How Not To Get SCREWED by Not Knowing the Rules

by Larry Chiang on May 4, 2012

From hyperinkpress.com >

> > Is this email not displaying correctly? > View it in your browser. > > > From Chapter 2 of The Startup Law Playbook: “The Top 10 DOs and DON’Ts For Raising Capital” > > 1. Do Only Offer and/or Sell Securities to “Accredited Investors.” > > As a general rule, a company may not offer or sell its securities unless: > > the securities have been registered with the Securities and Exchange Commission (SEC) and registered with applicable state commissions; or > there is an applicable exemption from registration. > The most common exemption for startups is the so-called “private placement” exemption under section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder. > > The rule of thumb in connection with private placements is only to offer and sell securities to “accredited investors” under SEC Rule 506. There are two significant reasons for this: First, Rule 506 preempts state-law registration requirements — which means, in general, that the company merely must file a Form D notice with the applicable state commissioners (together with the SEC) and pay a filing fee. Second, there is no prescribed written disclosure requirement under Rule 506. > > There are eight categories of investors under the current definition of “accredited investor” (http://www.sec.gov/answers/accred.htm). > > If a company offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues under both federal and state securities law. Yes, there are ways for entrepreneurs to sell securities to non-accredited investors under SEC Rules 504 and 505 (and perhaps other exemptions). However, this often requires that specific disclosure requirements be met and registration/qualification under applicable state law, both of which are very time consuming and costly. > > For more on securities laws, visit: http://walkercorporatelaw.com/securities-law-issues/ask-the-attorney-securities-laws/ > > 2. Don’t Play Securities Lawyer. > > Again, the federal and state securities laws are a potential minefield for the unwary. Noncompliance with applicable securities laws could lead to severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and even criminal prosecution. > > Accordingly, now is not the time for entrepreneurs to play lawyer. Nevertheless, there are always a handful of clients who decide they don’t want to pay legal fees to comply with securities laws, and they handle the issuance themselves. > > This is, in a word, reckless. > > 3. Do Remember to File a Form D with the SEC and Applicable State Commissions. > > As I discussed above, the rule of thumb in connection with private placements is to only offer and sell securities to “accredited investors” under SEC Rule 506 of Regulation D. What many entrepreneurs forget to do, however, is to file a Form D with the SEC and applicable State securities commissions. > > Form D is the SEC’s official notice of an exempt offering of securities in reliance upon Regulation D. It requires certain prescribed information with respect to the issuer and the offering, including: > > i.) the issuer’s identity; > > ii.) its principal place of business and contact information; > > iii.) the names and addresses of its executive officers and directors; > > iv.) the specific exemption claimed under the Securities Act of 1933; and > > v.) most importantly, the identity (and contact information) of any broker-dealer, finder or other person receiving “any commission or other similar compensation” relating to the sale of securities in the offering. > > An executed Form D must be filed with the SEC and each of the applicable state securities commissions in which the offer originated, the offer was delivered or received, and/or any part of the sale transaction took place. Certain states may also require the filing of a consent to service and the payment of a filing fee. The SEC does not charge a filing fee for a Form D notice or amendment. > > 4. Don’t Use an Unregistered Finder to Sell Securities. > > Entrepreneurs often make the mistake of retaining unregistered finders (commonly referred to as consultants, financial advisers or investment bankers) to raise capital for their companies. The problem is that finders must be registered with the SEC and applicable State commissions if they are operating as a “broker-dealer,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others” (http://www.sec.gov/about/laws/sea34.pdf). > > If the finder is receiving some form of commission or transaction-based compensation, which is usually the case, the finder will generally be deemed a broker-dealer and thus be required to be registered with the SEC and applicable state commissions. If the finder is not registered as required and sells securities on behalf of a company, the private placement will be invalid (i.e., it will not be exempt from registration) and the company will have violated applicable securities laws. This is grounds for serious adverse consequences. > > Note that the Form D filed with the SEC and applicable state commissions requires disclosure of the identities of all finders engaged in the offering of securities of the company. > > For more on finders, visit: http://walkercorporatelaw.com/securities-law-issues/ask-the-attorney-beware-of-finders/ > > 5. Don’t Advertise or Solicit Investors. > > Subject to certain limited exceptions, companies are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities. These terms have been broadly construed by the U.S. Securities and Exchange Commission (SEC) and, accordingly, many entrepreneurs get trapped in the SEC’s wide net. > > “Advertising” includes not only the traditional definition (e.g., newspaper ads, radio ads, banner ads, etc.), but also blog posts, articles and other publications publicizing the offering of a company’s securities. > > The term “general solicitation” is even trickier and includes any offer to sell securities via mail, email or other electronic transmission unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor. > > A relationship is deemed “substantive” if the company (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication. > > In other words, the nature and quality of the relationship must be such that the company (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor. To be “pre-existing,” the relationship must be in place prior to the offer. > > Accordingly, spam emails or solicitations via Twitter, Facebook or LinkedIn are all prohibited by the SEC because the offer would be reaching persons with whom the issuer (or the person acting on behalf of the issuer) does not have a substantive, pre-existing relationship. > > Note that Congress and the SEC are currently weighing a crowdfunding exemption which may permit “general solicitations” in certain limited circumstances. > > For more on crowdfunding and solicitation, visit: http://walkercorporatelaw.com/crowdfunding/house-passes-crowdfunding-bill-faq%E2%80%99s-for-entrepreneurs/#more-2750 > > http://walkercorporatelaw.com/securities-law-issues/can-i-raise-money-for-my-startup-via-twitter/ > > 6. Do Due Diligence on the Investors. > > The most common mistake I have seen entrepreneurs make in any deal-making context, including fundraising, is the failure to investigate the guys or gals on the other side of the table. Indeed, this is more a business tip than a legal one; but it is critical. > > Remember: if you’re going out and raising funds, you will, in effect, be married to your investors for a number of years. At a minimum, entrepreneurs should get references and speak with others who have raised funds from the investors. Then you can make an informed judgment as to whether the particular investor is an appropriate individual to partner with. > > Questions to ask yourself include: > > Has the investor done investments like this before? If so, how many and what role did he play? > Can the investor be counted on and trusted? > Will the investor add significant value (e.g., through his contacts, technical expertise, etc.)? > What is the investor’s motivation to invest? > Is the investor a good guy or a jerk? > Sadly, there are a lot of bad apples out there, and entrepreneurs need to be very careful whom they allow to invest in their companies. > > 7. Don’t Sell the Same Shares at Different Prices. > > Another big mistake that startups make is selling shares of common stock at the same time to its founders and investors, but charging them different prices. In other words, valuing the shares differently depending upon the purchasers. > > This issue often comes up when a startup has waited to incorporate until it has found investors and then issues a majority of the shares of common stock to the founders for a de minimis price and a minority stake to investors for a few hundred thousand dollars (if not more). Simply put, startups cannot do that without triggering potential tax problems. > > The IRS will take the position that the shares were properly valued at the price sold to the investors, and that the difference between what the founders paid and their actual value will be deemed compensation to the founders – triggering not only income tax liability to the founders, but also withholding tax liability to the startup. > > 8. Do Limit the Number of Investors. > > It’s important that entrepreneurs raise money from as few investors as possible. Why? Because the more investors a company has, the more likely that one of them will create problems as a minority stockholder. > > Minority stockholders have certain significant rights, including the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company and certain protections against oppression by the controlling stockholders. > > The ideal investor is an experienced, sophisticated angel who can add substantial value through his or her domain expertise and/or Rolodex. If such an investor makes a significant investment, he or she will be there in the trenches if and when things turn sour. It’s worth it to find a superstar investor and give him or her a great deal to get them on board as a funding partner. > > Having a bunch of small, unsophisticated investors is also a nightmare from a practical standpoint — as founders will typically get inundated with daily or weekly emails and phone calls from such investors inquiring as to the company’s prospects and the status of their investment. > > 9. Do Sell Securities to “Friends & Family” Only as a LAST RESORT. > > Many entrepreneurs initially reach out to friends and family as a source of capital. This is understandable, but generally a mistake for two significant reasons: > > i.) Friends and family investors are often not “accredited investors” under SEC Rule 501, which generally triggers tricky compliance and disclosure issues. > > ii.) They are inappropriate investors from a business perspective. > > A sophisticated angel understands that most startups fail and he may lose his entire investment. This is why sophisticated angels typically have 20 or more investments in different startups and are merely looking for a few of them to succeed to get a strong return. > > This mistake is further magnified by a large number of friends and family investors. For example, having 15 or more family members, former college classmates and neighbors invest $5,000+ each is a recipe for disaster. Not only will this scare away many sophisticated angel and VC investors, but the founders will likely find themselves constantly peppered with questions about their company and how things are going. > > Not to mention turning holidays, like Thanksgiving, into stockholders’ meetings: “Hey Steve, can you pass the salt — and by the way, how’s the company doing? How much money have you made so far? When will I get my first dividend check?”, etc. > > 10: Do Issue Convertible Notes, Unless You’re Raising $750,000 or More. > > Finally, unless the startup is raising at least approximately $750,000, it’s generally not in the company’s interest to issue shares of preferred stock. Sophisticated angel investors will generally push hard for shares of preferred stock because they want to receive special rights and preferences for their money and share in the increase in the company’s value that they arguably helped to create. > > However, preferred stock financings are complicated, time-consuming and expensive, despite the “Series Seed” documents and other stripped-down forms (http://walkercorporatelaw.com/vc-issues/should-we-execute-the-%E2%80%9Cseries-seed%E2%80%9D-documents-with-no-negotiations/). > > Moreover, the company would need to be valued at the time of the investment, which is obviously difficult at an early stage and could be extremely dilutive to the founders. Accordingly, entrepreneurs are usually better served by issuing convertible notes to angel investors, not equity. In other words, the angels loan money to the company, which automatically converts into equity in the first professional (the “Series A”) round of financing. > > This approach keeps the financing relatively simple and inexpensive and will defer the company’s valuation until they’re a bit more established. If the angel insists on equity, issue shares of common stock. This places them in the same boat as you, though it still requires a valuation and could cause problems with respect to stock option grants. > > For more on angels and securities laws, visit: http://walkercorporatelaw.com/videos/five-common-mistakes-entrepreneurs-make-in-raising-capital/ > > Click here to check out the rest of the book. > > follow on Twitter | forward to a friend > Copyright © 2012 Hyperink, All rights reserved. > You are receiving this email because you have previously expressed interest in Hyperink. > Our mailing address is: > Hyperink > 333 Bryant St > Suite 330 > San Francisco, CA 94107 > > Add us to your address book > unsubscribe from this list | update subscription preferences >

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