Lack of funding can doom even well-managed operations and brilliant business models. Consequently, starting a business can require entrepreneurs to develop skills and competencies specifically for fundraising. But after grasping financial and other aspects of fundraising and investment, even the most adventurous entrepreneurs should not rashly blaze a trail into the unknown. Instead, they should pause, take a breath—and call a business lawyer with relevant experience in financing transactions.
Fundraising & Securities Law
When investors offer a profit opportunity in exchange for investment, entrepreneurs should be aware of the significant legal risks involved. Whether in the form of corporate stock certificates, equity interests in an LLC or partnership, digital assets, crypto tokens, or other intangible contract rights, investment arrangements create “securities.” Both the offering and sale of securities result in the application of a complex legal framework at the state and federal levels.
At the core of this framework is securities law and the rule that a security may not be offered or sold unless it is “registered” with the appropriate regulator or unless an exemption to registration applies. See Section 5 of the Securities Act (the “Act”). A registration statement is an extremely detailed and costly filing intended to ensure that investors have adequate disclosure regarding the risks and characteristics of the business proposition associated with the security. The non-compliant issuance and sale of non-registered or non-exempt securities can result in significant public and private liability including damages, civil fines, and criminal penalties (depending on the facts and circumstances of each violation).
The Private Placement Exemption and the 506(b) Safe-Harbor
Fortunately for entrepreneurs, the Act provides several exemptions from the registration statement requirement, including the “private sale” exemption in Section 4(a)(2). Additionally, SEC regulations detail several avenues for the offering and sale of securities pursuant to exemptions under the Act. These include several “safe harbors” including Rule 506(b), which assures fundraisers that the offering and sale of an investment opportunity will qualify as a private sale (or “placement”) under Section 4(a)(2). For peace of mind that Rule 506(b) applies to minimize securities-related legal liabilities, entrepreneurs must strictly adhere to its guidelines.
More on 506(b)
Rule 506(b) allows companies to raise an unlimited amount of money. Additionally, it does not place any limit on the number of accredited investors to which a company may sell securities. However, a company may sell securities to only 35 non-accredited investors. Consistent with the notion that 506(b) is an exemption applicable to “private placements,” investments cannot be promoted or marketed to the public by general solicitation or advertising. Any securities sold pursuant to 506(b) are deemed “restricted securities” under the Act, which places restrictions on the owner’s ability to trade the security.
Despite the explicit authorization under 506(b) to sell securities to up to 35 non-accredited investors, many companies exclude non-accredited investors from their offering because of additional requirements that apply when dealing with non-accredited investors, including the following:
- non-accredited investors must have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment or be represented by a purchaser representative that so qualifies.
- non-accredited investors must receive disclosure documents containing the same type of information, generally, as provided in Regulation A offerings, while disclosures are not required to qualify for a registration exemption if only accredited investors participate in an offering.
- The Company must give any non-accredited investors certain financial statement information specified in Rule 506; and
- Company officers must be available to answer questions from participating non-accredited investors.
Guidance from an attorney experienced in the field is important when negotiating and documenting the sale of securities under 506(b) and any other exemption. For several reasons, this is not an area in which companies or entrepreneurs should forego counsel. For instance, even if a fundraising process is compliant with the guidelines of a particular exemption, total compliance is not assured. A company’s sale of securities could result in liability for a material misrepresentation or for failure to disclose material information. Finally, 506(b) may not be the right exemption to use given the facts and circumstances of a particular opportunity and another exemption may be a better fit. Companies should discuss with counsel whether another registration exemption might be a better option given the particularities of the company, the prospective investors, and the opportunity.