Common Exemptions That Allow You to Raise Money Without an IPO. By Mary Hull, Partner, Stoel Rives LLP. March 7, 2014

Transcription

1 Common Exemptions That Allow You to Raise Money Without an IPO I. BACKGROUND By Mary Hull, Partner, Stoel Rives LLP March 7, 2014 If a start-up wants to issue securities, the start-up must comply with both federal and state securities laws. A. General Rule Registration Required Generally, under federal law, all offers and sales of securities must be registered, unless an exemption from registration applies (Section 5 of the Securities Act of 1933, as amended (the Act )). Section 12(a)(1) of the Act provides a private remedy for registration violations. Under Oregon law, all offers and sales of securities in Oregon must be registered, unless an exemption from registration applies (ORS ). ORS provides a private remedy for registration violations. Offers and sales of securities in other states must also be registered, unless an exemption from registration applies. B. Material Misstatements or Omissions Under federal law, a start-up may not sell securities by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. Securities and Exchange Commission ( SEC ) Rule 10b-5 promulgated under the Securities Exchange Act of 1934, as amended (the 34 Act ). This is generally true regardless of whether the securities themselves or the securities transactions are exempt from the registration requirements of the Act. Generally speaking, a private right of action exists for SEC Rule 10b-5 violations. ORS is similar to SEC Rule 10b-5. Oregon securities, or blue sky, law provides a private right of action for violations of ORS ORS (1)(b). C. Enforcement The SEC may bring actions for violations of Section 5 of the Act (Section 20 of the Act). The SEC may also bring actions for violations of SEC Rule 10b-5 (Section 21 of the 34 Act). Oregon may bring actions for violations of Oregon securities laws. ORS There may also be criminal enforcement of federal and state securities laws

2 II. COMMON EXEMPTIONS FROM FEDERAL REGISTRATION REQUIREMENTS A. Rule 506 Rule 506 is a Regulation D safe harbor exemption promulgated by the SEC under Section 4(a)(2) of the Act. 1. Rule 506(b) - Conditions to Be Met a. No more than 35 unaccredited investors in the offering. There must be no more than, or the start-up must reasonably believe there are no more than, 35 purchasers of securities in the offering. Accredited investors are not counted as purchasers. Generally, an accredited investor is a person or entity that is at least one of the following: o A corporation, partnership or limited liability company, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000, o A director or executive officer of the start-up. For this purpose, executive officer means the president; any vice president in charge of a principal business unit, division or function, such as sales, administration or finance; or any other person or persons who perform(s) similar policymaking functions for the start-up. o A natural person whose individual net worth, or joint net worth with his or her spouse, exceeds $1,000,000. For this purpose, net worth means the excess of total assets at fair market value (including personal and real property, but excluding the estimated fair market value of a person s primary home) over total liabilities. Total liabilities exclude any mortgage on the primary home in an amount of up to the home s estimated fair market value as long as the mortgage was incurred more than 60 days before the securities are purchased, but includes (i) any mortgage amount in excess of the home s fair market value and (ii) any mortgage amount that was borrowed during the 60-day period before the closing date for the sale of securities for the purpose of investing in the securities. o A natural person who had individual income exceeding $200,000 in each of the last two calendar years and has a reasonable expectation of reaching the same income level in the current calendar year. For this purpose, a 1 Although not specified in the list of organizations in SEC Rule 501(a)(3), a limited liability company may be treated as an accredited investor as defined in that rule if it satisfies the other requirements of the definition. See interpretation number 7 under section E (Regulation D and Rule 701) of the SEC Manual of Publicly Available Telephone Interpretations

3 person s income is the amount of that person s individual adjusted gross income (as reported in a federal income tax return). o A natural person who had joint income (as defined above) with his or her spouse exceeding $300,000 in each of the last two calendar years and has a reasonable expectation of reaching the same income level in the current calendar year. o Any entity in which all of the equity owners are accredited investors. SEC Rule 501(a) of Regulation D. b. Nature of purchasers (unaccredited investors may need a purchaser representative ). Each purchaser who is not an accredited investor, either alone or with his or her purchaser representative(s), must have such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the prospective investment (or the start-up reasonably believes immediately prior to making any sale that such purchaser comes within this description). c. Integration. A start-up cannot avoid the registration requirements of the Act by purportedly conducting separate offerings that are in substance a single offering. For example, a start-up cannot sell Series A Preferred Stock at $1.00 per share to 35 unaccredited investors in a single closing and treat that as one Rule 506 offering and then, in a subsequent closing two weeks later, sell Series A Preferred Stock at $1.00 per share to a new unaccredited investor and call that a new Rule 506 offering. Because the two offerings would, under those circumstances, almost certainly be integrated with one another, the separate offerings would be deemed to be a single offering and that single offering would not meet the requirements for the Rule 506 exemption (because there have been sales to more than 35 unaccredited investors in the offering). The five factors used for determining whether offerings should be integrated can be found in the note to SEC Rule 502(a). Note that there is a six-month integration safe harbor: offers and sales made more than six months before the start, and more than six months after the completion, of a Regulation D offering are not typically integrated with each other. See SEC Rule 502(a). d. Information requirements. Unaccredited investors must get prospectus-like information, including at least an audited balance sheet. e. No general solicitation or general advertising. Neither the start-up nor any person on its behalf may offer or sell the securities by means of any general solicitation or general advertising. f. Limitations on resale. Generally, the start-up must (a) make reasonable inquiry to ensure that each purchaser is acquiring the securities for himself or herself and not for other persons, and (b) inform each purchaser prior to sale that the securities have not been registered and cannot be resold unless they are registered or an exemption is available (and place a legend to that effect on the stock certificate or other document evidencing the securities). These matters are usually covered by representations and warranties given by the purchaser to the start-up at closing

4 g. No bad actors. Generally, the start-up should obtain a completed questionnaire from the following persons indicating that the person is not subject to any disqualifying events (which generally pertain to convictions or court or administrative sanctions for securities fraud or other violations of specified laws): The start-up itself, any predecessor entities and any affiliated issuers Any director or executive officer of the start-up or other officer of the start-up who participates in the offering Any beneficial owner of 20% or more of the start-up s outstanding voting equity securities, calculated on the basis of voting power Any promoter connected with the start-up in any capacity at the time of the sale of securities Any person who has been or will be paid remuneration for solicitation of purchasers in connection with the sale of securities (a compensated solicitor ); and any director, executive officer, general partner or managing member of, or any other officer participating in the offering of, any such compensated solicitor 2. Rule 506(c) a. Conditions to Be Met. (1) Integration. See discussion under Section II(A)(1)(c) above. (2) General solicitation and general advertising is permitted, so long as sales are made only to accredited investors and the start-up takes reasonable steps to verify that each purchaser is accredited. The start-up cannot simply rely on an accredited investor questionnaire to determine whether a potential purchaser is accredited the start-up must do more than that (e.g., obtain tax returns, bank statements, written confirmation from the potential purchaser s attorney or CPA, etc.). See SEC Rule 506(c)(2) for steps that will be deemed to be reasonable. (3) Limitations on resale. See discussion under Section II(A)(1)(f) above. (4) No bad actors. See discussion under Section II(A)(1)(g) above. b. Proposed SEC Rules. Currently proposed amendments to Regulation D would impose additional requirements. 3. Form D Requirement A notice on Form D must be filed electronically with the SEC no later than 15 days after the first sale of securities in the offering. Amendments to previously filed notices on Form D are required under the circumstances set forth in SEC Rule 503. Currently proposed amendments to Regulation D would expand Form D filing requirements in an onerous way and would impose harsh penalties for failure to comply

5 B. Rule 504 This is a Regulation D safe harbor exemption promulgated by the SEC under Section 3(b) of the Act. See footnote 5 to SEC Release No General Generally, a start-up can use Rule 504 to offer and sell up to $1,000,000 of its securities in any 12-month period. Rule 504 allows a start-up to offer and sell its securities to an unlimited number of purchasers without regard to whether they are accredited or whether they are sophisticated (i.e., have such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risks of the prospective investment). There are no specific information requirements. 2. No Preemption The Rule 504 exemption is not as useful as the exemptions provided by Rule 506(b) and Rule 506(c) because, unlike with respect to securities sold in Rule 506(b) and Rule 506(c) transactions, securities sold in a Rule 504 transaction are not covered securities. 2 With respect to covered securities, generally, states may require start-ups to make notice filings and pay certain fees, but states cannot require registration. See Section 18 of the Act, which was amended pursuant to the National Securities Markets Improvement Act of 1996 ( NSMIA ). So, while a start-up may meet the requirements for the Rule 504 exemption with respect to a particular offering, the offering will not have the benefit of preemption of state law that NSMIA affords. State law exemptions for a Rule 504 offering may not exist or may contain onerous requirements. C. Intrastate Exemption III. SEC Rule 147 provides an exemption from federal registration requirements for offers and sales by an issuer only to persons resident within the state where the start-up is incorporated and doing business within the meaning of the rule. Certain other requirements pertaining to resale restrictions also apply. This exemption is of limited utility, of course, because it does not allow for sales to out-of-state purchasers. COMMON EXEMPTIONS FROM STATE REGISTRATION REQUIREMENTS A. Oregon If a start-up is based in Oregon and wants to issue securities, the start-up needs to comply with Oregon blue sky law and also the blue sky law of each state in which a purchaser is located. 2 Note that securities issued in Rule 506(c) offerings are deemed to be covered securities for purposes of Section 18(b)(4)(E) of the Act only by virtue of Section 201(a)(1) of the JOBS Act. See SEC Release No ; No

6 1. Sales to Accredited Investors ORS (5) exempts from Oregon registration requirements any transaction by a start-up with an accredited investor, but only if there is no public advertising or general solicitation in connection with the transaction. This is a self-executing exemption (no filing with the state of Oregon is necessary to take advantage of the exemption). OAR in 12 Exemption ORS (12) exempts from Oregon registration requirements any transactions in securities by a start-up that result in not more than 10 purchasers within Oregon during any consecutive 12 months. Accredited investors do not count as purchasers for this purpose (so you do not need to count them against the 10- purchaser limit). Repeat transactions with the same purchaser during a 12-month period do not increase the number of purchasers (each purchaser is counted as one purchaser for the 12-month period). No commission or other remuneration can be paid, and no public advertising or general solicitation can be used, in connection with the offering. This is a self-executing exemption. OAR Federal Covered Securities: Rule 506 Offerings B. California For a SEC Rule 506 offering, the start-up must, within 15 days after the first sale in Oregon, file a completed Form D (including the state signature page) with the Oregon Securities Division, and pay a $250 filing fee. See ORS (3), OAR , OAR (4). 1. Section (d) of the California Corporations Code For a SEC Rule 506 offering, the start-up must, within 15 days after the first sale in California, file with the California Department of Business Oversight a copy of the version of Form D filed with and accepted by the SEC, and pay a $300 filing fee. See Section (d) of the California Corporations Code; Release No. 120-C, Preston DuFauchard, Commissioner of Corporations, and Colleen E. Monahan, Deputy Commissioner, California Department of Corporations, Section 25102(f) of the California Corporations Code Section 25102(f) generally exempts from California registration requirements any offer or sale of a security in a transaction that meets each of the following criteria: Sales of the security are not made to more than 35 unaccredited investors, including persons outside California (see Section 25102(f) and Rule under the California Corporate Securities Law of 1968); All purchasers must have either a preexisting personal or business relationship with the start-up or any of its officers, directors or controlling persons, or, by reason of their business and financial experience or the business or financial experience of their independent professional advisers, could be reasonably

7 assumed to have the capacity to protect their own interests in connection with the transaction; Each purchaser represents that the purchaser is purchasing for the purchaser s own account and not with a view to distribution; and The offer and sale must not be accomplished by any form of general solicitation or general advertising (see Rule (j) under the California Corporate Securities Law of 1968). Notice filing requirements apply. If in connection with the transaction, the start-up is filing a Form D with the SEC, then the notice to the California Commissioner of Business Oversight may be a copy of the filed Form D. The start-up must include with the filing a Form U-2 Consent to Service of Process (unless the start-up is a California corporation or already has a Form U-2 on file with the Commissioner). An appropriate cover letter must accompany the filing. A fee must also be paid. The filing must be made and the fee paid no later than 15 days after the first sale of a security in the transaction in California. See Rule (a) under the California Corporate Securities Law of As an alternative to filing the Form D with the Commissioner, the start-up may file with the Commissioner electronically a notice in the form prescribed by Rule under the California Corporate Securities Law of C. Washington The filing requirements for an offering exempt under SEC Rule 506 are a copy of the Form D filed electronically with the SEC, a check for $300 made payable to the Washington State Treasurer, and an indication of the date of first sale in Washington or that sales have yet to occur in Washington (which may be included in a cover letter). These items are due within 15 days after the first sale in Washington in accordance with WAC A-503(1)(a)(i)(A)