Friday, January 20, 2017

"Friends and Family" Investment Regulation

Many startups initially raise money by enticing their friends and family to invest.  This is what they need to know about the securities laws surrounding such transactions. Under the Securities Act of 1933, a company or private fund may not offer or sell securities unless the transaction has been registered with the SEC or an exemption from registration is available. A securities offering exempt from registration with the SEC is sometimes referred to as a private placement or an unregistered offering. Regulation D contains the rules providing exemptions from the registration requirements. Rule 506 is the most common exception for startups, but Rules 505 & 504 also have attractive features.

Rule 506: Sophisticated investors, PPM

Rule 506 allows to offer securities only to preexisting contacts (no advertising of the offering) who are either accredited investors or not. An accredited investor is anyone who:

- earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

On the income test, the person must satisfy the thresholds for the three years consistently either alone or with a spouse, and cannot, for example, satisfy one year based on individual income and the next two years based on joint income with a spouse. The only exception is if a person is married within this period, in which case the person may satisfy the threshold on the basis of joint income for the years during which the person was married and on the basis of individual income for the other years.
In addition, entities such as banks, partnerships, corporations, nonprofits and trusts may be accredited investors.

The following entities would be considered accredited investors:

- entity with total assets in excess of $5 million,  or
-any entity in which all of the equity owners are accredited investors.

In this context, a sophisticated person  means the person must have, or the company or private fund offering the securities reasonably believes that this person has, sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.

So, can you still raise money from those who do not fit any of the above definitions of an accredited investor?  Yes, but be careful.

Rule 506 permits a company to include up to 35 non-accredited investors
in the offering if each of them has “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” This is, of course, a very subjective standard that is potentially risky for the issuer, particularly if some of your investors had never invested sums as large as you are requesting into startups.  However, according to the SEC, the “sophistication requirement may be satisfied by having a purchaser representative for the investor who satisfies the criteria.”

Another problem is that the SEC requires to “give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.”   Private Placement Memorandum (PPM) is used to satisfy the disclosure requirement. Compiling these potentially complex disclosures may drive up the costs to the point where it defeats the purpose of conducting a “friends and family” round. In contrast, if you are raising money from only accredited investors, there are no specific disclosure obligations required.

Rule 505: Non-sophisticated investors, PPM, state registration

Is there a way to raise capital from non-accredited investors who are not “sophisticated”? Yes, Rule 505. It allows to raise up to $5 million in a 12 month period to no more than 35 non-accredited investors. Shares sold under Rule 505 cannot be sold for a minimum of six months. No advertising.

Major drawback of Rule 505 is that, if you sell shares to non-accredited investors, you have to provide similar disclosures to that of a public offering. This includes financial statements certified by a CPA. Rules 504 (below) & 505 have another major disadvantage as compared to Rule 506. Latter preempts state registration requirements whereas Rules 504 & 505 do not. That means that, when conducting a Rule 506 offering, as long as the correct notice filings are made, issuers do not have to look for exemptions from state securities registration requirements. But with Rules 504 & 505, the issuer may have to look for a separate exemption from state-level registration. Otherwise, it may be impossible to accept investments from residents of certain states without registration in those states. That's because states have their own "blue sky" law that regulates the offering and sale of securities and blue sky compliance can be burdensome.

Rule 504: Non-sophisticated investors, no PPM, state registration

Is there a way to include non-accredited investors without complex disclosures? Yes, through Rule 504 which is an exemption from the registration requirements of the federal securities laws for companies when they offer and sell up to $1,000,000 of their securities in any 12-month period. No advertising is allowed and all investors must be preexisting contacts. There is no obligation to provide disclosures. However, a company should still take care to provide sufficient information to investors to avoid violating the anti-fraud provisions of the securities laws. This means that any information a company provides to investors must be free from false or misleading statements. Similarly, a company should not exclude any information if the omission makes what is provided to investors false or misleading.

Generally, securities issued under Rule 504 will be restricted securities.  Two main things to know about those: 1) could be very difficult to resell them for at least a year after purchase and 2) the restricted status of those securities may also transfer to a new buyer.  For these reasons, it may be difficult to attract buyers. A buyer of restricted securities should not expect to be able to easily and quickly resell them.  In fact, they should expect to hold the securities indefinitely.

With Rule 504, there is no federal preemption, so the issuer may have to look for a separate exemption from state-level registration. E.g., Rule 25102(f) in California.

California "friends and family" exemption

Pursuant to 25102(f) a company can sell securities to an unlimited number of accredited investors and company executive, and up to 35 non-accredited investors, as long as the non-accredited investors have either one of the following:

- a preexisting personal or business relationship with the seller of securities; OR
- “capacity to protect their own interests” by reason of their financial experience or independent professional advisers.

Other compliance requirements are that the investors must also state in writing that they are purchasing for their own account, the offering must not be advertised to the public, and a 25102(f) exemption notice must be filed with the California Department of Business Oversight.

Form D

Companies relying on the Rules 504, 505 or 506 exemption do not have to register their offering of securities with the SEC, but they must file what is known as a "Form D" electronically with the SEC after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering.


Rule 506 remains the most attractive option for raising capital because of state law preemption. Dealing with accredited investors only is the easiest course of action. However, for those in states like California without rich uncles, Rule 504 is a good alternative because this state has a "friends, family and business partners" exemption.