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Fundamentals of Raising Startup Capital Through the Internet What Crowdfunding Is; Background and Overview of the Traditional Securities Law Regime June.

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Presentation on theme: "Fundamentals of Raising Startup Capital Through the Internet What Crowdfunding Is; Background and Overview of the Traditional Securities Law Regime June."— Presentation transcript:

1 Fundamentals of Raising Startup Capital Through the Internet What Crowdfunding Is; Background and Overview of the Traditional Securities Law Regime June 18, 2015 Peter I. Dunn, Esq. Casner & Edwards 617.426.5900

2 Crowdfunding Basics What Crowdfunding Is: the solicitation of growth capital in relatively small amounts from a broad base of providers over the internet. Types of Crowdfunding Rewards – purchase or pre-purchase by customers of products, promotional items (i.e. mugs, t-shirts, etc.), recognition, founder access, etc. – largely unregulated Capital Raising – the sale of debt or equity securities - regulated 2

3 Traditional Securities Law Regime Origins of Securities Laws – the Great Depression Principal U.S. Laws Governing Securities Securities Act of 1933 – regulates the offer and sale of securities. Securities Exchange Act of 1934 – requires reporting for public companies, regulates securities trading on securities exchanges, contains key antifraud provisions relating to securities transactions and is the source of the regulatory framework that governs exchanges, brokers, dealers and other market participants. Blue Sky Laws - state securities laws that, if not pre-empted, present additional regulations of securities issuances, transactions and market participants. Philosophy – demand disclosure of material information to allow investors to make informed decisions and hold promoters and issues accountable. 3

4 Traditional Securities Law Regime US Securities Regulators Securities and Exchange Commission – the principal federal regulatory authority. State Securities Regulators – each state has its own state securities bureau or agency that is in charge of that state’s blue sky laws and regulations. FINRA (Financial Industry Regulatory Authority) – a self- regulatory body that governs certain market intermediaries such as brokerage firms and securities representatives (stock brokers). 4

5 Traditional Securities Law Regime Definition of a Security – Section 2(a)(1) of the Securities Act lists a number of financial instruments including stock, bonds, notes and investment contracts. SEC v. W.J. Howey Co. - under the Howey test, an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” 5

6 Traditional Securities Law Regime Securities Act Regulates the offer and sale of securities. Section 5 requires the registration of securities unless an exemption applies. Unless a registration statement has been filed with the SEC, offers of securities are prohibited. Filing of a registration statement has traditionally been a long and expensive process requiring audited financial statements and detailed information about the issuer and its principals. Unless an exemption applies, sales can be made when the registration statement becomes “effective” – which generally means thoroughly reviewed by the SEC. Once the securities are registered, the issuer generally becomes subject to the reporting requirements under the Exchange Act (i.e. a listed stock). 6

7 Traditional Securities Law Regime Principal Section 5 Exemptions Exempt Securities – sovereignty issues (government bonds) or subject to some other competent oversight such as bank regulators or court approved sales. Exempt Transactions – while there is a laundry list under Section 4(a) of the Securities Act (ex. Section 4(a)(1)(non- issuer transactions), the principal ones relied upon are Section 4(a)(2) transactions not involving a public offering and certain other exempt transactions expressly provided for by statute or under SEC regulations. 7

8 EXEMPTIONS Registration Statement “Light” – Reg. A, Reg. A+ and Proposed Federal Crowdfunding Rules Form D Without State Pre-emption – Rule 504 and 505 Offerings under Red. D (i.e. unaccredited investors) Form D With State Pre-emption – Rule 506 No Filing without State Pre-emption – Ralston Purina Others Intra-state offerings (Rule 147) and state-crowdfunding rules Rule 701 – employee and consultant shares/options 8

9 TYPICAL 506 PRIVATE PLACEMENT BACKGROUND Working Understanding of the “Typical” Rule 506 Private Placement No un-accredited investors No finders or brokers No “bad boys” No general solicitation or advertising No other offers or sales of securities within six months Where all of the above apply, the issuer has the greatest flexibility in terms of disclosure and blue sky compliance. 9

10 TYPICAL SCENARIO Client identifies a need for funding - we would like to do X and need money to fund the X budget Rule out other sources of funding (ex. bank loans or government grants) Select security to be issued (ex. common or preferred equity or convertible notes) and outline proposed terms Identify potential purchasers (can include lead investors) and approach them regarding an interest in the prospective issuer Finalize term sheet/conduct due diligence Finalize definitive offering documents Make offers/close deal Make securities filings 10

11 DEFINITIVE DOCUMENTS EquityDebt Term Sheet Subscription Agreement of Stock Purchase Agreement with Disclosure Schedules Note Purchase Agreement with Disclosure Schedules Investor Questionnaire Corporate Authorizations (Board and Shareholder) Corporate Authorizations (Board) Securities Issuance (stock certificates) Securities Issuance (promissory notes) Securities Filings Offering Memorandum Amended and Restated Certificate of Incorporation Usury Filing (deal dependent) Amended and Restated Bylaws Shareholders’ Agreement 11

12 SUBSCRIPTION DOCUMENTS At a minimum, the subscription document should include: A description of the security being acquired, its price and the amount to be purchased. Representations from the investor necessary to obtain the benefit of the Rule 506 exemption, per Rule 502(d). These include:  Representation that the purchaser is acquiring the securities for himself and not for other persons;  Representation that the purchaser understands that the securities have not been registered under the 1933 Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and  Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities. Other terms such as confidentiality provisions, certification as to truthfulness of information provided in the investor questionnaire which state’s law governs the agreement, and representations as purchaser sophistication, access to information and reliance only on offering materials. Investor Questionnaire typically sees subscriber providing legal name, state of residence, tax identification number and an indication as to type of accredited investor 12

13 PRIVATE PLACEMENT MEMORANDUM Whether to Use a PPM: If the offering is to include non-accredited investors, then an offering statement will be required as Rule 502 of Regulation D mandates the scope and substance offering information. If the offering is solely to accredited investors, Regulation D does not require the use of an offering memorandum. Issuers are still subject to the antifraud rules and must supplying potential investors with information free of material misstatements and omissions. Remember: the case law under Section 4(2) of the 1933 act has emphasized offerees in nonpublic offerings must have access to the “kind of information that registration would disclose.” Advantages and Disadvantages of a PPM: 13 AdvantagesDisadvantages Record of Disclosures Time and Expense Marketing Tool Potential for Material Misstatements and Omissions Planning Tool

14 PRIVATE PLACEMENT MEMORANDUM ALTERNATIVES Direct Access to Information - Investors can be given opportunities to tour company facilities, examine company records, talk with company personnel, customers, suppliers and bankers. Business Plan - Issuer can give potential investors a comprehensive written business plan with a list of risk factors. Investor Representations as to Access - to reduce exposure to liability for material omissions, the issuer can obtain representations from each investor, to the effect he or she had access to all information considered material is aware of certain risk factors. Securities Purchase Agreement with Disclosure Schedules – series of representations and warranties regarding the issuer made accompanied by appropriate disclosures. Most common in deals with VCs and Angel Groups. Hybrid/Combination – term sheet, business plan (including financials), risk factors and investor representations. 14

15 PRIVATE PLACEMENT MEMORANDUM CONTENTS The Standard: offerees in nonpublic offerings must have access to the “kind of information that registration would disclose.” Registered Offering Form S-1Registration Statement – NYSE/NASDAQ IPO FORM 1-A – Offering Statement Under Regulation A Registration Form Architecture Generally, “Items” set the subject matter, then either directly dictate the required information or do so by reference to relevant regulation for the required content. 15

16 PRIVATE PLACEMENT MEMORANDUM CONTENTS (CONT.) Outline of Contents: PPM’s customarily contain the following: Cover page - the cover page should provide the name of the issuer, a brief description of securities to be sold, whether the issue is primary or secondary, the price per share, gross and net proceeds, the level of risk (typically “high”) in reference to the location of risk factor disclosure in the memorandum. The cover page typically also contains restrictive legend, state securities law legends, and a confidentiality legend. The cover page should also include a blank space into which the issuer can write the number of the memorandum and all copies should be numbered and logged. Summary of the Offering – essentially, the final term sheet with additional information regarding the risk factors (where to find them in the PPM), capitalization table (actual and pro forma), use of proceeds and actual or estimated expenses of the offering. Risk Factors - risk factors should be unique to the issuer, its industry, and the offering terms. 16

17 PRIVATE PLACEMENT MEMORANDUM CONTENTS (CONT.) Outline of Contents: PPM’s customarily contain the following (cont.): Substantive Terms – provides details of the offering’s terms summarized earlier in the PPM. Use of Proceeds – categories of expenses with percentages – comes out of the issuer’s budget. Financial Disclosures - historical financials, either audited or not, and financial projections with appropriate disclaimers. Description of the Business – this will come out of the business plan. Description of Management – bios and issuer holdings (if not disclosed elsewhere). Disclosure of Transactions Between the Issuer and Insiders – employment agreements, leases, stock options, licenses, etc. 17

18 CLOSING/REGULATORY FILINGS Closing Track subscriptions to wires/checks Close the round and send out countersigned subscription agreements and stock certificates/promissory notes to subscribers Regulatory Filings Federal - Form D – filed electronically with the SEC within 15 days of the first sale. Remember to get the EDGAR filer number from the SEC early in the process. States – NSMIA – restricts state’s ability to substantively review the offering. Generally, Form D, a check and a form U-2 consent to service of process filed in each purchaser’s state within 15 days of the first sale in the state, but you must check as to each state. Note: New York requires that the notice-filing and a bunch of other paperwork be filed prior to any offer of securities within the state. Usury – if issuing debt, a usury or similar filing may be required. In Massachusetts, it must be filed with the Attorney General before the closing. 18

19 Peter I. Dunn, Esq. Casner & Edwards 303 Congress Street Boston, MA 02210 617.426.5900 19

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