If you have spent much time around the world of private capital raising, then you know that there are only two avenues for a company that wants to bring on investors. Either you register your capital offering (equity, debt, or some hybrid) or you find a state or federal filing exemption that you can qualify for. In this second post of an ongoing series focusing on cannabis securities, we’re taking a first look at the world of state and federal filing exemptions.
Your Governing Securities Regulators Matter. The federal Securities Exchange Commission (“SEC”) and each state’s securities board, commission, or department has jurisdiction over public and private placement of securities. Their jurisdiction depends on where the company raising investment funds (the “Issuer”) is located, who or what is investing, where the prospective investors live (or where the investing entity is based), and what amount is being invested. To drive this issue home, I always ask my Issuer companies:
- What type of securities do you intend on offering?
- What percentage of the company’s equity will that entail on a fully-diluted basis? (or if it’s a debt offering, what percentage of the company’s total debt will that comprise?)
- How much total capital do you intend to raise?
- What type of investors are you targeting?
- How many interested investors do you have so far?
- Where do your prospective investors live?
- Do you intend to cap any single investor at a specific dollar amount?
- What have you promised your prospective investors at this point? (I always hope the answer to this is, “Nothing,” because that is the only correct answer, ever!)
What are the State and Federal Regulators Trying to Do? In lay person’s terms, each of the securities regulators has authority to decide whether the Issuer and the securities offering are safe for investors. The state and federal securities laws and regulations are designed to force Issuers to play by the rules so that prospective investors and their financial or legal advisers can help them see at a glance whether the Issuer is conducting a fraudulent or at least negligent securities offering. Those are the first set of red flags to avoid.
The laws and regulations are in place to protect unsophisticated (related term: non-accredited) investors from investing in an extremely speculative venture that may lose their entire investment. Even honest Issuers with sound business plans that engage in a proper securities offering can lose money. Many do. That is why prospective investors hire financial and legal advisers to help them review all of the related offering documents in search of the second set of red flags.
The Big Four Problem States. It is easy to get bogged down in the lingo. Either you “register” your offering at the federal or state level or you qualify for an “exemption” from registration. Qualifying for an exemption generally means you still need to file a “notice” filing with the applicable securities regulators. This is not the same as “registration” under securities law lingo.
A private placement of securities by a Washington Issuer to only investors living in Washington is treated differently from that Issuer seeking investments from Washington and Oregon. And it is treated very differently if the Issuer is seeking investors from all 50 states or even from one of the “Big Four” most populous states: California, Texas, Florida, or New York. These states have extremely robust “long-arm” statutes that layer additional requirements onto Issuers beyond those in most other states.
Financial Thresholds and Limited Offerings. As a general rule, when you are raising funds from only a few investors and up to a limited dollar amount, you can probably find an applicable exemption from registration, regardless of whether your prospective investors are accredited, sophisticated, or Jed Clampett (though in reality, Jed Clampett would have qualified as an accredited investor).
The financial threshold will depend both on the Issuer’s home state, as well as the home states of the investors. Many states have exemptions that are geared toward helping startup companies in cannabis and other industries so that they can get through some early seed rounds of investing without breaking the bank.
And many of these regulations are self-operative or self-executing up to a certain dollar amount or up to a certain number of investors. That means that even if an Issuer issues securities without realizing they have done so, their actions may fall under a safe harbor provision enacted to protect companies in that type of scenario, which is unusual given the laws’ general focus on protecting investors.
For instance, a “limited offering” in Utah means an offering made to not more than 15 purchasers in the state during any 12 consecutive months and in an amount that does not exceed $1MM. There are other criteria, as well, such as the Issuer cannot have used general solicitation or advertising or given any commission or compensation to any person other than a broker-dealer or a licensed securities agent.
Keep in mind that these safe harbor provisions will never shield a company or its primary personnel from fraudulent activities. In the next post we will continue on this thread regarding how an Issuer can qualify to take advantage of federal and state exemptions from securities registrations.
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