Raising equity capital for a startup properly can be challenging, but it is the first step before starting a successful business. Read below more information.
Introduction
If you are raising money capital from investors for your startup, no matter how you do it, there are rules you must be careful to follow. If you do this wrong, you can find yourself personally responsible for investor losses, which is never where you want to find yourself.
In general, under both state and federal law, if you want to sell an equity stake in your business, you have to either:
- Register the security with the SEC and/or state securities regulators (which is generally really, really expensive and time-consuming), or
- Identify and carefully comply with an exemption from registration, and ideally, a safe harbor exemption.
In startup land, you almost always seek an exemption because the costs of registration are so dauntingly prohibitive.
And so, you might wonder, what are these exemptions, and how hard and expensive are they to comply with?
We have summarized the six most common securities law exemptions startups use to raise investor money and ranked them by degree of difficulty and expense below.
From The Least Burdensome and Easiest to Use to the Hardest and Most Expensive
(1) The All Accredited Investor Rule 506(b) Offering
By far the easiest and least expensive exemption to use for raising equity capital for your startup is known as an “all accredited investor Rule 506(b) offering.”
An “all accredited Rule 506(b) offering” has the least requirements of probably any security offering anywhere.
The salient characteristics of an “all accredited investor Rule 506(b) offering” are these:
- You can raise an unlimited amount of money.
- You can accept investments only from “accredited investors.” An “accredited investor” is generally an individual with a $1M net worth excluding the equity in their primary residence or at least $200,000 in income in the last two years and the expectation of the same in the year of investment, or $300,000 with a spouse. The reason this type of offering is the easiest is because you are only taking money from accredited investors. If you accept funds from even 1 non-accredited investor, you have to provide registered offering level disclosure, which is a very substantial expense.
- You can’t generally solicit or generally advertise the offering. Meaning, you can’t post about it on Facebook, or LinkedIn, or Twitter, or send mass emails, etc.
- You have to file a Form D with the SEC and generally with each state where your investors are residents within 15 days of first taking money.
- Rule 506(b) does not have any specific information disclosure requirements.
With this exemption, you can begin your fundraising quest with your pitch deck, an executive summary, and a 1-page term sheet. The legal expense involved in this step is minimal.
Once you have commitments sufficient to close, you can then proceed to document the deal. This means your legal fees are generally coincident with the money coming in, which means you don’t have to pay your lawyer for the vast majority of the work until you have money coming in with which to pay the legal fees.
(2) Rule 506(c)
Rule 506(c) is the next easiest and least expensive type of offering to execute.
The salient characteristics of a Rule 506(c) offering are:
- You can raise an unlimited amount of money.
- You can only take money from accredited investors.
- You have to file a Form D with the SEC and generally each state in which your investors are residents, and your headquarter state within 15 days of making money.
- In Rule 506(c) offering, you can generally solicit and advertise your offering. Meaning, you can put on your company’s website that you are selling securities in the business, or on Twitter, our Facebook, or LinkedIn, mass emails, etc. (This is a massive difference from Rule 506(b)).
- But, you have to “verify” that the investors are accredited. Meaning, you have to ask the investors for copies of their tax returns or personal financial statements and run a credit report to confirm that they are accredited (you can’t rely on a simple verification from them like you can in Rule 506(b) offering). If you want, you can use a third-party service to provide this service.
(3) Rule 504
If you are a Washington company, and you want to raise money from both accredited and non-accredited investors resident in the State of Washington, then you might want to take a look at Rule 504 when it comes to raising equity capital.
The salient characteristics of a Rule 504 offering are these:
- You can raise up to $1,000,000 during any 12-month period from both accredited and non-accredited investors.
- You have to file a Form D 10 days in advance of the first sale of the securities with the Washington State Department of Financial Institutions (DFI). They may comment on your offering materials.
- You can only take money from a limited number of non-accredited investors. For offerings to Washington State residents, this limit is 20. You can accept subscriptions from an unlimited number of accredited investors, up to the $1,000,000 limit.
- You cannot advertise the offering.
- You have to provide adequate disclosure. For offerings to Washington State residents, the Washington State Securities regulator (the WA Department of Financial Institutions) refers you to the Small Company Offering Registration (SCOR) form as a good guide to the types of disclosures you will need to make. If you want to get an idea of the type of disclosures you will be required to put together, please take a look at the SCOR form, which you can find a link to this page: https://dfi.wa.gov/small-business/small-company-offering-registration.
- You have to have reasonable grounds to believe, after making the reasonable inquiry that, as to each purchaser, one of the following conditions, (i) or (ii) of this subsection, is satisfied:
- (i) The investment is suitable for the purchaser upon the basis of the facts, if any, disclosed by the purchaser as to his other security holdings and as to his financial situation and needs. For the purpose of this condition only, it may be presumed that if the investment does not exceed ten percent of the purchaser’s net worth, it is suitable. This presumption is rebuttable; or
- (ii) The purchaser either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he or she is or they are capable of evaluating the merits and risks of the prospective investment.
(4) Title III Equity Crowdfunding / Regulation CF
Title III equity crowdfunding is the type of equity crowdfunding created by the JOBS Act. The salient characteristics of the law are:
- You can raise up to $1,070,000 during any 12-month period.
- You can raise money from both accredited and non-accredited investors throughout the United States.
- You have to go through a registered broker-dealer or registered funding portal (such as Wefunder.com) and pay their commissions and fees.
- If you are a first time user of the law and you are raising up to $1,000,000, your financial statements have to be “reviewed” by an independent accounting firm.
- There are the same individual investor limitations as summarized in the section above on Washington State equity crowdfunding.
- You can conduct a Title III equity crowdfunding and a Rule 506 offering at the same time, as long as you comply with the requirements of both offerings.
- You can sell any type of security in a Title III equity crowdfunding, including revenue loans.
- Title III Equity Crowdfunding offerings are exempt from the applicability of 12(g) shareholder limits.
The SEC is currently considering rule changes that would make Title III even more friendly for companies.
(5) Washington State Equity Crowdfunding
Washington State has its own equity crowdfunding, and raising equity capital law. The salient characteristics of the law are:
- You can raise up to $1,000,000 during any 12-month period.
- Your financial statements must be prepared in accordance with GAAP, but they do not need to be audited or reviewed.
- You have to file the Crowdfunding Form and the Washington State Department of Financial Institutions must approve your form before you can start selling securities.
- You can only sell securities to Washington residents.
- You can sell convertible debt or convertible equity, preferred stock, common stock, or LLC interests, but you can’t sell revenue loans. (A revenue loan is a loan that is repaid by making monthly or quarterly payments that are a percentage of gross or net income until a multiple of the loan amount is repaid. Revenue loans can be an ideal way for a business to raise money in an equity crowdfunding.)
- You can advertise, but the advertisements have to be pre-approved by the DFI.
- You must use an escrow agent to hold the funds until the minimum amount is raised.
- Accredited investors can invest an unlimited amount.
- Non-accredited investors can only invest the lesser of
- $2,000 or 5% of their net worth or annual income if their net worth or annual income is less than $100,000, or
- 10% of income or net worth, if income and net worth are above $100,000.
- Under state law equity crowdfunding, you do have a Section 12(g) exemption because of the intra-state nature of the offering. Section 12(g) of the Exchange Act, in certain circumstances, limits the number of equity holders you may have before you must register your securities with the SEC (2,000 holders of record or 500 unaccredited investors).
(6) Regulation A+
Of the different types of exempt offerings summarized here, a “Regulation A+” offering is probably the most difficult to execute. There are two types of Regulation A+ offerings – Tier 1 and Tier 2. The salient characteristics of the law are:
- You can raise up to $20,000,000 in a Tier 1 offering and $50,000,000 in a Tier 2 offering in any 12-month period.
- You must submit your offering materials for review and comment to the SEC and/or applicable state securities regulators. They will comment on your filed materials, and you will have to revise your materials and reply to their comments. Sometimes this review process can take months (even with consolidated review), and really can drive up the costs of your offering.
- You must have financial statements that at the very least have been reviewed by an independent accounting firm, and in a Tier 2 offering they must be audited.
- You have a Section 12(g) exemption from the shareholder limits in a Tier 2 offering. 12(g) still applies to a Tier 1 offering.
- There are certain eligibility restrictions for Regulation A+ use, most notably your company cannot be a development stage company that either (a) has no specific business plan or purpose, or (b) has indicated that its business plan is to merge with an unidentified company or companies.
What About Section 4(a)(2)?
4(a)(2) is probably not relevant for the purposes of raising money from your company, at least in this context.
To qualify for this exemption, which is sometimes referred to as the “private placement” exemption, the purchasers of the securities must:
- either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment), or be able to bear the investment’s economic risk; and
- have access to the type of information normally provided in a prospectus for a registered securities offering.
As the SEC states:
“The precise limits of the private placement exemption are not defined by rule. 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 offering qualifies for this exemption. If your company offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.”
What’s more, 4(a)(2) is not a “safe harbor” exemption. In “safe harbor” exemptions, the company is deemed to have satisfied securities laws if it complies with certain safe harbor exemptions, e.g., 506(b) and (506(c). Since 4(a)(2) is not a “safe harbor” exemption, if an investor were to bring suit against your company, your company would bear the burden of proof that it disclosed all required facts, did not omit any material disclosures, etc. In the court system, this becomes what is called a “question of fact,” which is extremely expensive to establish in your favor.
In sum, the “private placement” exemption comes with so much risk, and there are so many better alternatives, that we do not generally recommend it.
Summary
In summary, when you plan your offering, think through your exemption strategy carefully to ensure that the exemption you use matches your fundraising goals and the specific attributes of your investor group (e.g., accredited, location, etc.). A modest amount of forethought will make the entire process much more painless and perhaps even enjoyable. Receiving funding is an exciting time in the life of your business. Make sure to choose the right exception so any compliance issues do not overshadow your success.
If you have any questions about the above, please feel free to contact Joe Wallin or James Graves.
Disclaimer: this post is for informational and educational purposes only and is not intended to be an exhaustive list of all securities law exemptions that are available. It is not intended to provide any legal advice
By: Joe Wallin and James Graves