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.

Since our last post on the state of the venture capital market, the industry has seen even more bad news emerge. A July 1 report issued by VentureSource, a research company focused on the venture capital industry, showed that liquidity in venture capital investments for the second quarter of 2009 fell 57% when compared to the same period last year. The report called the quarter “one of the worst for venture capital-backed liquidity since the doldrums of early 2003.” The entrepreneurial spirit, however, abhors a perceived piling-on of pessimism, and is, by nature, guardedly optimistic; this optimism is reflected in a survey of sentiment among venture capital professionals released on July 9 which showed, despite the gloomy figures for the quarter, a marked increase in confidence among industry figures. The survey noted that while the effects of the financial market disruption on the venture industry will linger for some time, most [venture capitalists] observed an increasingly determined and talented pool of entrepreneurs and a continuing march of innovation.” Similarly, Scott Austin, the author of the Wall Street Journal’s Venture Capital Dispatch, declared the second quarter figures released by Venture Source a “healthy surprise.” While he noted the dramatic (and not entirely unexpected) decline in liquidity for venture capital investments, he believed the numbers evidenced that “investors are putting money to work in health care, with big gains [in terms of investment] occurring across the board in biopharmaceuticals, medical devices, health care services and medical software and information services.” (http://blogs.wsj.com/venturecapital/2009/07/15/expect-a-healthy-surprise-in-2q-venture-funding-report/)

Venture capital managers are not only contending with difficult market conditions; they are also facing the possibility of increased regulation.  Legislation that would require venture capital management firms to register as investment advisers with the Securities and Exchange Commission is gaining momentum in Congress. Among other things, this would subject managers to extensive recordkeeping requirements, requirements governing the manner in which investor assets are custodied, restrictions on managers’ ability to receive performance-based compensation from a fund (such as the “carried interest” allocation customary in the venture capital context) and periodic examination by the SEC staff. Although primarily targeted at hedge fund managers, the investment adviser registration requirements currently supported by the SEC and the Treasury Department would include managers to venture capital and private equity funds within its scope.

Industry professionals as well as representatives from the National Venture Capital Association (or NVCA), the venture capital industry’s main trade association, have appeared before Congressional committees and government agencies argue that venture capital managers should be excluded from the scope of the legislation. These professionals and representatives argue that the potential failure of a large venture fund does not pose the same systemic risk to the U.S. economy as that of a major hedge fund, given that venture funds are not leveraged like hedge funds. In addition, they argue that the activities of venture funds make them less likely or able to engage in the misdeeds Congress seeks to prevent, since venture funds do not “short” stock, do not engage in short-term trading and do not purchase or sell publicly-traded securities that would be most subject to manipulation. As a result, the venture capital industry believes that SEC oversight of venture fund managers is unnecessary, and the resulting burden upon an industry essential to the American economy would outweigh the potential benefits gained or harms prevented. Stay tuned for more to come!

After much speculation Google has officially announced their new venture capital fund. They expect to invest up to $100 million dollars in it’s first year; this is fantastic news for all of you entrepreneurs with great ideas looking for capital. Your idea may very well be “the next big thing” that Google is looking for.

Below is the announcement on the Official Google Blog:

Today we’re excited to announce Google Ventures, Google’s new venture capital fund. This is Google’s effort to take advantage of our resources to support innovation and encourage promising new technology companies. By borrowing the best practices of top-tier, financially focused venture capital firms and bringing to bear Google’s unique technical expertise and brand, we think we can find young companies with truly awesome potential and encourage their development into successful businesses.

At its core, Google Ventures is charged with finding and helping to develop exceptional start-ups. We’ll be focusing on early stage investments across a diverse range of industries, including consumer Internet, software, clean-tech, bio-tech, health care and, no doubt, other areas we haven’t thought of yet. Central to our effort will be our fellow Googlers, whom we view as a critically important resource to help educate us about potential investments areas and evaluate specific companies.

Economically, times are tough, but great ideas come when they will. If anything, we think the current downturn is an ideal time to invest in nascent companies that have the chance to be the “next big thing,” and we’ll be working hard to find them. If you think you have the next big idea, or if you just want to to learn more, please see our website at www.google.com/ventures.