16 Nov Securities compliance is part of raising capital
For most people, a natural biological response to the phrase “securities law requirements” is the formation of a thin, opaque film over the outside of the cornea wall, coupled with a dull look and slumping shoulders. To avoid this, I will do my best to stick to the essentials. As a result, however, this article is far from comprehensive. So if your company is raising capital, it is important to contact an attorney who is familiar with securities laws early so that he or she can guide you through the process.
In connection with a private offering, there are generally two areas of concern related to securities law compliance: the anti-fraud requirements and the exemption from registration requirements. Fraud in the securities law context covers not just “lies” and intentional deception, but also covers material disclosures that are unintentionally misleading, and inadvertent omissions of something that would likely be an important part of an investor’s decision on whether to invest. While the anti-fraud requirements should never be overlooked, the focus of this article is on the latter requirement: that is, exemptions from the registration requirements.
Federal and state Blue Sky laws
Both the federal and the applicable state(s) securities laws (“Blue Sky” laws) have requirements for issuers of securities. Any time a company issues securities, such as stock, the securities must be registered as part of a public offering, or the issuance must qualify for an exemption from registration. Once a company issues registered securities, it will be required to act as a “reporting company,” subject to the various public disclosure requirements. So, whenever a prudent privately held company wants to issue its securities, but not become a public company, it ensures that the proposed issuance qualifies for one or more federal and state exemptions.
There are certain “super” exemptions under federal law that pre-empt state law requirements. If your company qualifies for one of these federal exemptions, there is virtually no need to be concerned by the state exemption requirements, except for simple filing or other minor requirements.
One commonly used super exemption is Rule 506. Below are some of its requirements:
• As with most other exemptions, the offering cannot involve a general solicitation or advertising to market the securities.
• While a company can sell its securities to an unlimited number of “accredited investors” (e.g., venture capital funds, individuals with more than $1 million in assets or more than $200,000/year income over two years, or $300,000 when combined with spouse), it is limited to 35 sophisticated investors who are not accredited.
• If there are any investors who are not accredited, there are numerous specific disclosure and other requirements, including audited financial statements in most contexts.
Rule 506 is beneficial in that a company in compliance with the rule can raise an unlimited amount of capital and still qualify for the exemption. Purchasers, however, still receive “restricted” securities, which they may not freely trade in the secondary market after the offering.
Once Rule 506 is complied with, most states where the securities are sold only require that a notice Regulation D filing be submitted along with a filing fee.
Not all offerings qualify for one of the super exemptions. Generally, with proper planning though, it is not a problem. For example, consider this common situation. A seed-stage company wants to raise $500,000 from friends and family. It is likely that, at the federal level, the offering would qualify for an exemption under Rule 504 since the offering is for less than $1 million. It may also be exempt from the federal registration requirements under Section 3(a)(11) of the Securities Act – if all the “offerees” are residents of the same state in which the issuer is incorporated.
However, neither Rule 504 nor Section 3(a)(11) is a “super” exemption in the sense that they pre-empt state laws, so the offering must also qualify for an exemption under the relevant state’s Blue Sky laws.
Common exemptions in Wisconsin and Illinois
In Wisconsin, a common exemption is Section 551.23(10). The following are the main requirements for this exemption: (1) the issuer must have its principal office in Wisconsin; (2) the aggregate number of persons holding directly or indirectly all of the issuer’s securities, after the securities to be issued are sold, cannot exceed 25 (excluding accredited investors); (3) no commission or other remuneration can be paid or given directly or indirectly for soliciting any person in Wisconsin, except to broker-dealers and agents licensed in Wisconsin (see my discussion on the use of finders); and (4) no advertising unless permitted by the state securities division.
In Illinois, pursuant to § 5/4(G) of the Illinois Securities Law of 1953, companies generally can avoid registration of its securities if (1) the aggregate sales in the preceding year are not made to more than 35 residents of Illinois or do not exceed $1 million; (2) no general solicitation or advertising in Illinois has occurred; and (3) no commission or other remuneration exceeding 20 percent of the sale price of the securities is paid. There are also a few other minor requirements, such as filing a notice with the state and a filing fee.
Complying with securities laws is not difficult if a good offering plan is put in place prior to commencing the offering. While attorneys are far from inexpensive, using an attorney familiar with securities law requirements early in the offering process will likely save money and reduce the risk of a bad offering in the long run.
Previous articles by Matt Storms
• Matt Storms: Raising capital through placement agents
• Due diligence and corporate clean-up
• Matt Storms: The mechanics of raising capital for your business
• Sarbanes-Oxley for the Rest of Us
• SBIR/STTR Programs: Free Money or an Invitation to Governmental Bureaucracy
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of the Wisconsin Technology Network, LLC (WTN). WTN, LLC accepts no legal liability or responsibility for any claims made or opinions expressed herein.