By: Adam M. Slipakoff, Esq.
For the uninitiated, the phrase “venture capital” may trigger fever dreams of indistinguishable tech firms crusading to “disrupt” anything and everything in sight. It may conjure images of TV mahogany boardrooms, leather club chairs, and Mark Cuban. For the initiated, however, “venture capital” is the catchy buzz-phrase encompassing a vast, intricate, and often disorienting jungle of strategies, regulations, and obstacles. Without the proper guidance, aspiring Zuckerbergs will find themselves astray, sinking rapidly in a wide, winding river, as investors abandon the very flotilla they championed days earlier. But!—for the tenacious entrepreneurs who voyage into the heart of darkness and navigate the chaos deliberately, thoughtfully, and confidently, the spoils of a successful capital raise await.
Alright. Raising capital for an early-stage startup isn’t quite that intense. There is no jungle, no armada, and (most importantly) no snakes. What there are—and what is the topic of this guest blog—however, are a bevy of strategic and regulatory considerations arising from decades of federal and state securities laws and regulations. Unfortunately, these laws don’t fit nicely onto a one-page cheat sheet.
A Little Background
A perusal of Wikipedia’s article about the Securities Act of 1933 (typically referred to as the Securities Act or the ‘33 Act) will tell you everything you need to know about its history. So, here’s the bullet point version:
- The Securities Act was enacted on May 27, 1933, in response to the stock market crash of 1929. The Securities Act regulates offers and sales of securities in the United States and was enacted to ensure issuers of securities fully disclose all material information that a reasonable shareholder would require in order to make up his or her mind before they invest in a security.
- Prior to the Securities Act, state “blue sky laws” governed the regulation of securities, imposing qualitative requirements on offerings.
- The Securities Act requires that any offer or sale of securities using “the means and instrumentalities of interstate commerce” be registered with the Securities and Exchange Commission (the SEC) unless an exemption from registration exists under the law.
- A company required to register under the Securities Act must create a registration statement, a prospectus (which includes extensive information about the security, the company, the business, and audited financial statements), among other compliance requirements.
Registration or Exemption?
In the United States, under the Securities Act, every offer or sale of securities must be registered with the SEC unless it satisfies certain criteria for exemption from those registration requirements. In essence, every company that wishes to offer or sell a security must answer this question first: Is this offering exempt from registration?
Section 4(a)(2) of the Securities Act is known as the “non-public offering” (or “private placement”) exemption. It is the catch-all exemption and exempts from registration “transactions by an issuer not involving any public offering.” But, beware: The limits of the exemption are not defined in the rules, resulting in a history of confusion and unsteady application.
The risk of a 4(a)(2) offering is that there is no objective standard to determine if your company’s offering meets the requirements of the exemption. Determining if the offering is exempt under this section is a case-by-case evaluation; however, generally, as the number of investors increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the offering qualifies for this exemption. If your startup offers securities to even one person who does not meet the conditions of the exemption, the entire offering may be in violation of the Securities Act.
If the thought of all this uncertainty gives you anxiety, don’t fear. There are objective standards to ensure your company’s offering is exempt.
Regulation D (typically referred to as Reg D), adopted in 1982, provides for three exemptions from the registration requirements of the Securities Act, including a “safe harbor” for the “non-public offering” exemption in 4(a)(2). Reg D was intended to make access to the capital markets possible for small companies that could not otherwise bear the costs of a normal SEC registration. The following are general summaries of Rule 504, 505, and 506 and are not exhaustive of each rules requirements and limitations:
Rule 504 of Reg D provides for an exemption from registration requirements for companies when they offer and sell up to $1 million of their securities within any 12-month period.
The company can use this exemption so long as it is not a “blank check company” (i.e., a company in a developmental stage with either no established business plan or a business plan that revolves around a merger or acquisition with another company) and so long as the company does not have to file reports under the Exchange Act of 1934.
Rule 504 generally does not allow companies to solicit or market their securities to the public, though there are certain exceptions to this prohibition. Investors in a Rule 504 offering will receive “restricted” securities, meaning they may not resell the security without registration with the SEC or one of these applicable exemptions.
Rule 505 of Reg D provides for an exemption from registration requirements for companies when they offer and sell up to $5 million within any 12-month period.
Under Rule 505, securities may be sold to an unlimited number of “accredited investors” and up to 35 “unaccredited investors.” An “accredited investors” is, generally, a person or entity that satisfies certain the requirements regarding income, net worth, asset size, governance status, or professional experience, and is thus deemed capable of dealing with unregistered securities. Moreover, the securities are “restricted.”
Rule 505 permits companies to decide what information to give to accredited investors, provided that they don’t violate antifraud laws. Companies must give non-accredited investors disclosure documents that generally are equivalent to those provided to investors in registered, public offerings (the scope of these documents can be extensive and preparation, expensive).
Under Rule 505, general solicitation or advertising to sell the securities is not allowed.
Rule 506: The “Safe Harbor”
Unlike Rules 504 and 505, Rule 506 of Reg D is a “safe harbor” created to provide objective measures to ensure that your offering meets the requirements of the “non-public offering” exemption in 4(a)(2) of the Securities Act. It is bifurcated into two exemptions: Rule 506(b) and Rule 506(c). Rule 506(b) is a long-standing rule and Rule 506(c) was added in 2013 to implement a statutory mandate under the JOBS Act.
Under Rule 506(b), a company can raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 unaccredited investors. This is where the rule differs from the others, and thus ensures exemption under 4(a)(2): Under Rule 506(b), all non-accredited investors must meet a legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the investment. Moreover, the company must furnish to non-accredited investors specific disclosure documents that contain the same information that would be provided in a registered offering (though the company is not required to provide any specific documents to accredited investors). The company must also be available to answer questions from prospective, non-accredited investors.
Otherwise, the remaining requirements of Rule 506(b) are similar to the other rules: The company may not use general solicitation or advertising to market the securities and investors will receive “restricted” securities.
Rule 506(c) eliminates the prohibition on using general solicitation under the other rules if all investors are accredited investors and the company takes reasonable steps to verify that the purchasers are accredited investors—meaning a company can broadly solicit and generally advertise the offering and still be deemed to be undertaking a 4(a)(2) “non-public offering” if it meets those and a few other certain conditions.
As with all the other exemptions, investors in a Rule 506(c) offering will receive “restricted” securities.
The Gold Standard
According to the SEC, in 2015 there were more than 33,000 private offerings conducted under the exemptions promulgated by Reg D, totaling over $1.3 trillion, with approximately 300,000 investors participating in those offerings. While only approximately $133 billion of the $1.3 trillion raised wasn’t raised by large hedge funds, investment banks, and private equity funds, the median size of the aggregate offerings in 2014 was $2 million, indicating that small, early-stage raises were likely the dominant trend. Far and away, the most commonly used exemption from registration under federal securities laws is Rule 506, which accounted for over 95% of those 2014 Reg D offerings.
Jumpstart Our Business Startups Act (JOBS Act) & “Regulation Crowdfunding”
If you’re reading this guest blog, odds are you’ve at least heard the phrase “crowdfunding.” For the last decade, the phrase has been an amorphous term to describe, effectively, the use of the internet by early-stage companies to raise capital through small, limited investments from a large number of investors on platforms like GoFundMe, Kickstarter, and Crowdfunder. These platforms have avoided triggering the application of federal securities laws by avoiding, generally, the offer of a share in any financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. When asked by The Economist in May 2015 what distinguished Kickstarter from other crowdfunding platforms, its co-founder, Perry Chen, did little to clarify the broader confusion surrounding crowdfunding:
I wonder if people really know what the definition of crowdfunding is. Or, if there’s even an agreed upon definition of what it is. We haven’t actively supported the use of the term because it can provoke more confusion. In our case, we focus on a middle ground between patronage and commerce.
Not even three months earlier, in March 2015, the SEC adopted “Regulation Crowdfund” (which went into effect this past May), pursuant to Title III of the JOBS Act, which is intended to help alleviate the funding gap and regulatory concerns faced by small businesses by making low-dollar-amount offerings of securities less costly. Moreover, Regulation Crowdfund is also intended to provide crowdfunding platforms a means to facilitate the offer and sale of securities without registering as brokers while establishing a framework for regulatory oversight.
Title III of the JOBS Act added new section 4(a)(6) to the Securities Act, providing for an exemption from the registration requirements for certain crowdfunding transactions. Generally, to qualify for the exemption under 4(a)(6), crowdfunding transactions by an issuer meet specified requirements, including the following (again, the following is a general summary and not exhaustive of the rule’s requirements and limitations):
- the amount raised must not exceed $1 million in a 12-month period;
- individual investments in all crowdfunding issuers in a 12-month period are limited to:
- the greater of $2,000 or 5% of annual income or net worth, if annual income or net worth of the investor is less than $100,000; and
- 10% of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more; and
- transactions must be conducted through an intermediary that either is registered as a broker-dealer or is registered as a new type of entity called a “funding portal.”
How to Cope
Since the JOBS Act passed in 2013, the regulatory landscape for raising capital has transformed at a dizzying pace. Regulators are only now beginning to catch up to the progress of the venture capital community and industry. Although the jungle is slowly being conquered, early-stage startups still face substantial obstacles to obtaining capital going both the traditional and emerging routes. The tried-and-true harbors of Reg D are reliable, tested paths, but even the most experienced climbers know that you’ll reach the summit of the mountain safer with the right guide. The untamed wilderness of Regulation Crowdfunding is exciting and audacious, but with every new regulatory structure comes risks. Ultimately, no path is without potential peril and entrepreneurs and investors, alike, should arm themselves with as much information as possible before embarking on a path.
Adam M. Slipakoff, Esq., is the managing partner and founder of Slipakoff LLP, a boutique law firm headquartered in Kennesaw, Georgia, and serving clients throughout Atlanta and the eastern U.S. We specialize in early- and mid-stage venture capital and concentrate on capital raise transactions, corporate agreements, SEC and state securities compliance, and mergers and acquisitions. This article is not legal advice and you should not rely upon it as legal advice. In some jurisdictions, this may be considered “Attorney Advertising.”