Raising Money for Your Business

by J. Kevin Bromiley

Does your business need an infusion of capital to grow into what you envision it becoming? Do you have a business idea, but lack the resources to bring the concept into fruition? If so, you have probably considered borrowing money from a bank and/or seeking private investors. This article will discuss the latter option, known as selling securities. As securities is a complicated area of the law, this article will be an introduction to some issues of which you should be aware.

“Securities” include stock, notes, or any other evidence of indebtedness, or any investment in a business venture where the investor expects some benefit for the investment, but does not have control over the decisions made by the business. Taking on private investors is a legitimate, but often complicated, method of raising capital for your business. Before we analyze the legal issues of selling securities, let us look at some practical issues.

When your business takes on private investors, you have someone to whom you are answerable. This can be a significant (and unwelcome) change for many entrepreneurs. Additionally, offering securities usually requires compliance with complicated federal and state securities laws, for which could easily spend tens of thousands of dollars in legal fees. Unless you are trying to raise a significant amount of money, it might not make any sense to incur such costs. Even if you are raising money through family, friends, and business acquaintances, you need to make sure you are complying with securities laws.

The sale of securities is regulated by each state as well as the federal government. The regulations focus on three key variables: (1) the security or transaction itself; (2) the persons and entities selling the security; and (3) the disclosures made to investors about the security.

1. The Security or Transaction Itself

Every security sold in the United States must either be registered with the Securities and Exchange Commission (SEC) or must qualify for an exemption from registration. In addition, the security must either be registered or exempt from registration in all states in which investors are offered or sold the securities, or that have sufficient contact with the sales process. Unfortunately, state registration exemptions differ dramatically from state to state. A federal exemption does not guarantee a state exemption (or vice versa), nor does an exemption in one state mean that a comparable exemption will be available in another state. Of the various state regulations, this article will only discuss those pertaining to Washington.

Securities regulations are intended to provide full disclosure of material facts regarding the business venture, so that potential investors can make an informed decision. At a minimum, “material facts” include anything that, if made known to the potential investor, would possibly make the potential investor not want to buy the security. While these disclosure requirements typically are complicated, the Washington State Department of Financial Institutions, Division of Securities (DFIDS) has attempted to provide programs that allow the offering of securities to raise smaller amounts of money.

One such program is known as the Rule 504 Small Offering Exemption, or “SOE”, which has a maximum offering amount of $1,000,000. When using rule 504, there is no required format for the disclosure statement to potential investors. However, you must disclose all material information required for a potential investor to make an informed decision. DFIDS recommends that you the plain-language, question-and-answer format available at http://www.nasaa.org/content/Files/SCORForm92899.doc.

For a Rule 504 offering confined to Washington, the only documents you need to file are a Securities Notification of Exemption form and a consent to service of process, available on the DFIDS website, http://dfi.wa.gov/sd/forms.htm. If you utilize rule 504, you need not file anything with the SEC. These forms must be submitted to DFIDS at least ten business days before you begin to sell the security.

If you need to raise more than $1,000,000, but not more than $5,000,000, then you can structure your offering to conform to the Rule 505 exemption. Complying with state and federal disclosure requirements is more time-consuming under Rule 505, and the plain-language, question-and-answer format available for Rule 504 offerings is not sufficient for Rule 505 offerings. Additionally, under Rule 505, a document known as Form D must be filled out and submitted to both the Washington Securities Division and the SEC.

If you need to raise more than $5,000,000, there are no programs to help minimize the cost of providing full disclosure of material facts. You will need to register with both the SEC and the DFIDS, and the cost of preparing the necessary disclosure statements and related documents is simply part of the cost of trying to raise such a large amount of money from private investors.

2. Those Selling the Security

Generally, a person selling securities must be registered with the state and federal government as a broker-dealer or agent unless an applicable exemption is available. A commonly used exemption to this is known as the “issuer” exemption. Under certain conditions, it exempts from registration the officers, managers and full-time employees of the company issuing the securities. If you utilize the Rule 504 exemption discussed above, you need to use the “issuer” exemption, because Rule 504 does not allow you to use a broker-dealer to sell the securities.

3. Disclosures Made to Investors

You must be extremely careful in your analysis and verification procedures for determining the status of investors and complying with the other pre-conditions to preserve the availability of the exemption under either Rule 504 or Rule 505. First, you must determine whether an investor is “accredited.”

Whether an investor is considered “accredited” depends on the investor’s classification and whether the investor meets the requirements for that classification. Individuals (rather than entities) will be accredited investors if they satisfy any one of the following standards: (1) have a net worth (with their spouse) in excess of $1,000,000, (2) individual income for the past two years and a reasonable expectation of income for the current year in excess of $200,000 (excluding spouse), or (3) joint income with their spouse in excess of $300,000 for the past two years and a reasonable expectation of such income for the current year.

An investor who does not come within one of the accredited investor categories is a nonaccredited investor. Under the Rule 504 and Rule 505 exemptions, you can sell to a limited number of nonaccredited investors, and you must “reasonably believe” that each of these investors has enough knowledge and experience in financial and business matters to evaluate the merits and risks of the investment, unless the investment is less than ten percent of the nonaccredited investor’s net worth. It is important to keep documents supporting your beliefs about investors’ financial status, such as investor questionnaires.

Additional Issues

Even if you utilize the Rule 504 or Rule 505 exemption, you must comply with state and federal antifraud regulations, the violation of which can result in civil liabilities. These antifraud provisions prohibit any person in connection with the purchase or sale of any security from misrepresenting or omitting a material fact, or engaging in any act or practice that constitutes a “fraud” or deceit upon any other person. This includes omissions in disclosure (sometimes even unintentional ones) rather than just deliberate misrepresentations.

Another important precondition to the availability of the exemption under Rule 504 and Rule 505 is that the company offering the securities (or any person acting on its behalf) is prohibited from offering or selling securities by any form of general solicitation or general advertising. Prohibited actions include: advertising; mass mailings; informational meetings with potential investors; and issuance of press releases. A conservative interpretation of the SEC’s view regarding general solicitation is that all potential investors should be people with whom the company offering the security (and its directors, officers, or full-time employees) has a pre-existing business relationship.

The first rule of securities law is that investors never sue when they make money - only when they lose it. You must remember that it is when things go wrong, frequently for reasons you did not predict or could not control, that regulators or disappointed investors may seek remedies. Be prepared for this and protect your business and yourself by complying with securities regulations.