What Every Startup Founder Needs to Know About Raising Capital
If you’re founding a startup, you understand that initial funding may be one of the most difficult tasks that you undertake. Most founders look to their personal savings, incur debt, and ask friends or family to help fund their dream. However, what every founder must also understand (unless they plan on being completely self-funded and never granting stock options) is that when they begin to deal with raising capital, they must also be cognizant of federal and state securities regulations governing their efforts.
What does every founder need to know?
As a starting point, understand that every offering or sale of securities either has to 1) be registered with the Securities and Exchange Commission, or 2) qualify under one of the applicable exemptions from registration. This means that any time your company issues stock, or any time your company grants stock options or compensatory equity awards of any kind (e.g. stock bonuses), you must comply with the above rule.
With regards to option one, the registration of securities is extraordinarily expensive, overly complex, and hugely burdensome — therefore, most startups will want to rely upon an exemption whenever possible. So, if you can qualify under an exemption described below, it will save you a headache (as well as a lot of time and money) in the long run. Specifically, familiarize yourself with Regulation D, as it contains exemptions that every startup founder should know.
Rule 505 of Regulation D permits up to $5M to be raised from no more than thirty-five non-accredited investors. Those using Rule 505 must provide strictly prescribed information to non-accredited investors, similar to the information required if the securities were to be registered. Rule 504 permits you to raise up to $1M from either accredited or non-accredited investors in a twelve month period – however, using 504 will require you to prepare disclosure statements, which are both complex and expensive, as with Rule 505. For this reason, neither Rule 505 or 504 is utilized often.
Rule 506 of Regulation D allows companies to raise an unlimited amount of capital from accredited investors. There are actually two distinct exemptions that fall under Rule 506.
Under Rule 506(b), a company cannot use general solicitation or advertising to sell its securities, but may sell its securities to an unlimited number of “accredited investors” and up to thirty-five other non-accredited investors. Companies may decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. Note still that companies must still give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.
Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but the investors must all be accredited. An accredited investor is specifically defined by the SEC, and includes those who have 1) a net worth or joint net worth with his or her spouse exceeding $1M (excluding the value of their primary residence); or, 2) annual income which exceeds $200,000, in each of the most two recent years, or a joint income with his or her spouse which exceeds $300,000, for those two years. This exemption is most often relied upon by startups, as it likely preempts state law, and disclosure requirements are absent if the company only sells securities to accredited investors. Not withstanding this fact, it is highly recommended that a private placement memorandum(referred to as a “PPM”) be prepared by a qualified attorney in order to protect the company from litigation, or SEC or state sanctions. The PPM will also serve as a great source for marketing material for an offering, and to really solidify your understanding of your own business.
Under each exemption, aside from the requirements described above, there are documents that must be submitted to the SEC or state securities office, fees, and sometimes disclosures, which you maybe required to provide to investors.
A Note on State and Federal Laws
Last, to complicate matters a little further, it’s important to highlight that there are state and federal securities laws that must be complied with – so for every state where you’re offering securities, you’ll also need to comply with their rules and filing requirements, in addition to requirements set forth in the federal regulations discussed above.
Consequences for Ignoring Securities Regulations
The process is complicated, so what happens if you choose instead to ignore all of these rules? By committing a breach of securities regulations, you expose yourself and your startup to enforcement actions by the SEC or state securities regulators. These penalties may include fines, and even criminal penalties. Additionally, each person who you sold unregistered securities to may sue you to reclaim the purchase price of the securities plus interest. In sum, failure to comply with securities laws put you and your business at risk, and can be a hugely detrimental to the success of your startup.
Conclusion
The complexities of securities laws and raising capital for your startup should not be diminished or ignored. There is really no easy way to deal with it (and certainly no “friends and family” exception, or other easy “out” as many would like to think). If you’re looking at raising cash, you’ll want to pick up the phone first and speak with an attorney with expertise in securities law. At Saunders & Saunders we have a number of attorneys highly experienced in the nuances of securities law, and are happy to help you get to where you need to go. If you’d like to speak to one, please call Christina Saunders at 303-396-0270, or send a message tochristina@saunders-saunders.com to schedule an appointment.