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Fundraising & Securities Compliance

New businesses often face one overwhelming obstacle: access to capital. Private lenders tend not to be willing to make loans to new startups, and often require personal guarantees from the business owner. Government loans such as those from the Small Business Administration likewise come with strings attached and may not be available. Friends and family might be willing to lend without these conditions, but can rarely offer enough funding to build a business from scratch.

How Can I legally Raise Money?

One potential solution is to issue securities – ownership shares in a business or specific assets like oil and gas wells – to raise funds from investors.  While securities normally must be registered (and extensive disclosures made), the Securities and Exchange Commission (SEC) and Texas State Securities Board (TSSB) offer certain limited exemptions to this requirement. Some SEC exemptions, called “Rule 506” exemptions, allow some sales of securities to be made to a limited number of buyers without being registered – but only under strictly-limited conditions.

 

Some cost-conscious entrepreneurs use form disclaimers to try and claim these exemptions, seeking to avoid registering with the government until after their business is funded. What they forget is that the government just has to show you made unregistered sales – you must prove you had an exemption. This reversal of the usual burden of proof can result in unprepared sellers of unregistered securities being fined, sued, and even imprisoned.

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If you fail to provide proof of exemptions, you could face legal repercussions. 

First, exempt sales of securities can only be made by “issuers” (entities selling securities) to accredited investors in most cases.

“Accredited” investors are essentially investors who have the financial ability to absorb the total loss of their investment.

 

For individuals, this means a net worth of $1,000,000 or more (only subtracting negative home equity, and not counting positive home equity), or individual income of over $200,000 for the last two years and reasonable expectations of achieving the same in the year they invest (or $300,000 if using spousal/joint income).

For entities, generally either all its owners must be accredited investors, or the entity must have over $5,000,000 in total assets.​ If your business can confirm that all investors are accredited, then a Rule 506(c) exemption is available.

 

To claim this exemption, you must obtain specific financial documents confirming the investor’s income or net worth. Otherwise, only a Rule 506(b) exemption is available – and taking investors’ word that they’re accredited when they aren’t can cause you legal trouble with investors, as well as regulators.

 

Under the Rule 506(b) exemption, no “general solicitation” can be used – this means that any advertising (print, radio, TV, internet, or otherwise) destroys the exemption. Any attempts to “cold call” or otherwise recruit unknown investors destroys the exemption – any “relationship” between the issuer and the investor must exist before sales efforts begin.What’s more, any seminar or meeting that was generally advertised, and where the securities were offered will also destroy this exemption. The SEC and Financial Industry Regulatory Authority (FINRA) take a very strict view of what counts as “public solicitation” – even educational seminars offered by a company linked to the issuer will count as “public.”

No general solicitation can be used or the exemption is void.

Second, every securities offering – exempt or otherwise – must include a full and accurate disclosure of all material information about the investment.

This effectively means disclosing the same information you would need to disclose if the securities were registered.

 

At a minimum, this typically includes:

  1. How many shares will be sold at what price

  2. Who will profit (including commissions and payments to business owners)

  3. How the funds raised will be used, and in what order

  4. Risks that may occur during the life of the investment and their potential impact; and

  5. The experience and past performance (in other offerings) of key management and employees.​

 

This is far from an exclusive list, and failure to comply may subject you to securities fraud claims by investors as well as SEC, TSSB, or even FINRA investigations.​

Third, Rule 506 offerings are not available to certain so-called “bad actors.”

Essentially, anyone who has been convicted of a securities-fraud violation or is still banned from the securities industry cannot use Rule 506 exemptions; doing so would allow these individuals to sidestep the ban. Moreover, these people cannot own over 20% of the issuer’s securities (including through other entities), help promote the offering, or even serve as an executive or director of the issuer.​

 

As even this brief and non-exclusive overview makes clear, fundraising by selling stock or working interests may be rewarding – but it is hazardous. Skilled counsel familiar with the securities industry can make the difference between a legally-compliant fundraising effort and a decade of failed attempts to contest a regulator’s judgment of violation. 

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