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Friends and family financing round: Raising capital from non accredited investors

Family and friends round

Background

Why a friends and family financing round can be challenging

When looking to raise money to start or grow a business, many people consider consider raising money from friends and family. But the friends and family financing round can be problematic.

Securities laws restrict how you can raise money for your business. The general rule is that before taking money from any investor, even friends and family, you have to register your securities offering with the SEC by filing a form called an S-1. This registration process can cost millions. So the vast majority of companies choose to find an exception to this general rule. (For example, in 2014 only 3.5% of reported securities offerings were public offerings and only a fraction of those were with the required form S-1. The other 96.5% were offerings made pursuant to an exception to the registration requirement.)

The most common exception to the registration requirement (Rule 506) is easiest to comply with if all investors are accredited investors. Basically, someone is an accredited investor if they are wealthy. Often, friends and family don’t meet the wealth requirements to be an accredited investor, and as a result the founder is left with only unappealing options for complying with securities regulations in a friends and family financing round.

State and federal regulations

To make matters more complicated, it’s not just the SEC you have to be worried about. Each state also has its own set of securities regulations. If you have an investor in a state, you need to comply with that state’s securities regulations. I’ve focused this post on compliance with federal and Washington state securities laws.

Two general types of exceptions

As you review state and federal securities laws, you’ll notice there are two types of exceptions to the general rule that you have to register your offering by filing an S-1. The most commonly used category of exceptions are exemptions. If you’re able to use an exemption, you don’t have to register your offering at all. The other category of exceptions are different forms of registrations. These registrations are easier and less expensive than the S-1.

Penalties for not complying with securities regulations

We encourage our clients to take securities regulations seriously. If a single investor doesn’t meet the requirements for your exemption, all your investors in that financing round can get their money back from your company, with interest. And founders can be personally liable for their company’s failure to comply with securities regulations. Not only that, but founders can even be subject to criminal penalties.

Ways to raise friends and family financing rounds

Friends and Family Financing Round Chart

Here’s a chart that shows the pros and cons of the different options for raising money from friends and family or other non accredited investors. Click on the image to view a larger version of it.

In today’s post we’ll talk about six different exceptions that allow you to raise money from folks who aren’t accredited investors. I’ll start by discussing the exceptions most likely to be helpful—though the best option for your friends and family financing round will depend heavily on your particular circumstances.

1. Kickstarter-type campaign

One great way to raise money for your company in a manner that is compliant with securities laws is to not sell securities. If a company raises money in exchange for the promise to deliver products in the future rather than a share of the company’s profits, the company is not likely within the realm of securities regulations. (See this post for an explanation of what a security is, and by extension why a Kickstarter campaign is not likely to run afoul of securities laws.)

A Kickstarter-type campaign might be a good option for your friends and family round because:

  • You likely don’t have to worry about complicated exemptions or registrations—though in an ideal world, you’d run your campaign details by a securities attorney.

But a Kickstarter-type campaign might not be a good option for your friends and family round because:

  • You can’t offer your backers stock in your company—if your company takes off, it won’t make them rich.

2. The small offering exemption—Rule 504

Rule 504 is a federal exemption from the requirement to register your offering. In Washington, there’s a similar exemption intended to work with Rule 504 called the small offering exemption.

Rule 504 might be a good option for your friends and family financing round because:

  • You can raise up to $1,000,000.[1]
  • There are no on-going reporting obligations.
  • The non accredited investors don’t need to have experience in business and investing in order to purchase stock, if the investment is “suitable” for the investor—there’s a presumption the investment is suitable if it does not exceed 10% of the investor’s net worth.

But Rule 504 might not be a good option for your friends and family financing round because:

  • While there aren’t specific disclosure requirements, Washington does recommend using the SCOR form, and it can take a lot of time (and money, if you’re working with professional advisors) to complete.
  • You have to file with the Washington Department of Financial Institutions 10 days before you sell any stock to Washington investors. Companies often need to move fast with their initial financing, and sometimes they don’t realize there are securities laws they need to comply with in advance of their first sales, so this obligation to pre-file can be significant.
  • You can only raise money from 20 non accredited investors in Washington.
  • You can’t advertise the offering. (Read this post for more information on what it means to advertise your offering.)
  • The stock is subject to resale restrictions, meaning your investors will be acquiring a relatively illiquid investment. (Read this post for more information on the resale of private stock.)

3. Rule 506(b)

Rule 506(b) is the primary exemption that companies use to raise money from accredited investors. Unfortunately for many companies, it is not usually a good tool for raising money from non accredited investors.

Rule 506(b) might be a good option for your friends and family financing round because:

  • You can raise an unlimited amount of money.
  • There are no on-going reporting obligations.
  • There is no advanced filing requirement.
  • It pre-empts state law, meaning you don’t have to worry as much about state-level compliance. Though you do still have to file a notice with states and pay a filing fee for that notice.

But Rule 506(b) might not be a good option for your friends and family financing round because:

  • The non accredited investors need to have experience in business and investing in order to purchase stock. Proving that the investors had sufficient experience can be difficult after the fact because this issue will only be litigated if the investor made an investment that didn’t pan out—so the company would be arguing that the investor had the necessary experience to avoid making the type of investment he or she actually made. Unlike with Rule 504, there’s no 10% of net worth standard to fall back on as an alternative to the investor passing the sophistication test.
  • If there are non accredited investors in a 506(b) offering, companies need to provide a disclosure on par with the form S-1 (the public registration form that everyone is trying to avoid in the first place by finding an exemption or easier registration). Providing that level of disclosure isn’t as bad for a new company because there isn’t as much information for a new company to disclose. Nevertheless, it is a significant obstacle and can double or triple legal and accounting costs for the financing round.
  • You have to file a Form D with the SEC and then send a copy of that form to the Washington DFI with a $300 check.
  • You can only raise money from 35 non accredited investors.
  • You can’t advertise the offering.
  • The stock is subject to resale restrictions, meaning your investors will be acquiring a relatively illiquid investment.

4. SCOR

Unlike rules 504 and 506(b) which are exemptions from registration requirements, a SCOR offering is a type of registered offering. SCOR offerings are registered at the state level and designed to be compliant with federal exemptions.

SCOR might be a good option for your friends and family round because:

  • You can raise up to $1,000,000.
  • The stock is not subject to resale restrictions.
  • You can advertise the offering.
  • You can raise money from an unlimited number of non accredited investors.

SCOR might not be a good option for your friends and family round because:

  • You have to prepare a lengthy disclosure form and include GAAP financial statements with the form. It can take quite a bit of time and money to prepare the disclosures.
  • You have to file the form with Washington and get approval before proceeding with any sales. This process can take months.

5. Regulation A+

Regulation A+ is a relatively new option. Like SCOR offerings, Reg A+ offerings are a type of registered offering. But Reg A+ offerings are registered at the federal level rather than the state level. There are two tiers to Reg A+ offerings, and there are different requirements for the different tiers. If you want to read about the differences between the tiers, check out our post that focuses on Reg A+.

Reg A+ is not likely to be suitable for your friends and family financing round unless you’re trying to raise a bunch of money from a bunch of other people at the same time. Here’s why it could be a good option:

  • You can raise up to $50,000,000.
  • The stock is not subject to resale restrictions.
  • You can advertise the offering.
  • You can raise money from an unlimited number of non accredited investors.

Reg A+ might not be a good option for your friends and family financing round because:

  • You have to advance file a 29 page form that ends up being more than twice that length by the time it’s filled out.That lengthy filing is the major drawback—preparing it and getting approval from the SEC to proceed with your Reg A+ is expensive. On that previous link with the completed Reg A+ form, you can see there were $200k in legal fees associated with the offering. And you may need to include audited financial statements with your disclosures. The legal and accounting fees are going to make this cost-prohibitive for most all friends and family financing rounds.
  • There are on-going reporting obligations—the company will have to file reports with the SEC on a regular basis. The company can be sued if the information is wrong. Creating the reports can be a significant drain on company resources.

6. State and federal crowdfunding

I was ready to be excited about crowdfunding. Unfortunately, it’s not a great option for many companies. Both the state and federal versions of crowdfunding have similar parameters to a SCOR offering, but with a higher filing fee, ongoing reporting obligations, and more restrictions. The Washington state crowdfunding form is a bit more streamlined than the SCOR form, and I think the crowdfunding form would be processed more quickly than the SCOR form. But the state crowdfunding option still hasn’t been a good fit for many companies (yet).

Crowdfunding might be a good option for your friends and family round because:

  • You can raise up to $1,000,000.
  • You can advertise the offering, though there are restrictions on how and through which mediums you can advertise.
  • You can raise money from an unlimited number of non accredited investors.

Crowdfunding might not be a good option for your friends and family round because:

  • You have to prepare a disclosure form and include GAAP financial statements with the form.
  • You have to file the form with Washington, pay $600 to the state, and get approval before proceeding with any sales.
  • You’ll have on-going reporting obligations that can be resource intensive and can create liability for the company.
  • The stock is subject to resale restrictions.
  • There are limits on how much you can raise from each individual investor that are dependent on the net worth and annual income of the investor. The most you can raise from any investor is $100,000.

As you can see, there are many factors to consider when deciding if you want to include folks who aren’t accredited investors in your fund raising, including your friends and family. There are quite a few options for raising funds in a compliant fashion, though none are perfect, and many are unworkable when taking money from non accredited investors.

If you have questions about your family and friends financing round or securities laws generally, please feel free to give us a call at (206) 745-5229 or to send us an email at team@invigorlaw.com.

Photo: Cristina Cerda | Unsplash

[1] The federal exemption allows you to raise $5,000,000, but the Washington exemption only allows you to raise $1,000,000.