The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) passed both houses of Congress and became law on July 21, 2010. Unfortunately, one of the provisions of this bill Recently enacted law will make it more difficult for start-ups and start-ups to raise funds from their friends, family, and middle-class investors.
Background: The Private Equity Fundraising Process
Early-stage companies typically raise capital from private investors through stock offerings commonly known as “private placements.” Securities are “placed” with investors privately, not in a public offering. You may have heard the term “IPO,” which stands for initial public offering. IPOs and subsequent public offerings require a long, complicated and expensive process. In addition, investors in a public offering must receive a document (called a prospectus) that discloses a significant amount of specific and detailed information about the company, including audited financial statements. Investors in a private placement do not need to receive a prospectus and private placements can be completed in a shorter time frame with less complexity and expense. The rules relating to various private placements are codified in Rule 501 through Rule 506 of the Securities Act of 1933, also known as Rule D.
Under Regulation D, provided the Company has not engaged in a blanket solicitation of its securities to the public and has met certain other requirements, it may sell securities privately to certain target investors. Also, the procedure for a private placement is much simpler if you only sell to investors who meet the definition of “accredited investor.” In summary, some elements of the definition of an accredited investor are: (i) a company or financial institution with more than $5,000,000 in assets, (ii) any director, executive officer or general partner of the company issuing the securities or (iii) ) ) an individual with a net worth of $1,000,000 or an annual income of $200,000 alone or $300,000 jointly with a spouse.
The effect of the Dodd-Frank Act
Before the Act, people could incorporate the value of their home in the calculation of their net worth. In states with high home values (such as New York, Massachusetts, and California), this allowed quite a few people to qualify as creditors who might not meet the annual income criteria. For the entrepreneur looking to raise funds for his company or project, friends and family in New York or California were more likely to meet the $1 million net worth threshold due to high real estate values.
One of the terms of the Dodd-Frank Act expressly excludes the value of an investor’s principal residence in calculating his net worth, for purposes of determining whether the investor is accredited. As a result, the pool of accredited investors has narrowed, and the likelihood that a friend or family member of an entrepreneur will meet the accredited investor criteria is significantly reduced. Additionally, on July 27, 2010, the Securities and Exchange Commission (SEC) published a “Compliance and Disclosure Interpretation” based on the Dodd-Frank Act. The SEC clarified that while a home’s equity must be excluded from an investor’s assets, its mortgage equity can also be excluded from an investor’s liabilities, unless the home’s equity is “underwater,” which means that the value of the home is less than the current mortgage. If this is the case, the amount of the mortgage that exceeds the home’s value should be considered a liability and deducted from the investor’s net worth.
Private Placements with Non-Accredited Investors
Regulation D allows several private placement exceptions, depending on the amount of money being raised. If your company is raising less than $1 million in any 12-month period, you can sell to accredited or non-accredited investors. However, you must provide your investors with, among other things, a written document that describes your business and the risks of the investment and that is free of material misstatements or omissions. This document does not have to meet the requirements of a prospectus and is generally known as a private placement memorandum (PPM).
However, if your company is raising more than $1 million, only 35 non-accredited individuals can participate. Also, the required disclosure when you sell shares to non-accredited investors is onerous. If only accredited investors are participating in your offer, you only need to provide them with a PPM. Unfortunately, if any non-accredited investors are investing in your offering, ALL of your investors will need to receive a document that generally meets the requirements of a prospectus, including audited financial statements. This adds considerable complexity, time, and expense to a company’s private placement.
Finally, if your business is raising more than $5 million, all non-accredited investors participating in your offering, either alone or with a buyer’s representative, must be “sophisticated.” This means they must have sufficient knowledge and experience in financial and business matters to be able to assess the merits and risks of a potential investment in your business. Your friends and family, who cannot meet the accredited investor net worth threshold, may not be able to pass the test to be a sophisticated investor. Therefore, you would have to incur the additional expense of hiring a purchasing representative to advise them on making an investment in your business.
Finally, in addition to federal regulations, many states impose additional charges on your business if it raises money by selling equity or debt to non-accredited residents of your state. These states may require additional filings and fees.
conclusion
The Dodd Frank Act has made it less likely that your friends and family will be able to participate in your offer as accredited investors, which could mean it doesn’t make sense for them to invest at all. The increase in legal, accounting and operating expenses that the company must pay for the participation of non-accredited investors may be greater than the investment made by your friends and family. If you are contemplating a capital raise, you should address the accredited investor thresholds with your friends and family early on, so you can manage this issue wisely. Also remember, if you are considering a follow-on offer, investors who met the accredited investor threshold before the passage of the Dodd Frank Act may no longer satisfy you now. It is a good idea to consult a securities attorney during the initial stages of your capital raising process.
© Clem Turner, 2010. All rights reserved.