1. Why do I have to Worry about the Securities Laws if I am just Raising Capital Privately?
Many business owners and entrepreneurs are surprised to learn that the law severely regulates their ability to raise capital, dictating the types of investors they may approach, the type of advertising and solicitation that they may undertake, the level of financial and other information that must be provided to potential investors, their ability to pay commissions to finders and other referral sources, and a host of other matters. These regulations apply to even the most informal friends-and-family type of investments, not to mention venture capital and other institutional financings. Furthermore, both Federal and state laws (which are not always consistent) are applicable, and if there are investors from more than one state participating in the financing then the laws of each state will need to be followed.
It may seem unfair that, with minimal effort and expense, anyone can set up a website and immediately begin taking in money from the general public for the sale of virtually any product or service with almost no regulation or interference from the government, short of fraud or other seriously bad behavior. Yet, when it comes to selling stock in a company, a host of Federal and state laws are triggered that make the process difficult, expensive, time consuming and fraught with traps for the unwary.
The reasons are partly historical. When Congress enacted the Federal securities laws in the early 1930’s, following the 1929 stock market crash, they made it the organizing principle that every purchase or sale of a security must first be registered with the Securities and Exchange Commission (SEC), an expensive and time consuming and time-consuming process that requires the preparation of a detailed prospectus disclosing material information about the company (including its audited financial statements). Failure to register can lead to civil (and in some cases criminal) penalties, as well as liability in private lawsuits.
2. What is a Private Placement?
Read literally, this registration requirement covers every transaction in every security, including the ordinary purchase of a couple hundred shares of a public company by a retail customer through his or her stockbroker. Obviously, registration of these routine transactions would be impractical, and the securities laws contain a laundry list of exemptions. Some of these apply to whole classes of securities (such as municipal securities and treasury bonds). Others apply to specific types of transactions (such as ordinary broker’s transactions executed over a stock exchange or in the over-the-counter market).
In the context of raising capital by a company, the main exemption usually being relied on, which has not changed since originally enacted in 1933, applies to purchases and sales of securities “by an issuer not involving any public offering.” There is a lot of hidden meaning in these few words, and literally hundreds of court cases, SEC no-action letters and other interpretations of the meanings of “security,” “issuer,” purchase and sale” and “public offering” have been handed down throughout the years. By the way, while the phrase “private placement” is not actually used in the statute, it is universally used to refer to a transaction by an issuer not involving a public offering.
3. A New Era: Advertising and Equity Crowdfunding for Private Placements
With the passage of the JOBS Act in April 2012, and the expected issuance in 2013 of long-overdue implementing regulations by the SEC, the private placement world is set to see the biggest changes it has experienced since the adoption of Regulation D in the early 1980’s, which many credit with contributing to growth boom we experienced in that decade. Two changes in particular have the potential to permanently alter the way private companies, include start-ups, access capital in the U.S.
The first is the elimination on the prohibition on advertising and general solicitation in offerings under SEC Rule 506, which governs private placements to accredited investors and limited numbers of additional investors who are financially sophisticated or meet other criteria. The second is a new regulatory scheme allowing companies to raise up to $1 million over the Internet through brokers or qualifying crowdfunding portals. A number of companies have already been formed to set up these types of portals and are making ready to jump into the market as soon as the EC regulations are enacted. Future articles in this series will discuss these developments in greater detail.