Entrepreneurs in search of cash and private investors in search of yield are increasingly turning to private markets to satisfy their respective business and investment goals. According to the Securities and Exchange Commission (SEC), in 2019 the total amount of cash raised privately outpaced the amount of cash raised via public offerings at a rate of 2:1. This result is in large part due to steps taken by the SEC in recent years to facilitate capital formation in the middle market by lowering barriers of entry for entrepreneurs and private investors alike. However, taking investor cash without a plan to manage the resulting federal and securities liability risk can lead to serious civil and criminal liability.

Entrepreneurs, whether company founders or real estate developers, raise cash to capitalize a business plan by offering to sell debt or a passive ownership stake in their company (the issuer). Since debt and passive equity interests are regulated as “securities,” issuers must carefully chart a course to navigate a range of liability traps involving the offer and sale of securities, investing in securities, and giving advice about investing in securities.

For example, all offers and sales of securities must be either (1) registered with the SEC or (2) conducted pursuant to an exemption from registration. State securities laws also require registration or an exemption from registration before securities may be offered or sold in the state of an investor’s residence. Even if an exemption from registration applies, the offer and sale of the securities are subject to anti-fraud provisions of the federal and state securities laws enforced by the SEC and state securities regulators. Private investors also have standing to bring claims for fraud or misrepresentation if, for example, the investment fails or simply does not meet the investor’s return expectations. Although the prospect of securities liability is onerous, the regulatory framework governing the vast majority of private equity fundraising is well-established and can be navigated in three steps:

1. Design the capital raise for compliance with federal exemption rules.

Federal and state securities laws provide several exemptions from registration as a public offering. The most flexible and commonly used exemption is Rule 506 of Regulation D of the Securities Act, which allows the issuer to raise as much money as it needs to capitalize its business plan. To rely on this “private placement” exemption (Rule 506(b)), the issuer must satisfy the following standards:

1. Bad actor disqualification. The issuer and the persons involved in the offering must have a clean securities record. Generally, an issuer with a history of bad actions involving violations of the securities laws is disqualified from relying on the private placement exemption.
2. No public advertising. The issuer must limit the offering to its network of substantive, pre-existing relationships. Public advertising or marketing is strictly prohibited. Public announcements or other communications that may “condition” the market are at-risk.
3. Restricted securities. The issuer must restrict the transferability of its securities. Investors must purchase for long-term investment and not a view to resell.
4. Accredited investors. The offering must be restricted to “accredited” investors, generally meaning persons who satisfy certain income, net worth or knowledge standards. An issuer may rely on a purchaser’s representation as an accredited investor. The offering may be sold to up to 35 non-accredited investors if the issuer delivers a higher standard of disclosures (i.e., audited financials and annual or interim balance sheets).
5. 15-day securities filings. Within 15 days of the first sale of securities, the issuer must make a notice filing with the SEC and a “blue sky” filing with the securities regulator in each state of each investor residence.

If the issuer’s capital-raising strategy involves offers and sales to persons outside of its network of substantive, pre-existing relationships (for example, by email blast, media announcement or establishing an online or social media presence), then the SEC will lift the prohibition on public advertising if the issuer takes reasonable steps to verify purchasers are accredited investors. Under this “accredited investor crowdfunding” exemption (Rule 506(c)), the SEC staff has published guidelines for issuers to satisfy this “reasonable steps” standard.

2. Deliver a private placement memorandum.

Notwithstanding the SEC’s recent efforts to simplify the exempt offering framework under the Securities Act, the touchstone for all securities offerings remains what it has long been: investor disclosure. Disclosures should be cost-effective, reliable, and not misleading. Investors should have free access to that information so that they can weigh risk and reward to make their own decisions. Under Reg D, there is no rule governing the medium through which these disclosures must be made but it is customary for the disclosures to take the form of a legal instrument referred to as a private placement memorandum (PPM).

Most offerings also include a presentation or pitch deck that discloses the issuer’s financial model, as well as the expense and revenue assumptions that inform the model. Although this information is critical to enabling an investor to evaluate the business model, it exposes the issuer to a claim that an unhappy investor relied on misleading information if the projections fail to materialize. To insulate against this risk, a pitch deck and PPM should clearly incorporate disclaimers for such forward-looking information.

3. Deliver a subscription agreement.

Whereas a PPM discloses the material terms and risks of an investment opportunity, a subscription agreement is a legal instrument that issuers use to close on investor contributions and allocate the risk of securities liability away from the issuer and onto the investor. The subscription agreement must, at a minimum, incorporate investor representations and warranties including that he, she, or it is (a) an accredited investor; (b) purchasing for investment and not a view for resale; and (c) making an informed investment decision based on their independent evaluation of the PPM.

The subscription agreement also includes the amount of investment, an accredited investor questionnaire, an agreement to join as an equity owner of the issuer, and payment instructions. For accredited investor crowdfunded offerings, the subscription agreement may also include a template accredited investor verification letter that is commonly used to satisfy the “reasonable steps” standard pursuant to Rule 506(c) of Reg D.

The purpose of securities regulation is to facilitate capital formation while protecting investors from fraud. Although the prospect of securities liability is onerous, the reality is that entrepreneurs and investors come together to create sums greater than their individual parts every day. Entrepreneurs with a business plan in search of cash and investors in search of yield should consult with their professional advisors on the suitability of the exempt offering framework to satisfy their respective business and investment goals.