New York Business Lawyers

Sin/Mistake 1 – Ignoring the Fact You are Selling Securities

Your company is raising money, which means chances are your company is selling a security of some kind.  Securities take on many forms, and a security by any other name is still likely a security.  As such, the sale of a security is governed by an intricate web of state and federal laws designed to protect investors.  These same laws can potentially cause serious injury to entrepreneurs should they not take the proper legal steps to sell their securities.  In short, a company may not offer or sell its securities unless 1) those securities have been registered with the Securities and Exchange Commission (and registered with any applicable state securities offices); or 2) the company seeks out and qualifies for an applicable exemption from said registration.

A common exemption, which has been discussed here, is the “private placement” exemption under Section 4(2) of the Securities Act of 1933, which is implemented primarily through federal Regulation D as a “safe harbor” (this route is also commonly used for start-up companies).  However, this safe harbor is not a simple “paint by numbers” affair.  Rather, it is a sophisticated process that requires the significant attention to detail and legal know how.  As a result, startup founders should not attempt to dabble in setting a private placement up themselves.  Failing to properly construct one can mean the difference between uptime and jail time, with other adverse results including the right of the investor to demand its money back (irrespective of whether such monies were legitimately utilized by the company; this is known as the right of “rescission”); various fines; being “blacklisted” by the SEC for future securities sales; and, to reiterate, criminal sanctions.

Sin/Mistake 2– Jumping into a Preferred Series Offering for Angel Investors, when Convertible Debt or Even Founders’ Equity is a Better Approach

Many startups believe that complexity begets investment.  That is simply not true.  Regardless of the chatter surrounding the desirability of convertible notes by Angels, sometimes that is the best route.  The simple fact is unless the company is raising 400K-500K or more, the legal fees, time, and confusion that often surround private offerings (e.g., a Series A Preferred Stock Round) can easily outweigh the benefits. And with any equity offering, the company has go through a valuation process (i.e., the founders have to make the case as to what their startup company is actually worth, which is a time consuming and sometimes combative process).  Therefore, startups should not overlook the simpler, less time consuming, and often lower cost route of issuing debt, specifically convertible notes (an added benefit is the ability to defer the company valuation discussion; in addition the note can offer investors a discount on the conversion price  (or other items) to provide greater incentive. ) However, if a startup is confronted with Angels that must have equity, then decisions will have to be made as to whether to accommodate that Angel or forego its offer (startups also often overlook the benefits of having an angel’s counsel and guidance as well as its money.)

Mistake #3 – Advertising or Soliciting Investors

With regard to Private Placements, the operative first word is “private”.  Hence, the Regulation D Private Offering Exemption generally prohibits the startup from so called “general advertising” or “general solicitation” to sell securities through its private placement.  The meaning of these two terms have been fleshed out through SEC advisory opinion letters.  “General advertising” has been deemed to include any advertisements, notices, or other items that are published in a newspaper, magazine or similar media, or broadcast through TV, radio, or the internet.  In a similar vein, “general solicitation” has been deemed to include any solicitations (i.e., a request or proposition to invest/purchase securities by mail, e-mail or other electronic platform), unless there is a “substantial and pre-existing relationship” between the startup and the investor.

Sin/Mistake 4 – Selling Equity (Stocks and/or Units) to People who are Not “Accredited Investors”

Many an entrepreneur fails to heed one of the most critical “best practices” in the world of selling business securities through private placements: sell only to “Accredited Investors”.  The Accredited Investor definition is an economic one found in Rule 501 under Regulation D and it speaks to the income level of the prospective investor.  The most critical one for startups is the Accredited Investor who: 1) has an income in excess of $200,000 in each of the two most recent years (or joint spousal income in excess of $300,000 for those years) with a reasonable expectation of maintaining such income level for the current year; 2) a net worth (or joint spousal net worth) in excess of $1 million at the time of the purchase.  Failure to sell to these accredited types can be a recipe for legal disaster, as the law typically provides the startup a greater degree of lenience, provided it deals exclusively with accredited investors in lieu of non-accredited investors (i.e., typically friends and family).

Nonetheless, many want to sell to “friends and family” or to random third parties, without doing any due diligence into the financial profile of the purchaser/investor.  This is a classic mistake.  Moreover, dealing with accredited investors solely lowers the threshold of legal planning and disclosures necessary to sell the securities. In fact if an offering can be tailored to conform with federal rule 506, through sales to accredited investors only, that can trump the often labyrinthine state rule requirements, thereby greatly streamline the endure private offering process.