Finding Investors
Many entrepreneurs start their companies thinking that they will easily secure investment money from outsiders who automatically believe in their ideas. The fact of the matter is that this could not be further from the truth. According to data Entrepreneur Magazine, using data from Fundable, fewer than 1% of all companies will raise money from Angel Investors, and only 0.05% of companies will secure VC funding. The most likely source of your money is personal savings and credit (~57% of startups) or money from friends and family (~38%). Even loans from banks secured by the Small Business Administration account for only ~1.5% of startup funding. Crowdfunding also makes up a small share of the funding scenarios.
Please keep in mind that raising any capital through outside parties, whether venture capitalists, angel investors, crowdfunding, or even from friends and family, is complicated, and highly regulated. You always want counsel of an experienced attorney who can make sure that you are doing it legally, with all the appropriate documents and government filings that are required.
If you are building a very specific type of company, (high risk, high return, “exit-able” in the right time frame, great team, platform technology, protectable IP, etc.) and are intent on aiming for that small sliver of outside investment dollars, let’s look at the ways in which you can raise capital.
The US Securities Act of 1933
The US Securities Act of 1933 says that any offer to sell securities (such as shares of your company), must either be registered with the SEC, or meet qualifications to be exempt. The rules for exemption are contained in Regulation D (referred to as “Reg D”). Reg D is generally, though not exclusively, for smaller companies that cannot afford the costs of registration. The Code of Federal Regulations lists the specific exemptions in certain sections in Title 17, part 230, but they are often referred to just by the section of the Code. If you raise money, it is very likely you are doing so under one of the following exemptions.
Rule 504 – Companies can offer and sell up to $1MM in securities in a 12-month period. Companies generally cannot advertise or solicit sales of these securities to the public. Sales of these shares by the investors are generally restricted. It is possible to sell non-restricted securities by meeting some criteria, which can be read at the SEC website: https://www.sec.gov/answers/rule504.htm
Rule 505 – Companies can sell up to $5MM of securities in any 12-month period. There is no use of general solicitation or advertising under 505, and securities can be sold to any number of Accredited Investors*, and up to 35 other persons who do not meet the requirements. Companies generally need certified or audited financial statements, and the securities are restricted for six months from purchase. https://www.sec.gov/answers/rule505.htm
Rule 506 – Companies can raise unlimited money under Rule 506, but will generally fall under 506(b), or 506(c), but not both. In both cases, securities are restricted, and cannot be re-sold within a year without registering them with the SEC. https://www.sec.gov/answers/rule506.htm
- 506(b) – No general solicitation or advertising to market the securities. Accredited Investors only plus up to 35 other purchasers. Even non-accredited investors must be sophisticated and experienced in finance. Same financial statement requirements as Rule 505.
- 506(c) – Company is allowed to broadly solicit and generally advertise the securities offering. All investors must be accredited, and the issuing company must take reasonable steps to verity this for every investor.
Regulation A+ – Money can also be raised under Regulation A (Reg A) of the same Securities Act of 1933. Reg A has two tiers, Tier 1 and Tier 2 under which investments can occur. More information can be found here: https://www.sec.gov/oiea/investor-alerts-bulletins/ib_regulationa.html
- Tier 1 – up to $20MM in a 12-month period. Allows money from non-accredited investors. Companies must have an “offering circular” which must be approved by the SEC and the regulators of the state in which they conduct their offering.
- Tier 2 – up to $50MM in a 12-month period. The offering circular is subject to review and qualification by staff at the SEC, but not state regulators. Tier 2 companies are subject to ongoing reporting requirements.
Regulation Crowdfunding
Regulation Crowdfunding (Reg CF) – The latest method allows companies to raise money from virtually anyone. There is no need to find accredited investors. Reg CF allows companies to raise up to $1,070,000 in a 12 month period. (Yes, you read correctly, 1 million and 70 thousand dollars) from either accredited or non-accredited investors, each of whom is subject to a yearly limit in the amount they can invest via this exemption (The formula to calculate an individual’s limit can be found here. There are limits on the companies that can or cannot use this exemption, differences in the reporting requirements, depending on the amount raised, or whether it is the first time raising via this exemption or not, and there are limits on what the company can say – basically, a company can only direct potential investors to an online crowdfunding platform and say a few minor other factual details.
As you can imagine, the legal work, interactions with the SEC, forms that must be filed with the state or federal government, contracts, cap tables, and rules and regulations that must be adhered to can be cumbersome, complicated, and expensive to comply with. There are very real differences in the cost in both time and money that will be borne by using these different types of offerings. Personally, I cannot imagine doing any of them without the help of a qualified attorney, as the penalties for violating securities laws can be severe.
That being said, there are many companies that raise money using these exemptions every year. If you are building the right kind of company, and outside investment is in your future, talk with competent, qualified, and experienced attorney to help you navigate a very complex set of laws and options that are available to you.
Also note: I am not an attorney. Nothing in this post should be considered legal advice. All the information was taken from publicly accessible sources which are linked above.
* Accredited Investors are defined by the SEC as individuals with over $200,000 in individual income, or $300,000 in joint income with a spouse, or over $1MM in net assets, excluding their primary home. Please see the SEC for full details on the definitions.
