The Startup Law Blog

The SEC has scheduled a meeting for this coming Friday to vote on the final equity crowdfunding rules under the JOBS Act.

The SEC’s notice of the meeting says:

Notice is hereby given, pursuant to the provisions of the Government in the Sunshine Act, Pub. L. 94-409, that the Securities and Exchange Commission will hold an Open Meeting on Friday, October 30, 2015 at 10:00 a.m., in the Auditorium, Room L-002.

The subject matter of the Open Meeting will be:

The Commission will consider whether to adopt rules and forms related to the offer and sale of securities through crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.

The Commission will consider whether to propose amendments to Securities Act Rule 147 and Rule 504.

If you are desirous of doing some reading in advance of this meeting, you can go back and read the proposed rules.

It is great that the SEC is finally getting around to this. Hopefully the SEC makes the process for companies easier in the final rules.

Unfortunately, because of the way the statute was written, I still think equity crowdfunding under the JOBS Act is going to be too complex for most early stage and startup companies.

What are the big hangups under the law?

In my opinion, the big problems are:

• the requirement of audited financials for offerings over $500,000. Given the expense and time and effort involved in doing a crowdfunding offering, it hardly seems worth the effort to do one if you are not raising more than $500,000. If that is the case, then I can’t see a lot of startups and early stage companies taking this path. Instead, I think most will continue to stick to Rule 506(b) or 506(c).
• The requirement that companies pay an expensive intermediary to conduct an offering.

In general, I am a huge fan of the idea of equity crowdfunding. But I am concerned that the rules are going to be too complex and cumbersome for most companies to use.

If you are going to spend the time and effort required to do a Title III equity crowdfunding, perhaps a Reg A+ offering would be a better choice.

In any event, it will be fun to see how things unfold.

The SEC’s Advisory Committee on Small and Emerging Companies recently issued recommendations regarding the regulation of finders.

If you are not familiar with the rules, the SEC takes a very narrow view of who can help companies find investors without having to register as a broker-dealer.

Broker-dealer registration is so onerous that people won’t engage in an activity if it would trigger broker-dealer registration.

Here is how the Committee described the problem:

Capital raised in private offerings using SEC Regulation D is large when compared to other exempt offerings and registered offerings. However, only 13% of Regulation D offerings reported using a financial intermediary, such as a broker-dealer or finder, between 2009 and 2012. This is due, in part, to lack of interest from registered broker-dealers given the legal costs and risks involved in undertaking a small transaction and ambiguities in the definition of “broker.”

One of the reasons fundraising is so hard today is because of all of the regulations in place.

As the Committee says:

Failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies.

I believe, as the Committee says, that “[a]ppropriate regulation would enhance economic growth and job creation.”

The Committee’s letter continues:

The Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protection safeguards, on private placement intermediaries that limit their activities to specified parameters, do not hold customer funds or securities and deal only with accredited investors would enhance capital fonnation and promote job creation.

I like the components of the above:

• limit activities to specified parameters;
• do not hold customer funds or securities; and
• deal with only accredited investors.

I agree with the Committee: the SEC ought to reduce the regulatory hurdles that small and emerging companies have to jump over to raise capital.

You can find the Committee’s full recommendations in the Committee’s letter to SEC Chair Mary Jo White.

But here they are, at least in part–the parts I find interesting.

First, the Committee recommends:

The Commission take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Securities Exchange Act.

This is really interesting. Notice the parameters:

• solely for providing names of or introductions to prospective investors.

Then the Committee goes on:

The Commission exempt intermediaries that are actively involved in the discussions, negotiations and structuring, as well as the solicitation of prospective investors, for private financings on a regular basis from broker registration at the federal level, conditioned upon registration as a broker under State law.

This is important.

• intermediaries actively involved in the discussions, negotiations and structuring, as well as the solicitation of prospective investors, on a regular basis, would have to be registered–but under state law.

These are clear lines.

I hope the SEC takes action on the Committee’s recommendations.

If you are administering a private company stock option plan, you need to do what is referred to as “the Rule 701 math” before every grant of stock options or equity awards.

What is “the Rule 701 math”?

Rule 701 contains a set of mathematical limitations on how many shares of stock you can offer service providers during any consecutive 12-month period. If you exceed Rule 701’s mathematical limits, you might not have a securities law exemption for the equity you award in excess of the limit (you couldn’t rely on Rule 701, but perhaps there are other exemptions you could find).

If you blew Rule 701 and issued securities without a securities law exemption, this would be a serious issue for your company. You don’t want to do this for all sorts of reasons. One reason is that it might cause the delay of your company’s public offering (this actually happened to Google).

The Mathematical Limitations

There are three mathematical measures under Rule 701. You get to choose the greatest of the 3 measures. The three measures apply during any consecutive 12-month period. The three measures are:

• $1M;
• 15% of balance sheet assets; or
• “15% of the outstanding amount of the class of securities being offered and sold in reliance on this section.”

The $1M test is the easiest to apply because you don’t have to refer to the company’s balance sheet or cap table. If you are a startup, and you are granting stock options at $1.00 a share, then during any consecutive 12-month period you can’t grant options on more than 1M shares.

So, the $1M test is especially helpful to early stage companies, whose common stock price per share might be low.

But as your price per share increases, you might find yourself having to rely on one of the 15% tests.

In particular, you might want to know–how do you determine 15% of the outstanding amount “of the class of securities being offered and sold in reliance on this section”? And what is meant by “class of securities being offered”?

If you are like most companies, your founders own common stock, and your option pool is common stock, but you have issued your investors convertible preferred stock.

If you keep reading Rule 701, you will find a rule explaining how you go about “calculating prices and amounts.”

In particular, Rule 701(d)(3)(iii) says as following:

In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.

The above language is helpful.

Let’s suppose your company has a typical cap structure. The Founders own 4M shares, there is an option pool of 1M shares, and your Series Seed Preferred investors own 1.5M shares of Series Seed Preferred. Your cap table thus looks as follows:

Common	4,000,000	61.54%
Pool	1,000,000	15.38%
Series Seed Preferred	1,500,000	23.08%
	6,500,000

Say you want to rely on the 15% of the outstanding class of securities being offering test. How do you determine the 15%? Is it 15% of the Founder Common Stock? Or is it 15% of the Founder Common Stock AND the Series Seed Preferred.

Well, if you read the rule on how to calculate prices and amounts it told you:

Rule 701(d)(3)(iii): In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.

This is helpful. The Series Seed is convertible to common by the holders at any time, and the Series Seed wasn’t issued under Rule 701 but Rule 506. So, it would make sense to include the preferred as well as the common in doing your math.

But what about the “class” of securities being offered component of the test? The “rules for calculating prices and amounts” don’t say anything about the “class” question. In fact, the only place the word “class” appears in Rule 701 at all is in the 15% of outstanding securities rule. There is no other mention of class.

There is an SEC no-action letter on the “class” issue. But what is odd about the Arclight no-action letter is there is no reference in it to Rule 701(d)(3)(iii). As the letter requesting the no-action letter says:

Rule 701 does not contain a definition of “class” of securities for the purpose of determining whether the A, B and C Units should be considered a single “class” of securities in calculating the amount of offers and sales Arclight may make under Rule 701.

Perhaps the lawyers writing the Arclight letter simply didn’t think Rule 701(d)(3)(iii) relevant because it says nothing about “class.”

Perhaps the word “class” is not to be given any special significance? This is probably too hopeful of an interpretation.

In trying to understand this issue a little more, I found this series of letter exchanges between the SEC and a company trying to go public helpful and informative.

Here is what happened:

The company filed a draft registration statement with the SEC. In the draft registration statement, the company’s statement of stockholders’ equity showed the issuance of common stock in exchange for services.

The SEC asked about this in its comment letter.

The Company submitted another draft registration statement, and a reply to the SEC’s letter.

In its response letter, the company said the following:

But the SEC still wasn’t satisfied, and asked in its next letter, a little more pointedly, the following question:

Please expand your response to prior 44 to provide us your analysis of the applicability of the authority on which you rely to conclude that you may consider “securities convertible into common stock” as part of the number of shares of “outstanding” common stock for purposes of Rule 701(d)(2)(iii).

In its response, company simply quotes Rule 701(d)(3)(iii), and rests its case.

19. Please expand your response to prior 44 to provide us your analysis of the applicability of the authority on which you rely to conclude that you may consider “securities convertible into common stock” as part of the number of shares of “outstanding” common stock for purposes of Rule 701(d)(2)(iii).

RESPONSE:    The Company respectfully advises the Staff that Rule 701(d)(3)(iii) provides as follows:

“In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.”

As such, the Company included outstanding common stock, outstanding convertible preferred stock and outstanding warrants to purchase shares of convertible preferred stock and common stock not issued pursuant to Rule 701 as part of the number of shares of outstanding common stock for purposes of Rule 701(d)(2)(iii).

It would be nice if the SEC issued a telephone interpretation putting any potential lingering questions here definitively to bed.

What is Rule 701? And if you are a startup or emerging company, why do you need to know about it?

Rule 701 is a federal securities law exemption for issuing equity to employees, contractors and advisors.

You need a securities law exemption or registration statement in place to issue securities, and so finding and complying with an applicable exemption is really important.

When you issue stock options or other forms of equity compensation to your employees, Rule 701 is likely going to be your federal securities law exemption, in large part because there aren’t very many other comparably good exemption choices available.

Here are the highlights of Rule 701:

• Rule 701 is only available to private companies.
• Rule 701 exempts offers and sales of securities under written compensatory benefit plans or written compensation contracts, for the participation of employees, directors, general partners, officers, consultants and advisors.
• Rule 701 only exempts offers to former employees, directors, general partners, officers, consultants and advisors if such persons were employed by or providing services to the issuer at the time the securities were offered.
• You can only issue stock options or other equity compensation to individuals; not entities. So, if you hire a contractor, and he or she wants you to issue the stock options to his or her business entity, you cannot do that under Rule 701. You have to issue the options to this person in their individual capacity.
• The issuance of the equity has to be for compensatory purposes. Rule 701 can’t be used to raise capital. Your capital raising exemption is likely Rule 506.
• You have to give everyone who receives an equity award under Rule 701 a copy of the applicable stock option plan documents.
• Rule 701 has 2 different sets of mathematical limitations. One is an outright cap on how many options or shares you can issue to workers in the aggregate during any 12-month period. Another is not a cap–but triggers a prospectus delivery requirement to workers as well.
• The absolute mathematical limitation allows you to issue the greater of the following three measures during any 12-month period:
  • $1M
  • 15% of balance sheet assets
  • 15% of the issued securities of the same class that you are offering, not counting securities issued under Rule 701.
• If you exceed $5M in equity grants during any rolling 12-month period, you will have a prospectus delivery requirement.

It is important as you move forward in building your company that you plan for Rule 701 compliance. In general what this means is that before each set of option grants you confirm, among other things, that you are operating within the mathematical limitations, and complying with the prospectus delivery requirements if you have triggered them. 

State Exemption

You also need a state securities law exemption to issue stock options or equity compensation to employees. In Washington, the statute to refer to is RCW 21.20.310(10). In California, the exemption is 25102(o) and there is a form that is required to be filed and a fee that must be paid.

As always, this information is provided for informational purposes only. Always consult an attorney. This blog post does not constitute legal advice or the establishment of an attorney-client relationship.

Startups raising money need to know how to do so in compliance with federal and state securities laws. The trouble is–it is not always easy to know what the rules are.

To make it more difficult, the rules keep changing. Congress passes new laws. The SEC issues new regulations. All of it becomes difficult and hard to keep up with; even for the lawyers who spend substantial portions of their time reading new laws and rules and pronouncements and thinking about them.

The law regarding fundraising has changed quite a bit recently.

• We had the JOBS Act make general solicitation of offerings under certain circumstances and under certain conditions legal — but watch out — you might not want to accept the conditions and limitations.
• We have had the SEC issue a bunch of recent guidance on what constitutes general solicitation and general advertising.
• We have also had the SEC issue the CitizenVC ruling, giving people instruction on how to form online relationships with people who can become your investors without you being considered to have generally solicited and generally advertised your offering.

This is a lot of change.

Here is what you need to know:

• Before you start selling securities; before you start talking to people about your securities offering; before you start doing anything with regard to your securities offering other than talking about it internally, you need to settle on which securities law exemption you are going to use in your offering.
• The various securities law offerings that are available can’t be mixed and matched. You can’t take ingredients from some you like, and discard others.
• You have to pick your exemption path, and then you need to stick with it.

So, if you pick Rule 506(b) as your exemption, then:

• you cannot generally solicit or advertise your offering; and
• you have to be careful, really careful, not to be considered to have generally solicited or generally advertised your offering.

If you pick the Rule 506(c) offering as your exemption, then:

• you can generally solicit your offering, but
• you have to ask your investors for their personal financial statements or persona tax returns to verify that they are accredited (or you can use a qualified third party service to verify).

What if you just met someone? Can you pitch them without being considered to have generally solicited your offering?

It depends. How did you meet them? Did you meet them because you generally solicited or generally advertised your offering? Or did you meet them because a friend introduced you to them? Or did you meet them because you read that they invested in companies and you cold emailed them asking for meeting?

The SEC has said that the existence of a pre-existing, substantive relationship is only one way to show that you did not generally solicit your offering. But that is not the only way to show you did not generally solicit your offering.

In general, if you are working through your friends and contacts, and meeting people who might be able to help you, including as investors, and you pitch those people–this can work and not be general solicitation. But it depends on how you do it. You are not going to want to be posting on LinkedIn that your company is raising money and you are looking for investors. But individual introductions from your contacts should not get you in trouble unless they are spamming their network or something along those lines.

When in doubt whether what you are doing might run afoul of the Rule 506(b) prohibition on general solicitation and general advertising, consult the counsel you have retained to help you make sure you are complying with the rules. They are tricky.

In the most recent SEC guidance, here is what the SEC that is most helpful to answering this question about pitching someone you just met:

Question 256.27

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

Disclaimer: This blog does not constitute legal advice, or the establishment of an attorney-client relationship. This blog is for informational purposes only. Always consult your attorney with your securities law exemption questions.

Guest Post by Randy Ottinger

Over 25 years ago my wife asked me to visit Seattle from Boston where we were living at the time. She is a native from Mercer Island, and most of her family is still living in the area. It was May, and the weather was sunny, just as it was this summer. I am sure she told me under her breath that the weather was not always like this in Seattle, but for some reason I never heard it!

In 1989, I was 4 years out of business school. I had worked for IBM, and then started a tech company with some business school friends, which we grew and successfully sold to a public company. So when we decided to move to Seattle I was looking for an MBA-type opportunity with an entrepreneurial tech growth company. Well back then it was slim pickings. Seattle was still a Boeing town. Microsoft was just beginning its rise (which I unfortunately missed). Amazon did not exist. And MBA jobs were few and far between. Ultimately, I made my way to McCaw Cellular, which was a fantastic experience and enjoyable every step of its meteoric rise.

Flash forward to today, and Seattle is one of the most exciting places in the country for a technology entrepreneur. Silicon Valley iconic companies are opening offices here to access Seattle area talent. Successful tech executives from Microsoft, Amazon and elsewhere are becoming tech entrepreneurs and Angel investors. The University of Washington is becoming more and more of a tech hub, following in the footsteps of Stanford. It is exciting times!

So I figured to keep my entrepreneurial juices flowing I would start a business advising tech entrepreneurs on building tech companies, finding the right investors, and identifying the top advisors to support them. I found this to be a bit more complex than I originally thought not only because the landscape was growing and changing so fast in Seattle, but because finding the right VC investors in particular led very quickly to Silicon Valley. As a result, I proposed a study of the Seattle Tech Ecosystem, and with the support of Brian McCarthy, a student at University of Washington’s Foster School, we created a guide for tech entrepreneurs identifying the Angels, VCs and professional networks that exist in the Seattle area along with free resources for tech entrepreneurs.

Today, I cannot imagine a better place to live for a technology entrepreneur than Seattle, and from everything I can see the best is yet to come.

Randy Ottinger has 30 years of business experience as an executive in tech companies such as IBM, McCaw Cellular (Claircom), and Captaris. He has also been an adviser to business leaders through Kotter International, a management consulting company he co-founded with Harvard Professor John Kotter. He now advises growth companies in the Seattle area through his firm Leader-2-Leader. Randy has a BA from Cornell University, and an MBA from Harvard Business School. He is member of the Young/World President’s Organization, the largest CEO network in the world, and is involved in technology initiatives that can positively transform lives.

Pitching your company to investors and trying to raise money involves meeting a lot of people you have never met before. This is true regardless of the depth of your network. To raise money for a startup, you have to work hard and meet a lot of new people.

The SEC has issued rules under the JOBS Act governing how you can raise money for your startup. These rules says that if you “generally solicit” or “generally advertise” your offering, then you have to ask your investors for the following information:

• their personal financial statements or personal tax returns.

If you do not generally solicit or generally advertise your offering, you can rely on a simple certification from the investor. 

Most companies do not want to have to ask their investors for their personal tax returns or financial statements. So they choose to not generally solicit or generally advertise their securities offerings.

But what does this mean exactly? Can you pitch someone referred by a friend? Someone you previously had no connection to? Or would that constitute general solicitation or general advertising, making your life more difficult?

The SEC recently gave guidance on this question. I have quoted the SEC’s guidance below. The answer is–you can pitch someone you just met. This will not blow your Rule 506(b) securities law exemption. But you need to comply with all of the conditions of the exemption. The below guidance from the SEC is helpful because it makes it clear that you do not have to have a pre-existing, substantive relationship with everyone you pitch. In all instances you should work closely with securities counsel throughout the course of your offering.

Question 256.27

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

The SEC recently issued guidance on angel groups and the general solicitation and general advertising of private company securities offerings.

General solicitation and general advertising of private company securities offerings is a hot area. The JOBS Act allows companies that are raising money solely from accredited investors to generally solicit and generally advertise their offerings. However, the SEC threw in an important new requirement if you generally solicit or generally advertise your offer:

• You have to ask your investors to verify that they are accredited by asking for copies of their tax returns or personal financial statements.

Most companies don’t want to ask their investors for their personal financial statements or personal tax returns. Most companies prefer to stay within the confines of Rule 506(b)–which does not allow general solicitation or general advertising, but also does not require verification. In a Rule 506(b) offering a company can rely on an investor’s certification that he or she is accredited, as long as they have a reasonable belief that the certification is true.

Companies that are trying to raise financing in a Rule 506(b) offering then need to be aware of the rules and carefully follow them.

And a reasonable question to ask here is–is a pitch to a group of angels a general solicitation or general advertising? The answer is–it depends. If the pitch is at a public meeting  — the answer is — companies don’t do this if you don’t want to take the additional verification step.

If the pitch is before a private angel group, you should be in good shape. I have quoted the SEC guidance below. It is helpful. It is a step in the right direction in terms of public policy pronouncements in the area.

Question 256.27

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

As the President of Seattle Angel, I’ve worked with a fair number of new angel investors over the years. I continually found that investors were exploring a personal interest and an investment return when they approached angel investing. This is a little different than a pure financial investor as a pure financial investor isn’t necessarily interested in being a part of changing the world through their investments. An angel investor, by nature of the outsized return their after is investing to change the world as well as earn a return. I wondered how best to help new investors direct their passion in a way that also provided a return and found there wasn’t a good set of angel investing models, so I went about interviewing as many of the best angel investors I could find to see what I’d learn and write a book on my findings.

I’ve now interviewed over 50 angel investors including a few of the top 1% of angel investors as reported by CB Insights. The list is pretty exclusive and unique including early investors in Uber, PayPal, Google, Invisalign, ZipCar, some Seattle stars like Dan Rosen, Mike Crill, Andy Liu, and Chris Devore, and some of the best investors from all over the country such as Brad Feld, Allan May, David Tisch, and Christopher Mirabile. It has been an incredible experience to interview early stage luminaries like these and get to know a little bit about what makes them tick. I’ve also written a book STARTUP WEALTH: How the Best Angel Investors Make Money in Startups for investors, entrepreneurs, and anyone interested in startups and investing can learn from.

I didn’t approach the project with a result in mind, I wasn’t looking for an answer, I was looking for more of a deeper understanding. I’d met so many brilliant investors over the years, but there was a clear difference to how the most elite investors were functioning and how everyone else approached angel investing. It never seemed like a better understanding of term sheets, although if you read all the luminaries blogs you’d think that investing was purely about the terms of the deal. Granted they’re important, but different terms are important to different people in different situations. The overwhelming consensus I learned was that investors need to know themselves and what they’re unique investment edge is before an investor can truly decide which terms mean the most for them as an investor.

Mark Suster put it perfectly in this excerpt from the book, [“Anyone who’s ever played pickup basketball, maybe they played high school ball, maybe they played a little bit in college, thinks they could jump on the court against Kobe or LeBron and carry their own. They don’t realize that Kobe has been playing all day, every day, religiously for hours against the best people in the industry. He wakes up earlier, he works out harder, he puts in the commitment. At that elite level people are so fucking good. What is it that makes Kobe better than everybody else? Absolute dedication and commitment. The thought that you could step on the court and compete against Kobe is fanciful.”]

The good news is that you don’t always have to go toe to toe with Kobe. As I worked through the 3,000+ minutes of recorded interviews, I found several models that most investors used and that any investor or entrepreneur can use to get a leg up in early stage investing. Entrepreneurs will benefit hugely from understanding these angel investing models. They’ll be able to easily categorize investors and spend more time with the ones that align to the type of investing partner they need for their business. They’ll be able to recognize when an investor is approaching them what kind of value they’ll likely add based on the way they approach the investment.

The main theme was a split between investors who were great at finding the next fad that would be a cultural or behavioral change like Google or Uber. These momentum investors share a lot of things with their more value oriented counterparts such as some reserve capital for following on and some don’t. The more value oriented investors are investing less on the fad becoming a reality in society and more on the rate at which the dollars are flying in the door from customers. Similarly, both groups have investors that do it part time and some that invest as a full time endeavor. Both groups have investors who want 100 different companies in their portfolio and some who just want 10 but want to be really hands on with those 10. The investors who fit into these different models tend to hang out together, they tend to invest with the same people and find companies to invest in the same way. Others are more promiscuous and invest with people who have different styles in an attempt to get investment style diversity. Not understanding these models as an entrepreneur raising capital is a recipe for a longer fund raising cycle and wasting time with a lot of the wrong investors.

[About the Author: Josh Maher is the President of Seattle Angel and the author of the new book STARTUP WEALTH: How the Best Angel Investors Make Money in Startups. STARTUP WEALTH delivers engaging interviews with early- stage investors in Google, Invisalign, ZipCar, Uber, Twilio, Localytics, and other successful and not so successful companies. Find out how an amazing IPO can result in early investors getting pennies on the dollar—or a 10x+ return. Learn more about the book and follow Josh on Twitter.]

The SEC recently issued guidance on what constitutes a “pre-existing, substantive relationship.” The guidance is helpful for companies raising money for a number of reasons.

The SEC guidance is especially helpful because there has been a fair amount of uncertainty about how to make sure a securities offering is not considered to have been generally solicited or generally advertised. If you are considered to have generally solicited or generally advertised your offering, you have to verify the accredited investor status of your investors. This means asking your investors for personal financial statements or their personal tax returns. Most companies want to avoid this, and thus want to make sure that their offerings fit snugly into Rule 506(b).

But how do you do this exactly? How do you make sure your offering is not considered to have been generally solicited or advertised? Well, one way is to be super scrupulous about not doing anything in the media or at public events to announce your offering.

This is why you do not see companies at Demo Days talking about their offerings. This is why you see companies exercise a lot of care during the middle of an offering when talking to the media.

But, what happens if you slip up? What if you mention in a meeting at which members of the general public were invited that you are raising money? What if a reporter catches you off guard and reports that you are raising money? Are you sunk? Do you have to go and change your offering from a Rule 506(b) to a Rule 506(c), and ask all of the investors in your round so far to give you their personal financial statements or personal tax returns?

Maybe not. At least, that is what the new SEC guidance indicates.

Here is what the SEC guidance says, exactly:

“The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering.”

How Do You Establish a Pre-Existing, Substantive Relationship?

How do you establish a “pre-existing, substantive relationship” with your investors? Well, first, your relationship with the investor has to pre-date the start of your offering.

Second, you have to do the following:

A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship. [August 6, 2015]

The CitizenVC ruling is helpful in showing you how to establish a pre-existing, substantive relationship.

Do You Have To Have a Substantive Relationship With All of Your Investors?

Do you have to have a “substantive, pre-existing relationship” with all of your investors in order for your offering to qualify as a Rule 506(b) offering?

No. There is no requirement in order to conduct a Rule 506(b) that you have to have a pre-existing, substantive relationship with all of your investors. Having such a relationship is just one means, and “not the exclusive means of demonstrating the absence of a general solicitation.”

The best way to keep your offering within the confines of a Rule 506(b) offering to super scrupulous to generally solicit or generally advertise the offering. Just don’t slip up. Why? Because it is not possible if you already started your offering when you meet a prospective new investor for the first time to have a pre-existing relationship. And also because the substantive relationship test is not necessarily an easy one to meet. If you want to see the lengths to which one company went, the CitizenVC letter is a good read.