placement.

Are You Prepared To Raise Money Legally and Properly?

Every day I receive phone calls and e-mails from entrepreneurs all over the country who want to raise seed capital for their, ideas, concepts and projects while others are business owners who require additional funding for their existing companies. The majority has never raised funding before and has no idea what’s involved in acquiring capital through private sources. The majority state they willing to offer a minority equity position in a corporation of limited liability company for the capital. When asked how they intend to provide the information to an investor to learn about their investment opportunity, I am often told “I’ll give them a business plan to look at.”

There are two serious problems when it comes to giving a business plan or executive summary to an investor to entice or create interest for them to invest.

First of all, a business plan is not the proper document to be used for raising capital. A business plan is okay if you are going for a bank loan, but when it comes to non-traditional funding, a business plan can lead to disaster. In addition, a business plan is usually the reason most entrepreneurs fall short in their attempts to raise capital from investors. Raising capital effectively and properly requires a very specific memorandum that far surpasses what a business plan provides.

Secondly, it is most likely illegal. Any entrepreneur or business owner who has formed a corporation or limited liability company and intends to provide the sale of equity (stocks or membership units) in their company is prohibited from doing so by the Securities & Exchange Commission unless the business has the appropriate exemption.

The selling of private stock or membership units from a company is considered a securities offering and without the exemption is a serious violation that can result in legal prosecution and/or fines from both the Federal and State level of government. A knowledgeable private investor is keenly aware that a company that is in violation of security laws could be shut down and the officers and directors could be fined and/or prosecuted that could result in the collapse of the company and loss of all investment dollars. Nearly every state has “Blue Sky” laws in place that could allow the prosecution of the principle officers and directors who have not complied with either the federal or individual state laws. That sophisticated investor will simply say, “I don’t think this is what I’m looking for.”

The SEC exemption is known as the Regulation D Series Exemptions. Depending on the amount of money intended to raised will determine the Regulation D Memorandum to be prepared.

It is extremely important that you understand what you can and can’t do and how the SEC regulates how you sell, who you sell and who can sell your private placement offering.

Let’s address these issues:

No Solicitation

Simply put, you are not allowed to advertise or solicit your offering.

Regulation D Offerings on the Internet

As noted, the raising of private capital for early stage businesses most often involves the issuance of securities, and the issuer must comply with certain registration and disclosure obligations, or qualify for an exemption from registration under applicable securities laws. These requirements are relaxed, however, in certain cases. For example, Regulation D (an integrated series of rules promulgated by the Securities and Exchange Commission (the SEC)) provides "safe harbor" exemptive relief for "limited" offerings of securities. The establishment of a Regulation D exemption generally requires, among other things, that the offering not involve a "general solicitation". Essentially, this means that the capital-raising firm must refrain from prospecting for investors through any form of broad-based or blind solicitation techniques or advertising.

The use of the internet to conduct offerings of securities under Regulation D has intrigued capital-raising firms for a number of years. However, there is an inherent tension between Regulation D's prohibition of general solicitations and the use of a public, broad-based medium such as the internet to offer securities. In response to the growing public interest in utilizing the efficiency of the internet to make securities offerings, the SEC and many states have explored ways to permit internet solicitations without such actions constituting a general solicitation.

As a matter of background, a general solicitation (which, as noted, is prohibited by Rule 502(c) of Regulation D) is typically not found when a pre-existing, substantive relationship between an issuer (or its broker-dealer) and an offeree exists. A 1996 SEC No-Action Letter (IPOnet, SEC No-Action Letter (July 26, 1996)) extended this principle to private offerings posted on the internet. In that case, access to private offering material was granted only after a "member" had been pre-qualified as an "accredited investor" by completing a generic questionnaire. Once qualified, the member was issued a password which enabled access to a website page containing a notice of a private offering. In addition, the operator imposed a suitable "cooling off" period before the qualified member was granted access to the private offering material. The SEC approved the operation of this website. In doing so, the SEC found that the website operator had taken sufficient steps to allow a "pre-existing substantive" relationship to be established between the issuer/broker-dealer and the offerees.

Angel Networks and Online Matching Services

In approaching the general solicitation question as it relates to online offerings, the SEC has focused on broker-dealer operated websites and the method by which they pre-qualify their customers. As noted, it appears that the SEC has demonstrated considerable acceptance of online offerings operated by broker-dealers. However, the SEC has routinely resisted providing no-action relief to non-broker-dealer website operators. In doing so, the SEC has repeatedly relied upon its high comfort level with the traditional methods of broker-dealer firms designed to establish a "pre-existing, substantive" relationship with prospective investors. This is because broker-dealers are required under their self-governing NASD rules to deal fairly with, and make suitable recommendations to, their customers. The SEC has noted, however, that the absence or presence of a general solicitation is always determined on a case-by-case basis, taking into account all relevant facts and circumstances. In so commenting, the SEC left open the slight possibility that third party (i.e. non-broker-dealers) service providers may obtain no-action relief.

Possible examples of non-broker-dealer website operators include unregistered angel networks and online matching services. Angel investors are typically high net worth, business-savvy individuals willing to invest patient capital in early stage, high-risk companies. Angel networks essentially provide a convenient forum (either real or virtual) for pre-screened, qualified angels to assemble, evaluate, collaborate among themselves and actually invest in emerging businesses. In addition to live presentations, investment opportunities are often presented to angels through access restricted/password protected private offering materials discretely displayed to them on an angel network website. Companies afforded the lucrative opportunity to present their offering materials to investors are often invited by a "sponsoring" angel and are typically pre-screened from a large group of companies which have previously submitted their business plans.

Angel networks (especially internet-enhanced ones) and online matching services bear a strong resemblance to one another. Online matching services attempt to join companies in search of capital with people looking to invest their capital. The capital seekers are typically earlier stage companies. The capital spenders are typically angels, venture capitalists and, on occasion, other institutional-type investors.

There are three primary regulatory considerations introduced by the operation of internet-enhanced angel networks and online matching services. First, and most importantly, due to the inherent nature of their activities, both of these operations may require licensing as a broker-dealer. As noted, the SEC has routinely denied no action relief from the broker-dealer registration requirements for unlicensed persons that sponsor angel networks or provide matching services for profit. See Progressive Technology Inc., SEC No-Action Letter (October 11, 2000) and Oil-N-Gas, Inc., SEC No-Action Letter (June 8, 2000).

Second, regulatory concerns stem from the fact that certain state private offering exemptions are expressly conditioned upon the issuer not paying "commissions" to any unlicensed persons (e.g. MCL 451.802(a)(8)(B); MCL 451.802(b)(9)(C)). If the angel network sponsor or matching service provider is not registered as a broker-dealer (or, at least, affiliated with a registered broker-dealer), payment of a transaction-based fee to such operator could render the private offering exemption unavailable to the issuer utilizing such services.

Finally, based upon the SEC No-Action Letters and Interpretive Releases discussed above, the means by which investors are accessed through an online angel network or matching service may involve a "general solicitation", thereby defeating an issuer's claimed private offering exemption. As noted, however, by taking certain precautions, the issuer may avoid the characterization of its offering as one involving a general solicitation.

Pre-Existing Relationships

Basically, you are prohibited from making cold call solicitations to anyone. The SEC rules require there to be a pre-existing substantive relationship before discussing a securities offering. Although the rule was intended for broker/dealers in covers the scope of officers and directors of a company.

Targeted Communications with Specifics

In some situations it is acceptable to send specifics regarding an offering directly to individual potential investors (by letter, email, etc.) that the offerorreasonably believesmeet the investor suitability requirements for the securities exemption that will be used. This may occur via lists of investors previously determined by a securities broker to be accredited investors, or with certain potential investors –- often suppliers, customers, colleagues, friends and family –- who have a substantive pre-existing relationship with the company or one or more of its principals. The specific exemption being used determines who may be contacted and how.

If there is any doubt, though, about whether a particular investor meets the suitability standards, the investor-questionnaire approach must be used.

Finders

By definition, a finder is not a broker. A finder does not regularly engage in securities transactions. Your job is to restrict the selling activities of your non-employee directors, advisers etc. so that they are finders, not brokers.

Why Care About Finders?

Recall from previous articles that a person who sells your stock may not regularly engage in securities transactions, unless that person is a registered broker. Most people who help you sell stock have not obtained their broker registration. Therefore, you must be sure that they don’t regularly engage in selling stock. This is where finders come in.

By definition, a finder is not a broker. A finder does not regularly engage in securities transactions. Your job is to restrict the selling activities of your non-employee directors, advisors etc. so that they are finders, not brokers.

How to be a Finder

A seller can limit his activities to that of a finder and avoid the requirement of registration as a broker. How does he do it? – A finder makes an introduction and walks away. The finder does not participate in the promotion, negotiation or sale of the securities.

Specifically, the finder should NOT do any of the following:

  • The finder should not advise the investor as to the merits of the transaction or the issuer, or provide detailed information to the investor.
  • The finder should not participate in the negotiation or drafting of subscription documents.
  • The finder should not participate in the closing of the sale.
  • The finder should not receive commissions based on the closing or sales, or otherwise be paid in a manner that would motivate the finder to encourage sales. This usually is the hardest requirement to deal with. The SEC looks favorably on flat fees paid to a finder solely for making the introduction, where the fee is not tied to the consummation of sales.
  • The finder should not have been involved in the past, or be involved on regular basis now in the sale of securities. The SEC looks for prior or ongoing involvement in securities transactions.
EXAMPLE – Paul Anka

A transaction involving Paul Anka (if you remember the singer) is useful to show the limits of what can be done. In Paul Anka, SEC No-Action Letter (avail. July 24, 1991), the SEC permitted Paul Anka to receive a commission on the sale of units in the Ottawa Senators Hockey Club Limited Partnership, without registering as a broker-dealer. Anka was a part owner of the issuer. Anka received a 10% fee for sales made to investors found by Anka. The primary factor in exempting Anka from registration as a broker was that Anka only provided names and numbers of persons he had a pre-existing relationship and whom he reasonably believed to be accredited investors. Anka did not participate in any other manner whatsoever with the sale of securities, and did not make any recommendations to the potential investors. In addition, Anka was not previously engaged in the offering of securities.

Licensed Broker/Dealers



What Does Dealer Mean?

  1. An individual or firm willing to buy or sell securities for their own account.
  2. One who purchases goods or services for resale to consumers.
What Does Broker-Dealer Mean?

A person or firm in the business of buying and selling securities operating as both a broker and a dealer depending on the transaction.

What Does Series 7 Mean?

A general securities registered representative license administered bytheFinancial Industry Regulatory Authority (FINRA) thatentitles the holder to sell all types of securities products with the exception of commodities and futures.

What Does Series 66 Mean?

An exam administered by the Financial Industry Regulatory Authority (FINRA). Successful completion of the Series 66 exam is equivalent to successful completion of both the Series 63 and Series 65 exams.

What Does Series 63 Mean?

A securities license entitling the holder to solicit orders for any type of security in a particular state. This license is required in addition to the Series 7 or Series 6.

What Does Series 65 Mean?

A securities license required by most U.S. states for individuals that act as an investment advisor.

Author:.

– Ken M. Hollowell, founder of both Prfran Consultants, Inc. and Profran Capital Group, Inc. and is a leader in the field of franchise development and non traditional methods of raising capital since 1980. Ken Hollowell has lectured before many business organizations, Universities and Colleges on the subject of franchising and hosted a radio talk show of radio for years.

Ken Hollowell conducts numerous seminars annually on franchise development and investing in a franchise bus...

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Have a question for Ken?

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craig sheinker
2nd August 2014 1:36pm
Can I pay a commission to sell my securities directly to the holder of a series 7?

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