Raising Money From Investors, Part 3: Common Federal Exemptions From Securities Registration

In Part 1, we covered why securities laws matter for small business owners who are trying to raise money to start or grow their business. Remember, anytime you raise money by promising some sort of return on investment, then securities laws apply. And if securities laws apply, then you must either register at both the federal and state levels or be exempt from registration. Not surprisingly, most small businesses try to fit within an exemption from registration to avoid some of the legal complexity. In Part 2, we discussed common exemptions to registration at the state level. This week, we turn to some of the common federal exemptions.

Intrastate Offering Exemption

The easiest federal exemption to fit within is the intrastate offering exemption. Put simply, local business transactions are exempt from federal securities registration requirements. To qualify, both your principal place of business must be in the state where you are seeking investors and you must satisfy at least one of the following “doing business” as requirements in that state: 

• At least 80% of your revenues are derived from operating your business or providing services in that state
• At least 80% of your consolidated assets are located in that state
• You intend to use at least 80% of the net proceeds raised from the investment offering to operate a business or purchase real property in that state
• A majority of your employees are based in that state

To maintain this exemption, you can only accept money from investors who are residents of the same state, and you should obtain a written statement from each investor to establish their residency. 
​
As you can see, this exemption is really meant for local businesses with local investors. So if your principal place of business is here in Ohio, and you satisfy at least one of the “doing business” as requirements here in Ohio, and your potential investors reside here in Ohio, then you can rely on the intrastate exemption.

Never assume that just because friends and family want to invest in your business, that you won’t have to worry about securities laws.

Accredited Investors

Both state and federal securities laws also recognize an accredited investor exemption. For individuals to be considered accredited investors, they must either:

• Have a next worth of at least $1 million (not including their primary residence), or
• Have an annual income of $200,000 or more (or joint annual income with their spouse of $300,000 or more) in each of the 2 most recent calendar years and a reasonable expectation of the same income level in the current calendar year

​At the federal level, this exemption allows your business to raise up to $5 million dollars, but like most other exemptions, general solicitation or advertising for investors is not allowed. Because these investors are accredited, no particular disclosure documents are required to be provided to your investors, but the anti-fraud rules still apply. 

Federal Private Placement Exemption

If you are fortunate enough to have potential investors for your business, you probably aren’t so lucky that all of those investors are located here in Ohio. Or your potential investors may not be wealthy enough to qualify as “accredited investors.” Enter the idea of private placements. As the name implies, a private placement means you’re not asking the general public to invest in your business or advertising that you are looking for investors. Instead, you are approaching potential investors privately.  

To use the private placement exemption, your investors must:

• Either have enough knowledge and experience in finance and business matters to be considered “sophisticated investors” (meaning they can evaluate the risks and merits of an investment in your business), or they must be able to bear the risk of losing their investment; AND
• Have access to the type of information normally provided in a prospectus for a registered securities offering; AND
• Agree not to resell or distribute the securities to the public. 

At the state level, this federal private placement exemption is often used in conjunction with the 3(Q) exemption we discussed in Part 2. But remember, you must satisfy a state-level exemption for each state where you have investors; otherwise, you will need to register with that state’s securities regulator. 
​
Offering an investment in your business to even one person who does not meet the private placement requirements means that your entire offering violates securities laws. In other words, everyone who ended up investing in your business could come back and claim violations of securities laws just because you offered the investment to one unqualified person, and you can be held personally liable for any securities law violations. To avoid this problem, we typically use private placement memorandums providing detailed information about your business and the risks associated with investing in your business to your prospective investors, and we have those investors certify that they meet the requirements. 

Regulation D "Safe Harbor"

Unfortunately, the federal securities laws do not provide any further guidance regarding qualifying for the private placement exemption. Some argue that this leaves the private placement exemption too open to interpretation, and “room for interpretation” can easily lead to expensive and drawn out litigation. This is especially true where you end up with a disgruntled investor who may have lost money investing in your business. Because of this, you might choose to rely on certain “safe harbor” provisions to make sure investments in your business meet the exemption requirements and minimize the risk of litigation later. In the next part, we’ll get into these Regulation D “Safe Harbor” provisions and how these exemptions tie into the state level exemptions.
​
Meanwhile, if you are considering raising money from investors, especially in these challenging economic times, schedule a consultation. Never assume that just because friends and family want to invest in your business, that you won’t have to worry about securities laws. Unfortunately, the dynamics of these relationships can easily make litigation even more likely, especially if your friends or family don’t get the kind of return on their investment that they were expecting, or they don’t get as much “say” in how you run your business as they (often wrongly) assumed they were entitled to because of their investment. 

Schedule a Consultation