Private Company Stock Investing: Until Recently, Limited to Accredited Investors
For most investors, investing in stocks starts and ends with public stocks – stocks that are traded on a national exchange, such as the New York Stock Exchange or the Nasdaq Stock Market. The reason for this is that investing in private company stocks (and other securities) has long been off limits to small time retail investors (as opposed to institutional investors, such as private equity financiers and venture capitalists). Private placements (the term for sales of private company stock and other securities) have primarily been the domain of private equity funds, venture capitalists and angel investors (angel investors are wealthy individuals who use their own money to invest in private companies). U.S. securities law has historically made it challenging for private companies to issue stock or other securities to non-accredited investors. With the introduction of equity crowdfunding under Regulation CF, that has changed.
What is an Accredited Investor?
An “accredited investor” is a term that most startup founders know well. There are many definitions of accredited investors, including certain types of entities and trusts, although, as of the time of publishing this article in 2017, an individual qualifies as an accredited investor if they earn at least $200,000 per year (or $300,000 including the income of their spouse) or have a personal net worth, not including the value of their primary residence, greater than $1 million. For the exact wording of the definition of an accredited investor, visit the SEC’s website to read Definitions and Terms Use in Regulation D.
Why the Government Has Restricted the Participation of Non-Accredited Investors
Contrary to popular belief, the government hasn’t been aiming to protect the private equity groups and venture capitalists by keeping other people out of the private capital markets. The government is concerned about unsophisticated investors losing money they can’t afford to lose. But, regardless of intent, the government’s paternalism has meant that investors who don’t qualify as accredited lack access to the same opportunities as more wealthy investors.
Meanwhile, startups and other businesses looking to raise capital have long been frustrated by advice from securities lawyers (like myself) that the hoops necessary to jump through to sell stock (and LLC interests and other securities) to non-accredited investors are usually too great, too onerous, to make it practical to deal with non-accredited investors, thereby closing off a large portion of the market of prospective investors.
Understanding Securities Law Basics: For Startups and Private Investors
Before we get into the nuts and bolts of equity crowdfunding (also called crowd investing), let’s talk about securities law compliance generally.
The Securities Act of 1933 requires companies who intend to sell securities to register those securities with the Securities and Exchange Commission (SEC) unless an exemption from registration is available.
A security is a term that describes a tradable financial asset. Securities can take many forms with many different characteristics, including stocks, bonds, CDs, convertible notes, and SAFE notes (a SAFE is a Simple Agreement for Future Equity. This was a response by Y Combinator, a startup accelerator/incubator, to onerous terms in typical startup convertible notes. To read more about SAFEs, visit https://www.ycombinator.com/documents/). The test for what exactly constitutes a security is known as the Howey Test and is based on a case from the 1940s. For more on the Howey Test, read The Regulation of Cryptocurrencies and Initial Coin Offerings Under Traditional Securities Law. For now, just know that many more financial instruments than just stocks can be deemed securities.
Companies seeking to raise capital through security offerings (the term for a company issuing securities is, quite creatively, an “issuer”) must either register the securities with the SEC or find an available exemption from registration. Note that issuers must consider exemptions at both the federal level and the state level wherever they offer and sell securities (an offer or sale is in a state where the prospective or actual investor resides). Complying with securities law is tricky business. US securities laws are a myriad of rules and they aren’t always crystal clear. This makes being a securities lawyer challenging, although it also pays decently – the knowledge is important and ability to apply that knowledge practically to help your business clients raise money without getting into trouble has great value.
Registering securities is time-consuming, complicated and costly (the securities and corporate attorneys, investment bankers and public accountants and auditors get paid well!). An initial public offering (IPO), which is the first time a security is made available for sale on the public market, is a grueling process for a business. Their books and records are poured over with tons of questions asked. The SEC wants to be sure the companies going public are transparent and disclose everything “material” (that’s the legal work for significant) to prospective investors.
Private Companies Rely Heavily on Private Placements (including Regulation D)
It is difficult to qualify to become eligible for an IPO. Companies need around $10 million in pre-tax earnings over each of the previous 3 years and must show projections of further potential growth (actually, this is a rule of thumb as of 2017, although it varies, going up and down based on the overall state of the public markets and something called the “IPO window.” In addition to meeting those standards, companies must disclose information about their financial standing, management and business structure, and should expect to pay $1 million+ out of pocket in various fees. Then, public companies must provide quarterly financial reporting and be subject to all sorts of auditing standards and internal controls. Consequently, going public is too difficult, time consuming and costly for small, early-stage companies and startups to pursue.
Because registering securities is so expensive and time-consuming, startups and small businesses rely on exemptions from registration, selling securities in transactions known as private placements. As a business lawyer in Texas and Delaware, helping startups (in Austin, Houston and outside of Texas) raise money through private placements is a large part of my business (for information about the role of private placement memorandums, which are the substantive disclosure document used by many companies when raising money from individuals and angel investors, read Introduction to Private Placement Memorandums (PPMs).
Using rules 505 and 506 of Regulation D of the Securities Act, companies have always had plenty of options to sell private placement securities to accredited investors—essentially, individuals who are able to take on the economic risk of investing in unregistered securities, including venture capitalists, angel investors, and individuals with a lot of wealth—without having to register with the SEC or, at least in most cases, having to disclose quite as much information.
Regulation CF (Equity Crowdfunding): Opportunities for Startups and Other Businesses to Raise Capital and Non-Accredited Investors to Invest in Startups
With Regulation CF (“CF” for Crowdfunding), which was adopted by the SEC as part of the JOBS (Jumpstart Our Business Startups) Act, non-accredited investors are now afforded access to many more private company investment opportunities. One of the main reasons for Regulation CF is to stimulate economic growth by modernizing our securities laws. The crowdfunding investment opportunities for non-accredited individuals has never been so great (technically, non-accredited investors weren’t prohibited from investing in private companies before, although the compliance a startup had to navigate to raise capital from non-accredited investors made it rare that startup founders would do so or that their securities lawyers would say it was okay to do so!).
While, it’s not likely that the new Reg CF exemption will lead most people to tremendous investment riches, it’s an interesting opportunity and one that has great potential. It also carries a lot of risk – the upside potential is higher and the downside outcome is more likely than investing in public company stocks. And, whereas public stock investing is fairly stable (especially if you invest in a diversified basket of stocks), private company investing is high risk and high reward. Venture capitalist Chris Sacca, for example, made 6,800 times the amount he invested in Uber. That investment, among others, is why he’s worth $1.2 billion today! All his wealth came from private company investing (not equity crowdfunding investments, though), including in Twitter.
For startup founders and other entrepreneurs, Regulation CF offers an exciting new avenue for raising capital. Whereas venture capitalists generally tend to be interested in a small range of companies and industries – technology, including software and hardware, biotechnology, artificial intelligence, big data, etc. (my business law startup clients who raise venture capital are almost always “scalable” technology-based startups) – crowd investors look at a broader range of investment opportunities. VCs and most institutional angel investors aren’t interested in investing in restaurants and breweries, although a lot of those types of businesses are getting funded on Regulation CF crowdfunding portals. If you are wondering where to find investors for your business, Regulation CF may be the answer for you.
Now, thanks to Title III (AKA regulation CF) of the Jumpstart Our Business Startups (JOBS) act, private businesses can publicly promote their business through an equity model of crowdfunding – equity crowdfunding (or crowdfunding investment). Now startups and small businesses can offer securities via crowdfunding campaigns. This is exciting news for companies raising capital and investors looking to strike it big by investing in startups and fast growing private companies.
Crowdfunding Intermediaries: The Role of Funding Portals
Issuers must conduct their equity crowdfunding offerings exclusively through an online platform operated by a registered broker-dealer or a funding portal, which is a special type of intermediary created by the JOBS Act. Unlike registered broker-dealers, funding portals are not allowed to:
- Offer investment advice or investment recommendations
- Solicit purchases, sales or offers to purchaser the securities offered on its platform
- Compensate employees, agents and other people for soliciting purchases
- Possess and manage investor funds or securities
All crowdfunding intermediaries (whether they are broker-dealers or funding portals) are required to do the following things:
- Provide investors with up-to-date educational materials that explain how to invest on their online platform, including the types of securities in which an investor can invest, risks associated with those securities and more
- Publish information about issuers conducting offerings on their platforms at least 21 days before any security may be sold in an offering
- Provide communication channels on their online platform to allow investors to interact with representatives of the issuer. All the discussions are publicly available for viewing to ensure that all members of the crowd (prospective investors) have access to the same information
- Require anyone who posts a comment in the communication channels on an online platform to disclose if they are a founder or compensated to promote the investment opportunity
- Maintain and preserve certain books and records relating to its business for at least five years, and permit inspections by the SEC and FINRA
Additionally, Regulation CF requires funding portals to adopt written policies and procedures that are designed to comply with federal securities laws and the related rules, as well as to comply with certain privacy rules aimed at safeguarding sensitive consumer financial information.
All crowdfunding intermediaries must register with the SEC and become a member of a registered national securities association. Since FINRA is the only current registered national securities association, they must become members of FINRA.
Crowdfunding intermediaries are prohibited from engaging in certain activities, such as allowing access to their platforms to issuers if the intermediary has a reasonable belief that any of the issuer’s officers, directors or beneficial owners of 20% or more of the issuer’s equity are disqualified from issuing securities pursuant to Regulation CF (“bad actors” are disqualified if they have previous securities law sanctions and for other reasons)
General Solicitation of Private Investors
Rule 204 of Regulation CF allows companies the opportunity to advertise their offerings—at least, to an extent. Issuers are allowed to advertise their equity crowdfunding deals by publishing notices, as long as the advertisement includes the address of the intermediary’s platform (crowdfunding portal) where potential investors can find additional information regarding the securities being offered. What a startup or other company (an issuer) can and cannot say is subject to many rules and interpretations of those rules. This is an area where you definitely want to seek the advice of a great business lawyer with experience in securities law compliance.
Restrictions on Reselling Securities Purchased Through a Regulation CF Deal
Unlike shares of stock of public companies, securities issued by companies under Regulation CF cannot be sold or traded within the first year of ownership unless they are sold to a family member, an accredited investor, or back to the issuing company. After the initial year, there still may not be a market to sell private securities. It’s far different than calling your Charles Schwab stock broker and selling shares of Amazon!
Investments in startups and other private companies can be very long-term investments. It is likely to be years, if ever, before the investment will be “liquid” (easily tradable due to a well-defined market for the investment).
Required Documentation for Regulation CF Deals: Form C
Any issuer conducting a Regulation CF offering (an equity crowdfunding deal) must electronically file an offering statement with the SEC. This offering statement is called Form C and it’s a substantive disclosure document (different, but similar to the private placement memorandums I mentioned earlier), which includes a lot of information about the issuer, including:
- Information about the officers, directors and owners of 20% or more of the equity (ownership) of the issuer
- A description of the business of the issuer
- A breakdown of how the funds that are raised will be used
- The purchase price for the securities and the method that was used to determine the price
- The target offering amount and the deadline to reach it, as well as whether the issuer will accept investments in excess of the target offering amount
- Disclosure of related-party transactions, which are arrangements between parties who have a unique relationship that could present a conflict of interest (e.g., if another company owned by the CEO sells products or services to the issuer)
- A discussion of the issuer’s financial condition and financial statements.
Equity Crowdfunding through Regulation CF is Risky Territory for Investors and Companies Must Be Conscious of their Compliance Obligations
While the new exemption opens up new investment opportunities for many more Americans to enjoy, there is undoubtedly a lot of risk on the line with these types of investments. In order to mitigate potential losses, the SEC has set strict guidelines for both the issuers and investors. Companies are limited to raising $1,070,000 dollars per year under Title III law (although, more can be raised under other exemptions, if needed). Investors are limited in the amount of crowdfunding securities they can invest in over any 12-month period according to the following rules:
- If either the annual income or the net worth of the investor is less than $100,000, they are limited to investing the greater of $2,000 or 5% of the lesser of their annual income or net worth
- If the annual income and net worth of the investor are both greater than $100,000, they are limited to 10% of the lesser of their annual income or net worth, up to a maximum of $100,000.
Equity crowdfunding through regulation CF is an exciting new exemption that will allow startups and other businesses to raise private capital in ways they never could before. For investors, there is a lot of money to be paid by investing in private company stocks. But, it’s risk territory for investors and requires a lot of compliance on the part of the issuers.
If you have questions that I can help with as a business lawyer with experience with equity crowdfunding (Regulation CF) deals, please get in touch. I have law offices in Houston and Austin, Texas, although I help clients all over the country.
FYI, I don’t specifically label myself as a technology lawyer (because I work in many other industries), although I have a lot of experience in technology (including time I spent as a venture capitalist and, before that, launching a technology company that raised venture capital in the late 90s) and always appreciate connecting with technology startups doing interesting things.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.