As most of you know, our firm works with many startups, or emerging companies, within the framework of our “Startup Stars” program. One of the issues that we have to deal with every single emerging company client is strategizing what is the best way to obtain initial financing.
Most startups get initial funds from their founders’ savings, money from friends and family, some debt and, at a later stage, approaching professional investors. Yet, what startup teams often do not realize is that by failing to consult qualified and experienced legal counsel and not following certain procedures they might have violated federal and state securities laws already at the initial stages of procuring investment.
A rather simple issue that is often overlooked by startup teams that are way too busy developing a product or service and securing some initial funds to achieve those goals is that every stock offering, i.e., every offering of securities, has to be either (i) registered with the Securities and Exchange Commission or (ii) qualify under one of the applicable exemptions from registration.
Two of the most common ways to procure initial financing by the emerging ventures in today’s environment are either (i) issuing stock to investors in exchange for money, or (ii) issuing convertible debt, usually in a form of promissory notes. The reality is that no matter how small the initial issue of stock or debt is, because of the broadness of the SEC’s definition of what constitutes a security, both of these types of transactions are likely to be considered securities offerings. Specifically, under the Securities Act, promissory notes are defined as securities except for notes with a maturity of 9 months or less. It is true that certain promissory notes are exempt, such as notes delivered in consumer financing, notes secured by a mortgage on a home, short-term notes secured by a lien on a small business or some of its assets, short-term notes secured by an assignment of accounts receivables, notes which simply formalize an open-account debt incurred in the ordinary course of business, or notes given in connection with loans by a commercial bank to a business for current operations. However, initial startup investment rarely falls within those categories.
Legally, in cases that do not fall within any of the above listed categories, the question whether a promissory note is a security turns on whether the note “looks” like a security and whether the selling of the note “looks” like a securities offering. Decisive factors here will include whether (i) the company’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest, (ii) the company’s plan of notes distribution is like a plan of distribution of a security, (iii) the investing public reasonably expects that the note is a security, and (iv) there exists a different regulatory scheme that significantly reduces the risk of the investment. When a company is issuing promissory notes to friends and family to raise money for general business use, and those people are investing with an expectation of a return, such promissory notes are likely to be considered securities.
So, since the assumption that whether stock or debt issuance by a startup should be considered securities is rather safe, according to the Securities Act, it must be either registered with the SEC or qualify under an exemption to registration. Emerging companies that have very limited rounds of initial financing can rely on one of the three exemptions contained within Regulation D, or Reg. D.
The exemption found under Rule 506 allows an unlimited amount of securities to be issued to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors. In those cases when the initial investors are all accredited investors, extensive disclosure is not necessary, but the offering must be conducted without general solicitation, the securities must be restricted, and the company will be required to file a Form D with the SEC. When some of the investors cannot be considered “accredited investors”, extensive disclosure documents to the investors are required, the company will need to comply with the state’s regulations, including filing of a copy of the Form D and paying a filing fee. This means that sale to non-accredited investors can turn into a rather expensive proposition for an emerging company.
Sometimes, however, startups procure initial funding from investors that are neither accredited nor sophisticated. While Rule 504 of Regulation D allows any company to raise up to $1,000,000 from non-accredited and non-sophisticated investors, it involves the preparation of extremely complex and expensive disclosure statements that need to be filed on both federal and state levels. Besides, at a later point, when the emerging company’s products and services gain traction, initial funding under Rule 504 is likely to deter professional and sophisticated investors because of potential problems could arise in the future when the company seeks VC money, a sale, or an IPO.
Therefore our advice to startup clients, with some rare exceptions, is simple — get your initial financing from accredited investors.