Chapter 8
SECURITIES LAW CONSIDERATIONS WHEN OBTAINING
VENTURE FINANCING
FOCUS
In this chapter we introduce several major legal aspects of fundraising for the new
venture. We discuss the central role of the Securities Act of 1933 and the exemptions
available to ventures seeking to issue securities without having to register them with the
Securities and Exchange Commission.
LEARNING OBJECTIVES
1. Identify five relevant components of the federal securities laws.
2. Explain what is meant by “blue sky” laws.
3. Define “security” according to the Securities Act of 1933 and explain why such a
designation matters.
4. Describe what is involved in registering securities with the Securities and Exchange
Commission (SEC).
5. Identify some of the securities that are exempt from registration with the SEC.
6. Identify some transaction exemptions granted under the Securities Act of 1933.
7. Describe and discuss how the SEC’s Regulation D serves as a securities registration
“safe harbor”.
8. Explain how Rules 504, 505, and 506 of Regulation D differ from one another.
9. Describe Regulation A and explain how and when it is used.
CHAPTER OUTLINE
8.1 REVIEW OF SOURCES OF EXTERNAL VENTURE FINANCING
8.2 OVERVIEW OF FEDERAL AND STATE SECURITIES LAWS
A. Securities Act of 1933
B. Securities Exchange Act of 1934
C. Investment Company Act of 1940
D. Investment Advisers Act of 1940
E. Jumpstart Our Business Startups Act of 2012
F. State Securities Regulation: “Blue–Sky” Laws
8.3 PROCESS FOR DETERMINING WHETHER SECURITIES MUST BE
REGISTERED
A. Offer and Sale Terms
B. What is a Security?
8.4
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8.5 SECURITY EXEMPTIONS FROM REGISTRATION UNDER THE 1933 ACT
8.6 TRANSACTION EXEMPTIONS FROM REGISTRATION UNDER THE 1933
ACT
A. Private Offering Exemption
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B. Accredited Investor Exemption
8.7 SEC’S REGULATION D: SAFE-HARBOR EXEMPTIONS
A. Rule 504: Exemption for Limited Offerings and Sales of Securities Not
Exceeding $1 Million
B. Rule 505: Exemption for Limited Offers and Sales of Securities Not
Exceeding $5 Million
C. Rule 506: Exemption for Limited Offers and Sales Without Regard to Dollar
Amount of Offering
8.8 REGULATION A SECURITY EXEMPTION
8.9 JOBS ACT INNOVATIONS
SUMMARY
APPENDIX A:
Schedule A (Securities Act of 1933, as Amended)
Requirements for Registration of Securities other than a Security Issued by
Foreign Government or Political Subdivision Thereof
APPENDIX B:
Selected Regulation D Materials
Regulation D’s “Preliminary Notes”
Rule 501: Definitions and Terms used in Regulation D
Rule 502: General Conditions to be Met
Rule 503: Filing of Notice of Sales
Rule 507: Reg D Disqualification Provisions
Rule 508: Reg D Insignificant Deviations Clause
Rule 144 (§ 230.144)
APPENDIX C:
Other Forms of Registration Exemptions and Breaks
Rule 701
Rule 1001
Regulation SB
DISCUSSION QUESTIONS AND ANSWERS
1. Briefly define the Securities Act of 1933 and Securities Exchange Act of 1934.
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
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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
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,
5. What is meant by the term “blue sky” laws and how do these laws apply when issuing
securities?
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-
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7. Why does it matter if an investment is, or is not, viewed as being a security?
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
9. Identify some of the types of securities that are “exempt” from registration with the
SEC.
10. Briefly describe what is meant by an intrastate offering. What are the major
difficulties in assuring that an offer is intrastate?
11. Identify and briefly describe two basic types of transactions that are exempt from
registration with the SEC.
16. How do Rules 504, 505, and 506 of Reg D differ from one another?
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
[Note: The following questions 18 through 27 relate to the material presented in
Appendixes B and C.]
18. Briefly describe how the SEC’s Regulation D expanded the original Securities Act of
1933 definition of an “accredited investor.”
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?
20. What are the four conditions of a Reg D offering that are covered under Rule 502?
21. What is integration as it applies to securities offerings and why does it matter?
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:
23. What is a restricted security? Why does this designation matter? What types of
buyers must the owner of restricted securities find?
24. Briefly describe the purpose of Rule 144 of Reg D.
25. Briefly describe Rule 508 of Reg D.
26. Briefly describe the types of exemptions from registration of securities covered under
Rules 701 and 1001.
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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.
INTERNET ACTIVITIES
1. Access the Securities and Exchange Commission Web site at http://www.sec.gov.
Identify recent developments and changes in Rule 504 of the SEC’s Regulation D.
Web-researched results vary due to constant updating of web sites.
2. NYPPEX is “one of the world’s leading secondary agents for transfers of large
single interests in private funds, unregistered securities in companies.”
Summarize their regulation-related posting at http://nyppex.com/regulatory.php.
Web-researched results vary due to constant updating of web sites.
3. Access the Nolo Press Web site at http://www.nolo.com. Develop a list of legal
references relating to securities laws.
Web-researched results vary due to constant updating of web sites.
EXERCISES/PROBLEMS AND ANSWERS
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
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“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.
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.
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
D. James Shastri is a software programmer for the NetCare Company.
Not on the basis of his employment status: employees are not automatically
E. Julie Kukoc recently inherited some financial assets and now has a net worth
of $2 million with an annual income of $35,000.
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
B. An interstate public offering
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C. An intrastate public offering
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:
MINI CASE: THE VIRTUALSTREAM COMPANY
The VirtualStream Company has developed proprietary server and control software for
providing communication and media-on-demand services via the Internet. The company
is in the process of collecting prerecorded video and audio content from clients and then
digitally transferring and storing the content on network servers. The content then is
available for replay by customers via the Internet. VirtualStream’s mission is to provide
the most dependable and user-friendly multimedia streaming service worldwide.
The Internet technology service industry is characterized by rapid revenue growth
with industry revenues predicted to exceed $300 billion in three years. Market
participants include companies engaged in video and audio teleconferencing, corporate
training, computer-based training, and distance learning. VirtualStream is attempting to
focus on helping large companies to communicate more effectively, using both archived
and live communications content, via the Internet. Video and audio content is digitally
stored in a central location and is available on demand to clients. This approach will
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save time and money required to duplicate and ship materials. The company also offers
a service that enables transmission of live broadcasts via the Internet.
VirtualStream raised $500,000 in the form of founder’s capital last year. The
firm is now seeking additional financial capital from investors by issuing or selling
“securities” in the form of stock in the firm. The firm is planning to obtain $750,000 as
soon as possible from private investors.
A. Discuss whether you would recommend “registering” these “securities” with the
Securities and Exchange Commission (SEC).
B. Some “securities” are exempt from the SEC registration requirement. Is it likely that
VirtualStream’s “stock” would qualify for such an exemption? Why, or why not?
C. Would you recommend that the initial $750,000 be obtained through an “intrastate”
offering? Explain.
Intrastate offerings present serious challenges to ventures seeking to acquire large
D. Briefly describe the two basic types of “transaction” exemptions that may be
available to VirtualStream that would allow the firm not to have to register its
securities with the SEC.
The two more likely transaction exemptions for VirtualStream are the private
E. The SEC’s Regulation D offers a “safe harbor” exemption to firms from having to
register their securities with the SEC. Describe how the VirtualStream Company
could use Reg D for issuing $750,000 in stock to private investors. In developing
your answer, describe the Reg D “rules” that would likely apply to this security issue.
Assuming that the previous round of funding falls outside the time interval where
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F. Now, assume VirtualStream also is planning to issue an additional $2 million in stock
towards the end of the year. Would this decision have an impact on the Reg D
“rules” which would govern the issuance of the firm’s securities? Describe. [Note:
The material in Appendix B may be helpful in developing an answer to this question.]
Since the future issue is for the same securities and could potentially be integrated
G. The other alternative is to seek to raise the total $2,750,000 amount now by selling
securities to investors. Which Reg D “rules” and/or other securities laws would be
“triggered” by such a plan? Describe why and how.