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A friend peppered me with questions about startup fundraising and recorded it. I thought you might find it informative and enjoy listening in. The transcript is below. Feel free to keep the dialogue going in the comments section.
What Do You Do?
My name is Joe Wallin and I’m a startup lawyer in Seattle, Washington. I work at the law firm of Davis Wright Tremaine and I work with a lot of startup and emerging companies.
How Do Startups Raise Money by Selling Securities?
The best and easiest way for a startup to raise money is:
to rely upon federal securities Rule 506;
not generally solicit or generally advertise your offering;
work from contact to contact, with people you know; and
only take money from accredited investors.
What Is An Accredited Investor?
An accredited investor is an investor with over a $1 million net worth, excluding their primary residence or more than $200,000 in income each year over the last two years with the expectation of the same in the current year, or, with their spouse, $300,000 of income each year over the last two years with the expectation of the same in the current year.
What Do The Securities Laws Require?
First off, what you should know is, before you can sell any security, you have to either register the security with the SEC and with state securities departments in states in which you wish the sell the securities, or you have to find an exemption from registration. Registration is a very expensive process, so finding an exemption is a critical step in a fundraising.
Most startup and early-stage companies rely on the federal exemption known as Rule 506. That is an exemption that allows you to raise an unlimited amount of money as long as you raise it from accredited investors. The requirements for using Rule 506 are not that burdensome. So, for example, you have to ensure that your investors are accredited. You have to file forms with the SEC and in each state in which you have investors. But there are no specific information requirements. You do not have to have multiple years of audited financials or any sort of detailed or lengthy prospectus, as long as you’re taking money solely from accredited investors.
What About Raising Money from Non-Accredited Investors?
Raising money from non-accredited investors involves a lot more complexity and expense. This is why most startup companies will limit their rounds to solely accredited investors.
Can you Generally Solicit Your Securities Offering?
Rule 506 was recently amended, so now, under Rule 506, you have what could be referred to as a non-generally solicited Rule 506 offering, and then you also have what could be referred to as a generally solicited Rule 506 offering.
I think right now, and probably for the foreseeable future, most companies are going to stick to the non-generally solicited Rule 506 offering.
So, if you’re going to go with what we’re referring to as the non-generally solicited offering, you cannot advertise your offering. You can’t publicize it; you can’t post it on the Internet. You can’t use Twitter or Facebook to promote the offering. You’ve got to work from one contact who you know to another contact who you know, with whom you have a preexisting, substantive relationship.
I think, for the most part, companies are going to continue to use the old Rule 506, which is the non-generally solicited Rule 506 and not generally solicit their offerings. And the reason for this is because if you generally solicit your offering, you have to ask your investors for proof that they’re accredited investors, proof of their income, proof of their net worth, and there is a potential reluctance on the part of investors to share that information with companies in which they are considering making an investment.
What If You Generally Solicit and an Investor Won’t Give You the Information?
So, there are third-party services. Suppose you’re a company raising money in a Rule 506 offering and you’ve chosen to solicit your offering, advertise your offering, and so now you have to ask your investors for their financial statements or proof of their income or net worth, and suppose your investors say they don’t want to give that information to you, the company. What are your alternatives?
There are third-party service providers like Second Market or 506Accredited.com or Second Market or Seed Invest that will work with the investor to verify the investor’s net worth or income, and then send you, the company, a letter saying that they have done that.
Has The Jobs Act Made Life Better for Startups?
There was a lot of hope surrounding the Jobs Act, and there was a lot of optimism that it was going to make things easier for companies. Unfortunately, the SEC rules implementing the Jobs Act hamper the promise of the Jobs Act. A lot of companies, I think, are going to generally steer away from generally soliciting their offerings just because of the additional work involved and the potential investor reluctance to share their personal financial information.
Isn’t There Such a Thing As a Friends & Family Offering?
There’s no such thing as Friends & Family Securities Law exemption. The easiest securities law exemption is going to be the all-accredited investor exemption under federal securities Rule 506, and so you generally don’t want to take any money from any friends or family unless they are accredited investors.
What Do You Recommend Startups Do When Raising Money?
If you’re trying to keep your legal costs down, you’re trying to keep your life as administratively simple and easy as possible, the answer is:
don’t generally solicit;
take money from only accredited investors; and
use what’s known as federal securities Rule 506(b), the non-generally solicited Rule 506 offering.
State Securities Law Compliance
Remember, if you are raising money, you need both a federal and a state securities law exemption. If your federal securities law exemption is Rule 506, you will need to make state securities law filings.
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