Raising Money From Investors

Private Placement
Memorandums
Investment Agreements

Raising money is a critical concern for most start-ups and businesses. Whether it's seed funding to get the business started or raising capital to take the business to the next level, every business needs money (and probably more of it). But it's not as simple as offering potential investors an opportunity and then letting the money pour in.

Anytime a business seeks to raise money from so-called “silent partners” by promising a return of some sort on their investment, then securities laws apply. This includes offering an ownership interest in the business (whether that's stock in a corporation or a membership interest in an LLC) and even debt obligations like promissory notes. And when securities laws apply, the business and its principals must comply with a complex set of federal and state regulations, even if you are just raising money from friends and family.

If you are willing to give up significant control over your business, then your potential “investor” is more likely to be treated like an ordinary business partner. This can potentially alleviate some of the complexities surrounding securities compliance, but taking on business partners comes with its own set of risks. Before going into business with anyone, you need to have a well-drafted operating agreement in place.

What laws should I be aware of before raising money from investors?
The two primary federal securities laws that apply when a business wants to raise money from investors are the Securities Act of 1933 and the Securities Exchange Act of 1934. If your business is selling securities through interstate commerce, then these federal securities laws apply. For example, let's say you have friends from college who live out of state that you believe might be interested in investing in your business. If there is an expectation that those friends could potentially earn a return on their investment in your business, then regardless of what you and your friends call the investment, it is a securities transaction. Because your friends are out of state, your business would be selling securities in interstate commerce (i.e., across state lines), and you must comply with federal securities laws. This means the transaction must either be registered with the Securities and Exchange Commission (the “SEC”) (thereby making the business a public company) or exempt from registration.

In addition to federal law, each state requires compliance with its own blue sky laws to protect investors who reside in that state. Thus, the transaction must be registered or exempt from registration in each state where you have investors.

What exemptions from registration do businesses rely on?
At the federal level, most businesses rely on one of 3 types of exemptions to the registration requirement: intrastate transactions, private placements, and the relatively new Regulation of Crowdfunding.

Intrastate Offering Exemption
Section 3(a)(11) of the Securities Act exempts from registration of local business transactions. A local business is one that:

Is organized in the state where it is offering the securities;
Carries out a significant amount of its business in that state; and
Makes offers and sales only to residents of that state.

There is no limit on the size of the offering or the number of investors as long as all of the investors are residents of the state. Typical problems businesses run into with the intrastate offering exemption include:

An investor resells the securities to an out-of-state investor shortly after the offering is completed (typically within nine months), thereby losing the exemption for the entire transaction (including the original offering);
The business holds assets outside of the state; or
The business derives a substantial portion of its revenues from outside the state.

Even with the intrastate exemption, businesses should be careful to document both their reliance on the exemption and the information shared with investors. And before money exchanges hands, the parties should execute an investment agreement documenting the terms.

Federal Private Placement Exemption
Section 4(a)(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering.” To qualify, investors must:

Either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment) or be able to bear the investment’s economic risk;
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.

Because these are not “public offerings,” general solicitation or advertising is generally prohibited.
The only downside to the private placement exemption is that it does not provide any further guidance regarding qualifying for the exemption. For this reason, larger privately held companies will look to the “safe harbor” provisions found in Regulation D.

Regulation Crowdfunding
With crowdfunding, a business is able to raise money from a large number of investors who each contribute a relatively small amount. The JOBS Act creates a securities registration exemption for crowdfunding that involves securities. This is not quite the same as crowdfunding services like Kickstarter that raise funds for charities or creative endeavors where backers get “rewards” rather than “securities.”

Securities crowdfunding is limited to $1 million in any 12-month period. The intermediary that actually sets up the crowdfunding must be registered with the SEC. During any given 12-month period, individual investors can only invest up to:

if their annual income or net worth is less than $100,000—the greater of $2,000 or 5 percent of annual income or net worth, or
if their annual income or net worth is more than $100,000—10 percent of annual income or net worth up to a maximum of $100,000.

When calculating net worth, the value of the investor’s primary residence is not counted.

Common State-Level Exemptions
In addition to finding an applicable exemption under federal securities laws, businesses must also comply with state blue sky laws. Here in Ohio, the Ohio Securities Act is administered and enforced by the Ohio Division of Securities (the “Division” or “ODS”) and applies to all sales of securities. Under state law, the securities must be registered with the Division or exempt from registration. Registration generally requires a merit review by the Division, meaning the offering must be approved by ODS before being offered to prospective investors. Transactions that are exempt from registration often still require a notice filing with ODS, but the Division doesn’t review and effectively “pre-approve” these transactions.

In order to avoid registration (and the delays associated with getting your offering approved), businesses typically use one of the following exemptions.

Ten or Fewer Purchasers
If the business is selling equity securities to ten or fewer investors in Ohio and reasonably believes that the investors are purchasing for investment (i.e., not looking to resell), then no filing with the Division is required. Reliance on this exemption should be documented in the business’s records. There is no limit on the amount being raised, but no general advertising or solicitation is permitted.

Private Placements
If the business is relying on the federal private placement exemption (Section 4(a)(2)), then it must file Form 3-Q and a copy of the offering materials with the Division within 60 days of the first sale in Ohio. There is a $100 filing fee.

Regulation D Private Placements
When a business is relying on the “safe harbor” provision of Rules 506(b) or 506(c), then a copy of Form D must also be filed with the Division within 15 days of the first sale in Ohio. Again, there is a $100 filing fee.

If there are investors outside of Ohio, then we also have to check their state’s particular exemptions (though most states have these 3 broad categories of exemptions) and whether that state requires a filing to claim the exemption and what fee that state charges.

What are the consequences of failing to comply with securities laws?
Unfortunately, too many entrepreneurs and businesses assume that they can ignore these complex legal requirements, especially when their investors are “just” friends, families, and colleagues who want to support their venture. But when these relationships sour, especially if the investment doesn’t return what the entrepreneur promised, then both the business and its principals may find themselves facing a lawsuit for securities fraud. And when that happens, the investors can demand a return on their entire investment from both the company and its principals. In other words, limited liability protection does not apply to allegations that you or your company committed securities fraud.

In addition to complying with the regulatory requirements, business owners should also be aware of the anti-fraud provisions of state and federal securities laws. This means that a business and its principals cannot make any false or misleading statements, whether orally or in writing, about the business, the securities offered, or the offering itself. You should be very careful about what you promise your potential investors long before accepting any money. The investors need to be told “the truth, the whole truth, and nothing but the truth,” including the very real risks involved with investing in the business.

Finally, you should always have a well-drafted, fully executed investment agreement in place before money changes hands. This is not a situation where you should rely on a handshake to get the deal done. Handshake deals inevitably lead to misunderstandings and very costly disputes. When it comes to securities laws, too many things can and do go wrong to not get the deal in writing.

What is the simplest way to raise money from investors?
Given the complexities involved in complying with securities laws, business owners often ask what the simplest path forward is, especially when raising money from friends and family. And while every situation is unique and should be discussed with counsel before any action is taken, there are a couple of key questions that need to be answered:

First, does the transaction truly involve a “security?” This is a legal question, not a game of semantics. Regardless of what you and the potential investor want to call the transaction, will the investor expect a return on their investment? Will they have a significant degree of control over the business? Can the investor’s involvement potentially impact the success or failure of the business? The more the investor looks like an involved business partner, the easier your path forward will be.

Second, if the transaction is a security, does federal law apply? If all of your investors

and business dealings are here in Ohio, then the transaction is “intrastate,” and federal laws don’t apply. Failing that, most businesses rely on one of the federal private placement exemptions. Which one to rely on ultimately depends on whether your investors are sophisticated or accredited and whether it is important to keep certain business information confidential.

Finally, at the state level, again, the intrastate exemption is the easiest to comply with. But if you have a larger group of investors or investors out of state, which notices filing needs to be submitted to ODS? What is required by the blue sky laws of other states where you have investors?

Raising capital is incredibly important but also incredibly complicated. Before you raise money from investors, discuss these issues with sophisticated legal counsel. Schedule a consultation below.

SCHEDULE A CONSULTATION

Investor Package: Includes Offering Document (i.e. Private Placement Memorandum), Purchase Agreement, and Company Operating Agreement: $14,500
+Federal or State Securities Registration Fees, if applicable
Alternative Retainer Option: $5,000

Private Placement Memorandum (or similar offering document): $6,200
Alternative Retainer Option: $5,000

Investment / Subscription Agreement: $1,050

Note: A standalone investor agreement (without an accompanying offering document) is rarely, if ever, appropriate. All securities transactions are subject to the anti-fraud provisions of state and federal securities laws. This means that the business and its principals cannot make any false or misleading statements, whether orally or in writing, about the business, the securities offered, or the offering itself. In addition to government criminal, civil and/or administrative enforcement actions, the investors in a business can bring a private action for securities fraud and potentially recover a refund of their entire investment.

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