Chap 8 Solutions

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 profitsharing 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.

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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 welladvised 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.]

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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.

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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

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[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.

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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. B. C. D. E.

$5 million offering limit (in a 12-month period) $1 million offering limit (in a 12-month period) No limit on the amount of offering (in a 12-month period) No limit on the number of investors 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] \