So you’ve got the next billion-dollar idea. You spend every waking moment thinking about how you’re going to develop an app or make a product that everyone – literally, everyone – will want, and will be willing to pay top dollar for.
Or maybe you’re already working on your project. Maybe you even have co-founders who have bought into the idea and are on board with what you’re sure is the next Google or Facebook.
As you get going, you’re thrilled – but you also realize a sobering fact: your little project is going to need money. Sure, you’re willing to put in your life savings, but that certainly won’t be enough to scale this thing up. No problem, right? Since everyone will surely agree that your product is a world-changer, everyone you meet is a potential investor. Talk to enough people, and you’ll undoubtedly be able to cobble together a few thousand (or tens or hundreds of thousands) of dollars.
Do Not Pass “Go”
Your realization that you’re in need of some serious capital has come at the right time: you’re just starting a huge PR/marketing push to generate the buzz around your product. It will be so easy to just get people excited about your idea and throw a few words in about how you need $50,000 and anyone who wants to invest can reach out for more information. How perfect!
Mentioning your funding could jeopardize your business before it’s off the ground.
Stop. Right now. Do not pass “Go” – and certainly do not collect $200.
Even mentioning your raise can create real problems for you. It could even jeopardize your business before it’s gotten off the ground. Why’s that? Read on.
Securities Law 101 for Startups
Let’s start at the beginning. The Securities Act of 1933 sets the legal framework for the sale of securities. The purpose of the Act is to protect investors by requiring companies to give them access to certain relevant information, thereby allowing investors to make an informed investment decision.
The protection mechanism of the Act, together with the Securities Exchange Act of 1934, is the reason publicly-traded companies are required to file periodic reports with the Securities and Exchange Commission to give stockholders and potential investors the chance to make fully informed decisions regarding their investments.
Although you might not think you’re selling a security, the truth is that almost any investment other than a bank loan is considered a security under the Act. This is important because the Act requires that all sales of securities either be registered with the SEC (requiring initial and ongoing releases of large amounts of information), or qualify for an exemption from registration.
Since registration is both expensive and time-consuming, startups generally want to find some exemption to avoid having to go through the process.
SEC Registration Exemptions: A Primer
Alright, you think, I definitely want to avoid registration, but how can I qualify for an exemption?
Exemptions can take a few different forms, and they’re complex. For the sake of this post, the one common thread is that each of the exemptions allows sales to certain groups of sophisticated investors without registration. In doing so, the Act and Regulation D (the regulation governing these exemptions) recognize that sophisticated individuals – those persons who have significant business and investment experience – might not need as much information to make an informed investment decision as a member of the general public. In addition, high-net-worth individuals can afford to make more speculative investments than, say, a minimum-wage employee.
Almost any investment other than a bank loan is considered a security.
A key point: To make sure that these offerings reach only those sophisticated or qualified groups of individuals, the registration exemptions prohibit “general solicitation” or “general advertising.”
Talking to the Media Could Violate Your Exemption
You’re probably wondering now why the prohibitions would even apply to you. After all, it’s not like you are taking out a newspaper ad and asking for investors; you’d just like to simply mention the fact that you’re raising funds in an interview.
This is where things get tricky, because the Act doesn’t actually define general solicitation or general advertising. Regulation D does provide a bit of guidance, but its description of the terms is very broad, including the following:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio;
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.*
How to Play It Safe Legally Speaking
So what does that Regulation D language actually mean? Is mentioning your fundraising in the media even a solicitation or advertisement, and therefore prohibited? If so, can you talk about your product or idea in the media at all?
The SEC classifies actions as general solicitations or general advertising on a case-by-case basis, meaning we are left with very little concrete guidance from the commission other than the language of Regulation D.
Generally, however, while you can promote your business and generate publicity and buzz around your product, you should never directly or indirectly reference your raise in the press. The best advice is to stay far away from mentioning anything that could be construed as relating to your funding.
The Bottom Line
That’s great to know, you think, but what if I end up talking about my raise in the press anyway? Can it really be that bad?
Yes, it can.
The Regulation D exemptions generally allow investors to self-affirm that they fall within the class of sophisticated investors we discussed earlier (referred to in the regulations as “accredited” investors). If your raise qualifies under an exemption (i.e., without general solicitation), you can just accept the investors’ self-affirmations at face value without any further diligence required.
While you can promote your product in the press, never reference your raise.
If you engage in general solicitation, the SEC requires that you independently verify each investor’s accreditation status. Now you’re required to review credit reports, account balances, tax filings and other highly personal documents to confirm that each investor falls within the “accredited investor” definition.
Those angel investors or VCs you’re hoping to get funded by? They’re not likely to want to share such detailed information with you, meaning you could lose out on those investment dollars. And if you end up accidentally selling a security to an unaccredited investor, watch out: the SEC can ban you from subsequent securities issuances (i.e., fundraising) for at least a year.
Your best bet? Just don’t talk about your raise publicly.
Although this post provides some basic information regarding exemptions, securities law is extremely complex, and there are a number of other requirements and factors to consider when raising capital. Please contact an experienced securities lawyer to guide you through the funding process.
*17 C.F.R. § 230.502(c)