Raising Private Capital

Bench to Market (article)This commentary in the Genomics Law Report’s ongoing series Bench to Market is contributed by Mark O. Henry, Robinson, Bradshaw & Hinson, P.A.

Last week in the Bench to Market series, we discussed the license-out business model as an alternative to raising capital for the commercialization process. Because the business idea is “your baby,” however, you are likely reluctant to let go of it so early in its journey. Instead, you may prefer the challenge of finding the money to bring your idea to market yourself.

We discussed earlier in this series the government funding that may be available for science and technology related research. Unfortunately, this source of funding does not pay for the expenses of commercialization. Thus, once you have maxed out your credit cards and fully drawn the home equity line your spouse warned you not to set up in the first place, you are likely to turn to the private sector to raise capital.

Naturally, the first place you will look for money is from the people you know best. As a school kid you learned it was easier to ask friends, family and neighbors to support your fundraisers than complete strangers. Looking for equity investors is no different. Pitching your business model to complete strangers such as angel investors or venture capital funds can be intimidating and frustrating; however, what may be less obvious is that asking your family and friends for an investment may implicate federal and state securities laws.

A common misperception is that securities laws apply only to the stock of large public corporations traded on an exchange. But Section 5 of the federal Securities Act of 1933 (the “1933 Act”) and most state securities laws prohibit the offer or sale of any securities without registration, unless there is a specific exemption from the registration requirement. For a private company that has not previously registered the sale of securities, registration refers to the process of filing with the U.S. Securities and Exchange Commission (the “SEC”) to go public. This is an onerous process that is not a viable option for an early stage company, and thus it is important to find an exemption.

The statutes define “security” very broadly. For example, a “certificate of interest or participation in any profit-sharing agreement” or an “investment contract” would each meet the test. One famous case considers whether interests in an orange grove constitute securities (though for you Eddie Murphy fans, orange juice futures are not regulated by the SEC as securities but rather by the CFTC as commodity derivatives). Generally any equity interest in a corporation, limited liability company, limited partnership or other business entity would be considered a security when the investor is relying predominantly on the managerial efforts of others to generate profits. Thus, if you and two of your fraternity brothers get together in a garage and form a company to sell personal computers and each of you intends to be an active part of the business, the equity interests you receive at formation are not “securities” under the federal and state securities laws. When you solicit money from your neighbor who is not an active part of the business, however, the equity being offered is a “security” and the sale of that equity (in fact, even the “offer” to sell that equity) is subject to the securities laws.

The good news is that just because an equity instrument is a “security” does not necessarily mean registration is required. The federal securities laws provide for several registration exemptions depending on the nature of the security or the nature of the transaction in which a security is sold. Equity securities in a company generally do not qualify for any of the security-specific exemptions. Instead, most issuers of equity securities must look to the transaction-specific exemptions. The most common exemption is Section 4(2) of the 1933 Act, which exempts transactions by an issuer not involving a “public offering.” Factors examined in determining whether a Section 4(2) exemption is available include (1) the number of offerees, (2) the pre-existing relationship of the offerees to each other and the issuer, (3) the number of units offered, (4) the size of the offering, (5) the manner of offering, (6) the information disclosure or access involved, (7) offeree sophistication, and (8) the absence of redistribution of the securities.

Unfortunately, this exemption does not always have clear, specific guidelines for determining whether it applies. The sale of equity on a one-off basis to your father, who is the chief executive officer of a major securities brokerage firm, is unlikely to be a “public offering.” On the other hand, buying an infomercial on late night cable television and hawking stock to anyone who calls your 800 number is a problem. In between those ends of the spectrum, things can be confusing. To bring some clarity to the issue, the SEC has over the years issued specific safe- harbor exemption rules. Among other things, these rules include limits on the aggregate amount of equity that may be issued and describe the types of investors who may be involved depending on their wealth and financial sophistication.

Prospective issuers of securities must also consider the laws, rules and regulations in each state where securities are offered or sold. Most states have laws that are similar to the federal scheme, though it is important to carefully review and consider the individual state laws as there may be important differences.

Another over-arching consideration when soliciting investments from your friends and family are the general anti-fraud laws. Both the federal securities laws and most state securities laws impose liability on any person who offers or sells any security where there is fraud, an untrue statement of material fact, or an omission to state a material fact necessary to make statements not misleading. This standard applies to all offerings of securities, both public and exempt private offerings.

If all of this is making your head spin, you are not alone. A careful securities analysis can be costly and time-consuming, and thus you may be tempted to skip this step during early stage fundraising efforts. This can be a costly mistake. Remedies for breaching federal and state securities laws include, among other things, (1) rescission of the purchase, (2) an injunction on the offering, (3) damages, and (4) government fines. In addition, improperly documented and conducted securities offerings can hamper future capital raises with funds or other institutional investors when the stakes are higher.

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