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Legal Issues In Raising Capital (Third in a Series)

On Behalf of | May 7, 2014 | Business Transactions

Venture Funding/Private offering

There is some overlap between Angels and Venture Capitalists. The primary distinction besides the amount of money being raised is that the later tend to be very sophisticated and will on occasion want to take a role in the company either on the board or in some cases as a CEO or a CFO.

Given the increased level of sophistication and the increased scrutiny with a Venture Capitalist, you will need to have the same level of sophistication on your side of the table as well. Issues such as preference rights in the event of liquidation, voting rights, calls and dividends, warrants and attached debt instruments and dilution and ratchet-rights are all part of the discussion when negotiating with a Venture Capitalist along with the biggest issue and that is valuation.

In short, you depending upon the leverage you have, are going to have to fight to retain as much control and equity as you can during the fundraising process and the other side is trying to maximize its return in the event of the purchase of the company or an IPO.

A Venture Capitalist may for instance require certain financial goals to be met for you and the other founders to retain positions in the company.

You can raise money during this phase by yourself or with the help of a licensed dealer-broker.

In either event you will need to prepare an offering document, such as a private placement memorandum and you will have to make sure that you are raising money pursuant to one of the exemptions.

Under the Act any offer to sell securities must either be registered with the Securities and Exchange Commission (the “SEC”) or meet an exemption. Regulation D (or Reg D) (also attached) contains three rules providing exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the securities with the SEC. The exemption may be found in Rules 504, 505, and 506 of Regulation D.

While companies using a Reg D (17 CFR § 230.501 et seq.) exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

In February 2008, the SEC adopted amendments to Form D, requiring that electronic filing of Form D. Although as amended, the electronic Form D requires much of the same information as the paper Form D, the amended Form D requires disclosure of the date of first sale in the offering. Previously, disclosure of the first date of sale was not required.

Rule 504 applies to transactions in which no more than $1,000,000 of securities are sold in any consecutive twelve-month period. Rule 504 imposes no ceiling on the number of investors, permits the payment of commissions, and imposes no restrictions on the manner of offering or resale of securities. Further, Rule 504 does not prescribe specific disclosure requirements. Generally, the intent of Rule 504 is to shift the obligation of regulating very small offerings to state “Blue Sky” administrators, though the offerings continue to be subject to federal anti-fraud provisions and civil liability provisions of the Exchange Act.

Rule 505 applies to transactions in which not more than $5,000,000 of securities is sold in any consecutive twelve-month period. Sales to thirty-five “non-accredited” investors and to an unlimited number of accredited investors are permitted. An issuer under Rule 505 may not use any general solicitation or general advertising to sell its securities.

Rule 506 has no dollar limitation of the offering. Rule 506 is available to all issuers for offerings sold to not more than thirty-five non-accredited purchasers and an unlimited number of accredited investors. Rule 506, however, unlike 504 and 505, requires an issuer to make a subjective determination that at the time of acquisition of the investment each non-accredited purchaser meets a certain sophistication standard, either individually or in conjunction with a “Purchaser Representative.” Like Rule 505, Rule 506 prohibits any general solicitation or general advertising.

Section 201(a) of the JOBS Act (You may know this as Crowdfunding) required the SEC to remove the general solicitation prohibition under Rule 506, in the situations where all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors. We have dealt with this topic in previous articles.

IPO/Public offering

This is a process usually done in conjunction with your Venture Capitalist and the underwriter.

In that so few companies make it this far, we will not spend a lot of time on it. The process of selling the offering is a complicated one. I have taken some companies “public” by what is called a reverse merger. That is a company that wants to be listed on an exchange, purchases a public company shell. A shell is just what is sounds like, that is a company that is listed on an exchange, but has no assets, or the holder of the shell agrees that as part of the share exchange it will strip the assets out of the company and allow your company to take over the company. You merge your company into the shell and exchange the shares in the private company for shares in the public company and now the owners have shares that can be sold to the general public without filing a registration statement with the SEC. The registration statement is an S-1. This also is used if the shareholders believe that the use of public stock will provide liquidated for future acquisitions.

The IPO or Public Offering is a registration and opens the company to another set of rules and regulations.

If you have any questions or would like additional information on this issue or other corporate challenges, please contact Paul D. Creme.

Paul D. Creme is an attorney with Hamblett & Kerrigan PA. His practice is focused on business and corporate law. Of particular interest are the areas of software and emerging technologies. You can reach Attorney Creme at [email protected].