Thursday, March 1, 2012

Some Thoughts on Friends and Family Financing for Startups

Many founders I speak with are interested in obtaining financing for their businesses first from their friends and family members, and then from professional investors. I agree, this seems to be the common path. However, many founders do not realize the importance of complying with applicable federal and state securities laws when asking friends and family for money.

Typically, a friends and family round of financing can be done by either issuing stock to investors in exchange for their money or by giving them a promissory note (typically convertible into equity). If friends and family members receive stock, no matter how small their investment is, it is likely to be deemed a securities offering. The definition of what constitutes a security is very broad. Courts have determined, for example, that an investment contract can be a security, if a person invests his or her money in a common enterprise with an expectation of profit derived solely from the efforts of others. There is no requirement to issue formal certificates to such investors. So, if a founder’s friend invests in the startup but does not partake in actively running it, his or her contract with the startup is probably a security.

A promissory note may also be a security. Under the Securities Act, promissory notes are defined as securities except for notes with maturity of less than 9 months. There are numerous exceptions to this general rule. Here is a link to a great discussion of whether a promissory note is a security. To summarize, the question of whether a promissory note is a security turns on whether the note looks like a security and whether the selling of the note looks like a securities offering. Factors to consider include the number and sophistication of the investors/lenders, whether the note is collateralized, whether the investors/lenders are also owners of the business they are lending money to, etc. It is likely that in a family and friends round of financing, where the business is raising money for its general operations, and the investors are investing with an expectation of return, the promissory note will be deemed to be a security.

Every offering of securities has to be either registered with the Securities and Exchange Commission or comply with one of the applicable exemptions from registration. Regulation D is where the most commonly used exemptions are found.

The most frequently used rule under Regulation D is Rule 506 that allows unlimited amount of securities to be issued 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 need to provide 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. 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.

The problem arises when the founders’ friends and family members are not accredited and not sophisticated. What can startup founders do then?

They can resort to Rule 504 of Regulation D that allows to raise up to $1 million from non-accredited and non-sophisticated investors. Compliance with Rule 504 is more difficult, it involves preparation of complex and costly disclosure statements. Unlike Rule 506 offerings, state securities laws regulate Rule 504 offerings and the amount and type of disclosure that needs to be provided.

Many securities lawyers will not represent a company that is conducting an offering of securities to non-accredited investors because of the high risks involved. Some professional investors will not invest if the company has non-accredited investors. If challenged, the offering will raise problems when the company is conducting a round of VC financing, being sold, or is doing an IPO. At the IPO process, the Securities and Exchange Commission will study all prior equity issuances by the company and ask the company to cure any deficiencies or violations of securities laws, which can delay or even kill the IPO.

In conclusion, it is advisable that founders obtain their friends & family financing only from accredited investors. Although raising funds from non-accredited and non-sophisticated investors is possible, risks involved in dealing with such investors often outweigh the benefits of receiving such funding.

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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