The a,b,c's of raising capital: Start-up edition

You’ve heard it before: “You need money to make money.” While established companies have the option of obtaining financing from a bank, for most start-ups, that is easier said than done. No operating history, no loan. If your company has reached this point, you may be considering a private offering.

In a private offering, you offer potential investors an ownership interest in your company, typically in the form of common stock, in exchange for money. You can control what rights accompany the stock, what price you charge for the stock, how many shares you are willing to offer, and who you offer it to. Unlike debt financing, equity financing does not require you to pay your investors back. Instead, you give the investors a right to participate in the management of the company and receive dividends as it grows. If you carve out a majority ownership interest for you and/or your other founders prior to the offering, you will retain control of your start-up despite your growing shareholder base.

But we can’t ignore the elephant in the room: securities laws. Enacted as a consumer protection measure, securities law have received the reputation of being an expensive roadblock to corporate fund raising. Used correctly, however, securities laws provide significant assistance to start-ups with minimal compliance costs compared to public companies. In this article, I will discuss some of the most common methods of raising capital without triggering securities laws that require you to register your stock with the Securities and Exchange Commission or undergo ongoing reporting requirements.

Regulation D

“Regulation D” is securities lingo used to refer to a handful of SEC rules published in the Code of Federal Regulations, the U.S. Code’s administrative cousin. The most common Reg D rules are Rule 504, Rule 506(b), and Rule 506(c). These rules distinguish between two types of investors: accredited and unaccredited. An explanation of the distinction is crucial to understanding who you should target for capital.

Accredited investors can be individuals or entities. If your investor is an individual, s/he is generally accredited if s/he has an annual income exceeding $200,000 personally or $300,000 with his/her spouse. In the alternative, s/he may have a net worth of at least $1 million, not including his/her primary residence to qualify. Notwithstanding, if your investor is an officer or director of your company, s/he is automatically considered accredited regardless of his/her net worth. If your investor is an entity or trust, it should generally have over $5 million in assets to be considered accredited.

Unaccredited investors are everyone else. These investors are not officers or directors in your company and they do not have a significant income or net worth. If they are a business, they are

typically a small business. The SEC rules favor accredited investors because they can absorb more risk.

Rule 504

If your company needs to raise less than $5 million in the next 12 months from more than 35 unaccredited investors, this is probably the exemption for you. Rule 504 allows you to sell to an unlimited number of investors, regardless of whether they are accredited or not and what state they live in. Your ability to advertise your offering under this rule is limited, so it is best used when you have investors in mind. Resale of securities offered under Rule 504 is restricted.

Rule 506(b)

Unlike Rule 504, Rule 506(b) caps the number of unaccredited investors that can buy your stock to 35 persons. Like Rule 504, Rule 506(b) prohibits advertising and the resale of securities sold under this rule is restricted. Yet, Rule 506(b) remains one of the most popular ways to raise capital because there is no limit on the number of accredited investors who can participate in your offering or the amount of money you can raise. In other words, you should offer stock under this exemption if your capital needs exceed $5 million in the next 12 months, your investors are in multiple states, and you don’t anticipate seeking funds from more than 35 unaccredited investors.

Rule 506(c)

Like Rule 506(b), Rule 506(c) allows use to raise an unlimited amount of money and sell to an unlimited amount of accredited investors. Resale is still restricted. However, you cannot sell to unaccredited investors under this rule. Rule 506(c) offsets this negative by permitting general advertising. This exemption is a good fit for a company that needs over $5 million and has to engage in general advertising because they have yet to identify an investor pool.

Local Offering

Your company can also conduct a local offering. This is not a “Regulation D” offering, but it still exempts you from having to register your stock with the SEC. This rule permits sales to an unlimited number of investors in your state, regardless of accreditation and offering amount. Resale is still restricted.

Housekeeping

When your company is ready to conduct a private offering, it should consult its attorney and prepare an offering memorandum. An offering memorandum is the document you deliver to potential investors to relay the details of your offering, the particulars of your business plan, and the disclosures required by securities laws. When investors are ready to purchase, your company

will enter into subscription agreements with them whereby you issue stock, they deliver the purchase price, and you both agree to certain terms.

The article provides an overview of the equity side of the capital raising process and does not account for the nuances that exist in securities laws, other exemptions from registration, or the pros/cons of choosing equity v. debt financing. For example, your company will have to comply with state Blue Sky laws unless it conducts an offering under Rule 506. You will also have to file a Form D with both the SEC and your state securities division under certain exemptions. If you wish to utilize multiple exemptions and conduct multiple offerings close in time, you must take certain steps to ensure your offering is not “integrated” by the SEC, thereby foreclosing your ability to use certain exemptions to avoid registration. Finally, you may want to consider having a shareholder’s agreement in place for new shareholders that specifies their rights, including: preemptive rights, rights of first refusal, put rights, drag-along rights, tag-along rights, and many more.

The Start-up Group understands that the needs of your company differ from corporate giants, which is why we specialize in practical, cost-efficient ways to help you grow quickly. We look forward to assisting you with your capital needs.

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If you have questions about raising capital, please contact the Dickinson Law Firm at (515) 244-2600 to speak with an experienced attorney.

This material is not intended, nor should it be construed or relied upon, as legal advice.  Please consult with an attorney if specific legal information is needed.