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Entrepreneurial Finance 5th edition by

Leach ISBN 8131528235 9788131528235


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Chapter 8

SECURITIES LAW CONSIDERATIONS WHEN OBTAINING


VENTURE FINANCING

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

1. Identify five relevant components of the federal securities laws.


2. Explain what is meant by “blue sky” laws.
3. Define “security” according to the Securities Act of 1933 and explain why such a
designation matters.
4. Describe what is involved in registering securities with the Securities and Exchange
Commission (SEC).
5. Identify some of the securities that are exempt from registration with the SEC.
6. Identify some transaction exemptions granted under the Securities Act of 1933.
7. Describe and discuss how the SEC’s Regulation D serves as a securities registration
“safe harbor”.
8. Explain how Rules 504, 505, and 506 of Regulation D differ from one another.
9. Describe Regulation A and explain how and when it is used.

133
134 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

CHAPTER OUTLINE

8.1 REVIEW OF SOURCES OF EXTERNAL VENTURE FINANCING


8.2 OVERVIEW OF FEDERAL AND STATE SECURITIES LAWS
A. Securities Act of 1933
B. Securities Exchange Act of 1934
C. Investment Company Act of 1940
D. Investment Advisers Act of 1940
E. Jumpstart Our Business Startups Act of 2012
F. State Securities Regulation: “Blue-Sky” Laws
8.3 PROCESS FOR DETERMINING WHETHER SECURITIES MUST BE
REGISTERED
A. Offer and Sale Terms
B. What is a Security?
8.4 REGISTRATION OF SECURITIES UNDER THE SECURITIES ACT OF 1933
8.5 SECURITY EXEMPTIONS FROM REGISTRATION UNDER THE 1933 ACT
8.6 TRANSACTION EXEMPTIONS FROM REGISTRATION UNDER THE 1933
ACT
A. Private Offering Exemption
B. Accredited Investor Exemption
8.7 SEC’S REGULATION D: SAFE-HARBOR EXEMPTIONS
A. Rule 504: Exemption for Limited Offerings and Sales of Securities Not
Exceeding $1 Million
B. Rule 505: Exemption for Limited Offers and Sales of Securities Not
Exceeding $5 Million
C. Rule 506: Exemption for Limited Offers and Sales Without Regard to Dollar
Amount of Offering
8.8 REGULATION A SECURITY EXEMPTION
8.9 JOBS ACT INNOVATIONS
SUMMARY

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

DISCUSSION QUESTIONS AND ANSWERS

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 Investment Company Act of 1940 provides a definition of an “investment


company.” The Investment Advisers Act of 1940 focuses on people and
organizations that seek to provide financial advice to investors and defines
“investment adviser.

3. Describe the Jumpstart Our Business Staertups Act of 2012.

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.

5. Describe the meaning of a “security” in terms of the Securities Act of 1933.

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

option, or privilege entered into on a national securities exchange relating to


foreign currency, or, in general, any interest or instrument commonly known
as a “security,” or any certificate of interest or participation in, temporary or
interim certificate for, receipt for, guarantee of, or warrant or right to
subscribe to or purchase, any of the foregoing.

6. Why does it matter if an investment is, or is not, viewed as being a security?

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:

2(a)(15) The term “accredited investor” shall mean:

(i) A bank as defined in Section 3(a)(2) whether acting in its individual or


fiduciary capacity; an insurance company as defined in paragraph (13) of
this subsection; an investment company registered under the Investment
Company Act of 1940 or a business development company as defined in
Section 2(a)(48) of that Act; a Small Business
Investment Company licensed by the Small Business Administration; or
an employee benefit plan, including an individual retirement account,
which is subject to the provisions of the Employee Retirement Income
Security Act of 1974, if the investment decision is made by a plan
fiduciary, as defined in Section 3(21) of such Act, which is either a bank,
insurance company, or registered investment adviser; or

(ii) Any person who, on the basis of such factors as financial


sophistication, net worth, knowledge, and experience in financial matters,
or amount of assets under management qualifies as an accredited investor
under rules and regulations which the Commission shall prescribe.

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.

13. What is the purpose of the SEC’s Regulation D?

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
138 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

form of Reg D, relates to state registrations and information dissemination. Issuers


considering general solicitation in connection with a 504 offering would be well-
advised to seek specific legal counsel on the current conditions required in a 504
offering.

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.

Regulation A is technically an exemption from full registration, but in practice is like


a limited registration where the process involves many of the same types of activities
in doing a full registration. The monetary limit is $5,000,000, the issuer is allowed to
“test the waters” for the offering, and the shares can be issued to the public and
eventually trade freely.

[Note: The following questions 16 through 25 relate to the material presented in


Appendixes B and C.]

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.

21. What types of information need to be disclosed to offerees under Reg D?

When required, the type of information to be disclosed varies by the venture’s status
and size. Summarizing from the Reg D text:

The issuer shall furnish to the purchaser, to the extent material to an


understanding of the issuer, its business, and the securities being offered:

(A) non-financial statement information similar to that required in a Reg A (or


registered) offering.

(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.

23. Briefly describe the purpose of Rule 144 of Reg D.

To provide conditions under which restricted securities can be resold.

24. Briefly describe Rule 508 of Reg D.

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.

Rule 701 is an exemption for certain types of employee compensation arrangements


involving the issue of the employer’s securities. Rule 1001 is a “qualified
purchaser” exemption for the State of California that assures certain California
140 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

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.

It is unclear whether similar pre-distribution business models employing pre-sales


(deferred revenue) strategies would be successful in raising capital from investors
through securities crowdfunding efforts. Investor-provided funds could be used to
help cover the costs of manufacturing and shipping pre-sold inventory which would
not produce new cash inflows. Of course, until securities crowdfunding laws and
interpretations are worked through, major uncertainty remains as to the likely degree
of success of securities crowdfunding.

INTERNET ACTIVITIES

1. Access the Securities and Exchange Commission Web site at http://www.sec.gov.


Identify recent developments and changes in Rule 504 of the SEC’s Regulation D.

Web-researched results vary due to constant updating of web sites.

2. Offroad Capital (now owned by NYPPE) was an early provider of online


technology for selling new issues. Summarize their regulation-related posting at
http://www.offroadcapital.com/Webpagesw/regulatory.aspx.

Web-researched results vary due to constant updating of web sites.

3. Access the Nolo Press Web site at http://www.nolo.com. Develop a list of legal
references relating to securities laws.

Web-researched results vary due to constant updating of web sites.

EXERCISES/PROBLEMS AND ANSWERS


Chapter 8: Securities Law Considerations When Obtaining Venture Financing 141

1. [Accredited Investors] The NetCare Company, which operates living assistance


facilities, is planning to issue or sell shares of stock to “accredited investors.”
Briefly explain whether each of the following individuals would qualify as an
“accredited investor” under the SEC’s Regulation D. [Note: Materials in
Appendix B are useful in answering this exercise.]

A. Amy Smith is the chief executive officer (CE0) of the NetCare Company.

Yes. All officers and directors of the company are accredited.

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.

C. Jean Wu also is considering purchasing shares of stock that will be issued by


the NetCare Company. Jean’s annual income has been $250,000 in each of
the past two years and she expects to have a comparable amount of income
next year.

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.

D. James Shastri is a software programmer for the NetCare Company.

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.

Yes. She has a net worth above the $1 million threshold

2. [Securities Law] The CareAssist Company, a web-based provider of information


for the elderly, is planning to sell $4 million in securities. Management is trying
to decide which, if any, securities laws must be complied with. For each of the
following situations, describe the securities laws that might apply.

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.
142 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

B. An interstate public offering

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.

C. An intrastate public offering

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:

A. $5 million offering limit (in a 12-month period)


B. $1 million offering limit (in a 12-month period)
C. No limit on the amount of offering (in a 12-month period)
D. No limit on the number of investors
E. No limit on number of accredited investors; limit of 35 unaccredited investors

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]

MINI CASE: THE VIRTUALSTREAM COMPANY

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?

Virtual Stream’s issue of stock is potentially covered by the transactions exemption


features of the 1933 Act and Regulation D.

C. Would you recommend that the initial $750,000 be obtained through an “intrastate”
offering? Explain.

Intrastate offerings present serious challenges to ventures seeking to acquire large


amounts of funding in stages. While it is possible that VirtualStream’s current
offering might be eligible for an intrastate exemption, it seems unlikely in their line of
business with their growth prospects.

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.

F. Now, assume VirtualStream also is planning to issue an additional $2 million in stock


towards the end of the year. Would this decision have an impact on the Reg D
“rules” which would govern the issuance of the firm’s securities? Describe. [Note:
The material in Appendix B may be helpful in developing an answer to this question.]

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).

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