Raising Capital? 3 Tips for Entrepreneurs (Part 3)

by Scott Edward Walker on October 20th, 2011

I’ve been helping entrepreneurs raise capital as a corporate lawyer for 17+ years, and there are certain fundamental legal mistakes that I’ve seen entrepreneurs repeatedly make.  Accordingly, I thought it would be helpful to share three tips for entrepreneurs in connection with raising capital.  This is part three of a three-part series, which was  originally published on The Huffington Post.

Tip #1: Do Not Advertise or Solicit Investors.  Subject to certain limited exceptions, companies are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities.  These terms have been broadly construed by the U.S. Securities and Exchange Commission (SEC) and, accordingly, many entrepreneurs get trapped in the SEC’s wide net.

Indeed, “advertising” includes not only the traditional definition – e.g., newspaper ads, radio ads, banner ads, etc. – but also blog posts, articles and other publications publicizing the offering of a company’s securities.

Moreover, the term “general solicitation” is even trickier and includes any offer to sell securities via mail, e-mail or other electronic transmission unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor.

A relationship is deemed “substantive” if the company (or a person acting on its behalf) has reliable knowledge or information regarding the prospective investor such that it can evaluate the investor’s financial circumstances and sophistication.  In other words, the nature and quality of the relationship must be such that the company (or a person acting on its behalf) can determine that the person receiving the offer would be a suitable investor.  To be “pre-existing,” the relationship must be in place prior to the offer.

Accordingly, spam emails or solicitations via Twitter, Facebook or LinkedIn are all prohibited by the SEC because the offer would be reaching persons with whom the issuer (or the person acting on behalf of the issuer) does not have a substantive, pre-existing relationship.  (Note: Congress and the SEC are currently weighing a crowdfunding exemption which may permit “general solicitations” in certain limited circumstances.)

Tip #2: File a Form D with the SEC and Applicable State Commissions.  As I discussed in part one of this series, the rule of thumb in connection with private placements is to offer and sell securities only to “accredited investors” under SEC Rule 506 of Regulation D.  What many entrepreneurs forget to do, however, is to file a Form D with the SEC and applicable State securities commissions.

Form D is the SEC’s official notice of an exempt offering of securities in reliance upon Regulation D; it requires certain prescribed information with respect to the issuer and the offering, including (i) the issuer’s identity, (ii) its principal place of business and contact information, (iii) the names and addresses of its executive officers and directors, (iv) the specific exemption claimed under the Securities Act of 1933, and (v) most importantly, the identity (and contact information) of any broker-dealer, finder or other person receiving  “any commission or other similar compensation” relating to the sale of securities in the offering.

An executed Form D must be filed with the SEC and each of the applicable State securities commissions in which the offer originated, the offer was delivered or received, and/or any part of the sale transaction took place.  Certain States may also require the filing of a consent to service and the payment of a filing fee.  (The SEC does not charge a filing fee for a Form D notice or amendment.)

As of March 16, 2009, the SEC requires the electronic filing of Form Ds through the SEC’s Electronic Data Gathering, Analysis and Retrieval System (commonly referred to as “EDGAR”).  There is currently no electronic filing with the States.  Accordingly, an issuer must file a Form D with each applicable State securities commission in hard copy.

Tips #3: Limit the Number of Investors. Finally, it is important that entrepreneurs raise money from as few investors as possible.  Why?  Because the more investors a company has, the more likely that one of them will create problems as a minority stockholder.  Indeed, minority stockholders have certain significant rights, including the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company and certain protections against oppression by the controlling stockholders.

Moreover, as discussed in part two of this series, the ideal investor is an experienced, sophisticated angel who can add substantial value through his or her domain expertise and/or rolodex.  If such an investor makes a significant investment, he or she will be there in the trenches when and if things turn sour.  As experienced entrepreneurs understand, this is very important and one of the reasons you try to find a superstar investor and give him or her a great deal to get them on board.

Having a bunch of small, unsophisticated investors is also a nightmare from a practical standpoint – as founders will typically get inundated with daily or weekly emails and phone calls from such investors inquiring as to the company’s prospects and the status of their investment.  OneWire recently touted the fact that it raised $30 million from 101 angel investors.  They will likely learn the hard way what this means in the real world.

Conclusion.  I hope this series has been helpful.  The securities laws are a potential minefield for the unwary, and it is critical that entrepreneurs understand some of the legal basics to capital-raising.  As I have previously discussed, non-compliance with applicable securities laws could lead to severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.


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2 Responses to “Raising Capital? 3 Tips for Entrepreneurs (Part 3)”

  1. Thank you for your post. These topics are very important for executives to understand. There are many companies that need advice like this prior to starting the capital formation process, unfortunately, many don’t… 

  2. Agreed – thanks Patrick