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Entrepreneurial Finance 5th Edition Leach Solutions Manual Download
Entrepreneurial Finance 5th Edition Leach Solutions Manual Download
Chapter 8
FOCUS
In this chapter we introduce several major legal aspects of fundraising for the new
venture. We discuss the central role of the Securities Act of 1933 and the exemptions
available to ventures seeking to issue securities without having to register them with the
Securities and Exchange Commission.
LEARNING OBJECTIVES
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134 Chapter 8: Securities Law Considerations When Obtaining Venture Financing
CHAPTER OUTLINE
APPENDIX A:
Schedule A (Securities Act of 1933, as Amended)
Requirements for Registration of Securities other than a Security Issued by
Foreign Government or Political Subdivision Thereof
APPENDIX B:
Selected Regulation D Materials
Regulation D’s “Preliminary Notes”
Rule 501: Definitions and Terms used in Regulation D
Rule 502: General Conditions to be Met
Rule 503: Filing of Notice of Sales
Rule 507: Reg D Disqualification Provisions
Rule 508: Reg D Insignificant Deviations Clause
Rule 144 (§ 230.144)
Chapter 8: Securities Law Considerations When Obtaining Venture Financing 135
APPENDIX C:
Other Forms of Registration Exemptions and Breaks
Rule 701
Rule 1001
Regulation SB
1. Briefly define the (a) Securities Act of 1933 and (b) Securities Exchange Act of 1934.
The Securities Act of 1933 is the main body of federal law governing the creation
and sale of securities. The Securities Exchange Act of 1934 deals with the
mechanisms and standards for public security trading.
2. Briefly discuss the (a) Investment Company Act of 1940 and (b) Investment Advisers
Act of 1940.
The JOBS Act of 2012 is a federal law passed to stimulate the initiation, growth and
development of small business companies. Title II of the Act eliminates restrictions
on general solicitation and advertising for Regulation D 506 accredited investor
offerings. This is a significant departure from prior restrictions.
4. What is meant by the term “blue sky” laws and how do these laws apply when issuing
securities?
Blue Sky Laws are the state laws designed to protect individuals from investing in
fraudulent securities offerings. They are the state equivalent of the federal securities
laws.
The term “security” means any note, stock, treasury stock, bond, debenture,
evidence of indebtedness, certificate of interest or participation in any profit-
sharing agreement, collateral-trust certificate, preorganization certificate or
subscription, transferable share, investment contract, voting-trust certificate,
certificate of deposit for a security, fractional undivided interest in oil, gas, or
other mineral rights, any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities (including any
interest therein or based on the value thereof), or any put, call, straddle,
136 Chapter 8: Securities Law Considerations When Obtaining Venture Financing
Any investment considered to be a security under the 1933 Act comes under its
provisions. In particular, unless an exemption is secured, it must be registered with
the SEC prior to being offered to the public.
7. Briefly describe what is meant by the statement “Registering securities with the
Securities and Exchange Commission (SEC) is both costly and a time-consuming
process.”
There is a great deal of expertise involved in preparing the documents and filings
associated with a public offering. Most ventures do not have the resources to employ
a staff specializing in this area. Consequently the venture will retain legal and
investment banking experts to assist in the offering. The associated costs are
substantial and require much of the information be provided by venture insiders (the
time element) who typically have been working on the non-financial aspects of
growing the venture.
8. Identify some of the types of securities that are “exempt” from registration with the
SEC.
Some of the exempt securities are: government securities (federal and state),
securities issued by banks, certain securities issued by insurance companies and
certain securities of not-for-profit issuers.
9. Briefly describe what is meant by an intrastate offering. What are the major
difficulties in assuring that an offer is intrastate?
An intrastate offering is one where the issuer and investors are considered by federal
securities law to be confined to one state. SEC Rule 147 lays out guidelines under
which the SEC will consider the offering to be intrastate.
10. Identify and briefly describe two basic types of transactions that are exempt from
registration with the SEC.
The most widely used exemption is the private placement exemption: transactions by
an issuer not involving any public offerings. The accredited investor exemption is a
second transaction exemption and lays much of the groundwork for the types of
exemptions that involve a certain type of investor.
Chapter 8: Securities Law Considerations When Obtaining Venture Financing 137
11. What does the term accredited investor mean in terms of the Securities Act of 1933?
Why does the designation matter?
Accredited investors under the 1933 Act are assumed to have sufficient financial
expertise and wherewithal to make an intelligent and informed investment decision.
Formally:
12. Briefly describe the importance of the 1953 SEC vs. Ralston Purina case in terms of
securities registration requirements.
The U.S. Supreme Court took an important step toward defining a private (nonpublic)
offering in SEC v. Ralston Purina. The case involved the sale of securities to
employees. The court found that because Ralston Purina’s offering included
employees who would not necessarily have access to the appropriate type of
information, it did not fall within the private placement exemption of the 1933 Act.
Reg D provides a set of safe harbor conditions under which an issuer can shield
themselves from SEC action for failure to register securities.
14. What are the restrictions on general solicitation and advertising covered in Rule
504?
Rule 504 is the most lenient and the only exemption in Reg D that allows for any
conditions under which the solicitation can be to the general public. The specific
conditions under which general solicitation and advertising are allowed, in the current
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15. How do Rules 504, 505, and 506 of Reg D differ from one another?
Rule 506 has no limits on the amount raised, but has a limit of 35 investors that fall in
categories that have to be counted and those 35 must be “sophisticated.” Rule 505
has a monetary limit of $5 million and a limit of 35 investors that fall into categories
that must be counted. Rule 504 has a $1 million limit but no limit on the number or
sophistication of investors.
16. Provide a brief description of the use of Regulation A when issuing securities.
17. Briefly describe how the SEC’s Regulation D expanded the original Securities Act of
1933 definition of an “accredited investor.”
For the purposes of Reg D, investors are considered accredited if they fall into one of
eight categories. Rather than leaving the notion of “accredited” as vague (thus
making the safe harbor less certain), the SEC chose to provide specific criterion
whereby an individual can be designated as “accredited.”
18. What are the income and net worth requirements for being an accredited investor?
What in the requirements for designation as an accredited investor relates to the level
of sophistication? Do the criteria act as good proxies for sophistication?
The income requirements are currently $200,000 for single filers and $300,000 for
married filers. The wealth requirement is $1,000,000. While the requirements for
accredited investor status do not necessarily reflect “sophistication”, they appear to
create categories highly correlated with sophistication or the ability to hire
sophisticated advisers during the investment decision process.
19. What are the four conditions of a Reg D offering that are covered under Rule 502?
Rule 502 (§ 230.502) deals with four conditions of a Reg D offering: integration
(when multiple issues count as one), information (what you need to disclose when
Chapter 8: Securities Law Considerations When Obtaining Venture Financing 139
you must formally disclose), solicitation (what you can’t do when promoting the
offering) and resale (serious restrictions).
20. What is integration as it applies to securities offerings and why does it matter?
Integrated offerings are those that may be treated as combined into one offering. For
integrated offerings it is the aggregated total dollar amount which must not exceed the
dollar limits of the Reg D exemption being sought.
When required, the type of information to be disclosed varies by the venture’s status
and size. Summarizing from the Reg D text:
(B) financial statement information depending on the size of the offering and
ranging from S-B and S-B2 type information up to the same financial
statements as required in a regular registration.
22. What is a restricted security? Why does this designation matter? What types of
buyers must the owner of restricted securities find?
Restricted securities cannot be freely resold. This is the typical status of securities
sold in a private placement. The resale of restricted securities typically requires
locating an accredited investor as a buyer.
Rule 508 allows for the possibility that an offering will be granted safe harbor when
the only deviations from Reg D’s requirements are deemed to be “insignificant.”
25. Briefly describe the types of exemptions from registration of securities covered under
Rules 701 and 1001.
issuers that their exemption under California law will receive concurrent exemption
from federal registration.
26. From the Headlines – From Pebbles to Bamm: Discuss the elements of success in
Kickstarter’s model for fundraising. Will the same elements transfer to securities
crowdfunding?
Pebble Technology was able to raise over $10 million by pre-selling its smartphone
watch. It was estimated that potential deferred revenue of over $27 million was
created even though Pebble was a pre-distribution startup. Manufacturing delays
and the harsh reality of shipping pre-sold smartphone watches with no concurrent
cash inflows set in. Ill-will with some pre-order customers occurred when those
customers believed they were being by-passed in the queue when Pebble began
selling to Best Buy. Also, fierce competition was developing resulting in concern
that Pebble may not survive as a successful venture.
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3. Access the Nolo Press Web site at http://www.nolo.com. Develop a list of legal
references relating to securities laws.
A. Amy Smith is the chief executive officer (CE0) of the NetCare Company.
B. Bruce Jones, who has a net worth of $750,000, is planning to purchase shares
of stock to be issued by the NetCare Company.
Not on the basis of net worth: a minimum net worth of $1 million is needed to
be accredited.
Yes. A minimum of $200,000 annually over the past two years and the
expectation of earning above the threshold next year is one criterion for being
accredited.
Not on the basis of his employment status: employees are not automatically
accredited unless they are officers or directors.
E. Julie Kukoc recently inherited some financial assets and now has a net worth
of $2 million with an annual income of $35,000.
A. A private placement
For the $4 million offering, CareAssist can consider a Rule 505, 506 or a
general Section 4(2) exemption or accredited investor exemption. Absent
securing an exemption, the firm will be subject to the full registration
requirements of U.S. securities law.
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As the amount is over $1 million a Rule 504 offering to the general public is
out of the question. A Reg A offering allows up to $5 million and is a
possibility for CareAssist.
If the offering were only to investors in the single state in which CareAssist
operates, it might be possible to consider an intrastate exemption. Ben &
Jerry’s Vermont offering is an example of an offering that used the intrastate
exemption.
3. [Regulation D Exemptions] Three Rules (504, 505, and 506) under Regulation D
relate to the (a) amount of offerings and (b) number of investors. Match Rules
504, 505, and/or 506 with each of the following:
Solutions:
A. $5 million offering limit (in a 12-month period) [Rule 505]
B. $1 million offering limit (in a 12-month period) [Rule 504]
C. No limit on the amount of offering (in a 12-month period) [Rule 506]
D. No limit on the number of investors [Rule 504]
E. No limit on number of accredited investors; limit of 35 unaccredited investors
[Rules 505 and 506]
The VirtualStream Company has developed proprietary server and control software for
providing communication and media-on-demand services via the Internet. The company
is in the process of collecting prerecorded video and audio content from clients and then
digitally transferring and storing the content on network servers. The content then is
available for replay by customers via the Internet. VirtualStream’s mission is to provide
the most dependable and user-friendly multimedia streaming service worldwide.
The Internet technology service industry is characterized by rapid revenue growth
with industry revenues predicted to exceed $300 billion in three years. Market
participants include companies engaged in video and audio teleconferencing, corporate
training, computer-based training, and distance learning. VirtualStream is attempting to
focus on helping large companies to communicate more effectively, using both archived
Chapter 8: Securities Law Considerations When Obtaining Venture Financing 143
and live communications content, via the Internet. Video and audio content is digitally
stored in a central location and is available on demand to clients. This approach will
save time and money required to duplicate and ship materials. The company also offers
a service that enables transmission of live broadcasts via the Internet.
VirtualStream raised $500,000 in the form of founder’s capital last year. The
firm is now seeking additional financial capital from investors by issuing or selling
“securities” in the form of stock in the firm. The firm is planning to obtain $750,000 as
soon as possible from private investors.
A. Discuss whether you would recommend “registering” these “securities” with the
Securities and Exchange Commission (SEC).
Paying all of the costs (present and future) of a full public registration would most
likely not be advantageous to VirtualStream. Consequently, they should initially seek
the less expensive and faster option of a private placement.
B. Some “securities” are exempt from the SEC registration requirement. Is it likely that
VirtualStream’s “stock” would qualify for such an exemption? Why, or why not?
C. Would you recommend that the initial $750,000 be obtained through an “intrastate”
offering? Explain.
D. Briefly describe the two basic types of “transaction” exemptions that may be
available to VirtualStream that would allow the firm not to have to register its
securities with the SEC.
The two more likely transaction exemptions for VirtualStream are the private
placement exemption (Section 4(2) broadly and its Regulation D extensions) and the
accredited investor exemption (Section 4(6)). Both would allow VirtualStream to
avoid full registration costs, at least at present. Note, however, that both require that
VirtualStream screen the types of investors they allow to purchase the securities.
E. The SEC’s Regulation D offers a “safe harbor” exemption to firms from having to
register their securities with the SEC. Describe how the VirtualStream Company
could use Reg D for issuing $750,000 in stock to private investors. In developing
your answer, describe the Reg D “rules” that would likely apply to this security issue.
144 Chapter 8: Securities Law Considerations When Obtaining Venture Financing
Assuming that the previous round of funding falls outside the time interval where
integration is an issue, the $750,000 offering potentially falls under the guidelines of
Reg D’s 504, 505 and 506. The least restrictive of these (with respect to investor
qualification and solicitation restrictions) is Rule 504 with a limit of $1 million.
Since the future issue is for the same securities and could potentially be integrated
into the current offering (from the SEC’s viewpoint assuming that its “6-months-
either-side” safe harbor is not satisfied), VirtualStream needs to worry about
integration. Practically, this means that they should probably abandon a 504 offering
and consider the more restrictive conditions of a 505 or 506 offering.
G. The other alternative is to seek to raise the total $2,750,000 amount now by selling
securities to investors. Which Reg D “rules” and/or other securities laws would be
“triggered” by such a plan? Describe why and how.
Reg D’s 505 and 506 apply, but much care needs to be taken as the 35 investor counts
could be binding. If the offering is not targeting accredited investors, VirtualStream
might seriously consider a Regulation A filing ($5 million maximum) or even an SB
registration (with significantly higher limits).