Fundraising for Small Businesses: SEC Registration Exemptions

Besides the State level requirements, on the federal level, you need to ask if you have to register with the SEC.

The answer is unfortunately complicated, but you may be able to qualify for one of several exemptions from federal registration requirements under the Securities Act.

You will notice an annoying number of “it depends” type statements below, but a good lawyer should be able to help you find a solution.

But remember, even if you are exempt from SEC registration requirements, you are still subject to the anti-fraud provisions of federal and state securities law. These provisions make businesses responsible for false or misleading statements made verbally or in writing. You also must comply with the notice and filing obligations of various state laws, commonly known as blue sky laws, which can vary significantly from the federal requirements and even from state to state.

In addition, even if you qualify for an exemption, there are generally still complex documentation requirements. For example, you may need to put together a private placement memorandum (PPM), organizational documents and subscription materials (terms sheets) to provide to investors.  This helps satisfy your requirements under the anti-fraud rules mentioned above to provide full and complete disclosure to potential investors.

Among the exemptions from SEC registration are three options under Regulation D that are called Rule 504, Rule 505 and Rule 506, though in reality, Rule 506 is by far the most commonly used rule:

 

Rule 504

This rule provides an exemption for the offer and sale of up to $1,000,000 of securities in a rolling 12-month period. Like other Regulation D exemptions, you cannot generally use public solicitation or advertising to market the securities, though some states may allow it. Purchasers receive “restricted” securities, meaning they may not sell them without registration or an applicable exemption. However, you can use this exemption for a public offering of your securities and investors can receive freely tradable securities under certain circumstances.

Even though Rule 504 does not require you to make specific disclosure delivery requirements to investors, we strongly suggest that you take care to provide sufficient information to investors to avoid violating the anti-fraud provisions of the securities laws, especially if those investors are not accredited.

 

Rule 505

This rule provides an exemption for offers and security sales totaling up to $5 million in a 12-month period. Under this exemption, you can sell to an unlimited number of “accredited investors” and up to 35 other persons who don’t need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only (not for resale). The issued securities are “restricted.” Consequently, you must inform investors that they cannot sell for at least a year without registering the transaction. You may not use general solicitation or advertising to sell the securities.

 

An “accredited investor” is:

  • A bank, insurance company, registered investment company, Business Development Company, or small business investment company.
  • An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million.
  • A charitable organization, corporation or partnership (including an LLC) with assets exceeding $5 million, but such an organization could not have been formed for the purpose of investing in the company. Therefore, no pooling of non-accredited investors is allowed.
  • A director, executive officer, or general partner of the company selling the securities.
  • A business in which all the equity owners are accredited investors.
  • A person with a net worth of at least $1 million, excluding the value of their principal residence.
  • A 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.
  • A trust with assets of at least $5 million, which is not formed to acquire the securities offered. In addition, purchases of securities must be directed by a sophisticated person. This is described as someone with sufficient knowledge and experience in financial and business matters to make him or her capable of evaluating the merits and risks prospective investments.

You must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings (think of an IPO) and should provide the same to accredited investors as well. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well. You must also be available to answer questions by prospective purchasers.

There are some specific financial statement requirements applicable to this type of offering. For example, financial statements must be certified by an independent public accountant.

 

Rule 506

This rule is the most used exemption and is a “safe harbor” for the private offering exemption if your company satisfies the following standards:

You can raise an unlimited amount of capital.

You cannot use general solicitation or advertising to market the securities.  However, Rule 506(c), more recently adopted by the SEC, does allow general solicitation, but with greater restrictions including that your investors may only be accredited.

You can sell securities to an unlimited number of accredited investors (the same group discussed in Rule 505 above) and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be “sophisticated.” There are also some requirements associated with the information you provide to accredited investors.

You must be available to answer questions by prospective purchasers.

If you sell to any non-accredited investors, there are extensive financial and non-financial information requirements.  Financial statement requirements are the same as for Rule 505. Just like for Rule 504 and 505 offerings, you would be wise to provide disclosures about the business, the offering, risks to the business and other information to any investor regardless if accredited to help protect the company under the Anti-fraud rules mentioned before.

Purchasers receive “restricted” securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering.

 

Rules 504, 505 and 506 are only some of the several SEC exemptions from registration requirements.  Recently, Regulation Crowdfunding and Regulation A (Tiers 1 and 2) have been adopted that provide additional options to companies and are being used more frequently, despite significant hurdles. When contemplating investors, consider your goals, as well as the short and long-term effects of selling a stake in the company.

 

And now Title III

Small business owners will have a shiny new financing tool available to them after 2016. In perhaps the biggest change to hit small-business fundraising in the last 80 years, the Securities and Exchange Commission voted on Friday to enact the final rules of the Jumpstart Our Business Startups (JOBS) Act, which President Obama signed into law in 2012.

The new rule, known as Title III, will allow you to access a wider pool of investors than ever before–for instance, family, friends, and other interested parties who may not be Rockefellers. It will also unleash the nascent equity crowdfunding industry to become more important gatekeepers of small-business financing.

Starting August 2016, entrepreneurs will be able to offer equity stakes to non-accredited investors for amounts of up to $1 million, as a result of new crowdfunding rules put into place by the Securities and Exchange Commission in October.

The new rules, known as Title III, come from the Jumpstart Our Business Startups (JOBS) Act, which President Obama signed into law in 2012. Title III–conceivably the most important part of the JOBS Act, at least as far as startups go–allows unaccredited investors to buy into private companies, including startups and other small businesses. Title III was meant to help businesses raise money when banks pulled back from lending in the aftermath of the financial crisis. These companies can also start publicizing investing opportunities–this hasn’t been legal since before the Great Depression. While Title III was meant to help businesses raise money as banks pulled back and stopped lending in the aftermath of the financial crisis, the section got held up for years as the SEC tried to figure out the best way to protect investors and businesses from potentially reckless speculation. The SEC issued its final rules in late March 2016 following a public comment period, and set May 16, 2016 as the start date.

While the additional fundraising resource could prove useful, not everyone thinks there will be a rush to use it, and some legal and financial experts say they think the hassle and costs will outweigh the benefits.

“It will not be a significant tool, although I can see some companies wanting to use this to give them access to investors they might not have access to otherwise,” says Stephen Wink, a partner in law firm Latham and Watkins’ New York City office.

 

Here’s a brief summary of what’s new:

  1. How much you can raise.

Small businesses will be able to raise up to $1 million during a 12-month period from non-accredited investors. (A non-accredited investor, generally, is one who has less than $1 million in liquid assets and earns less than $200,000 annually.) They will, however, have to submit to an informal audit and produce documentation that describes investor and financial risks, legal experts say.

  1. What investors can invest.

In any 12-month period, non-accredited investors will be able to invest the greater of $2,000 or up to 5 percent of their income if they make less than $100,000, in company shares. Investors with annual income or a net worth of more than $100,000 can invest up to 10 percent of their income, up to $100,000.

  1. How to sell shares.

Sales will be handled via registered broker-dealers or funding portals that will act as gatekeepers, vetting investments and providing critical investment information to investors. The intermediaries will collect fees for the service, which the SEC will require them to disclose as a dollar amount or percentage of the deal.

Ten broker dealers and 50 companies that plan to run portals have applied to the Financial Industry Regulatory Authority to become official Title III intermediaries, the The Wall Street Journal reports, and five portals have been approved so far.

 

The flood gate is open for Crowdfunding!

Here’s what you need to know about the new crowdfunding rule, again a summary of the above information:

  1. How much you can raise.

Small businesses will be able to raise up to $1 million during a 12-month period from unaccredited investors. They will, however, have to submit to an informal audit and produce documentation that describes investor and financial risks, says Georgia Quinn of Ellenoff Grossman & Schole, a New York City-based law firm that specializes in securities law. “The real power and excitement of this is that it creates a new channel for businesses that are starved for capital,” Quinn says, adding the average small business raise is for $170,000.

  1. How much investors can invest.

In any 12-month period, unaccredited investors will be able to invest $2,000, or up to 5 percent of their income if they make less than $100,000, in company shares. Investors with annual income or a net worth of more than $100,000 can invest up to 10 percent of their income, up to $100,000. (An unaccredited investor, generally, has less than $1 million in liquid assets and earns less than $200,000 annually.)

  1. How to sell shares.

Sales will be handled via regulated funding portals that will act as gatekeepers, vetting investments and providing critical investment information to investors. In its hearing today, the SEC suggested the primary model would be internet portals, such as those that already exist in the crowdfunding world. Investors should, in theory, be able to sell those shares to secondary markets, as Inc. has previously reported. Commissioner Luis Aguilar, in his morning testimony, expressed concern that the secondary market for such shares was not robust enough to support the regulatory changes. Platforms such as SecondMarket and SharesPost already exist for accredited investors to buy and sell shares of private startups, and they could now face increasing competition. If nothing else, the cost of capital for all companies that now want to issue shares is likely to go down, SEC regulators said.

 

We hope this sheds some light to the complex roadmap of fund raising which many startup and small business owners sometimes are unprepared to tackle. We highly recommend to have an expert small business and especially startup business financier to give you advice along the way of your fund raising sprint.

Best of luck and always cover your behind for unexpected risks.