Raising Money – Legally: A Practical Guide to Raising Capital

By Bruce E. Methven, attorney

Copyright 2012-2013. All Rights Reserved.

ISBN: 9781483506159

Bruce E. Methven is an attorney who has been practicing law in the San Francisco Bay Area for more than 30 years. His practice includes private placement and direct placement securities offerings, business law and real estate, along with related matters. His firm handles federal Rule 506 and S-1 offerings nationwide, and all California offerings. He can be reached at 510-649-4019 and bmethven@methvenlaw.com; his web site is at www.methvenlaw.com and more material on this topic can also be found at http://thecaliforniasecuritiesattorneys.com/.

This book is designed to be a practical guide for entrepreneurs, business owners, organizers of real-estate funds (syndications) and others who want to make plans about raising money legally. (Although it discusses a number of legal requirements, it is not designed as a treatise for attorneys and there are almost no legal citations.)

More specifically, this book covers raising money by private placement offerings and by direct placement offerings (DPO’s), both of which are defined below. It does not cover initial public offerings (IPO’s). By the time a company reaches the point where it can make an IPO, it will be hiring many professionals for the process.

The book does cover the JOBS ACT advertised Rule 506(c) and crowdfunding offerings, along with much other information about offerings.

As a practical guide, the book discusses the major pieces that form an offering: Selection of the entity making the offering and the structure of the investment to be offered; the different categories of investors; choosing among the various types of offerings; preparing offering documents and filings; and some thoughts on marketing.

This book constitutes general information only and should not be relied upon as legal advice in specific situations. Small difference in the facts can have a huge impact on the legal result. In addition, this book is intended as an overview; given the complexity of the securities laws, one should never proceed with an offering without having the counsel of a securities-law attorney. It is all too easy to cross the line into actions that are prohibited.

TABLE OF CONTENTS

1. Basics of Private Placement Offerings

1.1 Philosophy of the Securities Laws

1.2 What Is a Security? Almost Everything

1.3 Registration and Exemptions from Registration

1.4 Federal Law, State Law and Intrastate (Single State) Offerings 3

1.5 The Basic Steps in Making a Securities Offering

2. Key Concept: Public Advertising v. Informational Advertising 6

2.1 Restrictions on Informational Advertising

2.2 Restrictions on Informational Advertising

3. Key Concept: Disclosure

3.1 The Basic Anti-Fraud Rule

3.2 List of Topics to Cover in Disclosure

3.3 Comments on Some Individual Disclosure Items

4. Types of Investors

4.1 Accredited Investors

4.2 Sophisticated Investors

4.3 Retirement Plans and Trusts

4.4 Founders, Sweat-Equity Investors and Employees

4.5 Other Types of Investors 12

5. Overview of Choosing an Exemption or Registration 13

5.1 Primary Factors to Consider 13

5.2 Chart Comparing Exemptions 15

6. Integration: Avoiding Two Offerings Being Classified as One 18

6.1 The Problem If Two Close Offerings Are Integrated

6.2 Ways to Avoid the Problem

6.3 The Issuer Integration Problem and Solution

7. Federal Exemptions

7.1 Traditional Rule 506

7.2 Advertised Rule 506(c) Offerings Under the JOBS Act

7.3 Comparison of Traditional and Advertised Rule 506 Offerings

7.4 Rule 505

7.5 Rule 504

7.6 Reg. A

7.7 Crowdfunding and Alternatives to Crowdfunding

7.8 S-1: Federal Registration of a Direct Placement Offering

7.9 4(2): Offerings to Super-Qualified Investors

8. State Exemptions

8.1 Categories of Exemptions

8.2 Rule 506 and Preemption

8.3 Model Accredited Investor Exemption

9. California Exemptions (Which Can Sometimes Be Used by Out-of-State Companies)

9.1 25102(f) 34

9.2 25102(n) Possibly Coupled with the Model Accredited Investor Exemption

9.3 Qualification by Permit (25113

9.4 New Requirements for Investment Fund

9.5 Special Exemptions for Sales of Promissory Notes

9.6 New Requirements for Real-Estate Related Offerings

10. The Reg. S Exemption for Foreign Investors

10.1 Reg. S Requirements

10.2 Using Foreign Finders With Reg. S Offerings

11. Choosing the Offering Entity 44

11.1 Corporations 44

11.2 C and S Corporations – Tax Differences

11.3 Limited Liability Companies (LLC’s)

11.4 Limited Partnerships

11.5 Other Entities

12. Structuring the Offering

12.1 Escrows and Minimum Raise Amounts

12.2 Valuing the Securities9

12.3 Considerations for All Equity Offerings

12.4 Waterfall/Preferential Payment Approaches

12.5 Exit Strategy

12.6 Additional Issues With Preferred Stock and Preferred LLC Units

12.7 Debt Securities/Promissory Notes

12.8 Options for Investor Liquidity in Real-Estate Funds

13. Offering Documents

13.1 Investor Questionnaire

13.2 Private Placement Memorandum1

13.3 Subscription Agreement

14. Who Can Sell the Offering

14.1 Officers, Directors, LLC Managers and General Partners

14.2 Finders

15. Marketing – and Finding Investors Without Public Advertising

15.1 Informational Advertising

15.2 Personal Contact

15.3 Finders

15.4 Social Media, Fans and Affinity Groups

15.5 Web Sites Restricted to Accredited Investors

15.6 Accredited Investor Lists

15.7 Seminars

16. Communicating With Investors, Getting the Money and Record Keeping

16.1 Investor Questionnaires

16.2 Electronic Disclosure Documents

16.3 Pre-Existing Substantive Relationship and Waiting Period

16.4 Getting the Subscription Agreement Signed

16.5 Bank Accounts, Escrows and Releasing Investor Money

17. Filings with the Securities Agencies

17.1 Timing of Filings

17.2 Cleaning Up Past Offerings to Investor

18. Length of Offerings, Renewals and Amendments

18.1 Length of Offerings and Renewals

18.2 Amendments to Offerings

19. Holding Periods and Renewals

19.1 Rule 144

19.2 Intrastate Offerings and Resales Across State Lines

20. Index and Sample Documents

Index

Sample Investor Questionnaire

Private Placement Memorandum Template

Sample Investor Subscription Agreement

1. Basics of Private Placement and Direct Placement Offerings

1.1 Philosophy of the Securities Laws

The securities laws exist because of past (and current) fraud regarding the sale of securities. Whether you agree with their approach or not, these laws attempt to find a balance between protecting investors and allowing companies or investment funds to raise money.

The securities laws try to protect investors by placing requirements on the types of investors allowed, by limiting the public advertising of offerings, by sometimes limiting the amount of money that can be raised, by controlling where the investors are located and by mandating certain disclosures to investors. Each offering approach has its own combination of these factors.

People who do not comply with the securities laws can be sued by their investors for large amounts, can be banned from the securities industry by the securities regulators, and can face criminal prosecution. Unfortunately, one can always find companies who are violating the securities laws.

1.2 What Is a Security? Almost Everything.

As the securities laws – by their very name -- apply to securities, one fundamental question is what constitutes a security. The short answer is that virtually every type of investment is a security unless one can prove that one of the rare exceptions applies. In other words, an investment is guilty of being a security until proven innocent. The basic federal definition includes promissory notes, stocks and bonds; profit-sharing agreements and investment contracts; interests in oil, gas or other mineral deposits; puts, calls and options; certificates of deposit; and anything commonly known as a ‘security’, etc. (15 U.S.C. §77b(a).) (For the California definition, which is similar, see Corporations Code Section 25019.)

Very few investments are not securities. Investments in general partnerships usually are not because each partner has full rights to enter into contracts on behalf of the partnership and each partner is personally liable for all of the obligations of the partnership. (It is a rare situation where a general partnership would be appropriate, given the personal liability.) Still, if even one partner does not play a substantive role in management, the partnership interests could well be found to be securities.

The law in California and some other states provides an exclusion for a limited liability company that is member-managed (all owners being managers) where it can be proven that all of the members are actively engaged in the management of the limited liability company. It is not enough that the members vote, or have the right to information, or the right to participate in management: Each member must have the skills to participate in management of the LLC and take a substantive role in management. Clearly that’s not a requirement that a passive investor could meet.

Tenancy-in-common (TIC) arrangements – where every investor is on title for a piece of real estate – are securities unless the organizer is willing to give up management control of the TIC, and most are not. Like member-managed LLC’s, every investor would have to exercise true management power or at the very least have the power to choose and replace the manager. In addition, the arrangement among TIC members is that of general partners, so again investors have individual liability unless they invest through an LLC or corporation.

Most promissory notes are securities even if they are secured. Certainly any promissory note that in addition to interest has an equity or profit kicker or that is convertible to equity is a security.

Under federal law, the presumption is that every promissory note with a maturity date in excess of nine months is a security, but there are exceptions. The case law – which is based on a four-factor test -- is uncertain, but it seems that at least any note that is sold to multiple investors is a security. There can be multiple investors in at least two ways. One is a fractionalized note where more than one investor owns a percentage of the note. Another is series of more or less identical notes sold to more than one investor.

State law can be more definitive. For example, under California case law, if the note is interest-only, there is only a single investor in the note AND the note is fully secured, the note is not a security. By implication every other type of note is a security.

Again, the only safe approach is to assume that everything is a security unless proven otherwise.

1.3 Registration and Exemptions from Registration

Given that virtually all investments are securities, we now reach a foundational rule in securities law: A security offering must be registered with – and receive approval from – a state or federal securities regulator before the offering can be made, unless an exemption from registration applies. Registration, though, is expensive and takes time, as the regulators often take months to review the application, which is extensive. (On the other hand, registration generally allows public advertising; that will be discussed later.)

Fortunately, there are a number of exemptions from the registration requirement. (One is the federal Rule 506 exemption, which is part of Regulation D.) Each type of exemption has its own requirements, but if those requirements are followed then the offering process is much faster and less expensive than registration. The requirements for exemptions frequently involve matters such as how much money can be raised, limits on public advertising, financial or other requirements for investors, and the number of investors.

Traditionally offerings using an exemption are referred to as private placement offerings because 1) they do not involve securities that can be publicly traded after the initial sale and 2) they do not involve a public offering but allow only communications targeted at specific potential investors or extremely limited public advertising (such as a tombstone ad).

This is changing some under the 2012 federal Jumpstart Our Business Startups Act, also known as the JOBS Act, which beginning September 23, 2013 will allow publicly advertised Rule 506 offerings if limited to accredited investors and which later will allow publicly advertised crowdfunding offerings; these will be discussed later.

There are also offerings called DPO’s (direct placement offerings) that use registration rather than exemptions from the securities laws. In other words, this type of offering must be reviewed and approved by a regulator (such as the SEC) before the offering can begin. These types of offerings allow public advertising but do not involve underwriters. (They are direct offerings from the company to the investors, rather than sales to the underwriters and then to the investors.)

While DPO stock may be publicly traded, it is not traded on a full public stock exchange like NASDAQ or the New York Stock Exchange. In some cases (if the required approvals are obtained) the stock may be traded as an over the counter or pink sheet stock through a platform like www.OTCmarkets.com. Some DPO offerings are not traded on an over-the-counter platform; if any owner wants to sell, it is up to the owner to find a buyer.

Although DPO’s involve registration, they are much faster, less complicated and less expensive than going public through an initial public offering (IPO). In some ways DPO’s may be seen as offerings that exist in between private placement offerings and initial public offerings. DPO’s include things like the federal S-1 offering and the California qualification by permit. (Each state has some sort of registration system.)

1.4 Federal Law, State Law and Intrastate (Single State) Offerings

In what strikes many people (especially from foreign countries) as odd, frequently both federal law and state laws apply to a securities offering. Often those laws are different and both must be satisfied for a legal offering. There are a few exceptions. (Law is frequently built on rules, then exceptions to those rules, then exceptions to the exceptions, etc. in an attempt to balance competing objectives more fairly.)

One exception is federal Rule 506, which preempts state securities law. The states are allowed to require Rule 506 offerors to make a brief notice filing when the offer has investors from that state – but the states cannot apply their own securities laws. This, though, is a rare situation: Most federal offering exemptions (for example, Rules 504 and 505) do not preempt state law. Unfortunately, that greatly limits their use as a practical matter.

The other main exception is when an offering is confined to a single state in what is called an intrastate offering. (This is the opposite of