|
LEGAL WAYS TO SELL TO INVESTORS: SECURITIES EXEMPTIONS
Companies selling stock or LLC interests, real-estate
deal-makers looking for investors, investment consultants helping
clients invest self-directed IRA funds and other others raising money
must comply with state and often federal securities laws. Non-compliance
can lead to lawsuits by investors and civil or even criminal prosecution
by government. Frequently the offering is structured to fit within
exemptions to the laws that generally require registration of the
securities. One must weigh the advertising needed, whether financial
requirements will eliminate too many investors, whether investors will
come from more than one state, etc. to determine the best exemption.
Background
Why the
Complexity? The securities laws are complicated because over the
years there has been a great deal of securities fraud. "Securities".
"Securities" includes stock, stock options, LLC memberships,
partnership interests, loans that have conversion rights to stock, etc.
Any time securities are issued, they must be registered or fit within an
exemption. If this is not done, the investors may later be able to sue
the principals – and the State and/or SEC can impose fines and jail
sentences. Location
of Investors. If you sell securities just in California, then you
only need to deal with California securities laws. If you sell in other
states as well, you generally must also comply with federal securities
laws and the laws of each state where you sell. IPO’s.
An "initial public offering" ("IPO") refers to offerings
registered with the SEC that lead to the stock being listed on public
stock exchanges. It’s a time-consuming and expensive process. This
presentation is about exemptions from federal and state registrations,
also known as "private
placements". Public
Advertising. With some exceptions, public advertising is not
allowed. Where it is allowed, other restrictions usually apply. Integration.
Often there has to be six months between each stock offering or
the offerings are considered to be part of one large offering. Such
"integration" may cause problems with the securities exemptions that
are available. Financials.
Although audited financials are often NOT required, as a
practical matter investors may insist upon them.
California Exemptions
If public
advertising is required, then either a 25102(n) or a SCOR
(Corporations Code Section 25113(b)) offering must be used.
25102(n).
The 25102(n) exemption allows up to $5 million to be raised, but
only a "tombstone" (bare bones) ad can be used – though it can be
placed on a web site too – and only "qualified" purchasers can
invest.
Complete information can only be given
to those who respond to the tombstone ad and then sign a document
verifying that they are a qualified purchaser. Qualified purchasers for 25102(n)
purposes are businesses with more than $5 million dollars in assets, and
individuals with either:
a minimum net worth (in conjunction with
their spouses) of $250,000 and gross income in excess of $100,000 or a minimum net worth of $500,000. The value of the home must be excluded
in both cases. Moreover, the amount of the investment
by each individual cannot exceed 10 percent of the net worth of the
individual.
The 25102(n) exemption can
be used with an LLC, but then the investors have to meet the
federal "accredited investor" standards.
There is no integration issue.
SCOR. The
SCOR (Small Corporate Offering Registration) is limited to $1 million.
California makes it much harder to
conduct a SCOR offering than do other states. Audited
financials are required for "open" offerings (as opposed to those
limited to, for example, accredited investors) or for offerings
exceeding $500,000. The money raised may only be used for
operations, not to retire debt. California requires a minimum price of
$2 per share. The exemption is limited to corporations
with one class of stock. With SCOR, transfers are allowed only
to other shareholders, the company or immediate family unless the
California Commissioner of Corporations gives approval. There is no integration issue.
25102(f)
and (h). If public advertising is not
required, the 25102(f) and (h) exemptions are much easier to use.
Similarities.
Both have no limit on the dollar
amount of the offering. Both are limited to 35 investors,
although generally insiders and accredited investors are excluded. There is no holding period. There are no restrictions on resale
except for interstate sales. There is no holding period for resale to
residents of California, except that the offering must have "come to
rest". One rule of thumb for this period is one year, to match the
federal Rule 144 provisions.
Differences.
25102(h) is limited to corporations
with one class of stock;
25102(f) can be used for all securities. 25102(h) does not allowing selling
expenses (commissions, discounts to brokers, promotional
expenses); 25102(f) does. 25102(f) requires the investors to
have a pre-existing relationship or the capacity to protect his/her own
interests (alone or in conjunction with an investment advisor); 25102(h)
has no restrictions on the type
of investor. Although "general solicitation" is
allowed with neither, 25102(h) allows single personal communications to
anyone. In contrast, 25102(f) allows advertising to be made only to
persons reasonably believed to meet the 25102(f) qualifications. There is no integration issue with
25102(h); there is with 25102(f). With a 25102(h), only cash
(not services, equipment or intellectual property) can be used to
acquire the shares, unless it’s an existing business that is being
incorporated.
Interstate Offerings
For offerings of $1 million or less, Rule
504 may be attractive.
It allows public advertising. There are no investor qualifications. There are no restrictions on re-sales
if one complies with 25102(n) or has the California Commissioner of
Corporations require a prospectus. The offering can be placed on ACE-Net. (http://acenet.csusb.edu/faq.html) If the
offering is limited to accredited
investors, there are approximately 40 states that have adopted the Model
Accredited Investor Exemption–and no registration is required in
those.
Alternatively, the exemption may be used with a SCOR offering.
Rule
505 covers offerings up to $5 million.
There are no
investor qualifications. One
advantage is that some states allow a Form D/Rule 505 filing rather than
requiring their own exemption forms. No general
solicitation/advertising is allowed. The
securities must be re-sold via registration or an exemption.
Rule
506 allows offerings in unlimited amounts – but only to
sophisticated or accredited investors.
One big
advantage is that it exempts the offering from all state regulation
(although notices have to be filed in some states). The
offering can only be advertised to accredited investors (although
sophisticated investors can invest as well as long as there is a
pre-existing relationship). Basically, accredited investors are:
Any
organization not formed for the specific purpose of acquiring the
securities offered and having total assets in excess of $5,000,000; Any
director, executive officer, or general partner of the issuer of the
securities being offered or sold, or any director, executive officer, or
general partner of a general partner of that issuer; Any
natural person whose individual net worth, or joint net worth with that
person's spouse, at the time of the purchase exceeds $1,000,000; Any
natural person who had an individual income in excess of $200,000 in
each of the two most recent years or joint income with that person's
spouse in excess of $300,000 in each of those years and has a reasonable
expectation of reaching the same income in the current year.
The
securities must be re-sold via registration or an exemption.
Required holding periods with Rules 505 and 506
Section
4(1½): The securities must have "come to rest" (probably 1 year),
and the buyer must be sophisticated and have access to the same
information as if the securities were registered. This is not available
for owners holding more than 10% of the securities. Rule 144:
There is holding period of one year, then the owner can sell only 1% of
the outstanding shares of the same class being sold each three months if
he/she is an officer, director or significant (> 10%) owner.
Non-affiliates may sell all after 2 years. Rule 144 is used only for
"public sales." Where the owner of a controlling block of
stock in a public company negotiates a private sale of his entire block
with a buyer, the Rule does not come into play. In a private sale of
unregistered stock, the buyers purchase restricted stock from the seller
under the terms of a stock purchase agreement. Because the restriction
is not removed in the process, the transaction is not subject to the
volume and solicitation restrictions associated with Rule 144.
While Reg.
A initially looks attractive because of its "test the water"
provision, the problem in California is that an application for
qualification – which is relatively complicated – must be filed with
the State first. Moreover, other state’s securities laws apply to Reg.
A offerings. (Reg. A offerings are also limited to a maximum of $5
million.)
With Reg A,
there is a holding period of one year, but no volume restrictions. A Reg. A
"test the waters" offering can only be done by a licensed
broker-dealer. If the entire offering is being done solely in
California, the broker-dealer only have to be registered with
California. If the securities are being offered to those in other
states, the broker-dealer must also be registered with the SEC.
Sources of Funding
Suppliers,
customers and strategic partners (who see some benefit to their company
if yours is successful) are the classic sources. One route
is to raise a modest amount using 25102(f) or (h) in a California-only
offering, wait six months, then use the proceeds to finance a larger
round. You can
buy lists of accredited investors, but because they receive so many
offers, you may well be better off with companies that offer
introductions to their lists of accredited investors. Brokers
are a possibility, but usually charge 5% to 15% of the amount that they
sell.
|