Corporate & Securities Focus: Five Legal Issues You Should Be Aware of When Raising Capital for Your Business

February 10, 2014 by

Of the many legal issues you should consider when raising money for your business, the following five are extremely important (and some of the most frequently overlooked).

Am I selling securities?

Regardless as to the form of your business (LLC, corporation or other), to whom you are selling (friends, family, institutional investors, or others), or the type of financing transaction (debt, equity, or other), if an investor transfers funds to your business with an expectation of profits arising from a common enterprise, the success of which is determined solely by the efforts of a third party, then there is a likelihood that you have sold securities.*

Whether your business is selling securities is extremely important because if it is, the securities must either: 1) be registered with the Securities and Exchange Commission (SEC); or 2) be exempt from registration. Since registering an offering with the SEC would make your business a public company, making sure each capital raise is conducted in accordance with one of the many registration exemptions under the Securities Act becomes extremely important.

To whom should I sell exempt securities?

For most closely held companies who prioritize efficiency and operate on a budget, each investor should be an Accredited Investor. The term “Accredited Investor” refers to an individual or entity meeting certain financial criteria promulgated by the SEC. While it is true that Rule 506 (one of the most popular exemptions to registration) permits you to have up to 35 non-Accredited Investors and still qualify for the exemption, Rule 506(b) states that if you allow even one non-Accredited Investor to invest in your business, you have to comply with very comprehensive disclosure obligations. On the other hand, if you limit your financing round to Accredited Investors only, there are no prescribed disclosure obligations.

How can I approach potential investors?

Historically, businesses have been restricted to selling exempt securities to purchasers with whom they (or their placement agent, broker/dealer, finder, or other agent) had a “pre-existing relationship” and, therefore, were not permitted to engage in “general solicitation” to find potential investors. This prevented issuing companies from advertising in newspapers and magazines and public websites, communications broadcasted over television and radio, and participation in seminars where attendees have been invited by general solicitation or general advertising.

On July 10, 2013, the SEC issued rules (spurred by the JOBS Act) doing away with the prohibition on general solicitation when selling exempt securities to Accredited Investors. The new rules state that issuing companies may generally solicit and advertise their offering to any Accredited Investors, regardless as to whether there is a pre-existing relationship.

While the new rules promulgated by the SEC sound great, they come with significant additional filing and disclosure requirements which can be cost prohibitive to some businesses. Therefore, to the extent businesses want to advertise or solicit their exempt securities to Accredited Investors with whom they do not maintain a pre-existing relationship, they should be mindful of the accompanying filing and disclosure requirements.

Can I use a broker/dealer or a finder assist?

What if you don’t have a pre-existing relationship with an Accredited Investor who is willing to invest in your business and you don’t want to endure the disclosure obligations in generally soliciting others? Can you pay someone to locate potential investors and/or consummate the investment on behalf of your business?

The answer is “yes,” but you should exercise extreme caution in compensating others to assist in effecting exempt securities transactions. Businesses may retain a “broker/dealer” to find potential investors and assist in the consummation of the transaction (including solicitation, negotiation, execution, etc.), but such broker/dealer must be properly registered under federal law. Businesses may also retain a “finder” to make an introduction to a potential investor and have no further involvement in the transaction. Finders do not have to be registered under federal law, but there are a few states (including Texas) where a finder must be registered.

Due to the registration requirements and the ambiguity with which the terms are defined, it is paramount that businesses only use properly licensed and registered broker/dealers and finders. It is also very important to make sure a written agreement is in place clearly establishing (among other things) the specific obligations of the parties, compensation, licensing/registration requirements, and insurance requirements. Using an unlicensed broker/dealer or finder can result in an enforcement action by the SEC or applicable state regulatory agency.

What do I give to potential investors who may be interested?

The Private Placement Memorandum (PPM) is the document that you should provide to potential investors considering an investment in your business. The PPM discloses the information a potential investor should need to make an informed investment decision, and details the investment opportunity, disclaims legal liabilities, and explains the risks associated with the investment. The PPM typically includes, among other things, the details regarding the offering, the equity ownership structure of the business, disclosures about the securities being purchased, information on the business and its operations, risks involved with the investment, management information, use of proceeds, information on certain transactions that could affect the investor, and investor suitability data.

This article is a very brief summary of a few of the many legal issues that surface when you sell equity in your business. In the event that you are considering engaging in a transaction for the sale of an equity interest in your business, please seek competent legal counsel as soon as possible.

* The SEC’s definition of “security” is extremely broad and includes “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘’security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
Adam Fox

Adam Fox co-founded Brown Fox and has emerged as a go-to confidant and wise counsel for business leadership, ranging from billion dollar companies to innovative start-ups.

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