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Obtaining Investors without Registering with the SEC

There comes a time when many businesses need to raise money to take advantage of growth opportunities. Perhaps your small profitable company or promising start-up wants to attract investors.

Do you have to register with the SEC? It depends. You may be able to qualify for one of several exemptions from federal registration requirements under the Securities Act and the Securities Exchange Act.

The Laws and the History Behind Them

Congress created the Securities and Exchange Commission (SEC) in response to the stock market crash of 1929. The federal agency explains that in the “chaotic securities markets of the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits — without disclosing any meaningful information to investors.”

Today, the SEC administers two primary sets of federal laws that come into play when a company wants to offer and sell securities to the public. They are:

1. The Securities Act of 1933, which generally requires companies to give investors “full disclosure” of all “material facts.” These are the facts important in making an investment decision. This law also requires companies to file a registration statement with the SEC that includes information for investors. The SEC doesn’t evaluate the merits of offerings, or determine if the securities are “good” investments. Registration statements are reviewed by SEC staff members and declared “effective” if companies satisfy disclosure rules.

2. The Securities Exchange Act of 1934 requires publicly held companies to continually disclose information about their business operation, financial condition, and management. The companies, and in many cases their officers, directors and significant shareholders, must file periodic reports or other disclosure documents with the SEC. In some cases, the company must deliver the information directly to investors.

Your business may be exempt from these registration and reporting requirements if it qualifies for an exemption, such as those described in this article.

Note: Even if you are exempt from SEC registration requirements, you are still subject to the anti-fraud provisions of federal securities law. These provisions make businesses responsible for false or misleading statements made verbally or in writing. You also must comply with the notice and filing obligations of various state laws, commonly known as blue sky laws.

In addition, even if you qualify for an exemption, there are generally still complex documentation requirements. For example, you may need to put together a private placement memorandum, organizational documents and subscription materials to provide to investors.

Among the exemptions from SEC registration are three options under Regulation D that are called Rule 504, Rule 505 and Rule 506:

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. Like other Regulation D exemptions, you cannot generally use public solicitation or advertising to market the securities. Purchasers receive “restricted” securities, meaning they may not sell them without registration or an applicable exemption. However, you can use this exemption for a public offering of your securities and investors can receive freely tradable securities under certain circumstances. Consult with your attorney to see if you qualify.

Even if you make a private sale where there are no specific disclosure delivery requirements, take care to provide sufficient information to investors to avoid violating the anti-fraud provisions of the securities laws.

Rule 505 provides an exemption for offers and security sales totaling up to $5 million in a 12-month period. Under this exemption, you can sell to an unlimited number of “accredited investors” and up to 35 other persons who don’t need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only (not for resale). The issued securities are “restricted.” Consequently, you must inform investors that they cannot sell for at least a year without registering the transaction. You may not use general solicitation or advertising to sell the securities.

An “accredited investor” is:

  • A bank, insurance company, registered investment company, business development company, or small business investment company.
  • An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment advisor makes the investment decisions, or if the plan has total assets in excess of $5 million.
  • A charitable organization, corporation or partnership with assets exceeding $5 million.
  • A director, executive officer, or general partner of the company selling the securities.
  • A business in which all the equity owners are accredited investors.
  • A person with a net worth of at least $1 million.
  • A person with 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 the same income level in the current year.
  • A trust with assets of at least $5 million, which is not formed to acquire the securities offered. In addition, purchases of securities must be directed by a sophisticated person. This is described as someone with sufficient knowledge and experience in financial and business matters to make him or her capable of evaluating the merits and risks prospective investments.

You can decide what information to give accredited investors, as long as you don’t violate the anti-fraud prohibitions. But you must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, you must make this information available to the non-accredited investors as well. You must also be available to answer questions by prospective purchasers.

There are some specific financial statement requirements applicable to this type of offering. For example, financial statements must be certified by an independent public accountant.

Rule 506 is a “safe harbor” for the private offering exemption if your company satisfies the following standards:

  • You can raise an unlimited amount of capital.
  • You cannot use general solicitation or advertising to market the securities.
  • You can sell securities to an unlimited number of accredited investors (the same group discussed in Rule 505 above) and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be “sophisticated.” There are also some requirements associated with the information you provide to accredited investors.
  • You must be available to answer questions by prospective purchasers.
  • Financial statement requirements are the same as for Rule 505.
  • Purchasers receive “restricted” securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering.

Rules 504, 505 and 506 are only some of the several SEC exemptions from registration requirements. Consult with your attorney about the best option in your situation. And when contemplating investors, consider your goals, as well as the short and long-term effects of selling a stake in the company.