The pivot point of large scale funding…
Note: This chapter is specific to the rules and regulations of the United States. Canadian regulations are similar. For companies operating in other countries, your rules will vary.
First, a few key terms from the laws and regulations:
- “Securities” are any shares (a.k.a. equity) or loans (a.k.a. debt) sold by a company to investors.
- “Public” companies are listed on the public stock exchanges, e.g., the New York Stock Exchange or NASDAQ.
- Shares in public companies are “registered” with a regulatory body.
- “Private” companies are all other companies, including all startups; shares in these companies are “unregistered.”
- When you attempt to sell shares in your company, public or private, we say you are making an “offering” to investors.
In the 1930s and early 1940s, as a response to the 1929 stock market crash and Great Depression, the United States passed a series of securities laws, creating the Securities Exchange Commission (SEC) to protect investors from fraudulent entrepreneurs. These rules and regulations severely limited who is allowed to invest in private companies.
In general, the regulations are written as if all companies would register their shares with the U.S. Securities Exchange Commission and sell those shares on a stock exchange. In reality, the process to do that is far too expensive for most companies, costing at least hundreds of thousands of dollars, with those fees paid before their being allowed to sell the first share.
Instead, most startup companies rely on a series of exemptions to the regulations, which allow unregistered shares to be sold, but which set limits on the types of investors allowed to participate in these private offerings.
Accredited Investors
Specifically, Rule 501 of the Securities Act of 1933 limits the sale of securities to “accredited” investors.
The definition of “accredited” has been updated a few times. As of 2016, an accredited investor is roughly defined as an individual who earned at least $200,000 over the past two years or who has $1 million or more in net assets.
For the specific definition, see: www.sec.gov/answers/accred.htm.
It is estimated that five to six percent of Americans qualify under this definition as accredited. Of these, it is estimated that less than half have ever made an investment in a startup. Thus, in reality, this requirement restricts entrepreneurs to two to three percent of the population to find funding for their startups.
Solicitation
These regulations also limit what the SEC calls “solicitation.” Until 2013, it was illegal for private companies to advertise their fundraising offerings in any manner, including the fact that they were fundraising at all. Under many of the regulations, this continues to be the case.
The 2012 JOBS Act created an exemption which does allow for solicitation of private offerings, but, for companies using that exemption, new regulations were added, making it far more difficult to prove that investors are in fact accredited. Furthermore, the SEC has published a set of proposed rules which would make solicitation more difficult, requiring all advertisements to be registered with the SEC before they are used.
With or without the changes to the rules, a big issue is that the SEC has never clearly defined what is and what is not counted as solicitation.
Talk to a Lawyer
In short, the rules are highly complex. If you are planning to raise funding from anyone, talk to a lawyer before you begin. Ask them about the various options, and make your own decisions on what works best for your company.
And to keep up with the changes in regulations or for far more details on private offering exemptions, read the Startup Law Blog at startuplawblog.com.
