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.

Today, global commerce moves at the speed of information. Yet as powerful as the engine of information is, it remains vulnerable to disasters caused by the forces of nature, or those wrought by human hands. Even a simple power failure can cause disruption and data loss if your systems are not protected with redundant backup systems.

Harvard Business Services, Inc. maintains the records of tens of thousands of business clients from across the U.S. and around the world, which makes it a vital link in the global flow of information. Early on, HBS assessed the potential of disruption from natural or man-made disasters and got out in front of the issue. Our arrangement with Agility Recovery Solutions is a farsighted hedge against unforeseen disasters. Within 48 hours of a disaster, Agility Recovery Solutions delivers a comprehensive package of equipment to the site, or an alternate site we have selected including a fully furnished mobile office, computer equipment, Internet access, telephone capability, power and much more.

Harvard Business Services, Inc. uses a “vault” to store backup data off site. Daily, weekly and monthly backups are stored away from Harvard’s Lewes, Delaware headquarters and secured in a private storage facility.

Even a short disruption in the power supply can be damaging and because most of our business comes from outside the state of Delaware, we need to be prepared. In the event of an electric power outage, a generator starts automatically within ten seconds. (HBS’s UPS power backup equipment keeps the information systems online during those 10 seconds.) The generator can keep our operations running for up to 14 business days without electricity with 500 gallons of fuel onsite.

Viewed in the context of the other backup plans and systems in place, HBS is well ahead of the curve in tackling the issue of preparedness, so that you can rest assured that your company data is safe secure and accessible at all times. Surveys of businesses and government statistics both show that only a small minority of companies have contingency plan and backup systems in place.

Click HERE to learn about a new website that helps businesses get prepared and plan for the unexpected.

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.

In the years since student Michael Dell scrounged up $1000 and turned his room into an assembly line, many more students are following his lead. Faced with a bleak job market, enterprising students see advantages in starting their own company; costs are coming down and pressures on nimble, low-cost upstarts aren’t as great. Growth is often a result of the internet, where snazzy websites don’t betray a home-based operation. Entrepreneurs can be more profitable with less need for capital or office space. Taking a risk often isn’t the leap of faith it used to be. According to the Challenger, Gray and Christmas’ job market index, 8.9 % of job seekers started their own businesses in the second quarter of 2009, way up from the record low of 2.7% in the last quarter of 2008.

Young entrepreneurs may be in the spotlight, but baby boomers are becoming business owners faster than any other group. New businesses started from 2007 to 2008 by 55- to 64-year olds grew 16 percent, faster than any other group, according to Ewing Marion Kauffman Foundation, a nonprofit group that studies U.S. business start-ups. They predict a sustained boom, not in spite of the aging workforce, but because of it! This group has built-in advantages including accumulated business knowledge and funds, as well as a network of people to tap as customers, suppliers and financial advisors. Many find that starting a business around lifelong interests or past passions is very rewarding as well as profitable.

With this trend, the next decade will see the growth of small businesses continue, and the social and economic impacts of small business increase.

To read articles on this topic, click HERE and HERE.

A credit default swap is a privately negotiated agreement between two parties in which one party (the “protection seller”) agrees to pay the other (the “protection buyer”) a sum of money (the “notional amount”) in the event an event of default occurs with respect to an issuer of debt, such as a corporation, a pool of mortgage or other loans or a state or national government (the “issuer”).  An event of default would include the issuer’s failure to pay timely interest or repay principal on debt obligations, among other possible events that the protection seller and protection buyer agree upon.  In exchange for the protection seller’s agreement to pay the notional amount upon an event of default, the protection buyer pays the protection seller a periodic fee.  The amount of the fee reflects the risk that the protection seller feels it is taking on agreeing to pay the notional amount upon default; the fee, therefore, gives a rough measure of the protection seller’s belief regarding the likelihood of the issuer’s default.  If an event of default does not occur upon the expiration of the swap, then the notional amount is never paid and the protection seller has gained in the amount of the fee paid over the term of the swap.

Credit default swaps generally are documented using agreements published by the International Swaps and Derivatives Association, often referred to as “ISDA.”  ISDA’s agreements provide a common and consistent set of defined terms and contractual provisions which the parties can vary to suit their needs.  Starting with a common set of base agreements which each party has used before permits the parties to a credit default swap to avoid a great deal of confusion and negotiation that they would otherwise face in starting with a new form.  In addition, once a protection seller and a protection buyer have negotiated a credit default swap on ISDA’s agreements, they can quickly enter into additional swaps by simply using the same documents, modifying the terms only as needed to suit a particular transaction.

A credit default swap can be used to hedge risk or for speculation.  When used for hedging, a credit default swap is similar to an insurance contract.  A person or entity that holds the debt of an issuer may be worried that it will default and the debt will either not be repaid at all or the market value of the debt will fall precipitously.  As a result, the person or entity would become a protection buyer, paying the fee to a protection seller in order to offset (or “hedge”) the risk of the issuer’s default.  The fee paid to the protection seller will lower the debt holder’s returns if the issuer does not default, but entering into the swap will protect the holder if default occurs.  Similarly, a homeowner may pay a homeowner’s insurance plan premium for years without incident, but by paying the premium the homeowner is hedging the risk of catastrophic loss.

When used for speculation, the protection buyer does not own any debt of the issuer.  The credit default swap is a means by which the protection buyer can “bet” (for lack of a better term) that the issuer will default.

In the buildup to the credit crisis that began in 2008, use of credit default swaps for speculation far outweighed their use for hedging.  This is evidenced by the fact that during that period it was common to find that the aggregate notional amounts that would be payable upon a given issuer’s default would equal many times the issuer’s total outstanding debt.  In addition, the activities of protection sellers were a key contributing factor to the failure of AIG, among other entities.  In the frantic market for credit default swaps leading up to 2008, protection sellers would often agree to pay notional amounts that far surpassed their assets.  When a default occurred, such as the default of Lehman Brothers, the protection seller could not make the promised payment, and, without government intervention, the losses could potentially have rippled out to other financial firms reliant on such protection, causing them to also fail.