ABA Section of Business Law
ABA Section of Business Law
Business Law Today
July/August 2000
Outside bucks A practical guide to raising capital for a business
By WILLIAM W. BARKER
Raising capital is as important to the business of your clients as a good business plan. Without sufficient capital — raised in a timely manner — even a well-run business with great potential may fail. If corporate finance is not something that you do every day, or you are new to this area of practice, then it may be difficult to get started. When the CEO of a promising start-up shows up in your office, will you know what to do?
The financing history of start-up companies follows a predictable pattern, with money being raised from the same types of investors over and over and over. The regulatory scheme contemplates that financings will start small and grow larger. A typical equity investment cycle for a start-up company might be: issuance of founders’ shares, sales to "friends and family," sales to a mixed bag of accredited and nonaccredited investors, venture capital financing (VC) and initial public offering.
Of primary importance is the need to keep your client’s financing activities private in nature, whether they are between your client and investors or between a placement agent and investors. Following the market crash of 1929, Congress determined that to offer and sell securities to the public (a "distribution") requires the filing with and review by the SEC of a registration statement containing financial and other information about the issuer and its securities as well as delivery to investors of a prospectus.
After balancing the need for business to raise money quickly and cheaply against the need for investor protection, Congress determined that a "public" versus a "private" offering was the appropriate place to draw the line and require SEC registration of the offering, which can be costly and time consuming.
In limited circumstances, exemptions are provided for privately negotiated sales that by definition must not involve any public solicitation or public advertising. In very general terms, exemptions are premised either on the small size of the offering, the private nature of the offering, or the extent to which purchasers need the protections of the securities laws. In addition, since one attribute of a public offering is a large amount of capital raised over a short period of time, federal exemptions look at the total financing activity taking place within a 12-month window (six months before and six months after). Offerings that are not registered, and do not qualify for an available exemption, are illegal.
After applying the traditional five-factor analysis (same security, plan of financing, time, consideration and purpose), if appropriate, the SEC (or a court) may "integrate" sales made within any 12-month period (six months before and six months after) and then test the facts and circumstances of the combined offering to see whether it fits into an available exemption.
For example: If a Section 4(2) offering (private offering) and Section 4(6) offering (to accredited investors only) were integrated, the Section 4(6) exemption might be disqualified, or "blown," because of the presence in the (combined) offering of nonaccredited offerees. The Section 4(2) exemption might be blown because of the number of offerees or purchasers.
Remember that integration is applied with the benefit of hindsight. In practical terms, integration is used as a tool to provide aggrieved purchasers with a remedy (money back) that might not otherwise be available if one or more offerings were viewed separately (not integrated.) Be sensitive to how past, present and future sales of your client’s securities relate to each other.
Your client will at some point probably need some type of offering document whether or not it is required under the securities laws. A private placement memorandum (PPM) gives investors the same general type of information that registration would provide, which would include a description of your:
• market;
• business, products or services, properties, etc.;
• material legal proceedings;
• capitalization and securities being sold;
• management and principal shareholders;
• material risks;
• selected financial data and financial statements; and
• some type of discussion and analysis of the financial statement and operations.
Most start-ups begin by approaching investors with a business plan, which is a scaled down version of a PPM. Both a PPM and a business plan tell the story of the company and document disclosures made to investors. Both must convey credibility and accuracy, while at the same time generating excitement and enthusiasm. Both should be thorough, professional and realistic. And both must be concise.
Early-stage investors typically invest in a "concept" and do not require detail. Statements of fact should be supported as fact, and statements of opinion or belief must have a reasonable basis. When it comes to discussing risks and uncertainties, do not hide the ball from investors for to do so will impair the credibility of you and your client. For liability reasons, it is best to let your client write his or her own plan with the aid of your comments.
A PPM is not required for every offering. For reasons discussed below, a business plan would be sufficient to raise "seed capital" under Rule 504 of Regulation D but, for example, if more than $1 million is raised in a 12-month period, such that the limitations of Rule 504 are surpassed, a PPM would be required to offer securities to nonaccredited investors in reliance on Rule 505 or Rule 506 below. An offering to "all accredited" investors by comparison does not require a PPM. But, even if not required, delivering a PPM or at least a detailed business plan is probably advisable for liability and marketing reasons.
Remember that even exempt transactions are subject to the antifraud provisions of the federal securities laws. Advise your client that he or she and the company will be responsible for false or misleading statements, whether oral or written. The SEC enforces the federal securities laws through criminal, civil and administrative proceedings. Some enforcement proceedings are brought through private lawsuits.
Depending on the size of the offering and the nature of the purchasers, more or less documentation may be required. Typical documents in a private financing may include:
•Term sheet — contains the essential terms of the investment and business terms of the transaction, such as type of security, valuation/price, liquidation preference, conversion rights, registration rights, pre-emptive rights/rights of first refusal, voting rights, seats on the board of directors and dividends.
• Business plan or PPM — describes the business, products/services, and risks and may provide financial information.
• Board of director resolutions — authorizes transaction, reserves shares, etc.
• Stock purchase agreement — sets out the terms, representations and warranties of the parties, and conditions of closing. Establishes the factual basis for exemption under federal securities laws.
• Certificate of designations/amended and restated articles of incorporation — sets out the rights, preferences and privileges of preferred stock sold to investors.
• Investors’ rights agreement — sets out rights of investors such as registration rights and rights of first refusal.
• Co-sale agreement — sets out rights of investors to share in any premium and participate in sales of the company’s stock by founders and other major stockholders.
• Warrant — contractual right given to purchaser to buy a specified number of shares at a specified price. Sometimes offered as a kicker to lower the effective price of the securities purchased.
Although term sheets are not always used, using one will likely save you time and money in the long run because a term sheet helps the parties focus on key issues that need to be documented.
In addition to documenting the business terms, in all private placements each purchaser must:
• represent that he or she is acquiring the securities for his or her own account (investment) and not on behalf of others;
• acknowledge that the securities received have not been registered under the federal securities laws and therefore are "restricted securities;" and
• agree that he or she will not dispose of them in the absence of registration or an available exemption.
In offerings premised on access to or receipt of financial and other information about the issuer, the purchaser also represents that:
• he or she had access to or received this information (as the case may be), and
• that he or she (or his or her adviser) is sufficiently sophisticated to understand the information.
To enforce restrictions on resale (and protect your exemption), you will put restrictive legends on the stock certificates and give "stop transfer" instructions to your transfer agent.
Advise your client to document the manner of the offering. To document the private nature of the transaction, your client should keep a log of to whom offering documents are sent and how many are sent. Sequentially number each offering document and send them only to purchasers that qualify to buy securities in your offering. Restricting and tracking your offerings in this manner may help later to prove that you did not violate the requirement (applicable to all private offerings) not to solicit the sale of your securities generally or use general advertising. Require investors to fill out an "Investor Questionnaire" documenting their status (sophisticated, accredited, etc.)
It is difficult to generalize about people’s motivations and goals in the negotiation process. Founders may want to minimize the dilution they will suffer as a result of funding their business. Founders also want to maintain sufficient control over and avoid unnecessary restraints on the direction of their business, transfer of their shares, and their own economic interests. Founders may also not want to restrict their ability to seek additional financings or to be acquired in the future.
Investors have their own agenda. Aside from wanting the "upside" appreciation of owning equity, investors are most interested in anti-dilution protections and having an exit strategy. They also would like to avoid "downside" risks and avoid windfalls at their expense to noncash contributors.
In the negotiation process, investors may seek a variety of concessions, for example, restrictions on payment of dividends. Concessions that may be inappropriate in early rounds with angels may become more relevant in later rounds with venture capital financings. Similarly, concessions that might interfere with subsequent larger VC financings should be avoided. Ultimately, the deal points will depend on your leverage (what you have to offer investors) and, often, on how badly and quickly your client needs the money.
It is best for your client not to negotiate directly with investors. Bear in mind that some issues may not be of concern as a practical matter. For example, most start-ups do not pay dividends, both because any revenues are reinvested in the business and because of contractual limitations in favor of preferred stockholders or creditors.
Nor is it always necessary to negotiate every little concession in early rounds. For example, in the case of angels and other early-stage investors, it may suffice to agree to give them the same registration rights that the company grants to investors in later rounds. Remember, however, that concessions given up in one financing tend to be the starting point for negotiations in the next financing.
Representations and warranties are very important. They lay out a framework to come to a mutual understanding of the company and the financing before an investment is made. To the extent that the understanding is violated, the representations and warranties will provide investors with a basis for recovery. Therefore, it is important to be complete and, if there are exceptions, note them in a schedule of exceptions.
A few of the basic representations and warranties typically requested by investors are:
• status of your client as a legal business entity;
• proper authorization of the transaction and issuance of shares;
• assurances that your client owns the necessary assets or technology to operate its business;
• disclosure of material contacts; and
• that there are no undisclosed material liabilities or litigation.
Of primary interest to your client are representations and warranties establishing proper corporate and board of director authorization of the transaction, receipt by the investor of information regarding the issuer, the factual basis for the exemption relied on, and investor’s understanding that the shares he or she receives are "restricted securities" as well as the investor’s intention to hold the securities until eligible for resale.
"Due diligence" is the investigation necessary to reasonably assure that the documentation is accurate and complete and that all necessary issues have been adequately considered. You and your client have an obligation to conduct due diligence.
How much due diligence is required depends, in part, on the size of the deal and the issues raised. In smaller offerings, savvy investors and counsel will want to keep the due-diligence process simple, keeping in mind that start-ups have fewer documents to look at that are relevant to investors. Basic due-diligence items are likely to include:
• Charter documents (articles, bylaws and any amendments);
• Board of director minutes, resolutions, etc.
• Prior financing documents including any registration-rights agreement;
• Agreements with affiliates (voting agreements, rights of first refusal, etc.);
• Material contracts (such as leases, contracts with certain customers or suppliers, etc.); and
• Stock option agreements and other agreements potentially involving issuance of additional shares.
While the deal points are being worked out, you will need to think about which exemptions from the registration requirements of the federal securities laws are available to your client. If all conditions of the exemptions are not met, the sale will not be exempt and purchasers may be entitled to a refund of their purchase price. What follow are the most common federal exemptions.
Section 4(2) — the private-offering exemption. Section 4(2) of the Securities Act exempts from registration "transactions by an issuer not involving any public offering." To qualify for this exemption, the purchasers of the securities must:
• have sufficient knowledge and experience in finance and business matters to evaluate the risks and merits of the investment ("sophisticated investor"), or be able to bear the economic risk of investment;
• have access to the type of information normally provided in a prospectus; and
• agree not to resell or distribute the securities to the public.
In addition, no form of public solicitation or general advertising may be used in connection with the offering. In this regard, except in very limited circumstances, an offering made via the Internet is very likely to constitute a general solicitation.
The precise limits of the Section 4(2) private-offering exemption are uncertain. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption. Rank-and-file employees do not automatically qualify as purchasers under this exemption; the other requirements of the exemption must still be met.
Officers and directors (that is, quintessential insiders) have an easier time qualifying as purchasers. If your client offers securities to even one person who does not qualify, the entire offering may be in violation of the federal securities laws. Rule 506, another "safe harbor" rule, provides objective standards that you can rely on to meet the requirements of the Section 4(2) exemption. Rule 506 is a part of Regulation D discussed below.
Regulation A. Section 3(b) of the Securities Act authorizes the SEC to exempt from registration securities offerings based purely on their small size. Regulation A was created under Section 3(b) to exempt public offerings not exceeding $5 million in any 12-month period. If you rely on this exemption, your client must file an offering statement (called a "Form 1-A") with the SEC for review. The offering statement consists of a notification, offering circular and exhibits.
Regulation A offerings share many characteristics with registered offerings. For example, your client must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not "restricted," meaning they are freely tradeable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are:
• The financial statements are simpler and do not need to be audited.
• There are no Exchange Act reporting obligations after the offering (unless the company has more than $10 million in total assets and more than 500 shareholders).
• Companies may choose among three formats to prepare the offering circular, one of which is a simplified question-and-answer document.
• Your client may "test the waters" (make limited general solicitations) to determine if there is adequate interest in your securities before going through the expense of filing and review with the SEC.
All types of companies that do not report under the Exchange Act may use Regulation A, except "blank check" companies, those with an unspecified business, and investment companies registered or required to be registered under the Investment Company Act of 1940. In most cases, shareholders may use Regulation A to resell up to $1.5 million of securities.
If your client "tests the waters," it can use general solicitation and advertising prior to filing an offering statement with the SEC. This allows your client the advantage of determining whether there is enough market interest in its securities before running up significant legal, accounting and other costs associated with filing an offering statement. The client may not, however, solicit or accept money until the SEC staff completes its review of the filed offering statement and you deliver prescribed offering materials to investors.
Regulation A offerings historically have not been popular with investors, probably because there are other exemptions that are easier to use. However, because general solicitations are permitted in a Regulation A offering and are not permitted under other exemptions, Regulation A offerings have become slightly more popular as a means to offer securities over the Internet.
Regulation D. The three exemptions from Securities Act registration under Regulation D are Rule 504, Rule 505 and Rule 506.
Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a 12-month period. Your client may use this exemption so long as it is not a blank-check company and is not subject to Exchange Act reporting requirements. Like the other Regulation D exemptions, your client may not use public solicitation or advertising to market the securities. It is important, as with any private offering, that purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption. However, under recent SEC rule changes, your client can use this exemption for a public offering of its securities and investors will receive freely tradable securities under the following circumstances:
• Your client registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors.
• Your client registers and sells in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as your client delivers the disclosure documents mandated by the state in which your client registered to all purchasers.
• Your client sells exclusively according to state-law exemptions that permit general solicitation and advertising, so long as your client sells only to "accredited investors," described in more detail below in connection with Rule 505 and Rule 506 offerings.
Even if your client makes a private sale where there are no specific disclosure-delivery requirements, he or she should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. That means that any information your client provides to investors must be free from false or misleading statements. Similarly, your client should not exclude any information if the omission makes the information that is provided to investors false or misleading. In this regard, it is said that a lie is the same as a half-truth.
Rule 504 is the typical means to accomplish a "friends and family" or "seed capital" offering.
Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, your client may sell to an unlimited number of "accredited investors" and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are "restricted." Consequently, your client must inform investors that they may not sell for at least a year without registering the transaction. Your client may not use general solicitation or advertising to sell the securities.
An "accredited investor" is:
• a bank, insurance company, registered investment company, business development company, or small business investment company;
• an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
• a charitable organization, corporation or partnership with assets exceeding $5 million;
• a director, executive officer or general partner of the company selling the securities;
• a business in which all the equity owners are accredited investors;
• a natural person with a net worth of at least $1 million;
• a natural person with 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 the same income level in the current year; or a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.
It is up to your client to decide what information he or she gives to accredited investors, so long as your client does not violate the antifraud prohibitions. But your client must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If your client provides information to accredited investors, your client must make this information available to the nonaccredited investors as well. This is a frequent area of misstep for entrepreneurs. You must also be available to answer questions by prospective purchasers.
Here are some specifics about the financial-statement requirements applicable to this type of offering:
• Financial statements need to be certified by an independent public accountant.
• If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s balance sheet, to be dated within 120 days of the start of the offering, must be audited.
• Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.
As discussed above, Rule 506 is a "safe harbor" for the private offering exemption. If the following standards are followed, your client can be assured that it is within the Section 4(2) exemption:
• Your client can raise an unlimited amount of capital.
• Your client cannot use general solicitation or advertising to market the securities.
• Your client can sell securities to an unlimited number of accredited investors (the same group we identified in the Rule 505 discussion) and up to 35 other purchasers. Unlike Rule 505, all nonaccredited investors, either alone or with a purchaser representative, must be sophisticated — that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
• It is up to your client to decide what information to give to accredited investors, so long as he or she does not violate the antifraud prohibitions. But your client must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, your client must make this information available to the nonaccredited investors as well.
• Your client must be available to answer questions by prospective purchasers.
• Financial-statement requirements are the same as for Rule 505.
• Purchasers receive "restricted" securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering.
Section 4(6) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.
The definition of accredited investors is the same as that used in Regulation D. Like the exemptions in Rule 505 and 506, this exemption does not permit any form of advertising or public solicitation. There are no document-delivery requirements. Of course, all transactions are subject to the antifraud provisions of the securities laws.
Rule 701 is a particularly useful exemption. It exempts sales of securities if made to compensate employees according to a written plan of compensation. This exemption is available only to private companies that are not subject to Exchange Act reporting requirements. It is useful because it frequently will exempt sales to employees that are not otherwise qualified purchasers under Section 4(2). Your client can sell at least $1 million of securities under Rule 701, no matter how small the company is.
Your client can sell even more if it satisfies certain formulas based on its assets or on the number of its outstanding securities (for example, up to 15 percent of assets). If your client sells more than $5 million in securities in a 12-month period, your client needs to provide limited disclosure documents to his or her employees. As with any exempt offering, employees receive "restricted securities" in these transactions and may not freely offer or sell them to the public.
An offering that is exempt under the federal securities laws is not necessarily exempt from state securities laws. But state exemptions do generally parallel federal exemptions. Often there is a requirement to pay a filing fee, supply state securities regulators with a copy of the offering document, and file a Form D with states in which securities are offered and sold.
Raising capital is one of the most important activities that emerging companies engage in. To be successful, it requires planning, good counseling and common sense. As you can see, many of the legal requirements are complex and interrelated.
However, there are things you can do to benefit your client’s cause now to move the process along. You can begin by writing a good business plan and keeping corporate records and documents in good order for review. Nearly every major city has a venture capital or technology forum where your client can meet entrepreneurs and investors. Successful entrepreneurs and counsel start early establishing relationships in the venture capital community.
For Caralee
Barker is of counsel at Nixon Peabody LLP in Washington. He was formerly a senior counsel to the Division of Corporation Finance at the Securities and Exchange Commission. As a matter of policy, the commission disclaims responsibility for any private statement or publication of its employees or former employees. The views expressed herein do not necessarily represent the views of the commission or its staff.
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