Typically, the first people that start-up founders turn
to for financing are their friends and family. Of course, most friends and
family members are not going to worry about valuations, projections, business
strategies. They invest because of their trust and strong personal ties to the
Actually, friends and family rounds of investing are securities offerings and,
like all other offerings, have to be either registered with the SEC or fall
under one of the exemptions from registration. I want to briefly touch upon two
such exemptions, Rules 504 and 506 of Regulation D. Also, each of these
offerings has to comply with the applicable state securities laws (blue-sky
laws) in each state where the friends and family members reside.
Rule 506 of Regulation D allows a private placement of securities to an
unlimited number of accredited investors and up to 35 sophisticated
non-accredited investors. See description of Rule 506 at
http://www.sec.gov/answers/rule506.htm. 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 securities.
If, however, not all of the investors are accredited, founders will need to
provide a lot 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.
Rule 504 of Regulation D applies to offerings of less than $1 million and
allows such offerings to be made to non-accredited and non-sophisticated
investors so long as the company is not subject to any reporting requirements
of the United States Securities Act of 1933, such as most public companies, and
is not formed solely for investment purposes. Also, the exemption generally
does not allow companies to solicit or advertise their securities to the
public, and purchasers receive "restricted" securities, meaning that
they may not sell the securities without registration or an applicable
Rule 504 does allow companies to sell securities that are not restricted and to
engage in solicitation and advertising if one of the following circumstances is
met (using the SEC description of the Rule at
"(1) The company registers the offering exclusively in one or more states that
require a publicly filed registration statement and delivery of a substantive
disclosure document to investors;
(2) A company registers and sells the offering in a state that requires
registration and disclosure delivery and also sells in a state without those
requirements, so long as the company delivers the disclosure documents required
by the state where the company registered the offering to all purchasers
(including those in the state that has no such requirements); or
(3) The company sells exclusively according to state law exemptions that permit
general solicitation and advertising, so long as the company sells only to
Compliance with Blue Sky Laws
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. For example, New York requires the pre-filing of Form 99
(Notification Form Under NSMIA), a State Notice, a Further State Notice and
Form U-2 if the company has been formed outside of New York. The filing fee in
New York is $300 for offerings under $500,000.
In case of Rule 504 offerings, New York provides an exemption for offerings to
40 or less investors.
More information can be found here.
Non-compliance with applicable securities laws could result in severe
consequences, including a right of rescission for the investors (i.e., the
right to get their money back, plus interest), injunctive relief, fines and
penalties, and possible criminal prosecution.
Please note that this blog is written for general informational purposes only
and does not constitute legal advice or create any attorney-client privilege.
Read more commentary from Arina Shulga on the
legal aspects of operating new and growing businesses at Business Law Post.
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