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Startup Equity Financing Alternatives: A Simplified Guide

Written by Patrick Henry

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A Number of Alternative are Now Available for Startup Equity Financing Including Crowdfunding with the JOBS Act

In the olden days, when a startup wanted to raise startup equity financing for their company, and they had exhausted their own funds and money from friends and family, they would look to Angel investors and eventually to venture capital firms. See Angel Investors versus Venture Capitalists: Where Do Startups Turn.

Although this is still a very viable method for funding your startup, with the passage and implementation of Title II, III, and IV of the U.S. JOBS Act, there are now a few additional alternatives for raising outside capital for your startup. This article is intended to give an overview of the four types of equity funding available to startups, prior to taking a company public in an Initial Public Offering, or IPO.

Rule 506(b) of Regulation D

This law allows small businesses to raise an unlimited amount of startup equity finacing from an unlimited number of accredited investors. Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption of Section 4(a)(2) of the Securities Act of 1933. Companies relying on the Rule 506(b) exemption can raise an unlimited amount of money from an unlimited number of “accredited investors” and up to 35 other non-accredited investors. An accredited investor, in the context of a natural person, includes anyone who:

  • Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
  • Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence)

The company cannot use general solicitation or advertising to market the securities. Under Rule 506(b), a company can be assured it is within the Section 4(a)(2) exemption by satisfying the following standards:

  • Unlike Rule 505 of the Securities Act, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment
  • Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.
  • If a company provides information to accredited investors, it must make this information available to non-accredited investors as well.
  • The company must be available to answer questions by prospective purchasers, and financial statement requirements are the same as for Rule 505 of the Securities Act.

Purchasers of securities offered pursuant to Rule 506 receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.

Reg D offerings are the traditional way that private companies raise money from Angel investors, which by definition are accredited investors. Private placements of preferred stock to venture capital funds and corporate investors are also issued as unregistered shares with restrictions under Reg D. There are also some more limited forms of Reg D offerings including 504 and 505 offerings. See the applicable SEC regulations for more information.

JOBS Act Title II

Title II of the U.S. JOBS Act allows businesses to publicly advertise their need for startup equity financing. The new exemption it created, Rule 506(c), lifted the ban on general solicitation that was adopted in 1933. Companies can raise an unlimited amount of capital from an unlimited number of accredited investors.

Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but still be deemed to be undertaking a private offering within Section 4(a)(2) if:

  • The investors in the offering are all accredited investors; and
  • The company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Purchasers of securities offered pursuant to Rule 506 receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.

Title II has allowed for syndicated Angel deals using online platforms like Angel.co.

JOBS Act Title III

Title III of the U.S. JOBS Act allows for non-accredited investors to invest in private startup companies. Title III of the JOBS Act, otherwise known as Regulation Crowdfunding or Reg CF, legalized retail investment crowdfunding. In other words, non-accredited investors can now participate broadly in this type of startup equity financing.  There is a good list from CrowdFund Insider that outlines what issuers, or those looking to raise funds, should know about Title III.  I’ve included it here:

  • You may only raise $1M in a rolling 12-month period
  • You must use an online intermediary
  • You must be a U.S. entity
  • You must disclose certain financial information, and depending on how much you plan to raise, your financial statements may need to be reviewed or audited by an accountant
  • You must fulfill certain ongoing reporting requirements
  • You may raise funds from both accredited and non-accredited investors, although investors are limited to investing a certain dollar amount based on their income or net worth.

Title III just went into effect in May of 2016. It allows for “retail” non-accredited investors to invest in private companies.

Reg A+ of Title IV of the JOBS Act

Reg A+ is a type of offering which allows private companies to raise up to $50 Million in startup equity financing. Check out Raising Capital using Regulation A+ Mini-IPO. Like an IPO, Reg A+ allows companies to offer shares to the general public and not just accredited investors. Companies looking to raise capital via Reg A+ will first need to file with the SEC and get approval. The fees associated with a Reg A+ offering are much lower than a traditional IPO, and the ongoing disclosure requirements are much less burdensome, and less expensive. Currently there is not a mainstream market for trading shares of stock issued in a Reg A+ offering. This is a major distinction from shares that are offered in an IPO on the NYSE, NASDAQ, or a secondary exchange.

Reg A+ opens up the market for “retail” non-accredited investors to invest in private companies even when they are raising large amounts of capital, without the company going through an IPO.

Summary

More than ever before, there are many innovative and creative ways to fund your startup. Pick the alternative that is right for you and your company. Another couple of other good articles that I found valuable are Wefunder: Legal Primer for Founders, and Practical Law: Venture Capital Investment in the United States: Market and Regulatory Overview.  However, if you plan to raise startup equity financing, no matter what path you take, make sure that you have a competent corporate attorney that understands securities law as it relates to startups, mergers & acquisitions, and public financing. Also, keep in mind that valuation of your startup is but one of many important deal terms in any equity financing.

This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.

 

 

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