As a corporate lawyer for entrepreneurs, I am frequently asked: “Hey Scott, can I raise funds for my new company via Facebook or LinkedIn? I have lots of friends and connections, and I know some of them would be interested in investing.” The short answer is no (except in rare circumstances) because it would violate securities laws.
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.]