Crowdfunding Update- SEC Adopts New Rules for Investments under Reg A+

Crowdfunding is going to continue to explode in the near future. On March 25, 2015, the SEC adopted new rules to implement the provisions of the JOBS Act and Regulation A surrounding raising capital up to $50 million by smaller companies and, most likely, raise that money online on their websites or through social media. (The rules don’t go into effect until 60 days after they are published in the Federal Register and here is a copy of the rules and the SEC Press Release).  The new changes have been called “Regulation A+” and hailed by many as significant improvements in giving smaller companies more access to capital.

There are requirements for certain disclosures and filings with the SEC as well as registration of the websites with the SEC as funding portals like a securities “broker-dealer.”  There are also tiers for the companies that depend upon factors like the amount of money raised and state what the requirements will be for each tier.  The end result is that you are going to see much more investment opportunities on the internet and social media geared towards everyday consumers without the requirement that they be classified by higher wealth or income as “accredited investors”, so caveat emptor and let the buyer beware!

For those who aren’t sure, what exactly is “Crowdfunding”?  Most of the discussion in this area involves securities laws.  When a company needs to raise money, they may offer an investment in the company by way of stock, LLC units, convertible debt, or other investments.  These are all securities covered by US and State law and regulated primarily by the US Securities and Exchange Commission.  The company does not need to be a publicly traded stock like a Facebook or Microsoft to worry about the SEC and state regulators.  Any company or person offering or selling stock or other “security” can be subject to regulation.  When companies want to raise capital without the expense of registering their stock with the SEC, they rely upon exemptions from registration.  Most of those exemptions limit companies to seeking investors who meet the definition of “accredited investors.”  These are basically people with over a $1 million net worth or whose income is over $200,000.  Smaller investors are often kept out of these investments by rules designed to protect them assuming that they don’t have the financial savvy to protect themselves.  Crowdfunding is an effort to raise money for a company or a cause from a large number of investors each investing a small amount of money.  It was difficult to use crowdfunding to seek investors for a company if you were limited to only finding “accredited investors” and fall under an exemption from registration.  The provisions of the JOBS Act and the rules that the SEC is issuing are meant to expand access to capital for smaller companies.  Part of the provisions of the JOBS Act were to allow and expand the use of crowdfunding.  Instead of a company raising $250,000 by seeking $25,000 each from 10 accredited investors, the company will now try to raise $250 each from 1,000 regular investors.

It is hard to know the future impact of crowdfunding and the JOBS Act’s attempts to increase access to capital due to many possible areas for possible fraud or misleading of investors.  It looks like the SEC is going to keep a close eye on this topic and they are taking years to be sure the rules implementing the JOBS Act from 2012 cover all possible problems.  We will have to wait and see the impact, but it seems like many smaller companies will be able to gain access to previously difficult to obtain capital.

Business Owners Beware: Document Loans to Your Company or Else- Trends in Debt vs. Equity

Asset Protection Attorney Alert:

Have you ever loaned money to your own company?  Have you ever loaned money from one company to another?  Do you have written loan agreements in place?  Do your accounting records properly document the amount owed, transfers made, regular payments, and accruals of interest? Courts are coming down on these types of arrangements.

It is all too familiar to see when it comes to small and closely held businesses.  The owner puts some of his or her own personal funds into a company or transfers money from one company to the other to cover expenses for that company.  Most owners don’t think twice about it since they don’t have many other shareholders to consider or seek approval from.   Rarely do we see clients who come in who have entered into those kinds of deals that present documented loan agreements or any kind of records, but they think “it’s my company, so it doesn’t really matter” or “I am not publicly traded with the SEC or a big board of directors watching, so who cares.”  What they may not realize is that it can end up hurting the company or the shareholder down the road and, in some cases, in a pretty drastic fashion.

Several recent court cases have emphasized just how much not documenting loans can hurt a company.  Most of these arise in the bankruptcy context, but can be applied to regular state law claims related to loans, which can affect nearly anyone.  Even a minority shareholder could try to use these principles to his or her advantage to avoid loans the company owes to a majority shareholder.

The cases involve an extension of the bankruptcy court’s powers when it comes to debts.  A bankruptcy court has broad equitable powers under Section 105 of the Bankruptcy Code to make changes to carry out a bankruptcy.  On March 4, 2014, the US Supreme Court in Law v. Siegel issued an opinion that put a few restrictions on the recent expansion of those powers, but the concerns for business owners are still there and it is clear that the bankruptcy court’s use of those powers is still valid.

Since this ruling, a bankruptcy appeals panel has held that Law v. Siegel does not go so far as to ban a bankruptcy judge from recharacterizing debt as equity, which is more relevant for business owners.  The case of In Re: Alternate Fuels, Inc. was decided by the 10th Circuit Bankruptcy Appellate Panel on March 18, 2014 finding that loans by a shareholder to the company were equity and not a loan, despite the ruling in Law v. Siegel.

The facts of other recent cases are similar in that the court eventually converted what was claimed to be debts owed by the company to a shareholder/owner into equity.  The shareholder would put money into a company and then claim the company was required to pay it back and make a claim in the bankruptcy court to get paid back.  The courts have found that some of these so-called “debts” were really equity investments by the owner into the company with little to no value.  In a bankruptcy liquidation, if there are assets available, the assets are distributed according to priority to certain liabilities and if all liabilities are paid, then what remains gets distributed to equity holders/owners.  In a bankruptcy repayment or reorganization, such as is common in Chapter 11, the debt holders get paid off over time, but the equity holders do not receive payments.  When the court says that someone with a debt really invested equity and converts it into equity, they are saying that in most cases, that person is out of luck and will probably not get anything.

The cases look to the elements reviewed by state courts when analyzing whether a transfer of an asset could be considered a fraudulent transfer to avoid creditors.  If there is no transfer for something of reasonably equivalent value and there is no real obligation to pay the loan back, it could be considered fraudulent resulting in the loan not being allowed as a legitimate claim and an unwinding of the transaction.  This could result in a company or shareholder loaning money to another company he or she owns and losing that money.

Additionally, these loans have an impact in the context of asset protection planning.  For example, say John Q. Shareholder owns 2 LLCs: Bad Credit, LLC and Money Maker, LLC.  Bad Credit, LLC defaults on some loans and gets sued by a bank.  The bank gets a judgment against Bad Credit, LLC, but learns that Bad Credit, LLC would frequently pay for expenses of Money Maker, LLC.  Mr. Shareholder saw nothing wrong with this and even used one bank account to receive income and pay expenses for both LLCs.  The bank will go to court and try to collect against Money Maker, LLC and Bad Credit, LLC arguing that they are really not different companies due to the commingling (sharing) of assets.  Mr. Shareholder will try to claim the expenses paid by Money Maker, LLC were just loans to Bad Credit, LLC, but when it comes time to prove they are loans, he fails.  The court decides that the two LLCs with common ownership, similar bank account, and shared expenses are really just one company and the bank can go over both LLCs for the debt.  Or even worse, the bank says that both LLCs are really nothing more than Shareholder’s alter ego and the bank can now collect against Shareholder personally.

So what can be done?

A court is more likely to find a valid and enforceable loan when there is a well drafted written loan agreement in place and it is actually treated like a real loan.  This could be an inter-company loan agreement, promissory note, revolving credit line agreement, or other debt document.  The loan has to be for reasonably equivalent value to what is being provided and actually have terms that could be enforced.  If there are regular payments due, those must be paid and documented.  If there is interest due (which there should be at least some minimum amount provided for), it should be regularly accrued and put on the company’s books or accounting records.  These are just some of the actions that need to be taken to protect those dollars you lent to the company.  The more a court would view the arrangement as similar to what a bank or some other outsider lending money would put into place, the more likely the court would enforce the loan or keep liabilities separated from the owner or other companies.  It is also highly recommended to avoid commingling (sharing) funds or bank accounts between companies or owners, but I realize that the day to day needs of a company may not allow that kind of requirement to be kept.  If you have an LLC or corporation, be sure you have a separate bank account in that company’s name and try not to run any personal expenses through it.

A little planning can avoid courts turning your loan into worthless equity or making your personal assets vulnerable to creditors. Avoid these situations altogether with valid legal loan agreements, documented accounting, and segregated accounts and funds, so business owner beware!

Don’t Go Advertising Your Funding Needs Just Yet

Anyone who has been watching the regulatory environment for securities and fund raising over the last few years or even months is familiar with the changes coming from the JOBS Act.  On July 10, 2013, the SEC announced that they will implement rules following the JOBS Act requirement that the ban on general solicitation and advertising in private placements be lifted in certain circumstances.

Although that sounds like good news, this was what the JOBS Act was intended to do when it was passed and the SEC is just now starting to implement rules based upon existing law.  The process is that the SEC proposes the rules to implement the provisions of the JOBS Act.  There is a public comment period and the rules go into effect 60 days after being published in the Federal Register.   This means the proposed rules are still not yet valid until that time frame has passed.

The new rules require a Form D to be filed with the SEC 15 days prior to any general solicitation and materials about the proposed offering need to be provided to the SEC.

Just like with crowdfunding, don’t listen to the hype and think that because the JOBS Act passed, people can start relying on crowdfunding exemptions.  The SEC has to fully implement the rules and procedures first.

Here is the SEC Fact Sheet on the July 10th, 2013 proposed new rules:

 

July 10, 2013

Background

Current Offering Process

Companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Most of the exemptions from registration prohibit companies from engaging in general solicitation or general advertising – that is, advertising in newspapers or on the Internet among other things – in connection with securities offerings. Rule 506 of Regulation D is the most widelyused exemption from registration.

In an offering that qualifies for the Rule 506 exemption, an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 nonaccredited investors. Under SEC rules, accredited investors are individuals who meet certain minimum income or net worth levels, or certain institutions such as trusts, corporations, or charitable organizations that meet certain minimum asset levels.

JOBS Act

In April 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS Act). Section 201(a)(1) of the JOBS Act directs the SEC to remove the prohibition on general solicitation or general advertising for securities offerings relying on Rule 506 provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors. By requiring the SEC to remove this general solicitation restriction, Congress sought to make it easier for companies to find investors and thereby raise capital.

While issuers will be able to widely solicit and advertise for potential investors, the JOBS Act required the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities.

Comments on the 2012 Proposal

Last August, in order to comply with the Congressional mandate to implement Section 201(a)(1) of the JOBS Act, the Commission proposed a rule that would remove the general solicitation ban in certain Rule 506 offerings in which sales would be limited to accredited investors and issuers would be required to take reasonable steps to verify such accredited status. After doing so, the Commission received comments from a wide range of commenters including issuers, investor organizations, individuals, law firms, state government officials, and professional and trade associations.

Some of these commenters suggested that the SEC consider measures that they believed would provide additional protections for investors in connection with removing the general solicitation ban. Several suggestions related to the notice that is required to be filed by an issuer in connection with a Rule 506 offering. This notice, called Form D, is filed with the SEC and available for review by the public. Other suggestions included changing the definition of accredited investor, imposing requirements governing the content and manner of general solicitations, and requiring issuers to file general solicitation materials with, or submit them to, the SEC.

New Rule Proposal

The Commission approved a proposal intended to enhance the SEC’s ability to assess developments in the private placement market now that the rule to lift the ban on general solicitation has been adopted. In particular, the proposal would improve the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and would address certain concerns raised by investors related to issuers engaging in general solicitation.

The proposal requires issuers to file an advance notice of sale 15 days before and at the conclusion of an offering…

Currently, an issuer – such as a company or a fund – selling securities using Rule 506 is required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. That form is a type of notice that provides information about the issuer and the securities offering. 

Under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would, in addition to the current requirements, be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Also, within 30 days of completing an offering, issuers would be required to update the information contained in the Form D and indicate that the offering has ended.

The proposal requires issuers to provide additional information about the issuer and the offering…

Currently, Form D requires identifying information about the company or the fund selling the securities, any related persons, the exemption the issuer is relying on to conduct the offering, and certain other factual information about the issuer and the offering. 

Under the proposal, issuers are required to provide additional information to enable the SEC to gather more information on the changes to the Rule 506 market that could occur now that the general solicitation ban has been lifted.

The additional information would include:

  • Identification of the issuer’s website.
  • Expanded information on the issuer.
  • The offered securities.
  • The types of investors in the offering.
  • The use of proceeds from the offering.
  • Information on the types of general solicitation used.
  • The methods used to verify the accredited investor status of investors.

The proposal disqualifies issuers who fail to file Form D…

Under the proposal, an issuer is disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering. As proposed, the disqualification would continue for one year beginning after the required Form D filings are made. Issuers would be able to rely on a cure period for a late Form D filing and, in certain circumstances, could request a waiver from the staff.

The proposal requires issuers to include legends and disclosures in written general solicitation materials…

Under the proposal, issuers are required to include certain legends or cautionary statements in any written general solicitation materials used in a Rule 506 offering. 

The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.

In addition, if the issuer is a private fund (a type of pooled investment vehicle) and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information. The issuer also would need to highlight the difficulty of comparing this information with past performance information of other funds.

The proposal also requests public comment on whether other manner and content restrictions should apply to written general solicitation materials used by private funds.

The proposal requires issuers to submit written general solicitation materials to the SEC…

Under the proposal, issuers are required to submit written general solicitation materials to the Commission through an intake page on the SEC website. Materials submitted in this manner would not be available to the general public. As proposed, this requirement would be temporary, expiring after two years.

The proposal extends guidance about misleading statements to private funds…

Currently, an SEC rule provides guidance on when information in sales literature by an investment company registered with the SEC could be fraudulent or misleading for purposes of the federal securities laws. 

Under the proposal, this guidance – contained in Rule 156 under the Securities Act – would be extended to the sales literature of private funds. It would apply to all private funds whether or not they are engaged in general solicitation activities. In the proposing release, the SEC would express its view that private funds should now begin considering the principles underlying Rule 156.

What’s Next

The proposal is now subject to a 60-day public comment period.

What are the life skills a startup CEO must learn to rise to the top?

There are tons of business skills, but life skills translate into good decision making (not always, but most of the time).  Gratitude, humility, and ability to listen (as mentioned) are key, but the ability to take life as it comes and be accepting of those changes, but willing to adapt to survive.  Many CEOs are so convinced in their product/service, that they fail to see the big picture of life and business, which I feel should include acceptance of today, gratitude for tomorrow and doing what you love, and willingness to change, no matter what.

See question on Quora

Flat Fee Lean Start-Up Business Legal Package Guide

Many entrepreneurs and founders are hesitant to talk to an attorney for fear of the dreaded hourly billing or unknown costs.  The other concern is that many people fear or don’t want to deal with lawyers, either because they don’t know what to expect or there have been bad experiences they have experienced or have heard about.  That is why many people avoid getting initial legal work complete when they are working on a startup idea. Learn more

Business Start-Up Toolkit- A Guide to Lean Startup Legal & Advisors

I was reading an article in this month’s (June 2012) Entrepreneur magazine by Ann C. Logue entitled “Beyond the Handshake- Having a business partner can be valuable.  Having the wrong-or no-partnership agreements can be disastrous.”  It details the experiences I hear every day by founders, entrepreneurs, and startups.  Most know they need quality legal and business advice in the early stages of their growth, but don’t want to spend the money on it.  With the advent of online document and template sharing, discount legal document prep companies, and companies out there like LegalZoom and RocketLawyer offering low-cost or free legal documents, I very often hear and see the impact that is having.  I have worked both in the trenches of many a cash-poor startup and also as an attorney advising these same type of companies or founders and wanted to give some additional guidance and solutions from both perspectives.

Education and information are some of the most critical areas for any start-up.  They need to know their product, know their market, learn how to commercialize their product or service, and how to go from idea to a functioning business.  I put together a handbook with some of the common areas operationally, administratively, financially, and legally in my Startup Bootcamp 101 e-Book (Click to download free pdf) to provide some basic education on those aspects of business start-ups.  There are web resources that I have tried to compile as well at this Blog, but there are tons of resources in the form of books and online materials.  Some recommended books are Venture Deals by Brad Feld, the Lean Startup by Eric Reis, and the Startup of You by Reid Hoffman.  I will discuss some of the do’s and don’ts when trying to stay within a “lean startup” mentality, but also when you do yourself a disservice by trying to cut corners to save money.

Learn more

Credit Report Use Limited In California Employment Decisions per AB 22

A common question asked by start-ups or even just average average businesses is what information they can ask or use in vetting their potential employees.  Some common forms used may be background checks, drug screening, and reference checks.  Due to the economy creating many credit problems for average citizens (even more so with entrepreneurs who often use their own personal credit to bootstrap their company), I will take a look at the use of credit reports in making employment related decisions.

Existing federal law provides that, subject to certain exceptions, an employer may not get a credit report without prior disclosure of that the employer wants to obtain one and the employee consents. Existing federal law further requires, subject to certain exceptions, an employer, before taking any adverse action based on the report, to provide the consumer with a copy of the report and a written description of certain rights of the consumer.

California enacted AB 22 which amended California Civil Code Section 1785.20.5 to provide additional protections in this state to protect the potential employee when dealing with similar uses of credit reports.  This law went into effect January 1, 2012.  In addition the California Labor Code added Chapter 3.6 to include additional requirements.  The law provides that the employer needs to follow the same federal requirements of disclosure that they want to obtain a credit report, but also requires the employer to state why they want it.  The law goes on to further indicate that credit reports can only be requested for the following certain categories of types of positions (except by certain financial institutions): Learn more

Entrepreneurs Suffer Credit Problems In Economic Hard Times

Many small business owners or other entrepreneurs start out with a great idea for a new product or service.  They start a business and focus on doing whatever it takes to make the company successful.  Many don’t take the steps necessary to properly protect the business from creditors or don’t really pay much attention to what they sign when they are making deals.  The ones who do read the fine print may just have the attitude that they are so confident in the business’ success, who cares if they use their own personal credit to get some working capital.  With the economic downturn over the last few years, many business owners have had to close their doors because they couldn’t get the funds they needed to even cover the simple things like payroll or rent.

Use of Personal Credit

Many entrepreneurs feel that they should put some ‘skin in the game’ by contributing some of their own money into the business.  In fact, the Small Business Administration backed loans often require the founders to contribute at least a certain percent of their own assets or some other major contribution in order to qualify for a business loan.  When the owner doesn’t have available cash, they look to other sources to get the money to contribute.  That can lead to things like taking out a home equity line of credit or using personal credit cards to help fund the business.  Obviously that is pretty risky, but often necessary to get early access to this seed money to start and grow.  The banks that issued the credit did so based upon the owner’s personal credit rating.  Just because the credit card may have the business’ name on it doesn’t mean the bank hasn’t covered their bases by making sure they can sue the owner personally if the business defaults in payment.

Learn more

Can I pay a startup attorney with stock or options?

So a major issue faced by many startup founders, especially when they are bootstrapping, self-funded, or just watching their cash, is how they can get legal or other services with little to no cash.  The fall back position is to give the advisor or service provider a “piece of the action.”  The founder often wants to use stock in the company they formed or stock options to avoid using cash, but still obtain needed advice and guidance.  Here are the main problems you will run into:

1)  Valuation–  You will have a difficult time agreeing on a valuation of the company’s stock (see Section on Valuation).  The founder often feels that they have the next greatest invention or idea of all time and the company is already worth billions despite having no business model or revenue (just watch an episode of Shark Tank on ABC).  The valuation is what you use to determine the value of the stock in comparison to what the services are worth.  (e.g. 1,000 shares of stock valued at $1 per share in exchange for $1,000 worth of services)  The service provider or advisor may have a different idea of what your company or idea is really worth.  If you can’t come to some agreement on the value of the stock, you won’t get them to sign on.

Learn more

SEC & CFTC Adopt Rules For Definitions of Terms in Derivatives Transactions under Dodd-Frank

On April18, 2012, the SEC, jointly with the Commodities Futures Trading Commission (CFTC), implemented part of the Dodd-Frank Act by adding definitions for use in interpreting what are swaps-related transactions.

The new Rule 3a71-1 under the Securities Exchange Act defines the term “security-based swap dealer” consistent with the criteria set forth in the Dodd-Frank Act as someone who:

  • Holds themselves out as a dealer in security-based swaps.
  • Makes a market in security-based swaps.
  • Regularly enters into security-based swaps with counterparties as an ordinary course of business for their own account.
  • Engages in activity causing them to be commonly known in the trade as a dealer or market maker in security-based swaps.

There is an exception for those who are only involved in a de minimis quantity of these transactions to not be held to this rule.  The rule will go into effect 60 days after the rule is published in the Federal Register.

You can read the entire release and rule through the SEC’s website at:
 http://www.sec.gov/news/press/2012/2012-67.htm