The Real Shark Tank: Overview of Private Securities Offerings and Crowdfunding

Author: William B. Helbling

Originally published in October 2021

Copyright © 2021 Knox McLaughlin Gornall & Sennett, P.C.

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Private Capital Markets / Securities

What are Private Capital Markets?

• The sale of securities in private companies, as opposed to publicly traded companies (i.e. Nike and Facebook).
• Private companies use private capital markets to raise capital through private placements and offerings.
• Private placements and offerings differ from initial public offerings (IPOs), as private offerings involve the sale of securities not registered with the Securities and Exchange Commission (SEC).

What is a Security?

Under Section 2(a)(1) of the Securities Act, the term “security” is defined as:

“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” (15 U.S. Code § 77b(a)(a))

Under the Howey Test:

"a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” (SEC v. Howey Co., 328 U.S. 293, 328 (1946))

Examples of Securities sold in Private Capital Markets

• Equity (i.e. Common Stock, LLC Membership Units, Limited Partnership Interests)
• Hybrid Debt Securities (i.e. Convertible Notes)
• Other Instruments (i.e. Options and Simple Agreement for Future Equity (SAFEs))

Why Does it Matter?

Private markets are outraising public markets by a significant amount. For 2020, the SEC reported that private offerings generated ~$3.33 Trillion in capital fundraising, as opposed to IPOs which only resulted in $2.1. Trillion in capital fundraising (Annual Report for Fiscal Year 2020, Office of the Advocate for Small Business Capital Formation).

Commercial lending has become less available and/or attractive to start-up companies and other existing private entities (i.e. lack of collateral, pandemic issues, etc.)

Developments and changes in securities regulation at the federal and state level have made private offerings more attractive and accessible.

How Are Securities Regulated?

History

• Stock Market Crash – On October 29, 1929 the US stock market crashed due to a bubble created by extremely speculative sales/trading of securities.
• Securities Act of 1933 – As a result of the 1929 stock market crash and lack of securities regulation under federal law, US Congress moved to enact the Securities Act of 1933. The sole purpose of the Securities Act of 1933 was to lay out the legal framework for regulating the sale of securities from an issuer (i.e. a corporation) to an investor.
• Securities Exchange Act of 1934 - In addition to the 1933 Act, US Congress enacted the Securities Exchange Act of 1934 to govern the sale of securities on the secondary market (i.e. stock exchanges).
• The Securities Exchange Commission (SEC) – The government agency created under the 1934 Act to regulate the sale of all securities throughout the US.

Blue Sky Laws

• In addition to federal securities laws, each state in the US has its own securities laws/regulations that cover the sale of securities to its residents.
• Many Blue Sky Laws predate the 1933 and 1934 Act, as there was a growing need for securities regulation due to honest investors being sold bad securities (Kansas first state in 1911).
• The term “Blue Sky” actually was coined from Judges and financial commentators who urged the states to regulate the sale of securities, as financial hucksters were selling investments in everything but the “blue sky.”

Origin of Securities Exemptions

Federal Securities Exemptions Background: Section 4(a)(2) of the 1933 Act provides that securities do not need to be registered if they are sold in connection with “transactions by an issuer not involving a public offering” (5 U.S. Code § 77d(a)(2))

Section 4(a)(2) of the 1933 is known as the private offering exemption, which has resulted in subsequent regulations from the SEC defining what is considered an exempt offering of securities.

Most Popular Federal Offering Exemptions

• Regulation D
• Regulation A
• Regulation Crowdfunding (CF)

Regulation D

Background

In 1989, the SEC adopted Regulation D to provide safe harbors to help issuers to ensure offerings were exempt from registration (17 CFR § 230.500).

“Accredited Investor”
17 CFR § 230.501

Entities:

• A bank, savings and loan association, insurance company, registered investment company, business development company, or small business investment company or rural business investment company.
• An employee benefit plan if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million.
• A trust with assets exceeding $5 million.
• Entities with assets exceeding $5 million.
• Entities whose equity owners are Accredited Investors.

Individuals:

• A person who has earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior 2 years, and reasonably expects the same for the current year.
• A person that has a net worth over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence).
• A director, executive officer, general partner or knowledgeable employee of the company selling the securities, or any director, executive officer, or general partner of a general partner of that company.

New Accredited Investor Categories:

• A person that holds in good standing a Series 7, 65 or 82 license.
• Any person who is a “knowledgeable employee” of a private fund for investments in that fund.
• A “family office” with over $5 million in assets under management (not formed for the purpose of making investment) directed by a person with knowledge and experience in financial and business matters who is capable of evaluating the merits and risks of the prospective investment.
• Any “family client” of a family office meeting the requirements in the new category above.

“Sophisticated Investor”

• Individuals with sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.

“General Solicitation”

• Advertisements published in newspapers and magazines, public websites, communications broadcasted over television and radio, and seminars where attendees have been invited by general solicitation or general advertising.

“EDGAR”

• The Electronic Data Gathering, Analysis, and Retrieval system.
• The SEC’s filing system for private and public entities who issue and sell securities.

506(b) Offering Rules
17 CFR § 230.506

• No fundraising limits.
• Accredited Investors only or up to 35 Sophisticated Investors.
• No General Solicitation.
• No need to comply with Blue Sky Laws.
• Securities sold are Restricted Securities.
• No financial disclosure if Accredited Investors only.
• If Sophisticated Investors participate then: (1) Reasonable steps need to be taken to confirm that investors are Sophisticated Investors; (2) Disclosure documents must be provided (i.e. PPMs); (3) Up to $20 million – Internal financial statements must be provided; and (4) $20 million and above – Audited financial statements must be provided.

506(c) Offering Rules

• No fundraising limits.
• Allows for General Solicitation.
• Accredited Investors only.
• Issuer takes reasonable steps to verify that the investor is an Accredited Investor.
• Securities sold are Restricted Securities.
• No need to comply with Blue Sky Laws.

504 Offering Rules
17 CFR § 230.504

• $10 Million limit within the past 12 months.
• No General Solicitation.
• Securities sold are Restricted Securities.
• Required to comply with Blue Sky Laws.

Regulation D Filings

• All 504 and 506 Offerings require the issuer to file a Form D with the SEC 15 days after the sale of securities through EDGAR.
• 506 Offerings only require an issuer to mail a copy of the Form D to the state securities authorities where investors are domiciled.
• 504 Offerings will require additional forms filed with state securities authorities where investors are domiciled.
• Form D is a notice filing that contains the following information: (1) Name of Issuer/Contact Information; (2) Industry Type/Issuer Size; (3) Type of Securities Sold; (4) Offering Terms; and (5) Broker Dealer Information.

Regulation A (The Mini IPO)

Background

• Regulation A was adopted in 1936 as one of the first exemptions from registration for small issuers.
• Title IV of the JOBS Act required revisions to Regulation A.
• Regulation A allows companies to offer and sell securities to the public, but with more limited disclosure requirements.
• In March 2015, the SEC adopted final rules to modernize and expand Regulation A.

Fundraising Limits
17 CFR § 230.251

• Tier 1 Offering – Up to $20 million within a 12 month period.
• Tier 2 Offering – Up to $75 million within a 12 month period.

Regulation A Rules

• Not Restricted Securities.
• Tier 1

1. No limit on investors (Can be Accredited or non-Accredited Investors).
2. Internal Financial Statements required.
3. Required to comply with Blue Sky Laws.
4. Exit Report filed with SEC after completion of offering.

• Tier 2

1. A non-Accredited Investor may invest no more than: (1)10% of the greater of annual income or net worth (for natural persons); or (2) 10% of the greater of annual revenue or net assets at fiscal year-end.
2. No need to comply with Blue Sky Laws.
3. Audited Financial Statements required.

Regulation A Filings

All Regulation A Offerings require the issuer to file a Form 1-A with the SEC before offering securities to the public.

Form 1-A is a notice filing that contains the following information:

• Organization of the Issuer.
• Directors and Officers of Issuer.
• Principal Owners of Issuer.
• Business Plan and Risk Factors.
• Terms of the Offering/Description of Security.
• Financial Information Required (based on Tier).

Tier 1 - Exit Report filed with SEC after completion of offering.

Tier 2 - Annual and semiannual reports with SEC (i.e. 1-K, 1-SA).

Regulation C/F

Background

• Title III of the JOBS Act required the SEC to adopt rules permitting crowdfunding.
• SEC adopted Regulation Crowdfunding effective as of May 16, 2016, which implemented the requirements of the JOBS Act.

Crowdfunding Platforms

All transactions under Regulation CF take place online through an SEC-registered “platform” or “portal”.

Popular Crowdfunding Portals

• WeFunder
• Seedinvest
• StartEngine

Regulation CF Rules
17 CFR § 227.100

• Issuers can raise up to an aggregate of $5 million over a 12 month period.
• Offering must be made solely through an SEC approved platform.
• The aggregate amount individuals may invest in offerings shall not exceed the greater of $2,200 or 5% of the investor's annual income if the investor's annual income is less than $107,000. If the investor's annual income and net worth are equal to or greater than $107,000, then the individual can invest up to the lesser of either 10% of his or her annual income, or 10% of his or her net worth, up to a maximum of $107,000.
• No need to comply with Blue Sky Laws.

Regulation CF Filings

In connection with an offering conducted by a funding platform, the platform will file a Form C on SEC’s EDGAR prior to the offering of securities to the public.

The Form C includes the following information:

• Organization of the Issuer.
• Directors and Officers of Issuer.
• Principal Owners of Issuer.
• Business Plan and Risk Factors.
• Terms of the Offering/Description of Security.
• Financial Information Required (based on offering size): (1) Less than $107,000 – Internal Financial Statements Certified by Officers; (2) $107,000-$535,000 – Reviewed Financial Statements; or (3) More than $535,000 – Audited Financial Statements.

Navigating Regulation D and A Offering Documents

Private Placement Memorandums

Regulation A and D issuers generally provide investors with what is known as “Private Placement Memorandums” (PPMs). Issuers will use PPMs to illustrate the following information and terms relating to the private offering:

• Exemption Disclosures – Properly drafted PPMs will include information relating to which particular securities registration exemptions are utilized in connection with the offering. For example, there will be language in ALL CAPS stating that the securities sold pursuant to the PPM are not registered with the SEC and are exempt from such registration under ______.
• Terms of Offering – In addition to the regulatory disclosures, a PPM will contain the terms of the offering including the type of security offered, value of the security sold and the fundraising limits of the offering.
• Business Plans/People – PPMs should contain an overview of the issuer and business plan. Such plan should include a description of the products or services sold and information relating to the officers, directors and key employees of the issuer.
• Risk Factors – PPMs will contain risk factors that will warn investors of the potential issues that the issuer may face, which will result in the loss of the investment amount. A good PPM will address all risks relating to the issuers business and industry.
• Instructions for Offering – Always look to see if a PPM has detailed instructions on how to submit Subscription Agreements.

Subscription Agreements

• Representations and Warranties - Within all Subscription Agreements, issuers will include representations and warranties to be made by the investor. It is crucial to determine what these representations and warranties are and confirm they can be accurately made by the investor (i.e. accredited investor status).
• Investor Questionnaires - Depending on the type of offering, an issuer may provide an “Investor Questionnaire” to confirm whether an investor is accredited.

Convertible Notes (if applicable)

• Interest and Maturity Date – Any form Convertible Note included with a PPM should contain a set interest rate and maturity date.
• Conversion Rights – Generally, convertible notes convert to equity upon a future fundraising events or at maturity.

Appendices

• Financial Statements – Always review the financial statements provided with a PPM to ensure they meet the disclosure requirements of the corresponding exemption.
• Use of Funds – PPMs should have some information relating to how the funds raised will be utilized by the issuer (i.e. purchase of equipment or real estate).
• Organizational/Governing Documents - PPMs should provide at least a summary of the terms of the governing documents of an issuer and/or actual copies.

Issues if Offering Documents are Not Prepared Correctly

• Investment Viability
• Federal and State Penalties
• Rescission Offers
• Ensuring “Bad Actors” are Not Present

Navigating Crowdfunding Investments

Online Profile Contents

• Business Background/Risks - Like a PPM, an issuer will have a profile on a crowdfunding platform that contains an overview of the issuer and business plan.
• Organizational Documents/Financials - Within the profile, search for any organizational documents provided (i.e. operating agreements and bylaws).
• Type of Security – Always determine what type of security that is being sold. Platforms will allow for issuers to sell equity, convertible notes, debt instruments and SAFEs.
• Information Not Readily Apparent - If you cannot find all information on the issuer, search the issuer’s Form C filed on EDGAR.

Author: William B. Helbling

Originally published in October 2021

Copyright © 2021 Knox McLaughlin Gornall & Sennett, P.C.