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Investors raising money for their startup business have a choice. The startup can spend the large amount of time and money needed for a full blown public security offering. This is impractical or impossible for nearly every startup business. In its place, the United States Securities and Exchange Commission has exemptions. They are faster, cheaper, simpler, and tailor made for startup business circumstances.
What Law Applies to Startup Private Investor Funding?
Section 4(a)(2) of the Securities Act of 1933 (the “Act”) exempts from registration “transactions by an issuer not involving any public offering.” It is section 4(a)(2) that permits an issuer to sell securities in a “private placement” without expending the money and time needed for registration under the Act.
Each startup business must decide what SEC exemption it will use. Startup companies that raise money in the United States must be aware of and comply with the rules and laws that apply to the United States Securities and Exchange Commission. The filing is typically regarding the capitalization of a business, using either an ICO, or equity investments. The default position of the SEC is that all security offerings must be registered.
What is Regulation D?
It is the job of the Securities and Exchange Commission to:
The Securities Act of 1933 created rules for disclosure of investments, stocks, and securities. There are many rules. Compliance with all SEC rules is expensive and time consuming. Thus, investors are protected at the expense of businesses, especially small startup companies. To balance, the SEC created “Regulation D” (and affiliated rules). These rules open up the disclosure requirements, speed the process, and reduce costs. In exchange, only certain investors may participate. Specifically, the SEC exemptions:
The Most Common Exemptions to a Full SEC Public Security Offering
The SEC has exemptions from a full registration. The most common exemptions are Rules 504, 505, and 506.
SEC filing requirements.
A full blown SEC registration has many filing requirements. However, a startup business must keep in mind; there are some filing requirements even when an exemption is being employed.
Does It Matter Whether You “Tip” People Off?
SEC filings are public. Therefore, each startup business needs to consider whether it is in its best interest to inform the public (creditors, customers, competitors) that the business is raising money through a security offering.
What Disclosures Can You Stomach?
Different SEC registration exemptions come with differing disclosure requirements. What are you required to disclose to your investors? Each investor will require some information and verification before giving money to the startup business. However, the failure to disclose what the SEC requires is a frequent source of lawsuit litigation. Your startup business does not want to put itself in that position. Therefore, disclosure requirements should be considered before choosing an exemption.
Safe Harbors
A “safe harbor” exemption gives clarity as to what is or is not required by the SEC. Non-safe harbor exemptions carry with them greater risk and area of interpretation.
State “Blue Sky” Laws
The registration requirements of a security are not limited to federal law. Individual states can and do have their own security registration requirements, known as “blue sky” laws. It is important for a startup business to decide whether its SEC exemption choice will subject it to state law, or not.
“Blue Sky” laws can be more onerous than one might imagine. Most security offerings involve investors in many states. Complying with blue sky laws in many states, with many differing, often conflicting laws may be impractical. A federal exemption can exempt a startup business from “blue sky” laws.
Do You Intend to try to Sell Your Security to the Public At-Large?
Many SEC exemptions do not allow a startup business to pitch for sale partial company ownership or investment to the general public. They require investors who meet very specific criteria.
There are Advantages to a Public Solicitation for Stock.
Private Offerings have Advantages, too.
What is an Accredited Investor?
An accredited investor is a person who meets the following criteria:
Exemptions come in Two Main Categories
Most start up funding occurs in Regulation D. Regulation D is part of the “Safe Harbor” provisions within the SEC that allows for greater certainty as to what is and what is not allowed.
Rule 504 under Regulation D – The “Seed Capital” Exemption:
Rule 504 is a popular exemption from SEC filing but is by no means the dominant exemption. There are reasons for its secondary status. The issuing company needs a business plan. It needs a purpose. This means no Special Purpose Acquisition Companies (SPACs).
There is no public solicitation under Rule 504. Blue Sky State laws are another Rule 504 burden. There is not federal exemption under Rule 504. The startup under Rule 504 must comply with the laws of each State where this investment activity occurs. Though, there are some exemptions under State law.
A Form D must be filed within fifteen days of the first investment (the first time money is received). There is also a money ceiling; there is a maximum amount of funding a company can received under Rule 504. The startup cannot raise more than five million dollars over a twelve-month period under Rule 504. Rule 504 has benefits. There is a clear definition of who can or cannot have the exemption. Another benefit is that it allows for investors who are not accredited. Another advantage is that there are no specific SEC disclosure requirements.
Rule 505
SEC Rule 505 is a good option when a startup wants investment from a relatively small pool of unaccredited investors and has investment needs below five million dollars. Specifically, Rule 505:
Rule 505 is not a common exemption used, however, it can be appropriate if the business has a relatively small pool of unaccredited investors who wish to invest a large amount of money.
Rule 506 (b) under Regulation D – “Private Fundraising”
The Rule 506 exemptions are the most common SEC exemption, accounting for ninety percent (90%) of offerings. Rule 506(b) is the most popular Regulation D exemption. There are certain rules with which the startup company must comply. Only accredited investors (and 35 unaccredited investors) are allowed. More information on the investors is required if unaccredited investors are used. More company disclosures are allowed if unaccredited investors are used. Public solicitation is only allowed on “demo day.” One must file a Form D within fifteen days of the investment. Rule 506(b) has advantages. There are no SEC disclosure requirements if the business uses no unaccredited investors. This saves on legal fees. This reduces lawsuit risk. It reduces regulatory risk. The determination of an accredited investor is easier under Rule 506(b). Investors can self-certify their investor status. A startup under Rule 506(b) is exempt from State “blue sky” laws. Rule 506(b) is a “safe harbor” provision, giving clarity as to what is and is not allowed. Rule 506(b) has no investment ceiling. A startup can raise any amount it can with no limit as to a maximum amount of investment capital. An SEC form D must be filed within fifteen days of the first receipt of money.
Rule 506(c) under Regulation D – “Public Fundraising”
Rule 506(c) is often thought of as crowdfunding for accredited investors, only. The startup must certify that only accredited investors have been used. This is different than Rule 506(b) where an investor can self-certify. Under Rule 506(c) the startup company itself must use due diligence to create a legal SEC certification of accredited investor status. This means additional legal fees are incurred. Additional administrative fees are incurred. An accountant may be needed for certification. The investors will not enjoy your company or its contractors looking through each investor’s private documents. An SEC form D must be filed within fifteen days of the first receipt of money. Only accredited investors may qualify for a Rule 506(c) security offering. A public solicitation is allowed. Rule 506(c) has no disclosure requirements. It creates a federal exemption from State “blue sky” laws, which reduces that level of expense and complexity. Rule 506(c) is a “safe harbor,” so there is relative clarity regarding what is and not required of the startup company. Best of all, an unlimited amount of investment is allowed with Rule 506(c).
Title III a.k.a. Regulation Crowdfunding Via The US Jumpstart Our Business Startups Act (JOBS Act)
2015 saw the adoption of Regulation Crowdfunding by the SEC. Its aim is to increase investor funding to emerging growth companies. Regulation Crowdfunding grants exemptions from many requirements listed companies must obey. The goal is to create a pro-growth environment for emerging companies by giving them a freer regulatory burden.
There are complicating factors with Regulation Crowdfunding. One complication is that solicitation of investors and security sales must be done through a third party. A startup business cannot solicit investors through regulation crowdfunding itself. This adds time. It adds expense. It adds complexity. It adds risk.
There are disclosure requirements. If the first round generates less than $107,000 in investment, the disclosure does not have to be reviewed. However, if more than $107,000 in investment is raised for the first round, a CPA must review and sign off on the disclosures. There is a maximum of five million dollars is allowed for investment under Regulation Crowdfunding. The SEC requires Form C to be filed within fifteen days of the first receipt of investment.
It allows for a public solicitation. The third party you contract will likely have specialized knowledge and experience with crowdfunding. Using a third party contractor for Regulation Crowdfunding may result in a larger net amount of investment raised. There is no accredited investor status required; anyone may invest. There is a federal exemption as Regulation Crowdfunding is considered a SEC “safe harbor” provision. There is no requirement that each State statute must be complied with.
What Is SEC Form D
SEC Form D is a required document most companies that issue must file. It identifies you. It identifies person to whom you are related, both biologically and professionally. You must disclose company revenue. You must disclose the Rule under which you are claiming an SEC offering exemption. You must identify your industry by code. You must disclose the state jurisdictions from which your company has derived sales.
The SEC Form D must be filed within 15 calendar days after the company closes its first security sale that qualifies for an exemption from the typical filing requirements
What are the penalties for violating Regulation D?
A person who willfully violates the Securities Act of 1933, its rules, or regulations of the SEC faces a fine of up to $10,000.00 and up to five years in federal prison, or both.
This includes:
SEC Regulation S – Pure Foreign Investments
SEC Regulation S governs offers and sales outside the US without SEC Registration. It was adopted in 1990. It is intended to facilitate scenarios where:
An American company issues securities, but only to foreigners
An American investor enters a foreign market to purchase securities
A good resource to look into the specific circumstance of Regulation S offerings is that by Pillbury Law, “Offerings Under Regulation S” (March 2013).
What is SEC Rule 144?
SEC Rule 144 pertains to resells of stock. It does not pertain to the issuer (the original company that created the stock). Rule 144 is important to the startup business because it allows a buyer to resell the startup company stock to “QIBs.”
A “QIB” is a Qualified Institutional Buyer. There is no limit amount of QIBs that can buy startup company stock. The sale is known as a “Rule 144A offering.” To be a Qualified Institutional Buyer, one must meet the following requirements:
QIBs use a number of nuances to get to the above figures, but that is a discussion beyond the detail of this explanation. Resellers do not need rock solid proof that a potential security buyer meets QIB status. A “reasonable belief” suffices the regulatory test. The seller must also take “reasonable steps” to verify that the buyer knows the seller contemplates a Rule 144A test. “Reasonable steps” nearly always come in the form of a “Notice to Investor” which accompanies the sale documents. Rule 144 does not permit a general solicitation to the public. Rule 144 does not block applicable State anti-fraud or anti-manipulation laws.
SEC Rule 144A became official in the Spring of 1990. The purpose of Rule 144A is to add certainty for large investors who wanted favorable pricing in private security placements without limitations on stock resale. Rule 144A, in essence, codifies Section 4(1-1/2). Rule 144A creates several market benefits:
Let's talk about whether you face regulation under S.E.C. or C.F.T.C. rules ... and how you can avoid risk from non-compliance allegations.
Trial lawyer Matt Hamilton graduated from the University of Missouri in 1995 with Science degrees in Logistics, Marketing, and Business Administration. Juris Doctor, 1999.
