When offering an equity financing round to friends and family investors, the primary considerations are the terms of investment and compliance with the federal and state securities laws. In this article, we discuss the most common forms of investment terms and the three best securities registration exemptions.
Terms of Investment
The primary options for structuring an early equity round are sales of equity, convertible debt, and equity-like rights. The terms of these arrangements are as follows:
Sale of Equity – Most friends and family rounds that sell equity to investors will sell common stock. Early in the life of a startup, it is rare for the company to have an authorized class of preferred equity. Further, revising and restating the articles of incorporation (at this point) may not be desirable or add unwarranted expense to the equity offering. If the company has not yet organized as a corporation, it is common to simply award investors a stated percentage of ownership interest (or membership units in some states) of the limited liability company. Some other less common forms of equity-like interest are profits interests or phantom equity rights. These investment provisions provide the investor with an equity-like interest without transferring any actual ownership.
Convertible Debt – A convertible debt instrument is a promissory note that can be converted into equity in the company at a later date. A early-stage startup is very difficult to value. Also, the early-stage startup has not yet achieve many of the value metrics that give is a high valuation. As such, selling equity in the company is very expensive for the owners. The owner loses a substantial percentage of ownership to the investors. As such, a common way of handling this situation is to receive a loan from the investors. When the company goes through future equity financing round, the original lender-investors receive an equity interest in the company. The equity interest is determined by the amount of the early loan. The early lender-investor gets the benefit of a discount from the later sale price. Generally, there is also a cap on the potential valuation of the stock in the future. This allows the lender-investor to receive the benefits of investing early without having to negotiate the value of the company and the many terms associated with an equity offering.
Simple Agreement for Future Equity (SAFE) – The SAFE functions very similarly to a convertible note. It grants investors the right to purchase equity in the company at a future date. Like a convertible note, it allows for a delay in negotiating the present value of the startup and negotiating the terms of preferred equity. The SAFE includes a valuation cap and a discount off of the purchase price for the equity. Unlike a convertible note, the investor is purchasing a right to future equity without the obligation to pay the debt. As such, the investor receives priority on the return of her investment before other investors. She may also receive a liquidation preference on her investment (meaning, if the company is sold, she gets paid some multiple of her investment before other shareholders are paid). The contract rights may also allow the investor to convert any future preferred equity to common shares.
state and federal securities laws
The next important consideration for a friends and family equity financing is complying with state and federal securities laws. Generally, any time a company offers equity for sale to third parties, the company must register the issuance or the securities with the Securities and Exchange Commission (SEC). Registering with the SEC is far to demanding and expensive for most startups. Fortunately, the securities laws allow for exemptions from registration. Most later-stage investments use a Regulation D, Rule 506 exemption. There are two exemptions under Rule 506, section (b) and (c). 506(b) allows for an unlimited capital raise, an unlimited number of accredited investors, 35 non-accredited investors. It does, however, require a detailed private placement memorandum and does not allow for general solicitation. 506(c) only allows for accredited investors, so it is not generally applicable to friends and family rounds.
In that case, Rules 504 and 147 are the two most suitable securities registration exemption provisions for a friends and family round. The major requirements are as follows.
Rule 504 – This offering allows for non-accredited investors. The maximum raise is $5 million within any 12-month period. The rule does not allow for general solicitation of investors, but this is not a problem in friends and family rounds. The company must still make adequate disclosures to the investor in the form of a private placement memorandum. It also requires filing Form D with the SEC. This is a relatively simply notice of issuance document.
Rule 147 – This rule is known as an “intrastate exemption”. As the name implies, it allows for sales of securities to investors who are all located within that state. This will work if the friends and family rounds meets this characteristic. It allows for sale to accredited and non-accredited investors. The company must be organized and located in a single state. 80% or revenues and assets must be held in that state. The capital raised must be employed primarily in the state. The investors cannot re-sell the securities to non-residents for at least 9 months. The securities must also contain a ledger stating that they should not be resold and are not federally registered.
Note, the startup must still comply with state registration laws, as Rules 504 and 147 do not provide a exemption from state registration. The complexity of the state registration process will depend upon the state. California has the most demanding registration requirements, which can be found under Section 25102(f) of the CA Securities Code.
State Registration Laws – As discussed, each state will have its own registration requirements. Most states are notice states. A full-blown filing is required in California un Rule 25102(f). It allows for sales of securities to up to 35 non-accredited investors if: 1) the non-accredited investor has a personal or professional relationship with the company, or 2) the investor has the ability to protect her interests. This normally means being financially sophisticated or working with a financial advisor.
When considering undertaking an equity financing round, it is important to work with competent legal professionals. The legal professionals at LawTrades are experts in matters of equity funding.