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Raising Money From Investors:
How To Avoid the High Cost of Securities Regulation?
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Business New Haven
11/30/1998
By: Richard Slavin
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Every growing small business needs capital. Usually, the founder taps friends, relatives, neighbors and any acquaintance who might be willing to invest. Some businesses turn to venture capitalists; others to public and private investors.
All of these alternatives have significant costs in loss of control of the business, time away from the actual operation of the business, and in the satisfaction of regulatory requirements.
Why Do Even Small Securities Offerings Cost So Much?
Federal and state securities laws all have anti-fraud provisions. Generally, a company that offers its securities to any investor must tell the truth about the company. It must describe its prospects, the risks of investing and a number of other factors necessary for an investor to make an informed decision. Over the years the various states imposed strict requirements as to how a company had to tell its story. To comply with all of these requirements and to avoid liability under anti-fraud provisions, the companies selling their securities hire teams of lawyers, accountants, investment bankers, investment advisors and other professionals to produce detailed offering documents.
Is There a Lower-Cost Way?
By enacting the National Securities Markets Improvement Act of 1996 (“the Act”), Congress reduced the level of regulatory review and provided a way to offer securities privately without incurring huge fees. The Act allows private offerings under Regulation D, the federal formula for offering to a limited number of investors who meet certain sophisticated criteria, to avoid state regulation.
The simplest way to comply is to offer securities to “accredited investors.” This term has a number of definitions; however, in its simplest form it includes individuals with $200,000 net income in the prior two years and who expect the same in the current year ($300,000 with a spouse). It also includes individuals with $1 million minimum net worth.
A company may offer its securities to as many accredited investors as it desires and may raise an unlimited amount of funds from these investors. A company may also offer its securities to non-accredited investors, but if it does, it must comport with federal rules which require information to be provided to non-accredited investors and accredited investors in the same offering. This information must be equivalent to what would be provided in a registration statement. Generally, to comply, a small company must provide a detailed offering memorandum with audited financial statements. This requirement often makes an offering prohibitively expensive for smaller companies.
The Low-Cost Alternative
Since 1982, Connecticut has had a low-cost alternative to the federal formula. Connecticut General Statute Section 36b-21(b)(15) is the Connecticut “de minimus” offering exemption. This provision allows a small company to offer its securities to a maximum of ten securities holders. The company may raise an unlimited amount of money, from individuals who reside in any state or country, without the need for these individuals to meet any particular standard of sophistication. No filing is necessary, neither is preparation of any offering document. The purpose of this exemption was to allow startup companies to raise funds without the expense and complication inherent in recognized private or public offering formulas. This exemption still works.
Similar to the private federal offering formula, no general solicitation of investors can take place. The company may not pay a commission, discount or other fee for the sale of the securities offered. Its expenses, excluding legal and accounting fees, must be limited to one percent of the amount of funds raised. In addition, while there is no requirement that a written offering document be provided to potential investors, the general anti-fraud provisions of the Connecticut Uniform Securities Act still apply. For this reason it may be advisable, albeit not required, to provide such a document.
There is no substitute for meeting regulatory requirements. With careful planning, Connecticut business people may raise funds at lower cost and still comply with complicated securities laws. BNH
Richard Slavin is an attorney and partner in the Bridgeport-based law firm of Cohen and Wolf, P.C., and chair of the firm's securities practice group.
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