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.)
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.
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.