Under federal law, any offer of securities must either be registered under the Securities Act of 1933 (the “1933 Act”) or qualify for an exemption from such registration. A registered offering under the 1933 Act is extremely time consuming and expensive, and generally occurs only once a company is thoroughly established. A company’s first registered offering is its initial public offering, or “IPO.” Section 4(2) of the 1933 Act provides an exemption from registration for “transactions by an issuer not involving any public offering.” In order to provide clear guidance on complying with Section 4(2), the Securities and Exchange Commission passed Regulation D under the 1933 Act, which creates three “safe harbors” under Section 4(2). An offering that complies with one of these safe harbors will be deemed not to involve any public offering. Prior to an IPO, companies generally engage in smaller, private offerings using these Regulation D safe harbors.

In this post we discuss the first of the Regulation D safe harbors, Rule 504, which permits an issuer to raise up to $1 million and does not require that investors must meet any net worth or sophistication requirements (“Rule 504”). This post is not intended as legal advice. A company considering raising capital through the sale of securities must contact an attorney to seek guidance. The federal and state securities laws can create enormous liability for improperly conducted offerings, even in the absence of any fraudulent intent on the part of the offeror. The applicable laws and regulations are complicated and often seem arbitrary, so the guidance and assistance of a professional is extremely important.

Who may use Rule 504? Rule 504 is available to any company except one which either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies. The SEC does not want so-called “blank check companies” to use Rule 504.

What conditions must be met in relying on Rule 504? Offerings under Rule 504 generally are subject to very few federally-imposed conditions. The conditions applicable to an offer mainly turn on whether the offer is registered under the laws of the states in which the offering is made. As described below, State registration may give issuers additional freedom or could impose additional restrictions in conducting the offering, depending upon the law of the state(s) at issue. Again, a company must consult with an attorney prior to attempting to conduct an offering to ensure the company is not unduly hampered in its capital raising and to ensure it is complying with applicable law.

State Registered Offerings. If the offering is conducted only in states in which the offering is registered (as discussed below), then there are virtually no federal conditions imposed on the offer. If an offering is registered under state law, however, the permitted offerees and manner of conducting the capital raising activities could be subject to certain substantive limitations and filing requirements that will vary by state. In addition, state law may impose limitations on an investor’s ability to sell or pledge its shares or interests in the company. These state requirements, depending upon the state at issue, could be more onerous or less onerous than the conditions imposed under federal law by non-state registered offerings.

Non-State Registered Offerings. Most states permit a company relying on Rule 504 to conduct its offering largely exempt from state law, subject to certain notice filing requirements. If a company elects to conduct its offering without state registration, the offering of securities cannot be made in that state through any “general solicitation” or “general advertising.” This means that a company cannot seek investors in that state through newspaper or magazine advertisements, television or radio advertisements or other public communications. The best way to avoid general solicitation is to solicit investors with whom the company or its personnel have pre-existing relationships, such as personal or prior business relationships.

How often may a company raise money using Rule 504? A company is not limited to one Rule 504 offering. It can conduct many Rule 504 offerings, or can rely on Rule 504 in one instance and later rely on another Regulation D safe harbor. The general rule is that after a Rule 504 offering is complete, a company cannot begin another round of fundraising in reliance on Rule 504 for six months. A company should consult an attorney, however, to ensure that its offerings are not integrated and treated as one offering, which could cause the company to exceed the $1 million limit imposed on a single Rule 504 offering.

Can investors sell the securities purchased pursuant to a Rule 504 offering? Generally, securities purchased in a private placement are subject to restrictions or limitations on resale. If the offering is registered with one or more states, state law determines how, when and if securities purchased in a Rule 504 offering can be resold. If the offering is not state-registered, the securities are treated as “restricted” securities under the 1933 Act. Resale provisions are available for investors to sell their shares, but such resales are subject to numerous conditions. A company should restrict the ability of investors to resell its securities without the consent of the company in the documents governing the securities’ terms, given that improper resales can cause the company to lose the ability to rely on Rule 504 (or any private offering exemption) and create significant liability for the company.

Our next post will deal with Rule 505 under Regulation D, pursuant to which a company may raise up to $5 million in a single offering.

****Always consult with an attorney before attempting to raise capital.

Capital is the life blood of any business. A business needs capital to launch and later to grow its operations by hiring additional staff, developing new products or services and expanding its marketing efforts, among other things. This is the first of a series of posts we intend to publish that will provide an overview of the laws and regulations that govern the sale of stock or debt instruments in order to raise capital.

A business can obtain capital through borrowing, such as a bank loan, or it can issue securities. These securities could be equity securities, which provide an interest in the gains and losses of the business or debt securities, which provide a fixed or variable rate of interest upon a principal amount for a fixed term, or they could be instruments that combine features of debt and equity, such as preferred stock or convertible securities.

Most small businesses raise capital through what are called private offerings. Private offerings are exempt from the registration and complex disclosure requirements of public offerings. The regulations governing private offerings, however, place various restrictions on the offer and sale, which can include limitations on the amount that can be raised, restrictions on advertising or public solicitations and/or net worth and financial sophistication requirements prospective purchasers must meet. In the coming weeks we will focus on the following exemptions, and may address related topics in the future:

• Part 1: Small offerings of up to $1 million; these offerings are exempt from most federal regulation, but are subject to state regulations on required filings and manner of conducting the offer and sale.
• Part 2: Offerings up to $5 million made to no more than 35 investors; these offerings are subject to restrictions on the manner in which the offering can be advertised but are exempt from most state regulation.
• Part 3: Offerings with no maximum amount made to “accredited investors” (meaning investors meeting certain sophistication and net worth requirements) and no more than 35 unaccredited investors; these offerings are subject to restrictions on the manner in which the offering can be advertised but are exempt from nearly all state requirements.

Although fund raising is an integral part of growing a business, it is heavily regulated by both state securities agencies and federal agencies such as the Securities and Exchange Commission (SEC). The discussion in the coming posts addressing offerings of securities are not intended as legal advice, and a business owner considering raising capital should consult with an attorney. The penalties for failing to comply with state and federal regulations in offering and selling securities can be severe. An offering that does not comply with applicable regulations can lead to a right of rescission on the part of the buyer (meaning a return of the invested amount) as well as monetary penalties for the offeror. In addition, any material false or misleading statements or omissions made in offering securities can give rise to liability for fraud under state and federal law, with penalties ranging from civil monetary penalties to imprisonment.

So, before you go looking for angels, find out everything you can about the devils.