Legal Corner Archive

I’ve received numerous inquiries and had many discussions regarding which way is the best way to become a public company. As the title to this latest article plainly suggests, there are indeed many considerations – more than can be covered in one article. This first article is a step though and will be followed by additional articles building on the information here.

Bucking the IPO System
When I first expanded my securities practice years ago to include reverse mergers and shell company transactions, I occasionally encountered skepticism from entrepreneurs and their lawyers from time to time regarding various alternative methods that allowed a company to become public without the traditional Initial Public Offering filing with the SEC (I’ll refer to these various methods and other going public strategies that don’t rely on an IPO as “IPO Alternatives”).

Even straightforward self-filings using an experienced securities attorney were considered out of the mainstream. This occasional skepticism and overly cautious view of IPO Alternatives was a result of several factors.

1. Going Public Raises Money for Operations. First, conventional wisdom had it that “going public” was to accomplish various goals – a primary one being the raising of money for operations and growth. Not only is the company registered with the SEC but shares of the company are also registered so that they may be legally sold to investors by one or more underwriters. IPO alternatives, like reverse mergers and self-filings, include the first element (the company is registered with the SEC) but financing is a separate element which, if needed, must be arranged. This may be a PIPE financing at the time of the transaction, a Regulation D private offering beforehand (refer to my articles in the archive on Reg D) or market makers lined up and in place for a self-filing.

2. Shareholder Base. In addition, a successful IPO creates a broad shareholder base as a result of the distribution of the shares by the syndicate of underwriters. This type of broad share distribution generally creates a diverse “float” of public shareholders and a healthy trading market. A self-filing or a reverse merger (which may also take the form of a share exchange or asset acquisition) doesn’t create new shareholders. The entities themselves generally need to have enough shareholders to have a float and trading market when the papers are signed. While the shareholder base can be grown over time, regulator preferences and market realities require a sufficient shareholder base to make your efforts worthwhile.

3. IPO Legitimacy. Finally, an IPO has always had legitimacy because that was the clear roadmap laid out and supported by the SEC and custom-made for the SEC’s integrated disclosure and reporting framework. Further, it way it was done by the big players – the large brokerage houses and investment bankers – and they earned huge fees along the way for underwriting a conventional IPO. Creative entrepreneurs who didn’t have access to Wall Street, or whose businesses were not mature enough to justify even a “best efforts” commitment by underwriters, or didn’t have adequate revenue or capital for the going-public process, had to find other ways to provide their investors with free trading stock.

Unlike an IPO, the SEC had some real and often justified concerns with the way some IPO Alternatives were being implemented. Beginning in the 1970’s and 1980’s, entrepreneurs, investment bankers and their attorneys began using Rule 504 of Reg D and/or various state and federal securities laws to sell stock that would be able to trade without restrictions. Even if there was no public market for the stock, the trading could eventually develop if a good company continued to have positive developments and it found support among market makers. Another strategy was to simply form a company with a basic business plan and attempt to raise money with a public offering (sometimes with every intention of continuing the business and sometimes with the intention to acquire a company with more substance to be identified in the future.

From the SEC’s point of view, many of the transactions employing these under-regulated alternatives resulted in complaints from investors claiming securities fraud. A typical example might involve a promoter who raised money for a company, but since it was not underwritten it was not nearly enough for the company to truly carry out its business plan or to have a healthy public market. Over time, the money raised is depleted paying fees or salary to the promoter while he is seeking other sources of financing or has moved on to other deals.

Much to the chagrin of those companies who were trying to do things right, the SEC decided it needed to step in and regulate IPO Alternatives more directly. Among other things, the SEC in 1992 required promoters of “blank check companies” to keep all money raised in escrow until a merger or acquisition was generally approved by the shareholders and appropriate filings were made with the SEC. (A “blank check company” was defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…”) If no acquisition was found or approved within 18 months, the funds had to be returned to investors with interest. Some readers may note the resemblance to a modern day specific purpose acquisition company, or “SPAC”, however SPACs, while structured generally in the same manner, raise well over $5 million dollars and are therefore outside the purview of Rule 419.

As reverse mergers increased in popularity, further problem areas inherent in the use of IPO Alternatives were addressed by the SEC. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies. Since 2000, therefore, no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting (although see my recent article on Rule 144 - with recent changes to Rule 144 in 2008, holders of shares issued in shell transactions have a way out of the Worm-Wulff restrictions if the company is no longer a shell files its required reports for 12 months).

Following the Worm-Wulff letters of 2000, the SEC adopted much more detailed filing requirements for reverse mergers in 2005 and prohibited shells from using Form S-8 (which had become commonly used in shell transactions as another form of compensation for insiders instead of its intended purpose related to employee-director stock grants).(See http://www.sec.gov/rules/final/33-8587.pdf.)

Even given the various limitations on IPO Alternatives which have been imposed along the way by the SEC, it is important to note that the SEC never prohibited shell company transactions – for the most part they have made promoters more forthcoming regarding transaction details. In its 2005 rulemaking, the SEC actually acknowledged there were legitimate purposes for the use of shells:

“The rules and rule amendments we are adopting today do not address the relative merits of shell companies. We recognize that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes. Similarly, our definition and use of the term “shell company” is not intended to imply that shell companies are inherently fraudulent. Rather, these rules target regulatory problems that we have identified where shell companies have been used as vehicles to commit fraud and abuse our regulatory processes.

SEC respectability has accompanied acknowledgement from the big players on Wall Street that IPO Alternatives should be considered along with the traditional IPO approach. The term “reverse merger” gained new respect when the venerable 215 year-old New York Stock Exchange concluded a reverse merger with the registered upstart Archipelago Holdings rather than select a traditional IPO. While not perfect, Google’s “Dutch Auction” strategy worked impressively despite an initial push towards going the traditional IPO route. There are a multitude of self-filings and other IPO Alternatives as well that have firmly established the notion that a conventional IPO is not the only way to go.

If you can get an underwriter’s commitment to take you public going the IPO route, you should seriously consider it and its costs. If you don’t have the luxury of a major brokerage house waiting to underwrite your deal, how do you choose the best IPO Alternative? These transactions are all complex and not for the faint of heart. You need experienced legal and financial professionals to discuss the multiple pros and cons of the different IPO Alternatives before you even start to consider those alternative ways for your company to become public. Regardless of what anyone says, this is not a situation where there are a couple of quick documents you can sign and then you are on your way.

Your company might be ideal for a reverse merger with one of many types of companies:

Your company might also be ideal for a straightforward self-filing. There may easily be several different IPO Alternatives that can be used to accomplish your objectives. With the cost ranging from $100,000 to over $1 Million, there is ample reason to consider the pros and cons of each alternative suitable to your company. (As an example, the fact that a company already has a trading symbol is only one aspect to consider – but clearly not enough upon which to base a decision on how you will achieve your objectives for your company.)

In follow-up articles, I hope to explore some of those various considerations with you. Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures.

This article provides general information only. It should not be construed as legal advice. We provide legal advice only to clients of the firm. Due to the complexities of securities law, the specific facts and circumstances must always be carefully considered and similar situations may lead to different conclusions.

Breakthrough for Shell Promoters, Self-Filers, PIPE Investors and Reporting Start-Ups

Following proposed changes in July 2007 and a flurry of subsequent formal comments, the Securities and Exchange Commission issued a release on December 6, 2007 detailing amendments to Rule 144 and Rule 145 (although the release also addresses important related issues). One of the SEC’s primary objectives in adopting these amendments was to facilitate capital formation. In large part, the SEC accomplished this and several of its other objectives.

Thinking through my experiences in past shell transactions, reverse mergers and other going public alternatives, I have to say there are certainly some revisions that could be expanded further. Don’t get me wrong though – there are plenty of reasons to be pleased with this release as is. In addition to shortened holding periods for Rule 144 stock, there are huge advances for shareholders of companies that are or used to be shell companies as well as companies that may fit the technical definition of “shell company” but are, in fact, bona fide small operating companies.

Some of the most significant changes are summarized below but bear in mind that the release is well over 100 pages long (and references hundreds of pages of related releases and commentary). Many of the changes are subtle and a full understanding requires a broader knowledge of securities law beyond what is written in the release. (Translated: Keep your securities attorney on speed dial when venturing into these areas, especially where anyone else’s cash might be on the line.)

Concepts and Terms

A quick review of some concepts and terms will be helpful.

Restricted Securities. Generally, if you acquire securities that are not registered with the SEC, they are deemed restricted securities and you must find an exemption from the SEC's registration requirements to sell them in the marketplace. Restricted securities are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings, Regulation D offerings, as compensation for professional services or in exchange for providing "seed money" or start-up capital to a company.

Control Securities. If you acquire control securities, you must also find an exemption from the SEC's registration requirements to sell them in the marketplace, even if those securities are registered, since they are deemed restricted for other reasons (e.g. stock held by those presumed to have insider knowledge has restrictions). Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise. If you buy securities from a controlling person or affiliate, you take restricted securities.

Section 4(1) and the Underwriter Presumption. Section 4(1) of the Securities Act of 1933 (the “Securities Act”) provides that the registration requirements of the Securities Act “shall not apply to transactions by any person other than an issuer, underwriter, or dealer.” Section 4(1) was intended to exempt only routine trading transactions between individual investors with respect to securities already issued and not to exempt distributions by issuers or acts of other individuals who engage in steps necessary to such distributions. If you receive newly-issued securities directly from the issuer (or an affiliate), or receive securities as a result of a business combination or similar transaction, you would likely fall under the SEC’s broad definition of an underwriter if you attempted to sell shares into the market without registration. (Even individual investors may be deemed to be “underwriters” within the meaning of the statute if they act as links in a chain of transactions through which securities move from an issuer to the public.)

For both affiliates and non-affiliates, the Rule 144 amendments significantly shorten the holding periods applicable to
resales of securities and lessen or reduce other requirements of Rule 144 as well.

Affiliates. If you are an affiliate of a reporting company, you may resell restricted securities after a six-month holding period (previously one year), subject to the public information, volume, manner of sale and Form 144 filing requirements. These requirements apply as long as you remain an affiliate. The time period increases by six months if the company is non-reporting.

Non-Affiliates. If you are a non-affiliate of a reporting company, you may resell restricted securities after a six-month holding period, subject only to the public information requirement. If the company is non-reporting, no sales are permitted for 12 months. After holding restricted securities of both reporting and non-reporting companies for 12 months, non-affiliates may resell their securities without restriction.

In the adopting release, the SEC summarized the revised holding periods and resale restrictions using the following chart:

In addition, the amendments changed additional parts of Rule 144 and raised the thresholds that trigger the requirement to file Form 144 to trades of 5,000 shares or $50,000 within a three-month period for affiliates. Of course, restrictive legends on stock certificates will still have to be removed to enable trading and issuer placement agents will likely continue to demand opinions of counsel acceptable to the company that all Rule 144 requirements have been met before they remove the legends.

Amendments to Rule 145

Rule 145 of the Securities Act provides that exchanges of securities in connection with business combination transactions subject to shareholder approval constitute sales of those securities, which must be registered under the Securities Act. Prior to the current amendments, shares received by certain shareholders of an acquired company in a stock-for-stock transaction were subject to resale restrictions because they were presumed to be statutory underwriters. The Rule 145 amendments eliminate the "presumptive underwriter" doctrine with regard to these business combination transactions except with regard to transactions involving blank-check or shell companies.

Other Significant Changes

Shell Companies / Reverse Mergers. The past seven years have required some extra work and creativity for entrepreneurs and attorneys structuring transactions with newly-formed and trading shells. On January 21, 2000, Richard Wulff of the SEC wrote a letter in response to an earlier letter from Ken Worm of the NASD (now known as the “Worm-Wulff letters”) advising that Rule 144 was not available for the resale of securities initially issued by companies that are, or previously were, “blank check” companies (defined by the SEC as “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company…” The SEC didn’t actually define the term “shell company” until later).

Remember the “presumed underwriter” issue discussed earlier in this article? It was the SEC’s view that “transactions in blank check company securities by their promoter or affiliates….are not the kind of ordinary trading transactions between individual investors of securities already issued that Section 4(1) [of the Securities Act] was designed to exempt.” Given that analysis, the SEC stated that “both before and after the [reverse merger], the promoters or affiliates of blank check companies, as well as their transferees, are “underwriters” of the securities issued. Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act.”

Therefore, the safe harbor exemption of Rule 144 was not available, even if there was technical compliance with the rule, because the resale transactions appeared to be “designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act.” This has generally been the prevailing law since 2000 – no resales of shares issued in connection with a reverse merger have been permitted without registration of the shares (as opposed to registration of the company) with the SEC. This became applicable to all holders of restricted and non-restricted shares of trading shells and non-trading shells, regardless of whether they were reporting or non-reporting.

With its December 2007 release, the SEC has reversed its “registration or hold” policy with respect to shell transactions and has opened a window for purchasers of shell securities. Upon the February 15, 2008 effective date of the release, a security holder may resell securities subject to the Rule 144 if the following conditions are met:

a) The issuer of securities that was formerly a reporting or non-reporting shell company has ceased to be a shell;

b) The issuer of the securities is subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act;

c) The issuer of the securities has filed all reports and material required to be filed under Section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to filed such reports and materials), other than Form 8-K reports; and

d) At least one year has elapsed from the time the issuer filed current Form 10 type information with the SEC reflecting its status as an entity that is not a shell company.

While many of us in the industry had hoped that we would also see a six-month holding period applied to these transactions as well, there is still ample reason to be pleased. Rule 144 is now available for the resale of restricted and non-restricted securities that were initially issued by (i) a reporting or non-reporting shell company or affiliate; or (ii) an issuer that has been at any time previously a reporting or non-reporting shell company or affiliate. Be aware, however, that numerous subtleties exist and your factual situation is often not as clear cut as you would like. (Issues regarding shares of companies that had been legitimate public companies but later became shells, late filings during the one-year period, when the clock starts ticking, and other twists are subjects for another article.) Suffice it to say for now, though, that if a company follows all of the SEC’s requirements, it can promise liquidity for its shareholders even if it is not able to complete a registration of its shares in a timely manner. This is yet another significant nod from the SEC that these transactions are legitimate and appropriate if structured and conducted properly.

PIPES and Self-Registrations. Investment in a shell through a PIPE transaction (private investment in public equity) faced the same prohibitions resulting from the Worm-Wulff letters. The securities had to be registered before they could be traded so detailed “registration rights” agreements were required as part of the transaction. These agreements were typically accompanied by harsh penalties such as liquidated damages to make sure the company performed on its promise to register the PIPE investor’s securities for resale.

In addition, because of the initial restrictions on share registration and concerns regarding what percentage of shares would be permitted by the SEC given certain other SEC rules and factors, shells often needed to accept the investment at a significant discount to value in the case of a trading shell.

While it is likely that PIPE investors will continue to insist on registration rights agreements and other protections, the current amendments will at least assure liquidity, assuming the conditions during the year are met, even if the company has not been successful with registration of its shares. In addition, the PIPE investor will enjoy this liquidity even if public information is no longer current after the one year period.

The amendments are also good news for companies planning a self-filing (when a company registers directly with the SEC on the appropriate form). While a self-filing may not always make sense, if it does the company will benefit from the new Rule 144 holding period as well. Be sure to check with your securities counsel since current amendments are phasing out certain forms and mandating the use of others.

Start-Up Companies

For a number of years, companies in the start-up or development stages that want to be publicly-registered for valid purposes (e.g. to be in a position to attract financing needed to accomplish their business plan) have faced a significant SEC problem. There is a risk of being categorized as a “Footnote 32 shell” (so dubbed because of a footnote in SEC rulemaking related to reverse mergers in 2005). In Footnote 32, the SEC refers to transactions where the company filing with the SEC is actually not a legitimate business, or where it is a legitimate business with only nominal assets. In either case, the intent of the promoters or affiliates is to find a private company with which to merge with a new business resulting. In Footnote 32 scenarios, however, none of this is disclosed to the SEC, thereby avoiding the characterization of the company as a shell and the numerous restrictions on shells.

Start-up companies conducting a reverse merger to become public have therefore faced the risk of being characterized as a shell because their limited operations or nominal assets. With the recent December 2007 release, however, the SEC indicated (interestingly in another footnote) that “Rule 144(i)(1)(i) is not intended to capture a “startup company,” or, in other words, a company with a limited operating history, in the definition of a reporting or non-reporting shell company, as we believe that such a company does not meet the condition of having “no or nominal operations.” Therefore, in the event a company is a legitimate business prior to any merger and that business continues into the future, the new six-month holding period should apply. (Warning however: Footnote 32 is very much alive at the SEC with regard to shell companies planning to conduct a reverse merger but, instead, masquerading as start-ups. Even a company that has ceased being a shell and has been trading for some time could have some significant risk if at some point in the past it was a Footnote 32 shell.)

Conclusion
For the most part, the SEC has taken significant steps to facilitate a company’s capital formation needs. Because of the recent amendments, companies can now offer potential investors faster liquidity and improved information in most circumstances. This should make capital raising and stock-for-stock acquisitions easier and less costly. Further, the revised holding periods and other amendments that have been adopted are “retroactive,” meaning that they are applicable to securities acquired before or after the effective date of February 15, 2008.

Regardless of the new amendments, however, continue to bear in mind that SEC rules are not available with respect to any transaction or series of transactions that, although in technical compliance, is part of a plan or scheme to evade the registration provisions of the Securities Act. In such cases, registration under the Act is required.

The final release is available at http://www.sec.gov/rules/final/2007/33-8869.pdf. Many other issues are addressed in the release. Perhaps I will deal with some of them in a future article.

Be sure to send me an e-mail and let me know if this article was helpful to you or if you have other questions before continuing further in your own ventures.

Whether it’s selling stock in exchange for equity of your company, selling notes to bring in money as a loan from private investors or whether other types of securities like preferred or convertible instruments are being offered, the process of raising money for your venture is made easier and safer for you if you comply with the requirements of Regulation D of the Securities Act of 1933 (“Reg D”).

These Reg D requirements extend far beyond document format. In fact, you can have a document formatted as a Reg D private placement memorandum (“PPM”), yet your offering may still fail to comply with Reg D for a variety of reasons, either because of the way disclosures are made in the PPM or the way the offering is conducted by the company or otherwise. If your offering does not comply with Reg D, (i) you will not benefit from the protections provided by the Reg D “safe harbor” and (ii) your potential exposure to liability in the future from an unhappy investor increases greatly. (One of the prime reasons to raise funds through a proper Reg D offering is to reduce your exposure to liability while at the same time increasing your control over the investment process.)

Attempting to comply with a complicated, interwoven set of securities regulations and statutes without using a securities attorney does your company no good and sometimes may cause a good deal of harm. You have put time and money into your venture but here is absolutely the wrong place to cut costs. This logic applies equally to an accounting firm. You should have your securities attorney and your accountant involved at the earliest stage. You are seeking money from other people – do it right! Even though I am a securities attorney and can tell you about the multitude of sections throughout the PPM that need to be drafted with the correct “twist of the phrase” (and the numerous other sections that must be qualified, limited or expanded), there are many practical reasons why you should not proceed without securities counsel. As mentioned previously, you limit your exposure greatly by raising funds in compliance with Reg D. In addition, investors are likely to think twice about investing in a company or venture that has not retained counsel. From a business standpoint, your attorney can assist tremendously in the structuring of the deal, perhaps finding more value than you thought was there, planning the roll-out of the offering to match capital requirements or making sure that your desired exit strategy is factored properly into the transaction. From an organizational standpoint, your attorney serves as your quarterback in lining up all the required pieces and information, reporting the progress to you as needed and freeing up your time to concentrate on your core business.

A securities attorney will often be amenable to working out a flat fee arrangement with you so that you can budget out your expenses. (Since we do so many Reg D’s, we have a good idea of what they will entail and have no problem offering the client a flat fee as an option to hourly billing but I can’t speak for all attorneys of course.) I will close this section by simply remarking that the law always changes – just recently new changes were made affecting Reg D offerings. You need to make sure the attorney is a securities attorney – not someone whose practice is, for example, litigation or wills and estates. If you want to sue someone or need a will, that’s the time to go to those specialists.

You may have a first-rate business plan but if you are seeking funding from a number of investors, it does not replace a PPM. While it may serve as an excellent internal document for determining attainment of sales or financial objectives, or to describe the business to a bank or another third party, it is not designed to satisfy the requirements of Reg D. In fact, a PPM is the ultimate business plan. It incorporates descriptions of management, the product or service, the competition and industry, the plan for marketing, sales and growth, and so forth and includes the many additional disclosures required by securities law as well (in a format experienced investors are used to seeing). It is not just the inclusion of additional information and disclosures that differentiates the PPM from the business plan. It is also the way the documents are written, which is actually a reflection of their intended use. The typical business plan is somewhat sales-oriented (appropriate for its intended reader) while a PPM is disclosure-focused and meant for review by investors. Because of this, some portions of a business plan may be used in a PPM as good supporting data but the actual text often requires a good bit of revision for a variety of reasons. This does not mean that a PPM can not be positive with respect to the market and potential growth of the company. Rather, favorable disclosure items are described consistent with securities law requirements and matters that may negatively impact the company are clearly disclosed as well – an investor reviewing a PPM for a Reg D offering knows he or she is getting the full story but a business plan will always leave questions.

You must view the PPM’s full disclosure of positive and negative aspects as your ally! When a client asks: “Do I really have to disclose that?” my response is always “Will it make a difference to the investor when considering whether or not to invest?” If it might make a difference, then it should definitely be disclosed. The PPM will also indicate there is no guarantee of success. Remember the end game – you are seeking investments from people who have money to invest (and have money for lawyers as well). You want to make sure that you decrease your exposure to liability during this process. If an unsatisfied investor comes to you in the future says “You never told me about ____,” you can refer him to the PPM where he was informed, probably several times, in writing. While there is, understandably, some discomfort with the extent of disclosures made in a PPM, my personal experience leads me to believe that investors are rarely surprised that there are risks – it generally comes down to the merits of the deal and they would be surprised if there were no flaws in the company or the transaction..

The general rule is that an entity may not make a public offering of its securities (stock, bonds, LLC interests, etc.) unless (i) the securities are registered with the SEC or (ii) the company is exempted from registering the securities being offered because the offering is deemed to be a private offering. Many factors determine whether this is the case and, if ever necessary, a company may have to prove those factors existed and it was therefore exempt from registration requirement. Recognizing the need for small companies to raise capital more easily, the SEC enacted Regulation D as a “safe harbor.” Reg D is not the only way to conduct a proper limited offering but if a company complies with Reg D, it will not have to prove it was exempt from full registration, if ever necessary in the future. This was a huge boon to the small to mid-size company capital market and Reg D continues to be revised in response to the market. While the format and content of the PPM are extremely important, the actions taken afterwards during the process of seeking investment are equally important in order to comply with Reg D. Advertising for investors, improper use of electronic media or the use of improperly drafted marketing pieces or executive summaries can be fatal to your attempts to comply with Reg D. In addition, the failure to make appropriate filings with the SEC and the states where your prospective investors reside can also preclude you from the benefits of Reg D. Following all the hard work by the company and its securities counsel during the preparation of the PPM, many mistakes can still be made – company and counsel must continue to dot the i’s and cross the t’s throughout the offering process to insure the Reg D exemption remains intact.

Many companies, complying with Reg D in other respects, go astray with their use of finders. The use of finders, even if you call them consultants, advisers, wholesalers or some other name, is a tricky matter and needs review on a case-by-case basis. It is not a question of integrity of the finder or amount of fee. (Value delivered deserves proper compensation). Rather, this is an issue related to the manner of your offering which, by its nature, must be non-public and limited in order to comply with Reg D. Remember that your company (through its key officers and directors) is one of the principals in the transaction, selling securities, and the other principal is the investor as buyer of the securities. Third party intermediaries presenting the offering, providing information, answering questions and otherwise facilitating the transaction are brokering the transaction between the two principals. When you buy stock in an exchange-listed company, you buy it through your broker representative who is licensed by the National Association of Securities Dealers (“NASD”). Brokerage firm representatives are regulated, are presumed to know the investment intentions and risk tolerance of their client investors and are traditionally paid a fee based on the amount of the purchase transaction (typically referred to as “transaction-based compensation”).

In the typical finder scenario, however, the finder often acts in a manner similar to a licensed broker, presenting the investment transaction, answering questions and then arranging a conference call or an initial meeting. If an investment follows, the finder expects transaction-based compensation (cash and/or stock), which is typically negotiated by a finder to be a percentage of the investment. The problem here, however, is that the typical finder is not licensed with the NASD. Nevertheless, if a finder is acting like a securities broker, the law generally requires the finder to qualify and register as a broker. This is clearly the case if a finder is providing this kind of service on a regular basis. If the finder is actually “in the business” of providing the services of a broker then he or she must be licensed. Both state law and federal law require it. The Reg D filing with the SEC requires a listing of the brokers in your offering and the states, in particular, have a strong interest in protecting their residents by regulating the parties who seek investments from them.

It is far preferable to utilize a licensed NASD broker to sell all or a majority of your securities. Simply said – just agree to pay the brokerage firm its standard fee for monies raised and let it present your deal to the firm’s investor pool in an organized, professional manner. If you cannot interest a broker in your deal, there are situations where isolated transactions, special provisions in state law or specific situations may allow a company to use the services of a finder. You may feel the pressure to accept funds through a finder but seek the advice of counsel and move forward cautiously. One complaint to one state securities administrator can lead to a real problem.

Despite your best efforts, a number of mistakes can be made when undertaking a Reg D offering. The positive side, however, is that Reg D offerings are conducted successfully every day throughout the country. They are flexible enough to suit most any company’s needs and can be structured as the financing component of a larger business objective such as a merger or PIPE transaction. In short, Reg D continues to be the best show in town for private financings.

Be sure to send me an e-mail and let me know if this article on Reg D was helpful to you or if you have other questions before embarking on your own funding efforts.

If you are seeking private investors to help fund your venture, you need to consider following the guidelines provided by Regulation D of the Securities Act of 1933. Why? Some of the many reasons are:

(i) Potential investors will receive the kind of professional investment package from you that they are accustomed to receiving from others seeking their investment dollars.

(ii) If you comply with certain rules of Regulation D you will not be subject to a ceiling on the amount of investment you can seek.

(iii) Because your investment is structured as a Regulation D transaction, you are better able to retain your desired equity or other deal terms in the face of investors who will be seeking better terms or concessions.

(iv) You will get the kind of protection from lawsuits and liability that you would never get using only a business plan (even a well-crafted one) or a similar generic investment document.

I have often begun seminars on venture financing with a simple maxim: If an investment is involved, it almost always involves an “issuance of securities” – in exchange for dollars, the company issues securities to the investor representing an interest in the company (in ownership, rights to payments or otherwise). It doesn’t much matter whether you call the interests issued to the investor shares of stock, LLC units, options, participating interests or otherwise – if someone invests money with the hope of receiving a profit mainly from the activities of the company or venture, you are dealing with a securities offering (you offered the securities, the investor gave something of value, you issued the securities.)

There are a lot of factors involved but its best to just assume you are involved in a securities offering (this is true even if it is a minimal dollar amount). As I learned as a young intern at the Securities and Exchange Commission, before you offer and issue any securities, they must be registered with the SEC (i.e. public registration subject to SEC review of prospectus and comments) or there must be an exemption from this type of registration.

The key is making sure you have an exemption from registration that you can “hang your hat” on. Companies taking in investor funds without regard to complying with an applicable exemption are taking on a significant risk because any company involved in a securities offering might be required in the future to affirmatively prove that there was an exemption that applied to them at the time securities were sold. For example, let’s say one of your investors has a problem with you or your company two years after investing and decides to sue (the thing about investors is that they also have the money to hire lawyers…) You should assume one of the claims will be that the company offered and sold “unregistered” securities in exchange for his investment. The inability to refute this claim could spell disaster for your company and its other investors (your situation just became more precarious). While there are a few exemptions other than Regulation D that may apply, there is no “slam dunk” because you still have to prove you complied which can be tricky.

Like many other practitioners, I will often rely on the exemption from registration provided by Regulation D because, when complied with, it provides the client with a “safe harbor” from the general registration requirements enforced by the SEC. This is key so I will repeat it - when the various rules and provisions of Regulation D are complied with, you can rely on this “safe harbor” exemption from registration while seeking your funding. Many issues (relating to numbers of investors, specific information disclosed, limitations on soliciting interest and so forth) are involved in complying with Regulation D but, if you do comply, you can breathe a bit easier.

Yes, it takes some additional legal and accounting fees in the initial stages to complete a Regulation D offering document and to conduct the offering in the required manner (changes to specific provisions of Regulation D occur occasionally with a number of revisions under way right now at the SEC). At the end of the day, rely on your professional advisors and their input to help guide you in your decision regarding funding strategy and future risk assessment.

A great number of issues touched on briefly here are beyond the scope of this article and will be covered in more detail in future Bizfin.com articles. If you have questions or comments, give me a call or send an email – perhaps I can address something of particular interest to you in the future.