The follow is a post by Mark Graffagnini, Managing Member, Graffagnini + Associates, LLC.
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Silicon Bayou News, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
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Until today, companies were legally banned from raising money through general ads targeting potential investors unless the company had basically registered with the SEC to conduct an IPO. The new SEC rules permitting companies to raise money through general advertising take effect today. These changes fundamentally change fundraising options for many businesses, and companies may now raise money by targeting accredited investors through means like online offerings and public pitch contests.
Section 4(a)(2) of the Securities Act exempts transactions by companies “not involving any public offering.” A startup relying on Section 4(a)(2) is restricted in its ability to make public communications to attract investors for its offering because public advertising is incompatible with a claim of exemption under Section 4(a)(2).
The changes taking effect today, however, allow companies to use general solicitations–such as internet offerings through online investment platforms–to raise money. However, before you go off to raise money using the internet, you should take certain precautions. Otherwise, you’ll find yourself in violation of the securities laws and may end up hurting your ability to legally raise capital.
The new changes require that companies make a choice regarding how they choose to raise money from investors. For companies that choose to raise money solely through private communications with investors, the company basically follows the law as it has stood until today. For any company that chooses to try to raise money on something like AngelList, for example, the company must follow the new rules to comply with law. This also applies to any company participating in any “pitch contest” or “demo day” in which they solicit investment. It is really important, therefore, to learn about these new rules.
So, what are these new JOBS Act requirements for general solicitations to raise money?
First, the stock that your company sells must be considered “restricted securities,” meaning that the stock cannot be resold to other people, except under limited circumstances.
Second, all investors must be considered “accredited investors.” This means, for individuals, that they must earn at least $200,000 for the previous two years and expect to earn at least $200,000 in the year they invest. Or, the investor must have a net worth of at least 1 million dollars, excluding the value of their primary home.
Third, and most importantly, the company must take reasonable steps to ensure that each investor is, in fact, an accredited investor. Among the factors that issuers should consider under this facts and circumstances analysis are the following:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
The SEC has clearly stated that the company has the burden of proving that its investors are actually accredited investors if it is using the new general solicitation exemption. In order to do this, the SEC essentially requires companies to examine financial records of its potential investors prior to making a general solicitation for investment. As an alternative, a company may engage verification service providers, such as attorneys, accountants, certified financial planners, or broker dealers, in order to verify investor status as accredited. These service providers, in turn, must examine sufficient records from the prospective investors to reasonably believe that the investor is accredited. For some investors, like angel capital funds and venture capital funds, the
Verification steps, however, may present some practical difficulties in ensuring that the investor is actually an accredited investor. For example, some investors may be reluctant to share their income statement or balance sheets with the companies in which they are thinking about investing. For a long time, companies have generally relied on investors simply answering a confidential investor questionnaire and checking the appropriate box to determine their accredited investor status. In the new amendments effective today, the SEC has clearly stated that this is no longer an acceptable practice to determine that investors are in fact accredited.
The SEC has offered a non-exclusive list of items that a company or verification service provider could review to determine investors status. These include the following:
- Income test: IRS records reporting a person’s income that demonstrate income of at least $200,000 for the two years prior to the investment and obtaining a written statement that the person expects the same level of income in the year of the investment. Note that in the case of an investor that has a spouse, the income level is $300,000,
- Net worth test: To determine if an investor meets the “net worth test,” the company should examine one or more of the following types of documentation, dated within the prior three months, and by obtaining a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed. In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing such documentation in regard to, and obtaining representations from, both the person and the spouse. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties are deemed to be satisfactory; and for liabilities: a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies is required.
- Third party verification: A company can satisfy the verification requirement in the new rules by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.
- Overlap with Previous Offerings. Many companies are currently raising capital, so the issue arises regarding how a company should deal with current investors that have not provided any documentation of accredited investor status. For any person who invested in a company’s financing as an accredited investor prior to the effective date of the new rules and remains an investor of the issuer, for any new general solicitation offering conducted by the same issuer, the issuer is deemed to satisfy the verification requirement by obtaining a certification by that current investor that he or she qualifies as an accredited investor and remains an investor of the issuer.
The new rules taking effect today provide companies with a powerful option to raise capital for their startup. However, that new option brings greater responsibilities for companies. Companies raising money through pitch contests, demo days or online platforms should review the new rules with their advisors to craft a fundraising strategy.