Many founders I speak with are interested in obtaining
financing for their businesses first from their friends and family members, and
then from professional investors. I agree, this seems to be the common path.
However, many founders do not realize the importance of complying with
applicable federal and state securities laws when asking friends and family for
Typically, a friends and family round of financing can be done by either
issuing stock to investors in exchange for their money or by giving them a
promissory note (typically convertible into equity). If friends and family
members receive stock, no matter how small their investment is, it is likely to
be deemed a securities offering. The definition of what constitutes a security
is very broad. Courts have determined, for example, that an investment contract
can be a security, if a person invests his or her money in a common enterprise
with an expectation of profit derived solely from the efforts of others. There
is no requirement to issue formal certificates to such investors. So, if a
founder's friend invests in the startup but does not partake in actively
running it, his or her contract with the startup is probably a security.
A promissory note may also be a security. Under the Securities Act, promissory
notes are defined as securities except for notes with maturity of less than 9
months. There are numerous exceptions to this general rule. Here is a great discussion of whether a promissory note is a security. To summarize, the question of whether a
promissory note is a security turns on whether the note looks like a security
and whether the selling of the note looks like a securities offering. Factors
to consider include the number and sophistication of the investors/lenders,
whether the note is collateralized, whether the investors/lenders are also
owners of the business they are lending money to, etc. It is likely that in a
family and friends round of financing, where the business is raising money for
its general operations, and the investors are investing with an expectation of
return, the promissory note will be deemed to be a security.
Every offering of securities has to be either registered with the Securities
and Exchange Commission or comply with one of the applicable exemptions from
registration. Regulation D is where the most commonly used exemptions are
The most frequently used rule under Regulation D is Rule 506 that allows
unlimited amount of securities to be issued to an unlimited number of
accredited investors AND up to 35 sophisticated non-accredited investors. Accredited
investors' definition includes individuals who have (i) a net worth (or joint
net worth with his/her spouse) that exceeds $1 million at the time of the
purchase (not including the value of the primary residence); or (ii) income
exceeding $200,000 in each of the two most recent years (or joint income with a
spouse exceeding $300,000 for those years) and a reasonable expectation of such
income level in the current year. If the founders' friends and family members
who are willing to invest are all accredited investors, then the compliance is
quite simple: there is no need for extensive disclosure, although some
disclosure is still recommended. The offering then must be conducted without
general solicitation or advertising; issued securities are restricted, and the
company must file a Form D with the SEC within 15 days of the first sale of
If, however, not all of the investors are accredited, founders need to provide
more disclosure to the investors, including a full-blown private placement
memorandum, risk factors and financial statements. Also, note that all
non-accredited investors in a Rule 506 offering must be sophisticated, which
means that the company must reasonably believe that non-accredited investors
(either alone or together with their investment representatives) have
sufficient financial and business knowledge to allow them to evaluate the risks
and merits of an investment. Regulation of Rule 506 offerings is preempted by
federal laws. States can generally only require a notice and a filing fee but
cannot impose their own regulations. Most states ask for a copy of Form D
(which the companies have to file with the SEC within 15 days of the offering)
and a fee (typically, about $300). Of course, regulation varies by state, and
about five states require pre-filing.
The problem arises when the founders' friends and family members are not
accredited and not sophisticated. What can startup founders do then?
They can resort to Rule 504 of Regulation D that allows to raise up to $1
million from non-accredited and non-sophisticated investors. Compliance with Rule 504 is more
difficult, it involves preparation of complex and costly disclosure statements.
Unlike Rule 506 offerings, state securities laws regulate Rule 504 offerings
and the amount and type of disclosure that needs to be provided.
Many securities lawyers will not represent a company that is conducting an
offering of securities to non-accredited investors because of the high risks
involved. Some professional investors will not invest if the company has
non-accredited investors. If challenged, the offering will raise problems when
the company is conducting a round of VC financing, being sold, or is doing an
IPO. At the IPO process, the Securities and Exchange Commission will study all
prior equity issuances by the company and ask the company to cure any
deficiencies or violations of securities laws, which can delay or even kill the
In conclusion, it is advisable that founders obtain their friends & family
financing only from accredited investors. Although raising funds from
non-accredited and non-sophisticated investors is possible, risks involved in
dealing with such investors often outweigh the benefits of receiving such
Please note this is not a legal advice, but for informational purposes only.
Read more commentary from Arina Shulga on the
legal aspects of operating new and growing businesses at Business Law Post.
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