I’ve been writing an article on general solicitation, a long one, and doing a lot of research. As part of that, I found the attached SEC No-Action letter that I wanted to share with everyone, because it directly hits on the question of whether “demo days” constitute general solicitation.
This has been a hot button issue for a lot of people.
You might recall that at the open meeting of the SEC’s Advisory Committee on Small and Emerging Companies held on Tuesday, September 17, 2013, that SEC staff refused to answer the question whether demo days constituted general solicitation.
Watch the SEC HEARING
(The key part starts at the 52:00 minute mark.)
Those who made comments to the SEC’s proposed Reg. D rules have also voiced alarm over the rules’ potentially adverse impact on demo days – a great thing in the startup ecosystem. Mitch Kapor had this to say:
Practices that have worked well without incident for decades could suddenly become unintentional minefields for honest startups and sophisticated investors alike. Demo days, where startups present to investors and press, will most certainly be called “general solicitation” by the law firms advising startups (and likely by SEC enforcement as well). This means that some of the most high profile ways new startups raise money transparently may now cause those same startups to go out of business if the penalties are enforced.
Read the attached SEC No Action Letter, Michigan Growth Capital Symposium (May 4, 1995). In the letter, the SEC concurs that presenting companies at the symposium won’t be deemed to have generally solicited. However, there are a number of key predicate facts that the SEC relies upon in reaching that conclusion, including “no specific financing details are a part of presentations made at the symposium and no private placement materials are distributed there…”
It is a helpful no-action letter, but I don’t think it will stop the debate.
Michigan Growth Capital Symposium SEC No-Action Letter (May 4, 1995)
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If you are still digesting the 585 pages of rule changes on crowdfunding the SEC dropped last week, don’t worry, you are not alone. Folks are still processing all of the rules the SEC issued in July, which means if you’ve been scratching your head all summer, keep scratching.
The other day I received this question from the CEO of a company that has already gone through several rounds of funding. The question was–what if I generally solicit my next round? What do I have to do then?
I gave the standard spiel:
- Additional administrative burden.
- Have to collect information from the investors showing that they are accredited.
- Forms W-2.
- Forms 1099.
- Personal financial statements.
- No non-accredited investors can participate.
- Have to check the box on the Form D indicating that you generally solicited.
“What if they say no? What if they refuse to provide their Forms W-2, etc.,”he asked
“Well, then you can’t take their money,” I said. “Just like in the old days, if an investor didn’t check the right ‘accredited investor box’ on their investor certification form, you couldn’t take their money or had to return it.”
“What about my existing investors,” he asked. “What if I generally solicit, and out of the 100 people who call me, only 10 are willing to provide the information, and the rest drop out, and I have to go back to my existing investor to fill the round, how do I treat them?”
And that leads us to this week’s Q&A question:
Q: If I generally solicit my next round, so that I have to take reasonable steps to verify my new investors are accredited, what about my existing investors who wish to participate in the round? Am I going to have to ask them for Forms W-2, 1099, personal financial statements, etc.?
A: Under the rules, there is a carve-out for existing investors. The rule says this, exactly:
“The issuer shall be deemed to take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and non-mandatory methods of verifying that a natural person who purchases securities in such offering is an accredited investor; provided, however, that the issuer does not have knowledge that such person is not an accredited investor:
In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to September 23, 2013 and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.”
In the commentary to the final rules, the SEC said this:
“We are including the fourth method in our non-exclusive list of methods that are deemed to satisfy the verification requirement in Rule 506(c) because we acknowledge that existing accredited investors who purchased securities in an issuer’s Rule 506(b) offering prior to the effective date of Rule 506(c) would presumably participate in any subsequent offering by the same issuer conducted pursuant to Rule 506(c) based on their pre-existing relationships with the issuer. Accordingly, for these existing investors who were accredited investors in a Rule 506(b) offering prior to the effective date of Rule 506(c), a self-certification at the time of sale that he or she is an accredited investor will be deemed to satisfy the verification requirement in Rule 506(c). This provision does not extend to existing investors in an issuer who were not accredited investors in a Rule 506(b) offering that was conducted prior to the effective date of Rule 506(c).”
Generally solicited Rule 506(c) offerings involve difficulties not present in non-generally solicited Rule 506(b) offerings. Meaning, if you want to make life easy (administratively speaking) the non-generally solicited route is the way to go.
If you are the founder of a startup, unless you plan to self-fund and never grant stock options or other types of compensatory equity awards, you will need to familiarize yourself with both federal and state securities laws.
The reason? Because if you don’t comply with the securities laws you may significantly harm the value of your company (not to mention exposing you and your company to potential civil and criminal liability).
If you can’t find an exemption, or you don’t have the time or money to file all the applicable forms and pay the required fees, do not issue the securities.
I know, I know, you’d prefer to spend your time on matters more directly related to the immediate success of your business, like typing out your next line of code. But here is the key for you to remember: Any time your company issues stock or any time your company grants stock options or compensatory equity awards of any kind (stock bonuses, for example), your company either must comply with the registration requirements of federal and applicable state securities laws (which, for the most part, are overly complex, burdensome and expensive to comply with at the startup stage of a company’s existence) or will have to identify an applicable exemption from the registration requirements.
The table below lists securities exemptions private companies commonly use. The table does not contain a complete list, but it might be helpful to you in understanding the most likely choices applicable to the typical emerging business. You should always consult with a legal counsel before issuing securities.
||The Securities Act of 1933, as amended, provides an exemption for “transactions by an issuer not involving any public offering.” This is the exemption relied upon when founders come together to form a company in which they are each going to be actively involved. See SEC Release No. 33-4552. (http://www.sec.gov/rules/final/33-4552.htm). If you issue securities based on Section 4(a)(2), you will also have to find a state law securities exemption. This can require the filing of forms with various states, and the payment of fees. See, e.g., California Form 25102(f).
|Rule 506 of Regulation D
Rule 506 allows companies to raise an unlimited amount of money from “accredited investors.” Effective September 23, 2013, there are now two types of offerings under Rule 506. A non-generally solicited type of offering – referred to as a 506(b) offering, and a generally solicited offering – referred to as a Rule 506 (c) offering. (“Accredited investors” generally are investors with either (i) a $1M net worth excluding primary residence (but taking into account debt on such residence in excess of the fair market value), or (ii) $200,000 of income for the last two years with the expectation of the same in the current year, or $300,000 with spouse.) Generally solicited 506(c) offerings involve complications not present in non-generally solicited Rule 506(b) offerings.
One great thing about Rule 506 is that a security sold under Rule 506 is considered a federal “covered security,” meaning that state securities regulators cannot condition or merit review the issuance of the security. They can require the payment of a fee incident to the filing of the Form D, but they cannot otherwise impose limitations or conditions on the issuance. See http://www.sec.gov/news/studies/uniformy.htm
||Rule 701 is a federal securities law exemption for compensatory equity issuances. For example, if you want to grant an employee or an independent contractor a stock option, you would typically rely on Rule 701 as your exemption. Rule 701 has a number of qualifications, conditions and limitations. See this blog post, What is Rule 701 and Do I Need to Worry About It?
|Washington Equity Compensation Exemption
||RCW 21.20.310(10) provides a Washington securities law exemption for, among other things, compensatory equity awards (i) issued pursuant to a plan that provides for the issuance of ISOs and NQOs and (ii) similar plans if the director of the DFI is notified in writing with a copy of the plan 30 days before offering the plan to employees.
|California Equity Compensation Exemption
||See California Corporation Code 25102(o). See also this blog post: California Compensatory Equity Issuances.
|Equity Crowdfunding Under Title III of the JOBS Act (Section 4(a)(6) offerings)
||Equity crowdfunding under the JOBS Act is not yet available. The SEC has issued the proposed rules, but those rules won’t be final for some time.
I am sometimes told by a company that they issued securities under the “friends and family” offering. There is no such thing as a “friends and family” exemption.
If you are looking for a more comprehensive exemption table, albeit one with many exemptions inapplicable to startups, see the Exemption Table.
Posted in Federal Law & Regulation, Startup Law
Tagged California Equity Compensation Exemption, Equity Crowdfunding Under Title III of the JOBS Act (Section 4(a)(6) offerings), Form D, Reg D Rule 506, Regulation D, Rule 506, Rule 701, SEC, securities exchange commission, Washington Equity Compensation Exemption
The beginning of a startup is generally a small operation with contractual agreements between founders. But as it grows and starts adding employees, things become increasingly more complicated. Even the leanest of startups is covered by a myriad of state and local employment laws.
Business owners and founders need to be aware of when key federal and state employment laws apply to avoid costly fines and lawsuits. This seminar will teach you:
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To register, email firstname.lastname@example.org
Cost: $35 for up to three attendees from a single company
Tuesday, November 12, 2013
Registration and Lunch: 11:30 a.m.
Program: 12:00 – 2:00 p.m.
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