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Climbing the Everest of Equity Capital Formation: Are You Prepared to Avoid Potential Pitfalls?

Post on: August 4, 2016 | Jim Raper | 0


Many, perhaps most, small businesses and ventures will require financing beyond mom and dad, credit cards, and traditional bank or Small Business Administration lending. When the belief in a new business plan is strong, inviting others to keep the party going through the sale of stock, membership or partnership interests becomes the next step. Often, the path followed is through the sale of registration exempt securities—a Regulation D offering of private securities.

Private capital is risky for both the investor and the issuer. For the investor, it’s an illiquid investment and there’s no ready market to determine value. Often there is a limited company and management team track record and the outcome is far from certain. For the issuer, for better or worse, he’s financing his future by selling part of the enterprise. The regulations governing private securities are for the protection of the investor and at the peril of the issuer in the case of non-compliance.

Granted, an entity requiring capital may mount a successful capital raise effort on their own, without help from an attorney, accountant, banker, or broker. It’s also possible to climb Mount Everest without a Sherpa.

In the private capital formation business, you’re not risking life or limb, but going out on your own may come with an unreasonable expectation of success...or ability to avoid failure. If one explores private securities issuer’s obligations to take advantage of and be compliant with the Regulation D exemption, it’s perhaps a reasonable list. However, there are many pitfalls that can be encountered, especially for the inexperienced issuer.

For example, as an issuer, if you've chosen to sell private unregistered securities to fund your business, here’s a short list of considerations to start with:

  • Is any control person disqualified from issuing private securities? How is a control person defined?
  • If a disqualified person is an officer or director and therefore the exemption is not available, how do you fix it?
  • Is the offering fraudulent according to the commission’s guidelines regarding structure, solicitation, investors, flow of funds, and offering amendment? What about verbal and written offering communications? How do you temper your unbridled optimism with regard to your securities offering to maintain compliance?
  • How is the offering to be structured? Preferred or common equity, debt, cumulative, convertible? Will the investor acquire any rights with his purchase, such as voting, tag-along or non-dilution?  Based on what? What composition of those elements might be similar in structure to others that have been successful in the market? How do you find out?
  • If you put your offering on your company’s website, do you need to put the offering behind a login and password? If not, (and you have chosen the 506(b) exemption so that you may accept 35 unaccredited investors allowed by that exemption) the exemption is not available to you and you are publically soliciting the offering. How do you fix it?
  • What evidence do you need to maintain to show that every investor was accredited? If you’re publicly soliciting your offering, you have to have the evidence to know that your investors are accredited by worth or income. How will you accredit entities that may invest?
  • How is the completion of a sale defined? Should the offering have a contingency to closing? 
  • Did you obtain your Central Index Key (CIK) number from the SEC before you started the offering? Did you solicit securities in New York? If so, whether you sold any securities or not, did you provide New York’s Blue Sky filing before you started?

I’ll stop there. 

There are many pitfalls involved with setting up a private securities offering. An attorney or broker is not a requirement, but the valuable experience that they possess may help inexperienced private security issuers stay out of trouble.

And, for the experienced serial securities issuer, how certain are you that your entity and/or employees are within the safe harbor of the issuers’ exemption? It’s a reasonably straightforward exemption. You may fit, as long as sales commission is not paid and sales are limited to certain types of investors, or there is only one offering per year...or the offering is not actively sold as defined in the rule...and that no person may participate in the offering if they are disqualified from the industry. In my experience, many serial issuers believe that they are operating compliantly, but it's often the case that they, in fact, are not—and more and more their attorneys are beginning to agree.

So, let’s say your capital raise was successful, you’ve filed the requisite notice filings on time and completely, for every state and the SEC, but one state has a concern with your offering documents. Or perhaps the SEC has a concern with the wording of an advertisement that a competitor brought to their attention about your offering...now what?

You’re now in a position of reacting. You did your best, attempted to follow every rule and nuance, but in the realm of private securities, the process doesn’t end at the closing table. Regulatory oversight may be just beginning at both the state and federal levels. The request will likely be for documents, there may be interviews, and if things go from inconvenient to worse, there may be a hearing. Then, there are fines, prevention from making another offering—and if it gets really bleak—the entire offering may be unwound with investor funds being returned and any proceeds from those funds being disgorged. And that process, if incurred, will require attorney representation.

Life and limb, not hardly, but a supreme distraction to that business plan with so much potential that you believed in so strongly.

What can the issuer do to reduce his risk of non-compliance? My suggestion is that he rent well-qualified experience. Go ahead and spring for that Sherpa. The cost of that rented experience versus the expense of gaining it is a straightforward calculation. The rented experience is a known cost, a percentage of the capital actually raised. The potential cost of the gained experience is also known—all of the capital raised and then some.

So what should be expected of the rented experience? Demonstrable expertise in the structure and execution of private capital formation. The list mentioned earlier of things to consider is just the tip of the iceberg. It’s familiarity and dedication to stay current with the ever-changing private security regulatory landscape that an issuer should seek and be willing to rent for the duration of their offering. 

When renting experience, ask for stories. Just like a Sherpa on a journey to climb Mount Everest, you want to make sure they know what they are doing. Which offerings did you not accept and why? Which investors were rejected and why? What is your interaction with regulators? What are the credentials of the folks that will be assigned to administer my offering? These are good and valid questions but what’s more important are the answers. As an issuer, evaluate the qualitative aspects of the process and experience that you are engaging. It’s worth your time.


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Securities offered through WealthForge Securities, LLC. Member FINRA/SIPC. This post is an industry update from WealthForge. The message does not constitute a research report or recommendation and does not take into account the specific investment objectives, financial situation or particular needs of the recipient. This message is not an offer to sell or the solicitation of an offer to buy any security or interest in any fund, which only can be made through a private placement memorandum that contains important information about the risks, fees and expenses of a fund.

Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

Disclaimer: Altigo provides this information for educational purposes only. It should not be construed or relied upon as legal or tax advice.

About author

Jim Raper

Jim Raper is the Chief Compliance Officer at WealthForge Securities, LLC, who is among the top 5 broker-dealers as measured by the number of original Form D filings over the past two years.
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