The past few months have seen action in the securities markets comparable to the breathtaking first drop of Cedar Point’s new Millennium Force roller coaster.
Unfortunately for investors and those seeking financing alike, the ride has not been what one would consider exhilarating. Technology stocks, the darlings of all just a few short months ago, have lost their sheen, and planned IPOs have been delayed, if not outright canceled.
While there is still plenty of money looking for good opportunities, there also is an overload of not-so-good deals seeking funds. The result, for start-ups and emerging growth companies, is a return to the tried and true method of raising much needed capital from “F&F” — friends and family.
Raising money from any source requires an awareness of, and strict compliance with, federal and state securities laws and regulations. However, if you are fortunate enough to have the right F&F, compliance isn’t so difficult. Below is a description of the requirements for Rule 506 of Regulation D — compliance with this federal rule makes state compliance easy.
Do I need a book? The preliminary issue is whether a disclosure document (a “Private Placement Memorandum”) will be necessary. There are times that a disclosure document is required, and times that it is desirable, even if not required. A book is required if your investors do not all qualify as “accredited” or if any are not “sophisticated.”
Accredited investors. A prospective individual investor qualifies as an accredited investor if his or her net worth exceeds $1 million or that person’s income was in excess of $200,000 in both 1998 and 1999 and he or she reasonably expects more than $200,000 in income for 2000 (or joint income with spouse was/is expected to be in excess of $300,000 in each of those years). Investors that are entities must meet other criteria. For example, a corporation must have total assets in excess of $5 million, or owners who qualify as accredited.
If any of your investors do not qualify as an accredited investor, a disclosure document will be required; thus, you must know your F&F. We advise prequalifying them to make certain. In no event may there be more than 35 nonaccredited investors.
Sophistication. Each nonaccredited investor must be “sophisticated” (i.e., possess sufficient knowledge and experience in business and financial matters to be capable of evaluating the merits and risks of an investment in your company).
Contents of book. If a book is required, it must disclose, among other things, the company’s business plan (e.g., sales and marketing plans and perceived competitors), historical and projected financial results, and the planned use for the money being sought. New business owners are most often dismayed by the risk factors that must be included — descriptions of how and why an investment could turn sour for the investor.
The book must provide the type of information that a prudent investor would find material in deciding whether to buy your stock, and must not fail to state anything material to that investment decision. Thus, a book must walk the tightrope of compliance with the technical requirements of securities laws while acting as a sales and marketing instrument for your stock.
Why do a book if not required? Even if a disclosure document is not required, it is often prudent and advisable to deliver one. If a disgruntled investor ever sues, claiming to have been deceived, the book would be introduced to show what the prospective investor was entitled to rely on in making his decision whether to invest. Obviously, this defense is only as good as the book.
Shortcut to a book. If you have created a comprehensive business plan, we suggest using that document as the centerpiece of a book. We would then attach a wrapper — 10 to 12 pages describing some of the legal, business and tax considerations attendant to the offering. This approach minimizes the time and effort necessary to put together a book, assuming, of course, that the business plan itself is comprehensive and reasonably well done.
Advertising and commissions. You are prohibited from publishing an advertisement, article, notice or other communication in a newspaper, magazine or similar media or broadcasting over television or radio (you may, however, publish a so-called “tombstone”). You also cannot hold a seminar or meeting whose attendees have been invited by any general solicitation or general advertising, though you can meet with F&F. Typically, no commissions may be paid in connection with the sale of such interests.
Monetary cap and governmental filings. If you comply with Rule 506, an offering of any dollar amount of interests in your company will qualify as a private placement that is exempt from any registration requirements. Only a notice filing with the Securities and Exchange Commission and applicable state securities authorities (and payment of a nominal fee) will be required.
Bart Sauer is an attorney at Arter & Hadden LLP and is a member of the E-Group, a multi-disciplinary group of attorneys who focus their practice on entrepreneurs, Internet, e-commerce and emerging growth companies. He can be reached at (216) 696-4661 or [email protected].
