Saturday, February 19, 2011

Part I: Family and Friends Round of Financing: How to Secure Financing and Comply with Securities Laws

Typically, the first people that start-up founders turn to for financing are their friends and family. Of course, most friends and family members are not going to worry about valuations, projections, business strategies. They invest because of their trust and strong personal ties to the founders.

Actually, friends and family rounds of investing are securities offerings and, like all other offerings, have to be either registered with the SEC or fall under one of the exemptions from registration. I want to briefly touch upon two such exemptions, Rules 504 and 506 of Regulation D. Also, each of these offerings has to comply with the applicable state securities laws (blue-sky laws) in each state where the friends and family members reside.

Rule 506 of Regulation D allows a private placement of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors. See description of Rule 506 here . Accredited investors’ definition includes individuals who have (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including the value of the primary residence); or (ii) 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 such income level in the current year. If the founders’ friends and family members who are willing to invest are all accredited investors, then the compliance is quite simple: there is no need for extensive disclosure, although some disclosure is still recommended. The offering then must be conducted without general solicitation or advertising; issued securities are restricted, and the company must file a Form D with the SEC within 15 days of the first sale of securities.

If, however, not all of the investors are accredited, founders will need to provide a lot more disclosure to the investors, including a full-blown private placement memorandum, risk factors and financial statements. Also, note that all non-accredited investors in a Rule 506 offering must be sophisticated, which means that the company must reasonably believe that non-accredited investors (either alone or together with their investment representatives) have sufficient financial and business knowledge to allow them to evaluate the risks and merits of an investment.

Rule 504 of Regulation D applies to offerings of less than $1 million and allows such offerings to be made to non-accredited and non-sophisticated investors so long as the company is not subject to any reporting requirements of the United States Securities Act of 1933, such as most public companies, and is not formed solely for investment purposes. Also, the exemption generally does not allow companies to solicit or advertise their securities to the public, and purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption.

Rule 504 does allow companies to sell securities that are not restricted and to engage in solicitation and advertising if one of the following circumstances is met (using the SEC description of the Rule at

“(1) The company registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;

(2) A company registers and sells the offering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or

(3) The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to accredited investors."

Compliance with Blue Sky Laws

Regulation of Rule 506 offerings is preempted by federal laws. States can generally only require a notice and a filing fee but cannot impose their own regulations. Most states ask for a copy of Form D (which the companies have to file with the SEC within 15 days of the offering) and a fee (typically, about $300). Of course, regulation varies by state, and about five states require pre-filing. For example, New York requires the pre-filing of Form 99 (Notification Form Under NSMIA), a State Notice, a Further State Notice and Form U-2 if the company has been formed outside of New York. The filing fee in New York is $300 for offerings under $500,000.

In case of Rule 504 offerings, New York provides an exemption for offerings to 40 or less investors.
More information can be found at this link.

Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the investors (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.

Please note that this blog is written for general informational purposes only and does not constitute legal advice or create any attorney-client privilege.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

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