stock; and if they do agree to accept convertible notes, they will often push for what’s called a “cap” (i.e., a set value at which the notes convert).

I’ve been helping entrepreneurs raise capital as a securities lawyer for 17+ years, and there are certain fundamental legal mistakes that I’ve seen entrepreneurs make over and over again.  Accordingly, I thought it would be helpful to share three basic tips for entrepreneurs in connection with raising capital.  (Note: this post was originally published on The Huffington Post.)

Fundraising Tips

Tip #1: Only Offer and/or Sell Securities to “Accredited Investors”. As a general rule, a company may not offer or sell its securities unless (i) the securities have been registered with the Securities and Exchange Commission (SEC) and registered/qualified with applicable state commissions; or (ii) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.

The rule of thumb in connection with private placements is only to offer and sell securities to “accredited investors” under SEC Rule 506.  There are two significant reasons for this: first, Rule 506 preempts state-law registration requirements – which means, in general, that the company merely must file a Form D notice with the applicable state commissioners (together with the SEC) and pay a filing fee; and second, there is no prescribed written disclosure requirement under Rule 506.

There are eight categories of investors under the current definition of accredited investor — the most significant of which is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including the value of their primary residence) or (ii) 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 such income level in the current year.   (Note that this definition is currently under review by the SEC and must be reviewed by the SEC every four years pursuant to the Dodd-Frank Act.)

If a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state securities law.  Yes, there are ways for entrepreneurs to sell securities to non-accredited investors under SEC Rules 504 and 505 (and perhaps other exemptions), but it often requires that specific disclosure requirements be met and registration/qualification under applicable state law, both of which are very time-consuming and costly.

Tip #2: Do Not Use an Unregistered Finder to Sell Securities.  Entrepreneurs often make the common mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for their companies.  The problem is that finders must be registered with the SEC if they operating as a “broker-dealer,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”

If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), the finder will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If the finder is not registered as required and sells securities on behalf of a company, the private placement will be invalid (i.e., it will not be exempt from registration), and the company will have violated applicable securities laws – and thus could be subject to serious adverse consequences, as discussed below.

Note that the Form D filed with the SEC and applicable State commissions requires disclosure of the identities of all finders engaged in the offering of securities of the company.

Tips #3: Diligence the Investors. The most common mistake I have seen entrepreneurs make in any dealmaking context, including fundraising, is the failure to investigate the guys (or gals) on the other side of the table.  Indeed, this is more a business tip, than a legal one; but it is critical.

Remember: if you’re going out and raising funds, you will, in effect, be married to your investors for a number of years.  Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and CEOs who have done deals with the investors in order to make an informed judgment as to whether the particular investor is an appropriate individual with whom the entrepreneur should be partnering.

Issues to consider include:  Has the investor done investments like this before?  If so, how many and what role did he play?  Can the investor be counted-on and trusted?  Will the investor add significant value (e.g., through his contacts, technical expertise, etc.)?  What is the investor’s motivation to invest?  Is the investor a good guy or a jerk?  Sadly, there are a lot of bad apples out there, and entrepreneurs need to be very careful whom they allow to invest in their companies.

Conclusion

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  That being said, no matter how many times I advise otherwise, there are always a handful of entrepreneurs who decide they don’t want to pay legal fees to comply with securities laws and they handle the issuance themselves.  In a word: imprudent.

The securities laws are a minefield for the unwary.  As a general rule, a company may not offer or sell its securities unless the securities have been registered with the SEC or there is an applicable exemption from registration.  A common exemption is the so-called “private placement” exemption (i.e., not involving a public offering); there are, however, a number of requirements that must be met to ensure that the offer and sale of securities is indeed private.  One such requirement is the prohibition against a general solicitation.

The term “general solicitation” has been broadly construed in SEC no-action letters to include any offer to sell securities via mail, e-mail or other electronic transmission unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor.

A relationship is deemed “substantive” if the company (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication.  In other words, the nature and quality of the relationship must be such that the company (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor.  To be “pre-existing,” the relationship must be in place prior to the offer.

A classic example of a general solicitation outside the investment world is the spam email for offers of Viagra (simultaneously sent to thousands of people).  Compare that to an email from your family doctor of 20 years who just examined you and offers to sell you Viagra in response to your recent complaints.

In the investment world, broker-dealers often have substantive, pre-existing relationships with hundreds of clients and others who have executed investor questionnaires and/or “accredited investor” documentation.  That’s how they’re able to raise capital in compliance with securities laws: a substantive, pre-existing relationship is in place with each of the prospective investors.

Based on the foregoing, if you try to raise funds via a posting on Facebook or LinkedIn, it will constitute a general solicitation in violation of securities laws unless you have a substantive, pre-existing relationship with each of your friends and connections (or group members).  Obviously, as you add more and more friends and connections (many of whom you barely know), the likelihood that you will have a substantive, pre-existing relationship with each of them becomes more and more remote.

And be forewarned: a general solicitation negates the private placement exemption and could result in serious adverse consequences, including a right of rescission for the investors (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

“But how’s the SEC going to find out?” clients often ask.  My response: “You must be joking.  You’re going to knowingly break the law and your position is that the SEC will never find out.”  First, all it takes is one disgruntled investor to report a securities violation to the SEC (which I’ve seen several times).  Second, there are also state securities regulators to worry about.  And third, as noted above, we’re talking about potential criminal liability.

In conclusion, while new technology and social networks may make raising capital easier, the securities laws still prohibit certain activities in order to protect unsophisticated investors.  Indeed, in light of the Madoff debacle (and Congressional and other external pressures), the SEC and state securities law commissions are significantly stepping-up enforcement of such laws.  You do not want to be the poster child – so only approach friends and connections on Facebook and LinkedIn with whom you have a “substantive, pre-existing relationship.”

“What about Twitter?”  I think you can answer that.

[Note: the foregoing article was originally posted in The Huffington Post.]

I get this question all the time (in one form or another): “Hey Scott, can I raise money for my startup via Twitter?  I have a lot of followers, and I know some of them would be interested in investing.”  As discussed below, the answer is no — unless the tweet is a direct message (a “DM”) to a follower with whom you have a substantive, pre-existing relationship. 

The Law

Under the Securities Act of 1933, as amended (the “Securities Act”), and Regulation D promulgated thereunder, a startup (or any person acting on its behalf) is generally prohibited from any form of “general solicitation” in connection with the offer or sale of securities.  Most States (including California) have similar laws, subject to limited exceptions.

The term “general solicitation” is not defined in the Securities Act, but has been broadly construed in SEC no-action letters to include any solicitations via mail, e-mail or other electronic transmission, unless there is a substantive, pre-existing relationship between the startup (or a person acting on its behalf) and the prospective investor.

Indeed, that’s the critical issue: whether there is a substantive and pre-existing relationship in place with the person receiving the offer.  Let’s break that down:

What Does “Substantive” Mean?.  Under SEC no-action letters, a relationship is substantive if the startup (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication.  In other words, the nature and quality of the relationship must be such that the startup (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor.

What Does “Pre-Existing” Mean?.  Under SEC no-action letters, to be “pre-existing,” the relationship must be in place prior to the offer.

What Is an “Offer”?.  Under Section 2(a)(3) of the Securities Act, the term “offer” is broadly defined to include “every attempt or offer to dispose of . . . a security or interest in a security for value.”  The SEC has actually expanded the definition in regulatory proceedings to include press releases.

Analysis

Based on the foregoing, it is clear that if a startup (or a person acting on its behalf) tries to raise money via a tweet to all of its followers (as opposed to a DM), it will in all likelihood constitute a “general solicitation” in violation of applicable securities laws.  Not only is it extremely unlikely that there will be a substantive relationship with each of the followers, but also the retweeting of any offer will raise significant issues.  Moreover, since a tweet is available for public viewing via the Web, it could constitute an “advertisement,” which is also generally prohibited under applicable securities laws.

Conclusion

The securities laws are complex and are a potential minefield for the unwary.  While new technologies and social networks may make raising capital easier, the securities laws still prohibit certain activities in order to protect unsophisticated investors.  Indeed, in light of the Bernie Madoff affair and other external pressures, the Securities and Exchange Commission and State securities law commissions are significantly stepping-up enforcement of such laws.  Entrepreneurs thus must be careful and should seek advice from experienced counsel prior to any capital-raising activity, including via Twitter.

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  I know this stuff tends to be very technical (and perhaps boring), but it is nevertheless critical that entrepreneurs have a basic understanding of the securities laws.

Question

We’ve been bootstrapping our startup and have pretty much run out of money.  We have a few friends and family members who said they would buy some stock to help us out.  We also thought we could put something up on our website and tweet about our need for funds.  Could you please give us a little guidance about these issues.  What are the biggest legal mistakes you’ve seen startups like us make trying to raise capital?

Answer

Any time you are raising capital you need to be very careful – and make sure you’re complying with applicable securities laws.  Below are the seven biggest mistakes I’ve seen startups make.

Mistake #1: Advertising or Soliciting Investors

Subject to certain limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities.  These terms have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or on a website or broadcast over television, radio or the internet.  “General solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor sufficient for the issuer/startup to determine that the offeree would be a suitable investor.

Thus, the bottom line is that you may not advertise on your website that you seek funding nor may you solicit investors via Twitter (unless it’s a DM to a person with whom you have a “substantial and pre-existing relationship”).

Mistake #2: Playing Securities Lawyer

A company may not offer or sell its securities unless (1) the securities have been registered with the Securities and Exchange Commission (SEC)and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  That being said, no matter how many times I advise otherwise, there are always a handful of clients who decide they don’t want to pay legal fees to comply with securities laws and they handle the issuance themselves.  In a word: reckless.

Mistake #3: Selling Securities to Non-“Accredited Investors”

The rule of thumb for startups in connection with a private placement is only to offer and sell securities to “accredited investors” under SEC Rule 506.  There are two significant reasons for this: (i) Rule 506 preempts state-law registration requirements – which means, in general, that the startup merely must file a Form D notice with the applicable state commissioners; and (ii) there is no prescribed written disclosure requirement.

There are eight categories of investors under the current definition of “accredited investor”– the most significant of which for startups is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) 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 such income level in the current year. 

If a startup offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.  Yes, there are ways for entrepreneurs to sell stock to non-accredited investors under SEC Rules 504 and 505 (and perhaps other exemptions), but it requires that specific disclosure requirements be met and registration/qualification under applicable state law, both of which are very time-consuming and costly.

Mistake #4 – Using an Unregistered Finder to Sell Securities

Startups often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.

If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus could be subject to serious adverse consequences, as noted above (in Mistake #2).  I discuss this issue in detail in my “Beware of Finders” post.

Mistake #5: Not Diligencing the Investors

In the course of my 15+ years of practicing corporate law (including nearly eight years at two major law firms in New York City), the most common mistake I have seen entrepreneurs and inexperienced deal people make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  Indeed, in the angel financing context, the entrepreneur will, in effect, be married to the angel for a number of years.

Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and founders who have done deals with the angel in order to make an informed judgment as to whether the angel is an appropriate individual with whom the entrepreneur should be partnering.  Issues to consider include:  What is the angel’s motivation to invest?  Is the angel a good guy or a jerk?  Can the angel be counted-on and trusted?  Will the angel add significant value (e.g., through his contacts, technical expertise, etc.)?

Mistake #6: Issuing Preferred Stock

Angel investors will sometimes request shares of preferred stock for their investment; however, unless the start-up is raising at least approximately $750K, it generally is not in the entrepreneur’s interest to issue such shares.  Indeed, preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders.

Accordingly, startups are better served by issuing convertible notes to angel investors, not equity — i.e., the angels would loan money to the company, which would automatically convert into equity in the first professional (the “Series A”) round of financing; this approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round.  If an angel insists on equity, the company should issue shares of common stock — which will place the angel in the same boat as the founders (though still requiring a valuation and causing potential problems with respect to stock option grants).

Bill Reichert, Managing Director of Garage Technology Ventures,  briefly discussed the “note vs. equity” issue on The Frank Peters Show (starting at the 22:51 mark) and expressly advised that: “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . [and] it’s not worth spending too much on the lawyers.”

Mistake #7: Selling the Same Shares at Different Prices

Finally, another big mistake that startups make is selling shares of common stock at the same time to its founders and investors, but charging them different prices; in other words, valuing the shares differently depending upon the purchasers.

This issue often comes-up when a startup has waited to incorporate until it has found investors and then issues a majority of the shares of common stock to the founders for a de minimisprice and a minority stake to investors for a few hundred thousand dollars (if not more).  Simply put, startups cannot do that without triggering potential tax problems.

Indeed, the IRS will take the position that the shares were properly valued at the price sold to the investors, and that the difference between what the founders paid and their actual value will be deemed compensation to the founders – triggering not only income tax liability to the founders, but also withholding tax liability to the startup.

Conclusion

I hope the foregoing is helpful.  Again, I know this stuff is very technical and hard to digest.  I think the takeaway, however, is to make sure you talk to an experienced securities lawyer before you start offering or selling securities to anyone.  In fact, you can feel free to call me directly if you have any questions (415-979-9996).  Many thanks, Scott

March 31, 2010 

Via Email 

Senator Christopher J. Dodd, Chairman 

Committee on Banking, Housing and Urban Affairs 

534 Dirksen Senate Office Building 

Washington, DC 20510-4605 

Re:  The Restoring American Financial Stability Act of 2010 (the “Reform Bill”)  

Dear Senator Dodd: 

As a corporate lawyer for entrepreneurs, I would like to get a few things off my chest with respect to the Reform Bill.  Indeed, I do not understand why a 1,336-page bill designed to address our recent financial crisis includes two major changes to the federal securities laws that could destroy angel investing.   

As you may recall (and as I discuss in detail in my recent blog post on VentureBeat), the first change relates to the definition of “accredited investor” and increases the qualification thresholds for an individual from $1 million of net worth to $2.3 million and from $200,000 of annual income to $449,000 (or from $300,000 of joint annual income with a spouse to $674,000).   

According to Business Week, this change would lower the number of individual accredited investors by 77%.  Should I repeat that?  77%!  Over two-thirds, amigo! 

If that weren’t bad enough, here comes the second change – which provides that even if all the investors are “accredited” under your new definition (and despite SEC Rule 506, discussed below), a filing must be made with the SEC, and the SEC will have 120 days to review it; and if the SEC does not review the filing within such 120-day period, then the applicable State securities commissions would have the right to review the merits of the angel investment. 

In case you or your staff haven’t done the math: 120 days equal four months.  Thus, under your bill, we will have 77% less angel investors and then startups will have to wait up to four months (or longer) while the SEC and/or State securities commissions review the merits of their angel investment.  With all due respect, Senator, this is fucking nuts!   

And, sadly, it gets even worse:  Alternatively, the SEC can designate that certain financings under Rule 506 are too small in size or scope to warrant SEC review and push such review to the State securities commissions altogether.  This is exactly what the National Securities Markets Improvement Act of 1996 (“NSMIA”) was designed to prevent.  Why are we moving fucking backwards? 

As you know, the beauty of NSMIA has been that startups could rely on Rule 506 if all of their investors were “accredited” – and thereby preempt state law and no longer have to deal with the excessive cost, delay and onerous disclosure requirements of State securities commissions (which was a significant problem pre-1996).  Indeed, NSMIA has facilitated the extraordinary growth of angel investing for the past nearly 15 years, which has contributed to the success of companies such as Google, Facebook, Twitter and many others (not to mention the concomitant job creation). 

Let’s take a simple example and see how this plays out in the real world: 

On April 26th, I will be co-sponsoring an Open Angel Forum event in Los Angeles, which will provide each of five startups with the opportunity to pitch 15-20 angel investors for an investment of approximately $500,000 to $1 million.  All of the angel investors are “accredited investors” under the SEC’s current definition and your new definition; in fact, some have a net worth in excess of $100 million. 

Under current law pursuant to SEC Rule 506, if an angel investor decided to invest in one of the startups, a deal could be closed and the investment funds could be wired to the startup within 24 to 48 hours – particularly if the deal were structured as a convertible note (as opposed to preferred stock) due to the simplified paperwork.     

Why?  Because under Rule 506, there is no written disclosure requirement (such as a private placement memorandum) if the investors are accredited; and, as a result of the enactment of NSMIA, Rule 506 preempts State law and thus the startup would not have to comply with any disclosure or other requirements under applicable State securities laws, other than filing a Form D notice (which is also filed with the SEC) within 15 days after the sale.     

Now let’s see what happens if your bill were enacted. 

First, instead of money being wired to the startup within 48 hours, it would presumably be put into escrow for up to four months pending the SEC’s review of the startup’s filing.  If the SEC did not review the filing within four months, the startup would then need to comply with all applicable State securities laws — which presumably would mean any State in which part of the offer and/or sale takes place (i.e., California and any other State implicated as a result of subsequent emails, telephone calls, delivery of the notes/stock certificates, etc.).  Again, fucking nuts!   

Alternatively, as noted above, the SEC could require the startup, due to the small size or scope of the investment, immediately to comply with applicable State securities laws even though all of its investors were “accredited” and may have net worth in excess of $100 million.  In other words, NSMIA would be thrown out the window, and we would be back to the pre-1996 days where counsel must work his way through the maze of State securities laws, including dealing with State regulators for weeks and weeks (and perhaps months and months), and legal fees mount, and investors walk away in frustration. 

The bottom line, Senator, is that not a lot of thought has gone into this aspect of the Reform Bill.  Clearly, you and your staff have been heavily lobbied by the North American Securities Administrators Association, who are anxious to repeal NSMIA and restore their power; it’s a classic regulatory turf battle.  The problem, however, is that you are about to destroy angel investing and job creation in the process. 

Sincerely yours,  

Scott Edward Walker

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question 

We launched our company about a year ago, and we’re having trouble raising money.  I met a consultant at a conference who said he has a lot of connections and could help us raise about $500K if we paid him 6%.  This seems like a pretty good deal.  Are there any legal issues we need to worry about?   

 Answer  

Yes, there are number of legal issues you need to worry about — and the one that jumps out front and center is whether the consultant is licensed as a “broker-dealer”; if he isn’t, I strongly suggest that you run the other way, as discussed below.

The securities laws are complex and are a potential minefield for the unwary.  Under both federal and California securities laws, a so-called “finder” – i.e., someone who holds himself out as being able to introduce companies to interested investors – must be registered with the Securities and Exchange Commission (SEC) and the California Department of Corporations if he is acting as a “broker-dealer”.   

The term “broker-dealer” is very broadly defined under both federal and California law and includes any finder who receives some form of commission or success-based compensation (such as in your situation).  Other broker-dealer activities include making presentations to investors, participating in the negotiations between the company and the investors, structuring the transaction between the company and the investors, and/or regularly engaging in the business of finding investors for companies (as opposed to a one-off). 

The bottom line is that if a finder does anything beyond merely introducing the company to potential investors, he will likely be characterized as a broker-dealer requiring registration.

You may be thinking, so what – not my issue.  Wrong!  If he is not registered (which is probably the case since he’s calling himself a consultant, as opposed to an investment banker) and you pay him his 6% commission, the company faces the following consequences:

First, the company’s issuance of securities will be in violation of applicable securities laws, which could result in possible SEC and/or state regulatory action, including injunctive relief, fines and penalties, and possible criminal prosecution.  Indeed, as I have previously discussed, in light of the Madoff affair and other external pressures, the SEC and state securities are significantly stepping-up enforcement of the securities laws.

Second, investors will be able to sue the company to rescind the transaction – i.e., to unwind the sale and get their money back, plus interest.  Under California law, they also arguably would have a right to sue for damages up to $10,000.

Finally, the company’s use of an unregistered finder may adversely affect any future capital raising activities, including an initial public offering, and may subject to the company to liability for “aiding and abetting” the securities law violations of the finder. 

Conclusion

I hope the foregoing is helpful.  I, of course, understand that this is a tough environment for entrepreneurs to raise capital – and adding one more hurdle (i.e., avoiding unregistered finders) makes the fundraising process even more difficult.  That being said, it is foolhardy for entrepreneurs not to comply with applicable securities laws.  Indeed, my firm is representing several clients who did not and now regret it.   If you would like to learn more about the five common mistakes entrepreneurs make in raising capital, you can check out my post here.   

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”   

The goal here is two-fold: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).

Question 

My buddy and I launched a software company about a year ago, and we’re running out of money.  Luckily, we have a few friends who are interested in investing in our company.  My neighbor, a divorce attorney, said we need to comply with the securities laws.  Do the securities laws apply to the sale of stock to friends?  If so, how do we comply?

Answer

This issue comes-up all the time.  The short answer is yes, the securities laws apply, and the best way to comply with them is to sell stock only to friends who are “accredited investors” (as discussed below).

Indeed, whenever a company offers or sells its securities – whether it be to founders, friends and family, angel investors, whomever – federal and state securities laws must be addressed.  Unfortunately, these laws are complex and are a potential minefield for the unwary.  Moreover, in light of the Madoff affair and other external pressures, the Securities and Exchange Commission (SEC) and State securities law commissions are significantly stepping-up enforcement of the securities laws. 

The basic rule is that a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an exemption from registration.  The most common exemption used by start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securites Act of 1933.  As the term implies, a private placement is a private offering to a small number of investors – like a few friends; however, there are different rules depending upon whether the investors are accredited or non-accredited.   

If a startup sells stock only to accredited investors, compliance is much simpler and cheaper because it can rely on SEC Rule 506, which has two important advantages over other SEC rules.  First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC).  Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.

On the other hand, if one or more of the investors is not accredited, it opens a Pandora’s box of compliance and disclosure issues under both federal and state law.  Yes, there are ways for a startup to structure an offer and sale of securities to non-accredited investors in compliance with applicable securities laws; however, the cost, risks and onerous disclosure requirements generally outweigh the benefit. 

So who is an “accredited investor”?  The current definition of accredited investor under SEC Rule 501 includes eight different categories of investors, the most significant of which is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase; or (ii) 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 such income level in the current year. 

Based on the foregoing, I strongly recommend that you only offer and sell stock to those friends who meet the above net worth/income test and represent and warrant that they are accredited investors in a written agreement.  Needless to say, I also strongly recommend that you retain an experienced securities lawyer to help you.  Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution. 

Our law firm in Los Angeles was recently retained by two separate issuers that received a “Cease and Desist” order from State securities law commissions in connection with alleged securities law violations.  In both cases, the matters were settled pursuant to agreements that required the issuers to effect a “rescission offer” – i.e., an offer from the issuer to each of the respective stockholders to purchase their shares for an amount equal to the original purchase price, plus interest.  This is a very tricky and costly process.  Accordingly, in light of my firm’s recent experience, I thought it would be helpful to provide briefly five tips to entrepreneurs who are required to effect (or are contemplating) a rescission offer to investors.

1.  Most States Have Statutes Addressing Rescission Offers.  Rescission offers are a creature of state law.  Indeed, there are no federal statutes providing for rescission offers.  Accordingly, each applicable State statute must be complied with, which presumably means (i) the State in which the offer originated, (ii) the State in which the offer was delivered or received (if different) and (iii) any State in which part of the sale transaction took place.  Generally, State statutes provide that any civil actions under state securities laws brought by an investor against the issuer will be barred if, before such action is commenced, the investor has received a written offer from the issuer offering to refund the consideration paid, plus interest, and the investor has accepted (or has failed to accept) such offer within 30 days following its receipt.  Investors would still nevertheless have valid claims for liability under common-law fraud or misrepresentation, if applicable, and perhaps under the antifraud provisions of the State securities laws.

2.  Rescission Offers Do Not Bar Enforcement Actions, Criminal Prosecution or Federal Claims.  Rescission offers do not prevent the SEC or applicable State regulators from bringing an enforcement action against the issuer; nor do they prevent criminal prosecution.  Moreover, Section 14 of the Securities Act of 1933, as amended (the “Securities Act”), expressly provides that: “Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title or of the rules and regulations of the Commission shall be void.”  Accordingly, an investor who rescinds his investment may still have a claim against the issuer under federal securities laws – though there is some case law which supports the proposition that investors may be estopped from asserting federal securities law claims subsequent to a valid rescission offer.  Despite the foregoing, it is still generally prudent for an issuer to commence a rescission offer if it has violated certain securities laws.  Indeed, my experience is that regulators and prosecutors will view such a step quite favorably.

3.  The Rescission Offer Must Comply with all Applicable Securities Laws.  A rescission offer is not only an offer to buy/redeem securities, it is also an offer to sell the underlying securities — and thus either must (i) be registered with the SEC and registered/qualified with applicable State commissions or (ii) be exempt from registration.  This is probably the most difficult issue for entrepreneurs to understand – i.e., that the rescission offer itself must comply with applicable federal and State securities laws.  Accordingly, if any of the investors are not “accredited investors” (as such term is defined in Rule 501 of Regulation D), the issuer may not rely on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996.  Moreover, an issuer should only offer rescission if it has sufficient funds to pay the investors; otherwise, such an offer could be deemed fraudulent under federal and/or state law.

4.  Retain an Experienced Securities Lawyer to Conduct a Legal Audit.  Prior to commencing a rescission offer, the issuer should take two significant steps: (i) it should refrain from making any offers or sales of its securities; and (ii) it should retain an experienced securities lawyer to conduct an internal investigation in order to determine what securities laws have been violated and when.  This will require that the issuer provide to its lawyer a list of all investors, their respective residences and dates of purchase, and copies of any documentation relating to any offers and/or sales of securities.  The securities lawyer can then analyze each of the transactions and determine the best course of action on a case-by-case basis (e.g., certain sales may arguably be exempt from registration under Section 4(2) of the Securities Act, despite its inherent uncertainties; and certain claims may be barred by applicable statutes of limitation).

5.  It’s Not the End of the World.  Rescission offers are time-consuming and costly; however, an issuer can work through this issue with competent counsel and eventually move on and prosper.  Google is an excellent case in point (and is probably the most high-profile rescission offer ever handled by the SEC).  In its prospectus filed with the SEC, Google offered to repurchase approximately 23 million shares of common stock and 5.6 million stock options because the issuances may have violated the Securities Act, as well as certain State securities laws.  As the prospectus expressly provided:

Q:    Why are we making the rescission offer?

A:    Certain shares of common stock issued pursuant to certain of our stock plans during the period from September 2001 through June 2004 were not registered under federal securities laws and we did not seek to exempt these securities from the registration requirements of these laws.  In addition, certain option grants and stock issuances pursuant to certain of our stock plans during this period were not qualified under state securities laws and we did not seek to exempt these securities from the qualification requirements of these laws.  Consequently, these option grants and stock issuances may have violated the Securities Act of 1933 and the state securities laws of Arkansas, California, Colorado, Connecticut, the District of Columbia, Georgia, Illinois, Maryland, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Texas, Virginia and Washington.  The rescission offer is intended to address these federal and state securities laws compliance issues by allowing the holders of the options and shares covered by the rescission offer to rescind the underlying securities transactions and sell those securities back to us.

Question #1: What are the “Securities Laws”?

When lawyers and others refer to the “securities laws,” they generally mean the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”), which were passed by Congress during the peak of the Depression in order to attempt to restore investor confidence in the capital markets.  As provided on the SEC website: 

“The main purposes of these laws can be reduced to two common-sense notions: [(1)] Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.  [(2)] People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors’ interests first.”

Moreover, each State has (i) its own set of securities laws (so-called “blue sky” laws), which vary from State by State; and (ii) its own State securities commission or department. 

Question #2: Do the Securities Laws Apply to Start-up Companies?

Yes, the securities laws apply to all companies that issue “securities” (which term is broadly defined).  As I have previously noted (see paragraph #6 here), pursuant to applicable securities laws, a company may not offer or sell its securities unless (1) such securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under SEC Regulation D, the safe harbor promulgated under Section 4(2) of the Securities Act (see mistake #2 here).  In order to comply with Regulation D, the issuer must, among other things, execute and file a Form D. The SEC recently issued rules and rule amendments adopting revisions to Form D. 

Question #3: What is Form D?

Form D is the SEC’s official notice of an exempt offering of securities in reliance upon Regulation D (or Section 4(6) of the Securities Act).  As you can see from the actual form, it requires certain prescribed information with respect to the issuer and the offering, including (i) the issuer’s identity, (ii) its principal place of business and contact information, (iii) the names and addresses of its executive officers and directors, (iv) the specific exemption claimed under the Securities Act and (v) as discussed below, the identity (and contact information) of any broker-dealer, finder or other person receiving  “any commission or other similar compensation” relating to the sale of securities in the offering. 

Question #4: Where Do I File the Form D?

An executed Form D must be filed with (i) the SEC and (ii) if the issuer is relying on Rule 506 of Regulation D, each of the applicable State securities commissions in which (A) the offer originated, (B) the offer was delivered or received and/or (C) part of the sale transaction took place.  Certain States may also require the filing of a consent to service and the payment of a filing fee.  (The SEC does not charge a filing fee for a Form D notice or amendment.)  

Question #5: How Do I File the Form D?

As of March 16, 2009, the SEC requires the electronic filing of Form Ds through the SEC’s Electronic Data Gathering, Analysis and Retrieval System (“EDGAR”).  To file online using EDGAR, an issuer must have its own filer identification number (called a “Central Index Key” or “CIK” number) and a set of password-like “access codes.”  An issuer may obtain a CIK number and EDGAR access codes at any time (even before it is ready to file its first online Form D); to do so, it must submit basic information to the SEC online at its Filer Management page and also submit a copy of a notarized paper document containing the same information on Form ID.  The paper document is called an “authenticating document,” which can be submitted either (i) by scanning and uploading it to the online submission in pdf or (ii) by faxing it to the SEC at (202) 504-2474 or (703) 914-4240.  (For more information on obtaining a CIK number and EDGAR access codes, you can review the SEC staff’s Guidance on Form D Filing Process.) 

There is currently no electronic filing with the States.  Accordingly, to the extent necessary, an issuer must file the Form D with an applicable State securities commission in hard copy.  There is nevertheless a strong desire on the SEC’s part to make the electronic system a one-stop filing center for filings with the States.

Question #6: When Must I File the Form D?

The Form D must be filed with the SEC no later than 15 calendar days after the “date of first sale” of securities sold based on a claim of exemption under Rule 504, 505 or 506 of Regulation D or Section 4(6) of the Securities Act.  For this purpose, the “date of first sale” is the “date on which the first investor is irrevocably contractually committed to invest, which, depending on the terms and conditions of the contract, could be the date on which the issuer receives the investor’s subscription agreement or check.”  In order to avoid any timing issues, an issuer may elect to file the Form D prior to its receipt of a subscription agreement or check (and merely check the appropriate box in Item 7 of the Form D that “First Sale Yet to Occur”).  If the date on which the Form D is required to be filed falls on a Saturday, Sunday or holiday, the applicable due date is the first business day following.

The timing of the filing in a particular State is governed by applicable State law or regulations; however, the SEC Division of Corporate Finance has stated (in Section 257.08 of its Compliance and Disclosure Interpretations) that an issuer’s failure to file timely the Form D in a particular State does not result in a loss of State preemption (though certain States may require a late issuer to pay a fine/penalty and/or take other administrative action). 

Question #7: Will the Information on the Form D be Publicly Available?

Yes, all Form Ds filed through EDGAR will be available for public viewing in an interactive and searchable format on the SEC’s website.  According to the SEC, the online filing system will enable interested parties “to view the information in an easy-to-read format, download the information into an existing application or create an application to use the information.”

Question #8: When Must the Form D Be Amended?

The Form D must be amended (i) to correct a material mistake of disclosure, as soon as practicable after the discovery of the mistake; (ii) to reflect a change in certain reported information (including any change in the issuer’s directors or officers), as soon as practicable after the change; or (iii) “annually, on or before the first anniversary of the most recent previously filed notice, if the offering is continuing at that time.”

The Form D need not be amended to reflect a change that occurs after the offering terminates.  Moreover, certain changes in reported information are expressly deemed not to trigger an amendment, including (i) changes in the issuer’s revenues or aggregate net asset value; (ii) changes in the amount of securities sold in the offering (or the amount remaining to be sold); or (iii) changes in the total number of investors who have participated in the offering.  

Question #9: Does the New Form D Have Any New Disclosure Requirements?

Yes, as noted above, the new Form D requires, among other things, the disclosure of the identities of all finders engaged in the offering of securities of the issuer.  This will obviously result in the increased scrutiny of finders that are not registered as “broker-dealers.”  Indeed, as discussed in paragraph #4 here, entrepreneurs often make the mistake of retaining unregistered finders to raise capital on their behalf.  If the finder is receiving some form of commission or transaction-based compensation in connection therewith, he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws (as discussed below).

Question #10: Why Should I Care About Any of This?

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

www.youtube.com/watch?v=NtSeN0wA598

Mistake #1 – Playing Securities Lawyer 

A company may not offer or sell its securities unless (1) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.  Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.

Mistake #2 – Selling Stock to Friends and Family Who Are Not “Accredited Investors”

The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 of Regulation D.  There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D, (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” – though it still may be prudent to furnish to investors a private placement memorandum (or at least a summary and a set of risk factors).  There are eight categories of investors under the definition of “accredited investor” – the most significant of which for entrepreneurs is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) 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 such income level in the current year.  Indeed, if a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.    

Mistake #3 – Advertising or Soliciting Investors 

Subject to certain limited exceptions, Regulation D of the Securities Act of 1933 prohibits issuers from “general advertising” or “general solicitation” in connection with a private placement.  These terms are not defined under the Securities Act, but have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or similar media or broadcast over television or radio or on a website; “general solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor.  That’s the test: there must be a “substantial and pre-existing relationship” – and there are a number of SEC no-action letters which discuss what that means; simply put, it means there must a business relationship that is in place prior to the offer sufficient for the issuer to determine that the offeree would be a suitable investor. 

Mistake #4 – Using an Unregistered Finder to Sell Securities 

Entrepreneurs often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker-dealer and thus will be required to be registered with the SEC and applicable state commissions.  If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus will be subject to serious adverse consequences (as noted in paragraph #1 above), including giving the securityholders the right of rescission. 

Two caveats: (1) In 2004, California enacted a law specifically addressing this issue, which provides for (i) an express right of rescission to any investor who purchases a security from a person or entity that acted as a “broker-dealer” but was not registered; and (ii) the right of the purchaser to sue the unregistered seller for money damages.  (2) In 2008, the SEC adopted a new Form D (which, as noted above, is the official notice of a private placement under Regulation D), which must include the identities of all brokers and/or finders engaged in the offering of securities of the issuer.  This will obviously result in increased scrutiny of finders that are not registered as broker-dealers.

Mistake #5 – Selling Preferred Stock to Angel Investors  

Unless a start-up is raising at least $750K for an angel financing, it may not make sense from a practical standpoint for it to issue preferred stock.  Indeed, preferred stock financing are complicated, time-consuming and expensive – plus the company would need to be valued, which could be extremely dilutive to the founders.  Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, which keeps the financing simple and inexpensive, defers the valuation until the Series A round and gives the investors a discount on the conversion price (or a warrant) as a sweetener.  Needless to say, if superstar angels are interested in investing in your company, but insist on preferred stock, bite the bullet and take the money; great partners trump all rules.

1.  Protect Yourself from Personal Liability.  The entrepreneur’s first step in connection with launching a start-up should be to form an organization that will protect against personal liability.  As discussed below, a Delaware C-corporation is the structure that VC investors will generally require; however, if a financing is not imminent, it may be prudent for the entrepreneur to form an S-corporation or a limited liability company to obtain “pass-through” tax treatment (and then convert the entity to a C-corporation down the road, if necessary) to take advantage of the company’s initial losses, if applicable.  The bottom line is that the entrepreneur should seek the advice of counsel in connection with the formation of any business organization, including the advice of tax counsel (e.g., shareholders in S-corporations — as opposed to C-corporations — are not eligible for the “qualified small business stock” capital gains tax break; and losses in C-corporations may be deductible up to $50,000/yr. or $100,000/yr. on a joint return with respect to “Section 1244 stock”).

2.  Form a Delaware C-Corporation.  VC funds generally invest in Delaware C-corporations.  From a tax perspective, funds generally avoid (and may be prohibited under their respective fund documents from) investing in pass-through entities.  From a corporate perspective, Delaware is the most common state of incorporation (regardless of where the operations are located) due to its well-developed case law, management protections and flexibility, and ease of corporate filings and related state-law administrative issues.  Despite Delaware’s appeal, however, if the business has substantial operations and a majority of its shareholders located in California (a so-called “quasi-California corporation”), it may be simpler to form the corporation in California (i) due to the uncertainty regarding Section 2115 of the California Corporations Code, which purports to apply certain significant statutory provisions to quasi-California corporations (even if they are incorporated in Delaware); and (ii) the state-law requirement that a quasi-California corporation (or a corporation that otherwise has sufficient contacts with California) that is incorporated in Delaware or any other state must qualify to “do business” in California (in effect, a mini-incorporation process).  Again, the entrepreneur should seek the advice of counsel with respect to choosing the state of incorporation.

3.  Incorporate and Issue Stock ASAP.  The venture should be incorporated and stock should be issued to the founders as soon as possible — i.e., before the company has any significant value.  Clearly, as milestones are met by the company subsequent to its incorporation (e.g., the creation of a prototype, the signing-up of customers, etc.), the value of the company will increase and therefore so will the purchase price of the stock (which could trigger significant taxable income to those founders receiving stock in exchange for past or future services).  Moreover, if a founder intends to transfer assets (e.g., technology) to the corporation in exchange for stock, Section 351 of the Internal Revenue Code (which permits a tax-free exchange under certain conditions) may only be available at the time of incorporation and not later after more stock has been issued.  Indeed, the same principle applies with respect to the issuance of stock options/equity to employees: the goal is to do it as soon as possible when the value of the company is as low as possible.

4.  Impose Reasonable Vesting Restrictions.  As discussed in my earlier post, “Founder Vesting: Five Tips for Entrepreneurs,” the founders should impose a reasonable vesting schedule on the stock issued to them at the time of incorporation for two important reasons: (i) a vesting schedule will be required by the VC investors, and if a reasonable schedule has already been established, it is more likely that the investors will simply keep it in place; and (ii) it makes good business sense because, in most cases, the stock has been issued not only for services or property relating to the conception of the venture, but also for the founders’ continuing commitment and efforts — indeed, it would be inherently unfair for one of the founders to leave the venture after a few weeks/months, but still be permitted to keep all of his/her stock.  The most common schedule for founders vests an equal percentage of options (25%) every year for four years on a monthly basis.  Vesting restrictions are addressed in a Restricted Stock Purchase Agreement, which each founder would be required to execute and which would grant the company the right to repurchase any unvested shares at the initial purchase price at the time of the founder’s departure (subject to certain exceptions).  As discussed in detail in paragraph #3 here, it is generally advisable for any founders receiving shares subject to vesting to make a Section 83(b) election with the Internal Revenue Service, which will prevent the founder from recognizing income at the time the stock vests.  Such an election must be filed within 30 days after the purchase date of the restricted stock.

5.  Execute a Stockholders’ or Voting Agreement.  If there are two or more founders, it may be prudent to execute a stockholders’ or voting agreement in order to address certain significant issues between or among the founders, including (i) the appointment of directors, (ii) veto rights and (iii) rights of first refusal (if not addressed in the Restricted Stock Purchase Agreements, as discussed in paragraph 4 above).  In the event there are only two stockholders with an equal number of shares, it may also be prudent to include certain so-called “deadlock” provisions in the agreement (such as a “Russian roulette” provision, a “Texan shoot-out” or a “Dutch auction”).  Needless to say, the closer the startup is to a VC financing, the less importance a shareholders’ agreement holds because it will be superseded by the applicable venture documents.

6.  Comply with Applicable Federal and State Securities Laws.  A company may not offer or sell its securities unless (i) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (ii) there is an applicable exemption from registration.  Fortunately for the start-up there are certain prescribed transaction exemptions which may be applicable, including the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933, as amended (the “1933 Act”), and Regulation D promulgated thereunder (as well as Rule 701 discussed in paragraph 9 below).  It is indeed imperative that the entrepreneur seek the advice of experienced counsel prior to the issuance of any securities: non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  The rule of thumb in this area is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506, which preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996.  (Note: anti-fraud rules are still applicable under Rule 506.)

7. Protect Your IP.  For many start-ups, intellectual property (or “IP”), such as copyrights, trademarks, domain names or patents, is their most valuable asset.  Accordingly, a number of steps should be taken to protect IP assets, including (i) developing a comprehensive strategy for IP; (ii) establishing and implementing IP policies and procedures — e.g., concerning proper use of third parties’ IP; (iii) if appropriate for the business, filing patent applications and registering copyrights, trademarks and domain names; and (iv) as discussed below, requiring independent contractors and employees to execute confidentiality and IP/invention assignment agreements.  It may be prudent for entrepreneurs to retain separate IP counsel to address some of the foregoing issues, particularly where IP protection is significant to the business model.

8.  Address Employment Issues.  If any employees are hired by the company, they should be required to execute two documents: (i) an offer letter agreement and (ii) a confidentiality and IP/invention assignment agreement.  The offer letter agreement will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.”  The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company.  (Note: under California Labor Code Section 2870, an employer may not require an employee to assign rights in an invention that the employee developed entirely on his/her own time without using the employer’s equipment, supplies, facilities or trade secret information except for those inventions that either: (i) relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or (ii) result from any work performed by the employee for the employer.)  Non-competition provisions may also be appropriate; however, such provisions are unenforceable in California other than in the context of the sale of a business — though California courts may enforce contractual provisions that prohibit employees from soliciting the company’s employees, provided that such provisions are reasonable (i.e., not overbroad) in scope and duration.  Moreover, it would be prudent for the company to create an employment manual setting forth the company’s policies (including with respect to equal opportunity/non-discrimination and sexual harassment) and establishing the parameters of the employer-employee relationship.

9.  Establish a Stock Option/Equity Compensation Plan.  In order to attract and retain key employees (and to conserve cash), it usually makes good business sense for the company to establish a stock option plan or other form of equity compensation plan.  Again, the goal is to do it as soon as possible when the value of the company is as low as possible.  As noted above, any offer or sale of securities must comply with applicable federal and state securities laws.  Rule 701 promulgated under the 1933 Act creates an exemption from registration for any offer or sale of securities pursuant to certain compensatory benefit plans and contracts relating to compensation, provided that it meets certain prescribed conditions.  Most states have similar exemptions, including California, which recently amended the regulations under Section 25102(o) of the California Corporate Securities Law of 1968 to significantly liberalize the requirements under California law to conform with Rule 701.  Moreover, under Section 409A of the Internal Revenue Code, the company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date; otherwise, the grant will be deemed deferred compensation, the recipient will face significant adverse tax consequences and the company will have tax-withholding responsibility.  The company can establish a defensible fair market value by (i) obtaining an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” relying on the valuation of a person with “significant knowledge and experience or training in performing similar valuations” (including a company employee), provided certain other conditions are met.  (Note: restricted stock is not subject to Section 409A.)  Again, the entrepreneur should seek the advice of counsel before issuing stock options or other equity.

10.  Pay To Play.  Based on the foregoing, it is self-evident that now is not the time for the entrepreneur to try to save money by doing legal work on his own or by relying on printed forms from a web service like LegalZoom (see FAQ’s).  Indeed, there are a number of significant legal issues that must be addressed to protect the entrepreneur and his venture.  Moreover, VC firms and other outside investors will be doing extensive due diligence on the company prior to making an investment and, accordingly, it is imperative that the entrepreneur demonstrate a certain level of credibility and sophistication.  Remember: “starting companies is a lot like launching rockets: if you’re a tenth of a degree off at launch, you may be a thousand miles off downrange.”  The Silicon Valley Edge, edited by C-M Lee, et al. (Stanford University Press 2000), p. 328 (quote by C. Johnson, Esq.).