Raising Capital

You have a great idea for a business or you have a successful business that you want to expand. You need funds to do this. You could borrow the money, but banks aren’t lending a lot right now and the interest cost could be prohibitive. Maybe you instead decide to bring in additional owners – whether as partners, shareholders, members of a limited liability company or otherwise. Before you start to solicit potential investors, you need to be aware of federal and Illinois securities laws.

“Securities” include all types of ownership and debt instruments, stock, bonds, limited partnership interests, options, etc. The US Supreme Court has stated that securities laws apply in a transaction if “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

Securities laws, both federal and state, have many onerous requirements. For example, whenever you purchase publicly traded stocks, you receive the prospectus – the thick book with the really small print. The prospectus is one of the requirements of securities laws, the purpose of which is to allow the investor to know what he is buying.

The primary federal securities laws are the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts were passed in response to the market crash of 1929 which triggered the Great Depression. According to the Securities and Exchange Commission website (www.sec.gov), the Securities Act of 1933, which is often referred to as the “truth in securities” law, has two basic objectives: (1) that investors receive financial and other significant information concerning securities being offered for public sale; and (2) prohibiting deceit, misrepresentations, and other fraud in the sale of securities.

A primary means of accomplishing these goals is the disclosure of important financial information through the registration of securities. In general, securities sold in the U.S. must be registered. Registration forms call for: (1) a description of the company’s properties and business; (2) a description of the security to be offered for sale; (3) information about the management of the company; and (4) financial statements certified by independent accountants.

For small businesses, however, there is some relief. There are certain exemptions from securities registration. Some exemptions from the registration requirement include: (1) private offerings to a limited number of persons or institutions; (2) offerings of limited size; (3) intrastate offerings; and (4) securities of municipal, state, and federal governments.

In order to qualify for the private offering exemption, the purchasers of the securities must: (1) have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (the “sophisticated investor”), or be able to bear the investment’s economic risk; (2) have access to the type of information normally provided in a prospectus; and (3) agree not to resell or distribute the securities to the public. In addition, the company may not use any form of public solicitation or general advertising in connection with the offering.

Rule 505 of the securities regulations provides an exemption for certain small offerings - those totaling up to $5 million in any 12-month period. Under this exemption, a company may sell to an unlimited number of “accredited investors” and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only and not for resale. The issued securities are “restricted.” Consequently, investors must be informed that they may not sell the securities for at least a year without registering the transaction. The company cannot use general solicitation or advertising to sell the securities.

An “accredited investor” is: (1) a bank, insurance company, registered investment company, business development company, or small business investment company; (2) an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; (3) a charitable organization, corporation or partnership with assets exceeding $5 million; (4) a director, executive officer, or general partner of the company selling the securities; (5) a business in which all the equity owners are accredited investors; (6) a natural person with a net worth of at least $1 million; (7) a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or (8) a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.

Intrastate offerings are exempt from federal registration if (1) the company is incorporated in the state where it is offering the securities; (2) the company carries out a significant amount of its business in that state; and (3) the company makes offers and sales only to residents of that state.

Even if you are exempt from federal registration of your securities, you may need to register with the state of Illinois. An exemption also exists in Illinois for certain securities offerings. Offerings are generally exempt if made to less than 35 persons or there is less than $1,000,000 in aggregate sales and where no general advertising or general solicitation has occurred in Illinois. In addition, any commission on the sale must not exceed 20% of the sale price.

A Report of Sale on Illinois Form 4G or Form D (Rule 504) must be filed with the Secretary of State by the issuer, controlling person or dealer within 12 months of the first sale to an Illinois resident in reliance upon the exemption. In addition to the name and address of the issuer and, if applicable, the controlling person and dealer, the report must include a description of the securities sold, a representation that there was no general advertising or general solicitation and the total dollar amount sold or to be sold.

The sale of unregistered securities can result in significant penalties and possible criminal charges. If you want to raise capital for your business, be sure you know if your offering will qualify for an exemption with the Securities and Exchange Commission and the State of Illinois.

by Sarah Delano Pavlik

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