Turning Probabilities Into Realities

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Private Capital Formation

You want to start a business and you have a wonderful plan to make money. All you need is money to get the project started. Where do you get the money? From your friends and family? From investors that you can find by advertising? This is a trap for the unwary.

Most people don’t realize federal and state securities laws (and criminal laws) could land them in lots of trouble. Having experienced securities counsel is absolutely necessary.

Most clients want to raise “private capital.” That means that the offering is being set up as an “exempt” offering (i.e., exempt from registration.) Just because the offering is exempt, however, does not mean that there isn’t work that has to be done. There is a whole separate category of work to get the exemption. Failing to do this work or do it correctly can be disastrous, both from a criminal and financial perspective.

The foundation of the securities laws is the principle that a person may not offer or sell a security that is not either registered or exempt from registration. One exemption from registration is for securities transactions “not involving any public offerings.” This is the exemption upon which most clients want to rely.

The SEC enacted Rule 506 of Regulation D which creates a “safe harbor” when a transaction does not involve a public offering. In other words, if the offering meets the requirements of Rule 506, the offering will Satisfy the exemption from registration. The role of a private placement memorandum is to assist in meeting the requirements of Rule 506. Important to keep in mind is that the burden is on the person offering and selling the securities to prove any exemption he relies upon, so the memorandum provides necessary evidence for that purpose. On a related but different note, it also serves as evidence to defend against any allegations of fraud. It is a separate violation of the securities laws to offer and sell securities by means of an untrue statement of fact. So, it serves these two critical purposes.

One thing Rule 506 prohibits is using any form of general solicitation or general advertising in connection with offering the securities unless you strictly adhere to Rule 506(c). This prohibition is where the phrase “friends and family” comes from. This is not to say that if you offer and sell only to “friends and family” that you meet the Rule 506 requirements. It simply says that offering and selling to “friends and family” (i.e., preexisting relationships) is not using general solicitation or general advertising in your transaction.

Separately, Rule 506 makes a distinction between “accredited” and “nonaccredited” investors. An investor being a friend or family member does not make them an accredited investor. Having a net worth exclusive of the value of your home of $1mm or more, for example, makes a person an accredited investor. Under Rule 506, if an investor does not meet the definition of an accredited investor, that investor must receive certain mandated information and must have a certain level of sophistication.

The memorandum is what provides the necessary information. To restrict an offering only to accredited investors (i.e., to choose not to meet the information requirements in your offering document) is a dangerous proposition. If you are simply wrong about a person’s status (and people do lie about these things), you have lost your exemption and have illegally sold a security. The consequence of this not only is that you’ve committed a felony, but also that you must now offer to refund the investment made by every investor (this is called a rescission offer). As you can see, the downside is huge. Our job is to manage against that downside because, trust us, when clients experience the downside, the regret is overwhelming.

Please contact us today at 713-568-9008 for a consultation on how to legally raise private money.