The Non-Existent "Friends and Family" Exemption Under Federal and State Securities Law Thumbnail

The Non-Existent "Friends and Family" Exemption Under Federal and State Securities Law

From time to time business lawyers get calls from owners of smaller businesses—sometimes startups and sometimes ones that have been in operation for a long time—saying that they want to raise some capital for their companies and that they generally are aware that doing so may involve federal or state securities laws. Often the amount of capital they seek to raise is small—say, $100,000—and they are concerned about the cost of compliance. They ask about using the “friends and family” exemption from the securities laws to avoid such costs.

Sadly, there is no actual “friends and family” exemption; any investment financing for small businesses—whether it be the sale of stock, limited liability company interests, and even investment promissory notes (as opposed to commercial loans)—is subject to both federal and state securities laws.

These laws invoke two primary principles. The first is that it is illegal to offer or sell any security (regardless of the size of the business) unless the offering (and or the security itself) is either registered with the Securities and Exchange Commission and/or with the analogous state agency that regulates the sale of securities, or is exempt from registration under federal and applicable state law. The second is that even if an offering or sale of securities is exempt from such registration, there are disclosure obligations, at least to the extent that the offering cannot contain any misstatement of a material fact, nor omit to state a fact that is necessary to render statements made not misleading.

Perhaps the greatest challenge to securities lawyers, and the corresponding problem for a small business seeking capital from investors who are friends and family, is finding a way to structure the financing in accordance with these two principles while avoiding costs that make the financing too expensive to pursue. While an offering for a small business may very well result in investors that are friends and family, it is not their status as such that creates the applicable exemptions.

For Ohio-based companies, we typically start with four questions:
  1. What is the amount to be raised?
  2. Is the funding to be in the form of debt, equity, or some combination?
  3. Is each of your targeted friends and family an “accredited investor”?—i.e., Did each individual have annual income in excess of $200,000 for the prior two years and expect to have such income for the current year OR does each such individual have a net worth exclusive of primary residence in excess of a million dollars?
  4. Are all of your intended investors residents of Ohio?

If the answer to (3) is “yes”, then there is an exemption from federal registration under Rule 506 of Regulation D of the SEC and under the laws of each state, without regard to the answers to (1) and (2). Just as importantly, a Regulation D offering limited to accredited investors does not require any specific disclosure requirements other than to avoid fraudulent statements or omissions, and places the burden on the accredited investors to ask questions and obtain information material to their investment decision. The only filing requirement is that a Form D must be filed with the SEC within 15 days after the first sale, and similarly, in the case of most states, within 15 days of the first sale in each such state. This exemption therefore gives the maximum flexibility in structuring the offering and minimizing the costs.

If the answer to (3) is no—that not all of the potential investors are accredited—it gets harder. There is a federal statutory non-public offering exemption for which no SEC filing is required, but the parameters have been developed by case law and this exemption lacks the certainty of Regulation D. Ohio has an exemption from registration for the sale of equity or debt securities to not more than 10 Ohio residents within a rolling 12-month period—known as the “3(O)” exemption—that does not have any filing requirement until that number is exceeded, at which time a Form D is filed with Ohio.  But neither the federal non-public offering exemption nor the 3(O) exemption provide any specifics regarding what disclosures must be made under the anti-fraud provisions of federal and state law. We therefore have to make disclosure decisions on a case-by-case basis.
In the analysis, we also look to another federal Regulation D exemption—under Rule 504—which exempts offerings of up to ten million dollars, and which in combination with Ohio’s 3(O) and in offerings in Ohio limited to $250,000 provides meaningful flexibility in determining what disclosures are needed, and hence to control offering costs. Rule 504 has a federal Form D filing requirement similar to Rule 506.

If the answer to (4) is yes, there is an exemption for the sale of securities to residents of a single state—the so-called intrastate offering exemption—which along with the SEC’s intrastate exemption rule (Rule 147a) works in conjunction with the Ohio’s 3(O). This exemption does not depend on whether the investors are accredited nor on the amount raised, but also does not specify what disclosures are required, thus leaving this to be determined on a case-by-case basis as well.

Obviously, this is complex. And since failure to comply with federal and/or state securities laws can have horrific consequences—private litigation, regulatory proceedings, and in extreme cases criminal liability—it is extremely important that small businesses do not offer investments in their companies without first consulting with securities counsel. Attorneys at Frantz Ward have considerable experience in identifying the applicable exemptions and disclosures and determining what documents will be needed to comply with disclosure requirements while minimizing the costs.

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