Chapter 8: Securities Law Considerations When Obtaining Venture Financing 133

Chapter 8

SECURITIES LAW CONSIDERATIONS WHEN OBTAINING

VENTURE FINANCING

DISCUSSION QUESTIONS AND ANSWERS

1. Briefly define the Securities Act of 1933 and Securities Exchange Act of 1934.

The Securities Act of 1933 is the main body of federal law governing the creation
and sale of securities. The Securities Exchange Act of 1934 deals with the
mechanisms and standards for public security trading.

2. Briefly discuss the Investment Company Act of 1940 and Investment Advisers Act
of 1940.

The Investment Company Act of 1940 provides a definition of an “investment

company.” The Investment Advisers Act of 1940 focuses on people and
organizations that seek to provide financial advice to investors and defines
“investment adviser.

3. Describe the Jumpstart Our Business Staertups Act of 2012.

The JOBS Act of 2012 is a federal law passed to stimulate the initiation, growth and
development of small business companies. The JOBS Act has six Titles (I through
VI) which we briefly cover in the chapter. We highlight three of the Titles here as
follows:

Title II: lifts restrictions on general solicitation and advertising for Reg D 506 
accredited investor offerings; SEC implemented the related rules on July 10, 2013

Title III: establishes a small offering registration exemption and calls for SEC rules 
relating to the sales of securities to an Internet “crowd” (securities crowdfunding); 
SEC adopted the final rules on October 30, 2015

Title IV: changes the maximum raise under a Regulation A­like offering (a Section 
3(b)2 offering) from $5 million to $50 million while softening the Reg A’s 
solicitation provisions; SEC implemented the rules on June 19, 2015

4. What is securities crowdfunding?

The term “crowdfunding” is sometimes used to refer to a general set of possible 
approaches to raising money from the crowd, including donation solicitations, 
134 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

advanced payment for to­be­manufactured products, as well as the sale of securities. 
We use the term securities crowdfunding to specifically refer to the use of The 
JOBS Act Title III’s small offering registration exemption from SEC registration 
requirements involving crowdfunding for the sale of securities.

5. What is meant by the term “blue sky” laws and how do these laws apply when
issuing securities?

Blue Sky Laws are the state laws designed to protect individuals from investing in
fraudulent securities offerings. They are the state equivalent of the federal securities
laws.

6. Describe the meaning of a “security” in terms of the Securities Act of 1933.

The term “security” means any note, stock, treasury stock, bond, debenture,
evidence of indebtedness, certificate of interest or participation in any profit-
sharing agreement, collateral-trust certificate, preorganization certificate or
subscription, transferable share, investment contract, voting-trust certificate,
certificate of deposit for a security, fractional undivided interest in oil, gas, or
other mineral rights, any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities (including any
interest therein or based on the value thereof), or any put, call, straddle,
option, or privilege entered into on a national securities exchange relating to
foreign currency, or, in general, any interest or instrument commonly known
as a “security,” or any certificate of interest or participation in, temporary or
interim certificate for, receipt for, guarantee of, or warrant or right to subscribe
to or purchase, any of the foregoing.

7. Why does it matter if an investment is, or is not, viewed as being a security?

Any investment considered to be a security under the 1933 Act comes under its
provisions. In particular, unless an exemption is secured, it must be registered with
the SEC prior to being offered to the public.

8. Briefly describe what is meant by the statement “Registering securities with the
Securities and Exchange Commission (SEC) is both costly and a time-consuming
process.”

There is a great deal of expertise involved in preparing the documents and filings
associated with a public offering. Most ventures do not have the resources to employ
a staff specializing in this area. Consequently the venture will retain legal and
investment banking experts to assist in the offering. The associated costs are
substantial and require much of the information be provided by venture insiders (the
time element) who typically have been working on the non-financial aspects of
growing the venture.
 Chapter 8: Securities Law Considerations When Obtaining Venture Financing 135

9. Identify some of the types of securities that are “exempt” from registration with
the SEC.

Some of the exempt securities are: government securities (federal and state),
securities issued by banks, certain securities issued by insurance companies and
certain securities of not-for-profit issuers.

10. Briefly describe what is meant by an intrastate offering. What are the major
difficulties in assuring that an offer is intrastate?

An intrastate offering is one where the issuer and investors are considered by federal
securities law to be confined to one state. SEC Rule 147 lays out guidelines under
which the SEC will consider the offering to be intrastate.

11. Identify and briefly describe two basic types of transactions that are exempt from
registration with the SEC.

The most widely used exemption is the private placement exemption: transactions by
an issuer not involving any public offerings. The accredited investor exemption is a
second transaction exemption and lays much of the groundwork for the types of
exemptions that involve a certain type of investor.

12. What does the term accredited investor mean in terms of the Securities Act of
1933? Why does the designation matter?

Accredited investors under the 1933 Act are assumed to have sufficient financial
expertise and wherewithal to make an intelligent and informed investment decision.
Formally:

2(a)(15) The term “accredited investor” shall mean:

(i) A bank as defined in Section 3(a)(2) whether acting in its individual or

fiduciary capacity; an insurance company as defined in paragraph (13) of
this subsection; an investment company registered under the Investment
Company Act of 1940 or a business development company as defined in
Section 2(a)(48) of that Act; a Small Business
Investment Company licensed by the Small Business Administration; or
an employee benefit plan, including an individual retirement account,
which is subject to the provisions of the Employee Retirement Income
Security Act of 1974, if the investment decision is made by a plan
fiduciary, as defined in Section 3(21) of such Act, which is either a bank,
insurance company, or registered investment adviser; or

(ii) Any person who, on the basis of such factors as financial

sophistication, net worth, knowledge, and experience in financial matters,
136 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

or amount of assets under management qualifies as an accredited investor

under rules and regulations which the Commission shall prescribe.

13. Briefly describe the importance of the 1953 SEC vs. Ralston Purina case in terms
of securities registration requirements.

The U.S. Supreme Court took an important step toward defining a private (nonpublic)
offering in SEC v. Ralston Purina. The case involved the sale of securities to
employees. The court found that because Ralston Purina’s offering included
employees who would not necessarily have access to the appropriate type of
information, it did not fall within the private placement exemption of the 1933 Act.

14. What is the purpose of the SEC’s Regulation D?

Reg D provides a set of safe harbor conditions under which an issuer can shield
themselves from SEC action for failure to register securities.

15. What are the restrictions on general solicitation and advertising covered in Rule
504?

Rule 504 is the most lenient and the only exemption in Reg D that allows for any
conditions under which the solicitation can be to the general public. The specific
conditions under which general solicitation and advertising are allowed, in the current
form of Reg D, relates to state registrations and information dissemination. Issuers
considering general solicitation in connection with a 504 offering would be well-
advised to seek specific legal counsel on the current conditions required in a 504
offering.

16. How do Rules 504, 505, and 506 of Reg D differ from one another?

Rule 506 has no limits on the amount raised, but has a limit of 35 investors that fall in
categories that have to be counted and those 35 must be “sophisticated.” Rule 505
has a monetary limit of $5 million and a limit of 35 investors that fall into categories
that must be counted. Rule 504 has a $1 million limit but no limit on the number or
sophistication of investors.

17. Provide a brief description of the use of Regulation A when issuing securities.

Regulation A is technically an exemption from full registration, but in practice is like

a limited registration where the process involves many of the same types of activities
in doing a full registration. The monetary limit was increased from $5 million to $50
million under the JOBS Act of 2012. The issuer is allowed to “test the waters” for the
offering, and the shares can be issued to the public and eventually trade freely.

[Note: The following questions 18 through 27 relate to the material presented in

Appendixes B and C.]
 Chapter 8: Securities Law Considerations When Obtaining Venture Financing 137

18. Briefly describe how the SEC’s Regulation D expanded the original Securities Act of
1933 definition of an “accredited investor.”

For the purposes of Reg D, investors are considered accredited if they fall into one of
eight categories. Rather than leaving the notion of “accredited” as vague (thus
making the safe harbor less certain), the SEC chose to provide specific criterion
whereby an individual can be designated as “accredited.”

19. What are the income and net worth requirements for being an accredited investor?
What in the requirements for designation as an accredited investor relates to the level
of sophistication? Do the criteria act as good proxies for sophistication?

The income requirements are currently $200,000 for single filers and $300,000 for
married filers. The wealth requirement is $1,000,000. While the requirements for
accredited investor status do not necessarily reflect “sophistication”, they appear to
create categories highly correlated with sophistication or the ability to hire
sophisticated advisers during the investment decision process.

20. What are the four conditions of a Reg D offering that are covered under Rule 502?

Rule 502 (§ 230.502) deals with four conditions of a Reg D offering: integration
(when multiple issues count as one), information (what you need to disclose when
you must formally disclose), solicitation (what you can’t do when promoting the
offering) and resale (serious restrictions).

21. What is integration as it applies to securities offerings and why does it matter?

Integrated offerings are those that may be treated as combined into one offering. For
integrated offerings it is the aggregated total dollar amount which must not exceed the
dollar limits of the Reg D exemption being sought.

22. What types of information need to be disclosed to offerees under Reg D?

When required, the type of information to be disclosed varies by the venture’s status
and size. Summarizing from the Reg D text:

The issuer shall furnish to the purchaser, to the extent material to an

understanding of the issuer, its business, and the securities being offered:

(A) non-financial statement information similar to that required in a Reg A (or

registered) offering.

(B) financial statement information depending on the size of the offering and
ranging from S-B and S-B2 type information up to the same financial
statements as required in a regular registration.
138 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

23. What is a restricted security? Why does this designation matter? What types of
buyers must the owner of restricted securities find?

Restricted securities cannot be freely resold. This is the typical status of securities
sold in a private placement. The resale of restricted securities typically requires
locating an accredited investor as a buyer.

24. Briefly describe the purpose of Rule 144 of Reg D.

To provide conditions under which restricted securities can be resold.

25. Briefly describe Rule 508 of Reg D.

Rule 508 allows for the possibility that an offering will be granted safe harbor when
the only deviations from Reg D’s requirements are deemed to be “insignificant.”

26. Briefly describe the types of exemptions from registration of securities covered under
Rules 701 and 1001.

Rule 701 is an exemption for certain types of employee compensation arrangements

involving the issue of the employer’s securities. Rule 1001 is a “qualified
purchaser” exemption for the State of California that assures certain California
issuers that their exemption under California law will receive concurrent exemption
from federal registration.

27. From the Headlines – Sock It to Me: The “Internet of Feet”: Discuss the role that
Indiegogo played in the initial funding of Sensoria. Do you believe it was important
in leading up to the $5 million A round?

Answers will vary: One aspect that crowdfunding plays in the launch of niche
products is that of a credible approach to elementary market research for that niche.
While not as elaborate or scientific as a full-blown market research study, the
willingness of consumers to lay out money in advance of a product’s availability can
send a strong signal regarding the size of the addressable market. However, for very
specific narrow niches, the crowdfunding approach may also represent more of the
entirety of that niche market rather than the likelihood that a randomly selected
individual at a mall would want to buy the niche product. Sensoria products are
likely not for everyone and crowdfunding may be a useful way to identify the
affinity group most likely to buy Sensoria products. The data produced by the
crowdfunding could very well be important in driving venture investors to invest
beyond the amount of the crowdfunding.

EXERCISES/PROBLEMS AND ANSWERS

 Chapter 8: Securities Law Considerations When Obtaining Venture Financing 139

1. [Accredited Investors] The NetCare Company, which operates living assistance

facilities, is planning to issue or sell shares of stock to “accredited investors.”
Briefly explain whether each of the following individuals would qualify as an
“accredited investor” under the SEC’s Regulation D. [Note: Materials in
Appendix B are useful in answering this exercise.]

A. Amy Smith is the chief executive officer (CE0) of the NetCare Company.

Yes. All officers and directors of the company are accredited.

B. Bruce Jones, who has a net worth of $750,000, is planning to purchase shares
of stock to be issued by the NetCare Company.

Not on the basis of net worth: a minimum net worth of $1 million is needed to
be accredited.

C. Jean Wu also is considering purchasing shares of stock that will be issued by

the NetCare Company. Jean’s annual income has been $250,000 in each of
the past two years and she expects to have a comparable amount of income
next year.

Yes. A minimum of $200,000 annually over the past two years and the
expectation of earning above the threshold next year is one criterion for being
accredited.

D. James Shastri is a software programmer for the NetCare Company.

Not on the basis of his employment status: employees are not automatically
accredited unless they are officers or directors.

E. Julie Kukoc recently inherited some financial assets and now has a net worth
of $2 million with an annual income of $35,000.

Yes. She has a net worth above the $1 million threshold

2. [Securities Law] The CareAssist Company, a web-based provider of information

for the elderly, is planning to sell $4 million in securities. Management is trying
to decide which, if any, securities laws must be complied with. For each of the
following situations, describe the securities laws that might apply.

A. A private placement

For the $4 million offering, CareAssist can consider a Rule 505, 506 or a
general Section 4(2) exemption or accredited investor exemption. Absent
securing an exemption, the firm will be subject to the full registration
requirements of U.S. securities law.
140 Chapter 8: Securities Law Considerations When Obtaining Venture Financing

B. An interstate public offering

As the amount is over $1 million a Rule 504 offering to the general public is
out of the question. A Reg A offering allows up to $5 million and is a
possibility for CareAssist.

C. An intrastate public offering

If the offering were only to investors in the single state in which CareAssist
operates, it might be possible to consider an intrastate exemption. Ben &
Jerry’s Vermont offering is an example of an offering that used the intrastate
exemption.

3. [Regulation D Exemptions] Three Rules (504, 505, and 506) under Regulation D
relate to the (a) amount of offerings and (b) number of investors. Match Rules
504, 505, and/or 506 with each of the following:

A. $5 million offering limit (in a 12-month period)

B. $1 million offering limit (in a 12-month period)
C. No limit on the amount of offering (in a 12-month period)
D. No limit on the number of investors
E. No limit on number of accredited investors; limit of 35 unaccredited investors

Solutions:
A. $5 million offering limit (in a 12-month period) [Rule 505]
B. $1 million offering limit (in a 12-month period) [Rule 504]
C. No limit on the amount of offering (in a 12-month period) [Rule 506]
D. No limit on the number of investors [Rule 504]
E. No limit on number of accredited investors; limit of 35 unaccredited investors
[Rules 505 and 506]