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There are a lot of rules and regulations governing how companies can solicit and raise capital from investors. These rules exist at both the federal and state levels. At the federal level, the Securities and Exchange Commission is the primary regulatory body. Each state also has its own securities division in charge of regulating the issuances of securities in its jurisdiction.
The term security is defined very broadly under U.S. securities law.* In general, a security is an investment in a common enterprise purchased with the expectation of profit, the value of which depends on the efforts of others.*
danger If a company is not following SEC rules around securities, it can lead to serious problems, such as investor rescission demands or government investigations,*—and the money to respond to such problems can come out of your investment. While these scenarios are not common, it is worth understanding the law so that you can avoid investing in companies that are flaunting it.
Understanding the rules will also help you understand why in some environments companies do not discuss fundraising as part of their pitch, and why in other circumstances companies might ask you for specific documentation on your income or assets. There are red flags to watch out for here as well, such as third parties soliciting funds for a startup for a commission.
important As a general rule, you cannot be an angel invesrtor unless you are accredited.
Startups raise money from accredited investors: either individuals or entities who meet the qualifications set by the Securities and Exchange Commission. According to the SEC, investors must meet a minimum level of income or assets (either high net worth or high income) in order to be accredited. The SEC rules make it challenging for companies to raise money from non-accredited investors who do not meet these standards.
For individuals, an accredited investor is someone who falls into one of the following categories:*
income of at least $200K a year for the two years prior to the year of investment with the expectation of the same in the the year of investment, or $300K with spouse; or
net worth of at least $1M (excluding equity in primary residence, but taking into account debt on that residence to the extent that the debt exceeds the fair market value of the residence); or
any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.
In addition, a family trust or family partnership may invest in a private company as an accredited investor so long as that family trust or family partnership qualifies as an accredited investor. However, entities such as these must meet different tests to qualify as accredited investors. For an entity to be an accredited investor, it must fit within one of the following categories:
an entity of which all of the equity owners are individual accredited investors (per the qualifications above)
a trust, with total assets in excess of $5M, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in 230.506(b)(2)(ii), or
any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts* or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5M.
By definition, therefore, one cannot form a limited liability company or another type of business entity to make an angel investment as a means of avoiding the “accredited investor” requirement.
founderIn general, under federal law, if a startup accepts even one non-accredited investor in their round, they have to provide what is essentially an IPO-level of disclosure to all investors, which is very costly. In contrast, if a private company limits its securities offering solely to accredited investors, there is no specific information the company has to provide to investors.
You can find an explanation of this dramatic dichotomy in the law on the SEC’s website, which provides:
Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.
The Securities Act (also known as the Truth in Securities Act) states that “every offer and sale of securities be registered with the Securities and Exchange Commission (the ‘Commission’), unless an exemption from registration is available.”
An exemption (or exempt offering) is an offer and sale of securities that does not have to be registered with the SEC because the SEC has adopted an exemption from registration that you can qualify to use.
The two most common ways for private companies to sell securities are through the following exemptions:
an “All Accredited Investor Rule 506(b) offering”
a Rule 506(c) offering
We’ll get into the details below, but the primary difference between Rule 506(b) and Rule 506(c) is that if a company generally solicits its offering it is taking the 506(c) exemption and must take “reasonable steps to verify” that its investors meet the criteria of accredited investors, while under 506(b), companies can solicit only to people who affirm beforehand that they are accredited investors, and there is no verification requirement for the company.
General solicitation (or general advertising or public advertising) means using radio, TV, the unrestricted internet, and other means of soliciting investors. General solicitation and general advertising are defined in Rule 502(c) of Regulation D.
“All Accredited Investor Rule 506(b) Offerings”
The All Accredited Investor Rule 506(b) offerings (or Rule 506(b)) is the most common way for private companies to raise money. Under Rule 506(b), companies cannot “generally solicit” or “generally advertise” their securities offerings. In a Rule 506(b) offering:
A company can raise an unlimited amount of money from accredited investors.
The company can’t generally solicit or advertise the offering.
The company is required to file a Form D with the SEC and state securities divisions within 15 days of its first sale of the securities in the offering.
Each investor has to check a box averring that they are an accredited investor, and the company does not have to take any further action to verify that the investor is accredited as long as the company’s belief that the investor is accredited is reasonable. This means you will not have to provide any personal financial information to the company to prove you are accredited.
State securities regulators cannot “merit review” or condition the offering on any basis.
founderBy following the 506(b) rules—only soliciting accredited investors and only allowing accredited investors to invest—a company dramatically reduces their securities offering requirements. Rule 506(b) offerings are popular because the rules are easy to follow. There are no specific information requirements, meaning companies don’t have to spend weeks preparing expensive disclosure documents. A company can raise money on a term sheet and an executive summary and pitch deck. And the company doesn’t have to prepare the definitive legal documents until it has commitments on its term sheet. This means that the legal fees for preparing the definitive documents come due at or after the money committed has come in (which is a nice timing coincidence). Finally, the company does not have to file anything with securities regulators until after it has closed the deal.
confusionUnder Rule 506(b), it is also possible to sell to up to 35 non-accredited investors, but if a company does this it has to provide registered offering level disclosure to all of the investors. This is why companies usually limit their offerings to accredited investors only.
Rule 506(c) Offerings
A Rule 506(c) offering is an exemption under Regulation D in which companies can generally solicit, but they have to take additional steps to verify the accredited status of their investors. Rule 506(c) offerings are less common than Rule 506(b) offerings primarily because of the verification requirement.
In a Rule 506(c) offering:
A company can raise an unlimited amount of money from only accredited investors.
The company can generally solicit and advertise the offering, which means:
posting on unrestricted websites
advertisements published in newspapers and magazines
communications broadcast over television and radio
seminars and meetings where attendees have been invited by general solicitation or general advertising
The company has to take reasonable steps to verify the accredited investor status of each investor.
confusion Until recently, general solicitation in (the public advertising of) private company securities offerings was illegal. If you generally solicited a private company securities offering, you risked jail time. This changed with the JOBS Act in 2012. Now it is not illegal to generally solicit your private company securities offerings, but if a company generally solicits or generally advertises its offering, then it is conducting a 506(c) offering and it must take reasonable steps to verify the accredited investor status of its investors before it can accept their investments.
Reasonable steps to verify means that a company might ask to see your Form W-2 or Form K-1 or Form 1099 to verify that you meet the income test. Alternatively, the company might ask to see your personal financial statements and ask to run a credit report on you to confirm your liabilities and verify that you meet the net worth test. This is a process many investors are not familiar with and is an additional burden to closing an investment. For this reason, many companies choose not to generally solicit or generally advertise their offerings.
Conveniently, service providers do exist that provide verification services (meaning verifying that the investors are accredited). Therefore, it is not necessary that the investors provide their personal financial information directly to a company; they can provide it to a third party instead, who would then provide a certification to the company, which the company could rely upon.
Crowdfunding and Other Less Common Exemptions
Though 506(b) is by far the most common exemption for private companies to raise money, followed by 506(c), there are others you may run into. are other ways for private companies to raise money other than Rule 506 of Regulation D. If you would like to review a comprehensive list of all of the exemption available, you can find one starting on page 11 of this 2020 SEC release. They include:
Title III equity crowdfunding (Regulation CF). Under this exemption, companies can raise up to $1.07M during any 12-month period. But they have to use either a registered broker-dealer or registered crowdfunding platform, such as Wefunder. Title III is becoming more popular, but right now the amount of money raised in Title III equity crowdfunding offerings is a small fraction of what is raised in Rule 506 offerings. However, as of the writing of this text the SEC has proposed new rules that would allow companies to raise up to $5M in a Title III equity crowd raise, and the individual investor limitation amounts would not apply to accredited investors. This favorable regulatory change might make the use of Title III much more common in the future.
Regulation A+. Regulation A+ is an exemption that allows companies to raise as much as $50M during any 12-month period. But the exemption is expensive to use, and thus not used very frequently by the overall startup community. It might become more popular in years to come, however.
State crowdfunding laws. Some states have laws allowing companies to raise money in crowdfunding-type offerings. For example, Washington State has a crowdfunding exemption allowing companies to raise up to $1M during any 12-month period, provided certain conditions are met.
Various state exemptions. Each state typically has its own rules as well. But for the most part, companies tend to raise funds from investors from a number of different states, and tend not to rely on state-specific exemptions.
Is There a Friends and Family Exemption?
It is very common to hear an entrepreneur say that their first round of investment was “friends and family.” This is understandable: when the company is little more than an idea, it is likely only to be able to get money from people who are betting on the entrepreneurs based on a pre-existing relationship.
Many states have exemptions allowing companies to raise money from non-accredited investors with whom they have a pre-existing, substantive relationship under Rule 504 of Regulation D. It is beyond the scope of this book to provide a state-by-state analysis, but, for example, California has such a law, as does Washington State, where companies can raise up to $1M during any 12-month period from both accredited and up to 20 non-accredited investors.
cautionAs an investor, you do need to be careful about this. There is no “friends and family” exemption from registration under the federal securities laws. There are federal securities law exemptions pursuant to which companies can raise money from unaccredited investors (Rule 504, Title III, Reg A+, Rule 506(b)), but none of these exemptions have as exempt a category of purchasers identified as “friends and family.” For the most part, the federal securities law exemptions require either that the purchaser of the securities be “accredited” or the company provide registered offering level disclosure so that the purchasers of the securities had access to the same information they would have had if the company had registered the securities.
Impacts of Securities Law on Pitching Events
Pitching to Angel Groups
You might wonder, do companies engage in general solicitation if they pitch to an angel group? The SEC has provided specific guidance around angel groups and how they can facilitate companies meeting angels without triggering the general solicitation rules:*
Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?
Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]
Pitching Outside of Angel Groups
Many startup incubators and accelerators have demo day events in which friends and supporters of the startups as well as angel investors are invited to attend. At these and similar events, entrepreneurs will pitch their startup but not disclose any fundraising terms—because not everyone in the audience is an accredited investor, they want to stay within Rule 506(b) guidelines and avoid any general solicitation. By including deal terms in their pitch, like, “We’re raising $500K at a $3M valuation,” they could be deemed to be soliciting the audience and thereby engaging in general solicitation.
Disclosure of Investment
In general, the law does not require that private companies disclose the names of their owners or investors, with the exception of what is required to be disclosed on the SEC’s Form D.*
If you accept a board seat, or if you become an executive officer of a company, the fact that you are a member of the board or an executive officer of a company may be disclosed on the Form D the company files with the SEC. Companies are required to file the Form D with the SEC when they raise money in a Rule 506 offering, and they are required to list on the Form D the directors and executive officers of the company. You can review the Form D from the SEC. Filed Forms D are publicly available on the internet, and many media outlets watch these filings so that they can report any interesting news.
caution Though they are not required to do so, a company may want to issue a press release or otherwise publicly disclose the fact that it has closed its investment round, and in those releases, the company may want to disclose the names of its investors. If you do not want your name disclosed in this process, you should take special care to require the company to agree to keep your name confidential.
What To Watch Out For
dangerA few important pitfalls when it comes to securities law and fundraising:
Make sure the company is complying with the law in regard to its fundraising. When you are evaluating a company, you should make sure the company is following the rules of whichever securities law compliance path it chose.
If the company is telling you that it is conducting a Rule 506(b) offering, but it is advertising its securities offerings on its website, that is a red flag. It means that the company is not complying with the law. The company may not be getting good legal advice, which is a signal that other things might be amiss as well.
While you’re investigating the company’s fundraising history, note that many angel investors are leery of companies that have crowdfunded or taken money from friends and family, partly because there may be a large number of non-accredited and potentially naïve investors on the cap table, which can complicate future fundraising.
If you run across a company with a large number of non-accredited investor shareholders, this may make it more difficult for the company to receive venture capital funding. The presence of a large number of non-accredited investors on the cap table can also indicate the company has not received good legal advice, and other things in the company’s corporate records are not correctly done either.
Sometimes companies are not careful in how they conduct their securities offerings. You want to make sure that the company you are investing in is well advised and scrupulous about its securities law practices. If a company violates the rules, your money may well be used to clean up the mess. You don’t want your funds used in this way.
Don’t inadvertently become a VC. Unless you are in the business of investing other people’s money, and you have all of the required licenses and credentials, complied with all legal requirements, and have insurance, do not invest other people’s money, charge other investors a fee for investing in your deals, or take a carry on other investor’s investments.
It is not uncommon for angel investors to want to follow a well-known investor who has access to deals that they might not have access to, because of their reputation or prior experience. You might run into someone who asks you to start investing their money in your deals. This might be alluring to you if you would like to have more negotiating power.
The problem is, the law in this area is onerous and easy to run afoul of. For example, if you charge other investors a fee to invest in your deals, you might have to be registered as a broker-dealer or an investment adviser. If you form a fund, even if you don’t charge any fees, you have to worry about compliance with the Investment Company Act.
You never want to be sued by another investor in a deal based on the claim that you advised that person to make the investment. Each investor in any deal should make their own independent decision whether to invest.
In general, securities regulators are hostile to non-registered broker-dealers (so-called “finders”) receiving a commission on the sale of securities. In general, if someone is receiving a commission on the sale of a security, the securities regulators will take the view that the person should be registered as a broker-dealer. Some states, such as California, provide investors with a statutory rescission right if a company paid a commission to a non-registered broker-dealer. You should be aware that finders and broker-dealers must be disclosed on the Form D that the company is required to file with the SEC, which is a public filing anyone can access.
The key advice here is: don’t act as a finder for a fee. Meaning, don’t help raise money for a startup in a way that provides you any kind of payment or commission or other remuneration such as additional stock.
To have the opportunity to make a good investment, you have to see a lot of deals.
Deal flow refers to the number of potential investment opportunities you review during a particular period. Ideally, if you are active, you will have the chance to review, if not all, a substantial portion of the investment opportunities in your particular area.
founderIf you’re new to angel investing—or a founder looking for ways to get in front of investors—here we include some recommendations on how to get access to deal flow.
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