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How Should I Raise Venture Capital and Stay Out of Legal Hot Water: The Do’s and Don’ts of asking people for money

By StartupProgram.com Team

StartupProgram.com

You might not be sure where to start when attempting to raise venture capital. Your questions may include “Can I ask anyone for money?” “Can I advertise that I am looking for VC funding on social media?” “How do I ask?” “Are there any rules?” “Is it OK to ask my friends and family?” Not knowing the answers to these questions can be detrimental if you start accepting money before getting answers.

Entrepreneurs already pay significant legal fees in the process of seeking venture capital funding so it’s in their best interest to not incur any extra fees and expenses simply because they did not know what to avoid. Raising capital by selling an equity interest in your startup is a sale of securities, and that means your capital raising efforts are subject to the rules and regulations of the Federal Securities Act of 1933 (the “Securities Act”), especially its rules regarding the offering and sale of securities and anti-fraud provisions.  Violating these rules could result in the company having to return the investment, or the person who was involved in raising the capital may have to return the investment personally, if the company is not sufficiently liquid. On the most extreme violations, the directors and officers of the company may face criminal charges.

This all sounds terrifying, but it is actually easier to comply with the Securities Act than you might think. For starters, it is best to stick to people in your personal network like friends and family to fund your startup. On the other hand, you should not solicit or cold call people you do not know to ask for money, nor should you advertise on social media that your startup is looking to raise money. In the course of fundraising, it is important to be honest and transparent about your goals and your business to whomever you speak with – being overly optimistic is acceptable, but do not lie or embellish the truth. Below are some Dos and Don’ts when raising money.

DON’T: Be Ignorant of the Law

The Securities Act requires that any offer or sale of securities be registered with the U.S. Securities and Exchange Commission (SEC), unless an exemption exists. Registration means the startup would go through a process of preparing and filing offering documents with the SEC that would be publicly available online. This is a very expensive process that requires you to hire lawyers, accountants and other professionals.  This is generally not an option for a startup, so to avoid this arduous process you will need to find an exemption from registration.

Two of the most common exemptions from registration that startups rely on are the exemptions under Section 4(a)(2) of the Securities Act and the safe harbor rules under Rule 506 of Regulation D of the Securities Act.  We’ll detail these exemptions below, but if you want to understand how to stay out of legal hot water when raising venture capital, you must understand the securities laws rules under Section 4(a)(2) and Rule 506. 

DO: Consider who your investors are 

Section (4)(a)(2) of the Securities Act exempts offers and sales that do not involve a “public offering.”

One of the main factors that has risen out of case law and SEC rulings to determine whether there has been a public offering is investor qualification and whether the investor can “fend for itself” to make a sound investment decision. The SEC wants investors who are sophisticated and have knowledge and experience in financial and business matters, such as qualified institutional buyers. The Courts interpreting Section 4(a)(2) did not provide an easy framework for determining investor qualification, so the SEC adopted a framework under Regulation D that put in place criteria to determine suitable investors, which are known as “Accredited Investors”.  

Accredited investors are institutional investors, registered broker dealers and investment advisors, directors and officers of the issuer (in your case, the startup) and certain natural persons who meet certain net worth or income requirements or who hold certain professional certifications.  The entire list of persons and requirements to qualify as an accredited investor can be found here. 

If you are selling to accredited investors only, you can be pretty confident that you are in compliance with either Section 4(a)(2) or Rule 506.  Both Section 4(a)(2) and Rule 506 allow the startup to raise an unlimited amount of capital with an unlimited number of accredited investors; however, Section 4(a)(2) does not have clear requirements like Rule 506, and so there is more certainty that you have a valid exemption under Rule 506 than if you are relying on the fact-intensive analysis of Section 4(a)(2).  

What if you have a few people who are not accredited investors, but you still want to allow them to invest in your company?  You may be able to rely on Section 4(a)(2), but Rule 506 has two key subsections – (b) and (c) – and 506(c) does not permit offerings that include any investors who are not accredited. Under Rule 506(b), you can raise money from up to thirty-five investors who are not accredited investors, but you will need to make significant disclosures of company and market information prior to their investments and likely provide the same information to the accredited investors so that they are not unfairly prejudiced. 

DON’T: Publicly solicit sale of your stock

Whether you want to rely on Section 4(a)(2) or Rule 506, there can be no general solicitation or general advertising of the offering by the issuer (your startup) or anyone acting on its behalf. An offering or distribution that violates this prohibition is considered to be a public offering of the securities and will require you to rely on a different exemption from registration or a full-blown registration of the securities.

General solicitation and advertising includes, but is not limited to: advertisements, broadcasts over television or radio (internet included), or any seminar or meeting where attendees have been invited by any general solicitation or advertising.  The startup must also reasonably believe that it did not solicit any investor through general solicitation. 

DO: Be TRUTHFUL in all your Pitches

It is important that you be truthful in all of your pitches and be careful not to embellish the truth to a point that you misrepresent the facts the investor relies on in determining whether to invest.  Section 17(a) of the Securities Act sets forth the punishments for fraudulent sales of securities. Section 10b and 10b-5 of the Securities Exchange Act of 1934 also protect investors against fraudulent sales. It is okay to have a rosy outlook on the company’s potential future growth, but it is not okay for you to lie about the current state of affairs or projected growth of the business.  

Furthermore, if you intend to sell to non-accredited investors under Rule 506(b), you must provide non-accredited investors with more robust disclosure statements that you otherwise would not have to provide to accredited investors, including disclosure of information related to your business and the securities in the offering as well as a description of any material information about the offering that is shared with accredited investors.  The form and manner of these disclosures is not codified by law, and varies based on the stage and nature of the investment and securities being offered. 

Conclusion

Selling stock in a startup can seem like an easy way to bring in capital to grow your business, but there are many legal topics to consider before you accept outside investments.  That said, if you review the law first, consider who your investors are, don’t perform a general solicitation, and don’t misrepresent your business to potential investors, raising money can be a huge boost to scale your company to get to the next level.

Note: An issuer is any person who issues, or proposes to issue, a security – typically the startup. 

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