Friday, March 12, 2010

Rules relating to solicitation and advertising in Regulation D private placement of securities

At some point in the early stages of growth, many start-up companies need external capital. One way to obtain such capital is by conducting a private offering of securities (either equity or debt) to angel investors or venture capital firms. Below I am discussing some aspects of federal law that every small business owner should be aware of when he or she is contemplating a private placement of securities.

Under the Securities Act of 1933, any offer to sell securities must either be registered with the Securities and Exchange Commission (the “SEC”) or meet an exemption. One of the widely used private placement exemptions under the Securities Act is Regulation D, which includes rules 505 and 506, each of which prohibit general solicitation or advertising to sell the securities.

In particular, Regulation D prohibits “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio” and “any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” This means that businesses cannot advertise their offers or solicit offers in the newspaper, TV, radio, or use mail to do so. If they advertise in violation of this restriction, this may turn the private offering into a public one, which then defeats the exemption and may require registration and/or return of investors’ money.

So, how can businesses find individuals or firms willing to invest in them?

The answer to this question is derived from multiple responses published by the SEC, called no-action letters, as well as various court decisions. In summary, no-action letters indicate that there is no general solicitation when the business owners, employees or agents send offering materials or describe the offer to potential investors with whom they have a substantial preexisting relationship (such relationship should be of substance and duration, and should enable the company to evaluate investor’s wealth, experience and financial sophistication). The numbers of potential investors that are contacted are not important, what matters is whether the potential investors have the substantial relationship prior to the solicitation.

Therefore, only those potential investors should be contacted with whom someone on the issuer side of the offering (founders, officers, directors, placement agents, lawyers, accountants) has a preexisting relationship. This list may include friends, business acquaintances or prior investors in the business. Placement agents (typically banks or investment firms hired by the company to facilitate the offering) may establish preexisting relationships by sending out generic questionnaires to potential investors well in advance of the offering asking individuals to share their financial information in order to establish whether they are “sophisticated” or “accredited” investors. (More on “accredited” investors in future blog posts). Placement agents can then use their list of pre-screened potential investors to send out offering materials. The SEC Staff has also said that there was no general solicitation by the company that required potential investors to (1) complete a questionnaire designed to allow the company to determine whether such investor was an accredited investor, (2) pay a subscription fee, and (3) wait for at least 30 days prior to accessing the password-protected website containing offering materials,. (See Lamp Technologies, Inc., SEC No Action Letter May 29, 1997).

It is important to keep records of all contacts made in connection with the offering.

In conclusion, business owners should be careful not to solicit offers from the general public or advertise a contemplated offering of securities and should seek advice of competent legal counsel well in advance of the offering.

Please note: nothing in this blog post constitutes legal advice.

Arina Shulga.

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