One of my clients has a very successful SaaS business with several high-profile clients that he has been cultivating for about a decade. But as is the case with many product-based businesses, as founder, he is the technical brains behind the operations. To take the business to the next level, I suggested he consider finding a business partner with sales and marketing expertise, as he needs both a cash infusion and expertise to expand his offering.
In a subsequent meeting, the client shared that he had attended several events frequented by executives and high-net-worth individuals in an attempt to find and recruit either an active partner or a silent partner so he could hire a sales and marketing director. The discussion raised several red flags in my mind. I could see that his recent actions had the potential to run afoul of the laws that govern the securities industry and are the subject of this blog post.
Security Definition
As a former investment advisor, I know that in the eyes of the U.S. Securities and Exchange Commission (SEC), a security is any financial asset that can be bought, sold, or traded. This includes stocks, partnership interests, or even memberships in a Limited Liability Company (LLC). A key point is that a security is defined as any investment where an investor provides money to a third party, relying solely on profits from the third party’s efforts.
This means that for any investor who invests in your business as either a shareholder of your corporation, a member of an LLC, or a partner in your partnership, the SEC may consider this offering as a security and subject to regulations imposed by the SEC.
Raising capital from investor(s) is a complex issue, specifically in the context of limited liability companies. One of the key elements regarding my client’s situation is, “When is an investment considered a security, and when is it not?” Because SEC rules and documentation are so complicated, even for the former investment advisor that I am, I sought additional clarification from an expert in the field to wrap my head around it.
To gain greater clarity and perspective on this issue before getting back to the client, I sought the counsel of John Lubitz, Esq., a partner with the law firm Practus, which specializes in corporate law and who is a fellow small business counselor with the Small Business Development Center (SBDC).
On the question of when SEC rules apply to raising money from investors, John clarified that:
“When the investor is not actively involved in the business or in control of their investment, it is considered a security and subject to the SEC’s securities regulations.”
John added that:
“If, however, the investor is actively involved in the business, then it is not considered a security.”
So, let’s say that you have an LLC and you get a friend or family member to invest in your business, but they are not actively involved in the business’s decision-making process; you are effectively offering them a security. In this case, John emphasized the importance of providing appropriate disclosures about the risks associated with the investment in order to mitigate potential investor fraud claims in the future if the investment goes bad or the investor becomes disgruntled.
Most LLCs are member-managed entities, meaning that, theoretically, all the members of the LLC are responsible for the business’s day-to-day operations. Therefore, in this situation, their investments in the business would not be considered a security. However, if the LLC is a manager-managed entity and a member is merely an investor, such as the founder’s parents, which I see quite often, and they are not involved in the business’s operation, technically, the business has offered them a security.
John stressed that the courts often make these decisions on a case-by-case basis.
The Role of SEC
The SEC is the Federal agency that oversees how a business can raise capital from investors. The primary goal of the SEC is to protect the general public from bad actors. As a result, they have established several rules governing the issuance of a financial interest in a business to protect the less sophisticated investor from being swindled by a fast-talking con artist.
Accredited vs. Non-Accredited
Not all investors are created equal. The sharks on the popular TV show Shark Tank are sophisticated investors and know how to analyze an offer. However, most people are not as sophisticated as the sharks when it comes to making their own investment decisions. As a result, the SEC categorizes investors into two broad categories: Accredited and Non-Accredited.
An accredited investor has either a net worth of at least one million dollars, excluding the value of their primary residence, or an annual income of over $200,000 for a single individual or $300,000 with a spouse or partner in the last two years. The SEC figures that an accredited investor is savvy enough to be able to determine if an offering is a wise investment or not.
Any investor who fails to meet the accredited investor threshold is considered a non-accredited investor. As previously stated, the primary goal of the SEC is to protect non-accredited investors from an unscrupulous predator looking to make a fast buck off an unsophisticated investor.
The key point is that a business has far greater latitude when working with accredited investors than with non-accredited ones. As such, the SEC has promulgated a set of rules to protect the less sophisticated non-accredited investors. However, outright prohibiting a private business from raising capital from non-accredited investors has many negative consequences, such as locking them out of the potential financial gains many accredited investors have used to generate wealth.
Registered vs. Unregistered Securities
Some securities are registered, allowing the issuing business to offer them to a broader audience. Other securities are offered as private placements and are not offered to the general public and, as such, do not require registration. Registered securities can be traded publicly and are often found in brokerage accounts and traded on the stock market. Offering registered securities is generally out of reach for all but very large businesses. That said, most small to medium-sized businesses have acquired investors via what are known as private placements, which are securities that do not require formal registration with the SEC, provided certain rules are followed.
Registering a security with the SEC is prohibitively expensive and time-consuming for a small business, so the SEC has carved out a few exceptions regarding the need to register a security.
Regulation D (Reg D) is an SEC regulation that allows companies to sell securities without registering with the SEC. It’s also known as a private placement exemption.
Reg D provides for exemptions from SEC registration requirements. It allows companies to raise capital by selling securities to investors without filing a full registration statement with the SEC. Reg D contains three rules, 504, 505, and 506; however, most private placements are conducted according to Rule 506.
Rule 506 is considered the Safe Harbor provision and allows for private placement (exempt from registration) under Reg D. Within Rule 506, there are two exemptions, 506(b) and 506(c).
Rule 506(b) allows companies to offer securities to an unlimited number of accredited investors and up to 35 non-accredited investors but prohibits general solicitation.
Rule 506(c) allows companies to offer securities to an unlimited number of accredited investors and allows for general solicitation but prohibits non-accredited investors.
In our discussion, John highlighted that under Reg D, while there are minimal disclosure requirements, it’s highly beneficial to make disclosures about the risk or the investment. Issues often arise if a partner, member, or shareholder feels deceived by the security offer and decides to take action. Generally, only a complaint attracts the attention of the SEC since most private placements are self-regulated until there is an issue.
Form D
Technically, private placements require the entity to file a Form D with the SEC if they offer a security.
A Form D includes:
The company’s name, address, directors, and executive officers
The size of the offering
The date of first sale
The use of proceeds
The principals of the company
How much money the fund raised
The types of investments the fund will invest in
Who is in charge of the fund
Related persons so the SEC can check their credentials
The process to file an online Form D requires that you create an account on EDGAR (Electronic Data Gathering, Analysis, and Retrieval system) to get an access code and CIK (Central Index Key) so you can complete the Form D. Here is a copy of the SEC Form D in pdf form. In most cases, you will want to have your business lawyer assist you when filing your Form D.
John emphasized that the first filing for investment matters needs to be made within 15 days of the entity receiving its first investment, with subsequent filings due 30 days apart until the investment is closed.
John added that companies going public face additional scrutiny. Moreover, companies undergoing a merger or acquisition may also face additional scrutiny during due diligence activities, especially if the purchasing entity is a public company. John mentioned that while there are specific penalties for not complying with other aspects of securities law, there are no penalties for failing to file a Form D. For the most part, filing a Form D provides transparency, which is invaluable for gaining investor trust and avoiding potential lawsuits from investors if things go bad.
General Solicitation
A general solicitation is the act of publicly advertising a capital raise to a broad audience. It can include any communication or activity that “arouses public interest in the issuer or its securities.”
According to the SEC, only registered securities and private placements governed by Rule 506(c), available to accredited investors only, can be offered to the general public via a general solicitation. However, private placements offered under Rule 506(b), which makes the investment available to non-accredited investors, require a pre-existing relationship between the business or person offering the security and the investor; therefore, general solicitations are not permitted.
Said another way, if you are raising money from only accredited silent partners, you can do a general solicitation. On the other hand, if you are raising money from accredited and non-accredited silent partners, you cannot use any form of general solicitation to bring awareness to your offer.
Since securities offered under Rule 506(b) require investors to have a prior relationship with the issuing company, I asked John what constitutes a prior relationship. He replied that while there is no hard and fast rule, at least 60 to 90 days is generally a good rule of thumb.
While the guidance from the SEC as to what constitutes a general solicitation is somewhat ambiguous, some often-cited examples include:
Social Media Campaigns: Engaging potential investors through platforms such as LinkedIn, Twitter, or Facebook to create awareness about the investment opportunity.
Public Speaking Engagements: Participating in conferences, webinars, or public events to present and promote an investment opportunity in your business.
Crowdfunding Platforms: Leveraging crowdfunding websites to reach a broader audience and attract smaller individual investors.
Email Campaigns: Sending targeted emails to a list of potential investors to inform them about the opportunity to invest in your business.
Advertisement in Publications: Placing advertisements in newspapers, magazines, or online publications to increase the visibility of your investment opportunity.
Because navigating SEC rules and regulations can be complicated, John underscored the importance of having a business lawyer for all investment-related matters.
Are you in compliance with SEC rules?
The advice and opinions provided in this post are for informational purposes only and do not constitute legal advice. It is recommended to consult with a qualified legal professional for specific legal concerns or issues.
