by Mark R. Sullivan, Esq.
Startup companies always pay lots of attention to cash—like every one of us, a startup can’t survive without it. Cash comes primarily from two sources: revenue from sales of products or services (or both) and investments by owners, friends and family, angel investors, venture capitalists, etc. You get the picture.
Investors put money into startups as a loan, a capital contribution or some of both. In exchange for their money, investors receive a promissory note, shares of ownership or some combination of the two. Promissory notes, shares of ownership and similar instruments are examples of securities.
When a startup exchanges its securities for money, it engages in an activity that is heavily regulated under both state and federal law—the offer and sale of securities. These regulatory programs require companies to register their securities with the appropriate governmental bodies (e.g., the federal Securities Exchange Commission) or fit within the rules that permit a company to issue securities without registration. Because registration is a large and expensive proposition, one that the garden-variety startup can only dream of, the vast majority of startups are left to navigate the rules that permit the offer and sale of securities without registration, known as exemptions.
While there are a number of exemptions that startups may use, only a few are used most commonly. Perhaps you have heard some of the terms that folks use when talking about these exemptions: “Reg D” and “private placement” are examples.
But, before a startup can sell securities to investors in exchange for money, it needs to find potential investors. One common way they do that is through participation in gatherings of companies (which are looking to raise money) and folks with money (who are looking for good investments). Such gatherings are called “demo days” or “pitch days.” Pitch days are open to the public and are promoted to the public by sponsors with an interest in assisting startups to find investors.
And therein lies the problem.
Remember those commonly-used exemptions from registration under the securities laws that we talked about a couple paragraphs back? Well, in order to fit within them, a company may not make use of any “general solicitation” while trying to find investors. “General solicitation” means selling to the public at large using the mass media. That means no newspaper ads, no radio ads, no internet promotion and solicitation.
(I know, I know, there was that JOBS Act thing a few years back. Doesn’t that permit sales of securities over the internet? Yes, to an extent, it does. But, that sale of securities to investors using the internet is a brave new world – one that is not yet working well for startups.)
Back to our pitch day: If the public were invited to attend and the invitations were sent out using the mass media or email or the internet, isn’t that a “general solicitation?” And, if it is a general solicitation, doesn’t participating in a pitch day mean that a company doesn’t qualify to use an exemption from the registration requirements of the securities laws?
All too often, the answers are yes and yes.
Help is on the way. There is legislation currently pending in Congress that would amend the federal securities laws to exclude pitch day participation from the definition of general solicitation. If this new legislation is enacted, startups could participate in pitch days without fear that, even though they may have found willing investors, they could not lawfully take their money in exchange for securities.
The legislation, known as the Helping Angels Lead Our Startups Act (called the “HALOS Act” in the jargon) was introduced in the US House of Representatives in early February and was favorably reported out of the House Finance Committee for consideration by the full House on March 2nd.
We will continue to monitor the progress of the HALOS Act in Congress and will let you know promptly of all significant developments. In the meantime, we are always happy to help keep clients in compliance with those pesky securities laws.
©2015 by Mark. R. Sullivan. All rights reserved.