The securities laws
Angel investors provide a very valuable and reliable means of capital for
start-ups and early-stage businesses. They tend to generate preconceived images
of being compassionate and charitable individuals who provide the much needed guidance
and support to struggling entrepreneurs. But as with every business transaction,
they are subject to federal and state securities laws.
When an entrepreneur offers an investor equity interest in his business, whether
it is common stock, a partnership interest, or an interest in a limited liability
company, he or she is offering to sell a security. These securities must be registered
for sale under federal and state securities laws, unless there is an exemption.
For first-time entrepreneurs, this registration process can be a bit time-consuming,
complex to understand, and costly.
Regulation D offerings
The Securities Act of 1933 states that when a company decides to sell stock,
they must either be licensed with the U.S Securities Exchange Commission (SEC) or
meet a federal exemption. In 1982, the SEC formulated Regulation D, which set forth
three exemptions of regulation requirements: Rules 504, 505, and 506. Regulation
D offers a common cost and a time-efficient method for raising capital from private
investors and allows smaller enterprises to offer and sell their securities without
having to register the offerings with the SEC.
The companies that use Regulation D must file a “Form D” after
their initial sales of securities. “Form D” is a brief document that
contains very little information about the company at hand, but includes all of
the names and addresses of the business owners and stock promoters. Private investors
who are interested in investing in a Regulation D company must first contact the
SEC’s Public Reference Branch to determine if their prospective investment
has filed such a form or to obtain a copy of that company’s document. It is
important to note that a company may not be in compliance with the federal securities
laws if they have failed to file a Form D.
Even though Rule 504 (Exemption for Limited Offers and Sales of Securities
Not Exceeding $1 million) provides an exemption from federal restrictions of stock
offerings, it does not exempt the individual state regulations. Investors are advised
to check with their state securities regulator to find out additional information
about a company and their owners and if that company was cleared the offering and
selling of securities in a given state.
Private placements for accredited vs. non-accredited investors
The most commonly used exemption is for private placements, in which securities
can be sold to an unlimited number of accredited investors and to a limited number
(no more than 35) of non-accredited investors. Accredited investors, among other
qualifications, have a high net worth ($1 million or more) and high income ($250,
000 individual and/or $350,000 combined salary with a spouse). Most angel investors
are also accredited investors; however, the differences between both types of investors
are significant under federal and state private placement exemptions.
For example, if only accredited investors are involved in an investment endeavor,
then no specific information is needed other than a prepared formal private placement
memorandum, which protects the company and its officers from fraud and future liability
proceedings. Accredited investors save the seller time and expense during the exemption
process, including any legal fees. On the other hand, if non-accredited investors
are involved, SEC regulations require the sellers to obtain a registration statement
concerning a non-exempt offering. In addition, the seller is required to have a
reasonable basis for preferring the non-accredited investors. This is called investment
sophistication (i.e. capability through education, employment experience, or other
experience of evaluating the merits and risks of the investment).
The importance of an attorney
An entrepreneur’s well-detailed business plan should be taken to
their law firm. Here their securities attorney will prepare the offering document.
Each of the potential investors must obtain a copy. At the time of investment, each
investor needs to sign a seen legal statement, read the offering document, and be
made aware of the risks in making such an investment.
A qualified securities attorney will be able to guide an entrepreneur through the
process of securities laws of their specific proposed angel investment. Every entrepreneur
and their investors must abide to the securities laws because non-compliance penalties
can be quite severe. For instance, if a securities offering is not registered and
no exemption is available, the investor may have a variety of securities claims
against the entrepreneur and his/her business, including the right to terminate
the investment deal and demand back their invested funds. It is important for the
business owners to properly comply with securities law regulations to avoid such
harsh investment consequences.
Entrepreneurs who seek capital for their early stage venture must have the counsel
of an experienced attorney who specializes in financial transactions. Obtaining
a securities attorney will enable the business owners to fully understand all federal
and state regulations regarding their business, protect business owners and investors,
and encourage compliance with these laws.