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Raising Capital - A Securities Law Trap for the Unwary

Written by: John Bentas

(Published in Business NH Magazine, August 2010)
 
In this current economic climate, start-up companies, as well as many small and medium sized businesses, are looking more frequently to varied sources of raising capital, such as from friends, family members, acquaintances, and “angels”, in addition to the traditional sources (such as venture capital firms).  Even for well established companies, banks have also become increasingly reluctant to lend in many situations in which they may have played a capital-raising role in the past, such as helping to finance growth opportunities.

Businesses are still very interested in growing, but with their funding sources curtailed they need to look elsewhere for the capital they need.  This capital raising need is being filled by persons who do not likely have the experience and sophistication of venture capitalists and financial institutions.  In these situations, it is quite possible that legal counsel is not involved, and therefore the risk of failing to comply with applicable securities laws increases. 

No matter the form of the transaction, it is more than likely that a security is being issued in connection with that capital financing.  What constitutes a security is defined by law and cases interpreting those laws.  Generally, under securities laws, the definition of a security is very broad and encompasses commonly used instruments, like stock, but it also can cover just about any other instrument in which a person contributes money to an enterprise in an effort to generate revenue for profit or the repayment of that contribution.  As you can imagine, this broad definition can cover many things, including money that is meant to be treated as a “loan” or other “investment.”  It really doesn’t matter what the instrument is called - if it acts like a security, it is a security for securities laws purposes.

Securities laws can be implicated in a number of ways in a capital raising transaction.  In general, when a company issues a security, the issuer should be concerned about (1) the method by which they offer that security, (2) who they sell it to, and (3) what the Company says (or fails to say) in that offering.  The focus of this article will be on the method of offering securities and the buyers of those securities.

Securities that are issued in a “public offering” likely need to be registered with the Securities and Exchange Commission.  This is a cumbersome and expensive process that can not be borne by most companies.  As a result, companies offering securities must rely on exemptions or “safe harbors” so that their offering is not considered a public offering.  These exemptions and safe harbors depend, at least in part, on the manner in which the security is offered and who they are issued to. 

What is considered a public offering of securities is a complex analysis of applicable laws as well as specific facts and circumstances.  Generally, advertisements and solicitations to those persons with whom the issuer (or the issuer’s agent) does not have a substantial and pre-existing relationship are prohibited.  An article, notice or other communication published in any newspaper, magazine, or similar media (including the Internet) or broadcast over television or radio is clearly a “public offering.”  Is an offer to invest in a business to your neighbors a public offering – the answer may be yes! 

The most often used exemptions under the federal laws are commonly referred to as the SEC Rule 504, Rule 505 and Rule 506 safe harbors as well as the “private offering” exemption.  Although there are many nuances to each that are beyond the scope of this article, and you should consult with an attorney before claiming any particular safe harbor or exemption, below is an outline of the general parameters of each exemption:

Rule 504
Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a 12-month period. Unlike the other exemptions referenced in this article, you may use public solicitation or advertising to market the securities.   However, you must also find state law exemptions to registration or you may be required to register the securities under applicable states laws, which can be time-consuming and expensive.  There are no specific disclosure requirements for this type of offering, but you should take care to provide sufficient information to investors to avoid violating the anti-fraud provisions of the securities laws. This means that any information you provide to investors must be free from false or misleading statements. Similarly, you should not exclude any information if the omission makes what you do provide investors false or misleading. 

Rule 505
Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, you may sell to an unlimited number of "accredited investors" and up to 35 other persons who do not need to satisfy sophistication or wealth standards associated with Rule 506 (see below). Purchasers must buy for investment only, and not for resale.  Unlike Rule 504, you may not use general solicitation or advertising to sell the securities. It is up to you to decide what information you give to accredited investors, so long as it does not violate the anti-fraud prohibitions. But you must give non-accredited investors disclosure documents that generally are the same as those used in public offerings. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well. Just like the Rule 504 safe harbor, you must also find state law exemptions to registration or you may be required to register the securities under applicable state laws.

Rule 506
Rule 506 is the most commonly used exemption because (1) you can raise an unlimited amount of capital and (2) states are preempted from requiring you to register the securities (although a state may still require the same filings you make with the SEC). Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated - that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.  Otherwise, the same contours of the Rule 505 safe harbor apply to Rule 506 with respect to the type and quality of information.

“Private Offering” Exemption
The “private offering” exemption excludes from registration "transactions by an issuer not involving any public offering." To qualify for this exemption, the purchasers of the securities must: (1) have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (the "sophisticated investor"), or be able to bear the investment's economic risk; (2) have access to the type of information normally provided in a public offering; and (3) agree not to resell or distribute the securities to the public.  In addition, you may not use any form of public solicitation or general advertising in connection with the offering.  The precise limits of this private offering exemption are uncertain. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption.

Accredited Investor
Those persons that do invest or are offered an opportunity to invest in your business should meet certain net worth or asset tests.    These persons are referred to as “accredited investors”.  An accredited investor includes, among others: (a) a natural person with a net worth of at least $1 million (excluding the value of their primary residence); (b) a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or (c) a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.

State Securities Laws
As mentioned above, if you rely on Rule 504 or Rule 505 of the federal safe harbors, then you must also find an applicable exemption from registration under the securities laws of the state from which you are selling and the state in which each buyer resides.  In New Hampshire, some of the most commonly used statutory exemptions include: (a) the “limited offering” exemption, (b) sales to existing holders of securities of the issuer and (c) the “pre-incorporation offering” exemption.  Among other limitations, the limited offering exemption limits the number of purchasers of securities of the issuer, in all jurisdictions combined to no more than 10 during any 12 consecutive months and 25 during the issuer's existence.  Moreover, the pre-incorporation offering exemption, among other limitations, limits the aggregate number of holders of all of the issuer's securities to no more than 10 persons and sales must be consummated within 60 days after the date of incorporation or formation of the issuer.  In some instances, you can combine the state exemptions.
 
The failure to comply with the registration requirements of applicable securities laws can be severe, and will likely include the obligation to return the investment to the investor with interest, which frequently comes at a time that the company can not fund it, and the possibility of the imposition of civil penalties.  Therefore, it is important that you carefully consider the implications of securities laws, including registration requirements, whenever you take money from a person in connection with the growth or continued operation of your business.

John Bentas is a member of the Corporate Department at the law firm of McLane, Graf, Raulerson & Middleton, Professional Association He can be reached at 603-628-1306 or [email protected]. The McLane Law Firm is the largest full-service law firm in the state of New Hampshire, with offices in Concord, Manchester and Portsmouth, as well as Woburn, Massachusetts.

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