Under U.S. law, every sale of securities must either be registered or fall under an exemption from registration. This determination must be made both with respect to federal law and the law of the particular state (the “blue sky” law) in which the securities are being offered. In the bad old days – pre-1990s – each state had its own unique set of exemptions and filing requirements, meaning that a securities offering in multiple states required a significant amount of research and form preparation. In 1996, Congress passed the National Securities Markets Improvements Act (NSMIA), which effectively pre-empted most state regulation of “covered securities,” including securities sold under Rule 506. Post-NSMIA, states can’t do much more in these transactions than require the issuer to send in a copy of a Form D (as filed with the SEC) and pay a filing fee.
When startups are seeking to obtain seed capital through a friends and family financing, most of the time, those friends and family members make a direct cash investment either in their individual capacity or through a business entity that acts as an investment vehicle. Another option that is not widely known is for the investor to use tax-deferred retirement funds for the investment, via what’s known as a self-directed IRA. Essentially, IRA funds can be used for many investments other than the familiar publicly-traded stocks, bonds, mutual funds, ETFs, etc., and among the other permitted investments are private company securities. However, the investment must be made through a custodian who administers the process, executing transaction documents on behalf of the investor, etc. The custodians are not the familiar brokerages like Fidelity and Schwab, but others you probably haven’t heard of that specialize in this area. [Read more…]
As much as I am always inclined to mock West Coast trends, there is a recent one that I grudgingly find intriguing: so-called “safe” equity (simple agreement for future equity), which is an alternative to convertible notes for startups seeking bridge financing to keep the lights on until they can raise substantial funds in a “real” equity round. Y Combinator offers open source safe equity forms with some background information. With a convertible note, the seed investor acts temporarily as a lender, with the note being converted to equity if and when the company has a qualifying equity financing. With safe equity, the investor simply receives the right to receive preferred equity when the financing is completed, without the need to temporarily treat it as a loan. There is no interest, maturity date, repayment terms or any other provisions that you’d associate with a debt instrument.
When companies are in need of financing, the threshold question is whether the financing will take the form of equity or debt. Of course, there are hybrid forms such as convertible debt, and some financings will involve equity investment completed simultaneously with a bank loan. And sometimes debt will not be an available option, particularly for start-ups with no steady revenue that a lender could rely on for assurance of payment. But in many cases, a company will have a choice of which way to proceed. [Read more…]
An advisory committee set up by the SEC, as directed by the Dodd-Frank law, has issued a report with recommendations for changing the “accredited investor” definition used for purposes of determining investor qualifications to participate in Regulation D private offerings. The report correctly identifies the flaws with a system that uses income and net worth as proxies for investment sophistication. It goes on to make a series of recommendations for changes to the system that, in my view, are on the right track.
I wanted to focus for this post on a few specific recommendations that I found particularly noteworthy.
In Recommendation 2, the report advocates relying on more direct measures of financial literacy, such as having securities or financial planning credentials or passing a basic test. There could be challenges in implementing something like this, but clearly we’d rather have a financial planner with a relatively modest income participating in private investments ahead of a 21-year old musician (not that there’s anything wrong with music) who just inherited a $1 million estate.
Recommendation 3 gets into possible limitations on amounts to be invested in private offerings if someone’s income or net worth barely meets the applicable thresholds. This is akin to the limits on investments in the not-yet-enacted Title III crowdfunding rules. This addresses one of the main goals of the securities laws, which is to try to prevent investors from losing a big chunk of their nest egg. If someone who makes $200,000 per year wants to plunk $5,000 in a private investment with a lottery-like risk-reward profile, it may not be the most prudent thing to do, but it’s not going to ruin the investor, so it’s appropriate to regulate it lightly.
Finally, Recommendation 4 promotes third party verification of accredited investor status, which is a somewhat overlooked part of the new rules permitting general solicitation for all-accredited investor offerings. Having trusted third parties in this role helps keep issuers out of the business of sifting through sensitive private financial information of their investors.