Entrepreneurs Beware: Regulatory Pitfalls of Early-Stage Fundraising

If anything is certain in these times of economic uncertainty, it is that innovation will sprout from the soil of hardship. Entrepreneurs who outlast the tight venture markets and credit clampdown will be ideally positioned as the capital freeze begins to thaw.

In the meantime, however, entrepreneurs seeking seed capital from friends and family should understand how the sophistication level and financial condition of early-stage investors can trigger fundraising risks and regulatory limitations in later financing stages.

What follows is a brief explanation of those limitations—and the ways in which they may have an adverse impact on a burgeoning company.

Development and Requirements of Rule 506

Section 5 of the Securities Act of 1933 requires every offering of securities (i.e. stock, membership interests, convertible notes, etc.) to be registered with the U.S. Securities and Exchange Commission unless a specific exemption from registration is available. One exemption is provided in Section 4(2) of the Securities Act and applies to offerings that are not made to the public. Unfortunately, the determination of whether an offering is not made to the public under Section 4(2) is extremely fact-intensive and made on a case-by-case basis.

In an effort to provide clarity, the SEC promulgated Rule 506 of Regulation D under the Securities Act, which sets forth a litany of requirements that, if met, provide a bright-line exemption to the registration requirements of Section 5 and allow an issuer to raise an unlimited amount of capital. These requirements include, among others, that all but 35 of the purchasers of securities sold in an offering are "accredited investors" having a high net worth or a large annual income, occupying a director or officer position with the issuer, or satisfying another criteria used to presume the investor's awareness of, and ability to undertake, the financial risks of investment.

Should an issuer decide to sell securities to any non-accredited investor while relying on Rule 506, the issuer is required to make financial and business-related disclosures to that investor, which disclosures are similar in nature to those that are required in connection with a registered offering. Thus, for most early-stage companies, the costs and delays involved with such disclosure effectively prohibit the sale to non-accredited investors in an offering exempt from registration under Rule 506.

Rule 504 as an Alternative to Rule 506

This leads us to Rule 504, also a part of Regulation D, which was adopted by the SEC using its authority under Section 3(b) of the Securities Act. Similar to Rule 506, this rule is intended to give issuers a set of requirements that, if met, exempt the offering from registration. Unlike Rule 506, however, Rule 504 permits sales to an unlimited number of non-accredited investors and imposes a $1 million limitation on the amount the issuer may raise in the 12-month period prior to and including the Rule 504 offering.

Additionally, Rule 504 does not require the issuer to provide any specific disclosure to the offerees, regardless of whether they are accredited. For many early-stage companies, $1 million is enough to start and maintain operations, but can only be obtained from family members and close friends who do not qualify as "accredited investors," making reliance upon Rule 506 impractical, if not impossible. With that said, reliance on Rule 504 can significantly complicate and often limit later financing activities.

Pitfalls of Integration Under Regulation D

Rule 502 of the 1933 Act requires that all sales of securities by an issuer that are part of the same offering under Regulation D (i.e. offerings made upon reliance of Rule 504 or Rule 506) be integrated and all of these sales, when aggregated, must meet the criteria set forth in the rule upon which the issuer has relied to avoid registration. Practically speaking, this prohibits an issuer from raising up to $1 million from non-accredited investors under Rule 504 and, at the same time or within a limited period of time, raising additional funds from accredited investors under Rule 506.

Assuming that the offerings under Rule 504 and Rule 506 are considered to be part of the "same offering" by the SEC, the additional funds raised in reliance on Rule 506 will be integrated with those raised in reliance on Rule 504, and if such funds, in the aggregate, exceed $1 million, Rule 504 will not be available to the issuer, and if the non-accredited investors in the proposed Rule 504 offering did not receive the information required to be delivered to non-accredited investors under Rule 506, Rule 506, too, will be unavailable to the issuer. Therefore, the issuer would be left to argue that the offering was not made to the public under Section 4(2), which can be a murky exemption.

Although what constitutes the "same offering" is not explicitly stated, the SEC has created a safe harbor for offers and sales made more than six months before the start of another offering or more than six months after the completion of another offering. The SEC deems these as separate offerings invulnerable to integration.

For example, let us assume that an issuer (we'll call it XYZ, Inc.) were to conduct an offering pursuant to which it raised $1 million from 20 investors, some of whom were non-accredited, in reliance upon Rule 504. The last sale as part of that offering occurred on July 1, 2009. As long as XYZ, Inc. and its representatives refrain from conducting another offering or soliciting further investment until January 1, 2010, it could, beginning on that date, initiate a new offering to accredited investors in reliance upon Rule 506 without fear of having the offering that began in January integrated with the offering that ended in July.

Problems With Severing the Integration Chain

Unfortunately for many startups, putting off fundraising for six months is not an option. Often, additional money is needed to keep the lights on, compensate suppliers and meet payroll obligations. But for XYZ, Inc., additional fundraising between July 1, 2009, and January 1, 2010, may have the effect of (1) making unavailable the exemption from registration on which XYZ, Inc. has relied and intends, in the future, to rely, and (2) increases XYZ, Inc.'s risk of having conducted a public offering without registration—giving to its 20 investors a potential claim to rescind their investment. Additionally, unless XYZ, Inc. waits the necessary six months or is comfortable that, based on SEC guidance, an offering conducted prior to the expiration of the six-month waiting period will not be integrated with its prior offering, XYZ, Inc. may never effectively sever the integration chain connecting its offerings (and any future offerings) and Regulation D may never be available to it as a safe harbor from registration.

This problem becomes especially significant if XYZ, Inc. intends to attract institutional investments from sophisticated angel networks or venture capitalists. It may actually be precluded from doing so because institutional investors insist an issuer have a clear exemption from registration with respect to sale of its securities, both past and present, and will often rely on a legal opinion that each such security has been validly issued.

Most law firms, however, are hesitant to provide a legal opinion regarding the validity of unregistered offerings conducted solely in reliance upon Section 4(2)—or where there is a risk of spoiling an exemption from registration under Regulation D as a result of integration.

Be Aware of Restrictions Before Conducting an Offering

Unfortunately, many startups are without the choice to sell securities only to accredited investors in reliance on Rule 506—and have to fall back on Rule 504 to obtain much-needed seed capital.

To the extent this is the case, startups should be aware of potential restrictions they may face with respect to future fundraising activities. They can then incorporate into their budgets a plan to allow a six-month break in fundraising—and strive to make a final sale and complete an offering as soon as possible to commence the ticking of the six-month integration clock.

Startups who have received a large commitment from accredited investors and are pondering whether to accept, as part of the offering, a smaller investment from a non-accredited investor should weigh the benefits they stand to derive from the smaller investment. Costs of preparing the disclosure required by Rule 506 should be a consideration, along with future restrictions that may be imposed if they decide to conduct a Rule 504 offering.

In all cases, issuers should consult with legal counsel prior to conducting an offering to ensure that their activities are permitted under applicable federal and state securities laws.