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Startups often get in big trouble with the Security and Exchange Commission when they raise business funding. 

If you raise funding from outside investors, you are required to register your offering with the SEC or file for an exemption.  Many startups don’t realize this.  Failure to do so will not only get you in major trouble with the Securities Exchange Commission, it will also land you in hot water with the State Security Commissioners in any of the states you sold securities in.

When you raise money from friends and family you are required to either register the offering with the SEC or apply for an exemption. 

Many startups raising business funding turn to friends and family for raising money.  There are some important things you need to take into consideration before accepting their money.  When you do this, you need to be aware that you need to either register your offering with the SEC or apply for an exemption.  In addition, you will be required to register with the state security commission in any state you sell your securities in.

Security and Exchange Commission

Startups often get in big trouble with the Security and Exchange Commission when they raise business funding.
NewBusinessCreator.com

You need to register with the SEC or apply for an exemption if you raise money using promissory notes that are for more than nine months. 

Many companies incorrectly believe that they don’t have to register security offering with the SEC because they are getting a small business loan rather than doing equity financing.   Making this assumption can get you in major trouble later on.  It is important to realize that what the SEC defines as a security is very broad.  In most circumstances, the SEC includes promissory notes as securities.  According to their rules, promissory notes are considered a securities unless they are a note for nine months or less.   Other types of notes that are not considered securities include:

  • Notes secured by a mortgage on your home.
  • Short-term notes secured by a lien on your business or some of its’ assets.
  • Notes regarding an unsecured loan
  • Short-term notes secured by your company’s accounts receivables.
  • Notes associated with commercial loans
  • Notes delivered in consumer financing

 The bottom line is that whenever you raise business funding from outside investors, either register your offering with the SEC or file for an exemption.

Registering a security offering with the SEC is usually reserved for an Initial Public Offering.

There are several reasons why registering a security offering with the SEC is usually reserved for an Initial Public Offering. One reason is the exorbitant cost. Another reason is that it takes many months to prepare the necessary documents.  As a result, for most startups it is not worth if they are raising modest amounts of capital.

Most startups apply for an exemption offered under Regulation D of the Securities Act of 1933 whenever they from outside investors.

The way to avoid registering your private offering is to apply for either a Rule 504, Rule 505 or Rule 506 exemption under Regulation D of the 1933 Securities Act. Each of these exemptions have various differences in the amount of money you can raise and who can invest in your company. With 506 offerings, a company can raise an unlimited amount of money.  With 504 and 505 offerings, on the other hand, the amount of funding you can raise is capped at $1 million and $5 million respectively.

Companies that apply for any of the exemptions from filing a security offering with the SEC can have an unlimited number of accredited investors.

Regardless of the exemption you apply for with the SEC, you can have an unlimited number of accredited investors. The definition of an accredited investor is spelled out in SEC’s Rule 501. In this rule, it states that for a person to qualify as an accredited investor, they have to have a net worth, or joint net worth with their spouse, that exceeds $1 million at the time of the purchase.  It is important to note that the calculation of net worth used to qualify an accredited investor cannot include the investor’s equity in their primary residence.

Another way a person can qualify as an accredited investor is by having an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years. This investor must also have a reasonable expectation of the same income level in the current year.

There are some significant differences between Rule 504, Rule 505 and Rule 506 offerings with regards to how many non-accredited investors can participate in your offering.

With a 506 offering, you’re limited to 35 non-accredited investors. It is important to note that Rule 506 requires that all non-accredited investors, either alone or with a purchaser representative, be sophisticated. This means that 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.

With Rule 505, the number of non-accredited investors you can offer your securities to is also limited to 35 people. Unlike with the 506 Rule, a 505 offering does not require non-accredited investors to satisfy the sophistication standards. With 504 offerings, you can have an unlimited number of non-accredited investors.  The 504 Rule also does not require investors to be sophisticated or to be accredited investors.

The amount of money you can raise varies drastically depending on what type of SEC exemption you apply for.

The size of your security offering is not limited when you do a 506 private placement. With a 505 offering, you can raise up to $5 million dollars in any 12-month period. 504 offerings are capped at $1 million dollars.

Failure to file a Form D 15 days before advertising your offering and 15 days before your first sale of securities can result is ruinous consequences for your company and for the issuers of the securities being offered.

Another important item that you must be aware of when applying for an exemption from registering with the SEC is that you must file a Form D fifteen days before advertising your offering and 15 days before your first sale of securities. Failure to do this can result in your being forced to return all of the money raised. That’s only part of the hurt that the SEC will be inflicting on you.  Failure to file a Form D on a timely basis will result in your company being unable to file for an exemption for a year.  That is not the worst part of the punishment for failing to comply with their rules.  Under these circumstances, the SEC will also ban the issuers of the securities from applying for Regulation D exemptions for a year following the date of the violation.

You are also required to comply with filing requirements in every state you sell securities.

When registering your private offering, don’t forget to register with all of the state security commissions in any of the states you intend to sell securities in. There is one loophole that will allow you to avoid registering with the states. Exemption of registering with the SEC and the states is offered in Rule 506 of Regulation D.  It is important to note, however, that this exemption from registering your offering with the SEC does not exempt you from filing a Form D.  It is also important to realize that private offerings must be registered with any state they are sold in if you use Rule 504 or Rule 505 to avoid SEC registration requirements.

Raising debt financing from a bank or lending institution does not require you to deal with the Securities and Exchange Commission.

As discussed above, raising debt financing from a bank or lending institution does not require you to deal with the Securities and Exchange Commission. For many small to medium businesses, an SBA loan is the best source of funding. One good source of SBA loans is Newtek. This company is currently the largest non-bank SBA lender in the United States.

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