Securities Law: The Perils of General Solicitation
At VentureSouth, we’ve learned a lot from Twitter. We also try hard to avoid trouble with regulators – both for ourselves and our portfolio companies.
Over the past few weeks, those previous sentences have created some cognitive dissonance as we’ve watched company after company, and venture fund after venture fund, openly discussing their fundraisings on Twitter. What are they doing??
Watching people doing what we think is, at best, poorly-advised prompted us to wonder what we were missing. We went back to refresh our knowledge about fundraising rules, and put together this article to recap the basic rules of fundraising.
So here begins: The Perils of General Solicitation.
Before you sigh and hit the X, wait! We cover terrible publicity, huge fines, unwound funds, and tales of incompetence, possibly fraud, and Twitter wars – all the good stuff. If you are raising money, or plan to raise money, please keep reading to ensure the next tale is not about you!
You may (understandably) not particularly care about the intricacies of the Securities Act of 1933, the resulting SEC rules, or their state-level equivalents. However, if you are trying to raise money from investors, then you need to know something: those intricacies, and especially the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and state Attorneys General (like in South Carolina, the Securities Division) who enforce these intricacies, care about you.
Even if contravening these rules does not result in enforcement action and big fines for you, be aware that good investors care deeply about this stuff, and often will not invest if they are even worried you might be raising money in the wrong way.
Some of this article involves laws, so it comes with several disclaimers. At VentureSouth, we are not securities attorneys, brokers, investment advisors or anything else – and we cannot, and do not, provide legal advice or fundraising assistance. Where we link to anyone, we are not acting as their brokers or advisors, or accusing them of violating any laws or rules. Everything here is just for your information and (dare I say it) entertainment.
Who was General Solicitation?
The short answer: publicly advertising that you are selling securities.
The longer answer begins in 1933. That year, Congress passed the Securities Act. (If you like primary sources you can download the full text here, from the SEC’s website; or if you prefer Wikipedia, go here.
The Securities Act was intended to ensure that anyone that bought securities (that is, gave money to a company in exchange for shares in the company, or other similar arrangements) received accurate and sufficient information before they made the purchase. It also set the SEC to ensure that happened. After the Act, all securities being sold have to be “registered” with the SEC – unless the “issuer” (the seller) of the securities proves it is exempt from that registration (under Section 4(a)(2) of the Act, which is popularly known as the “private placement” exemption).
The current rules about registration are set out in Regulation D (17 C.F.R. §230.501 et seq., text linked here) that was created by the SEC in 1982. There are several ways to be exempt from registration, but a popular one is set out in Rule 506.
Rule 506 says you can sell as many securities, and raise as much money, as you want, as long as you answer buyers’ questions, provide them with financial statements, and sell “restricted securities” (basically those are shares that are not easily sold). If you do that, then under part B of the rule (called 506(b)) you can sell them to an unlimited number of accredited investors and up to 35 non-accredited investors – as long as you do not engage in “general solicitation”.
(That’s how things stood until new rules (Rule 506(c)) permitted general solicitation on certain conditions. We’ll discuss these later on.)
So, if you want to sell securities but don’t want to register with the SEC, you do a “private placement” and do not engage in general solicitation.
Then back to the question: what actually is general solicitation?
In a related rule (Rule 502(c)) the SEC says general solicitation includes:
“Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio”
or (enjoyably circular) “Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”
And later guidance added that using a public website (with no passwords) to offer securities is general solicitation.
There isn’t a comprehensive definition of everything that might be “general solicitation,” but, in addition to the specific guidance from the SEC, it’s prudent to assume that anything that involves publicly stating specifically that you are selling securities – or even more vaguely that you are raising capital – opens you to a potential accusation of general solicitation.
Advertising in the NY Times; writing blog posts about your offering; tweeting about your fundraising plans and progress; creating Eventbrite events and advertising seminars where you invite people to come hear about your offering… All are definitely general solicitation.
Many other things – emailing to your entire contact list; emailing people from a list of angel investors you found online; tweeting about being in the process of raising capital; having other people do these things for you – are either definitely general solicitation or so debatable that only a reckless entrepreneur would do them without first thoroughly understanding the implications of doing general solicitation.
One way to avoid general solicitation is to ensure that securities are only offered to those with whom the issuer has a “pre-existing, substantive relationship”.
Naturally, this raises the question: what is a “pre-existing” relationship? How long must the relationship have been in place? The clear answer here is that you must have known the other person before the securities offering began. (Brokers and investment advisors that have special rules.)
Similarly: what is a “substantive relationship”? This answer is a little more complicated, but the SEC provides guidance in its Compliance and Disclosure Interpretations (CDIs), specifically CDI 256.31 at this link.
An issuer must have enough information to evaluate if the buyer’s financial circumstances and sophistication is enough to make them an accredited investor or a sophisticated investor. That sounds like a pretty close relationship.
As you could probably guess, it is not actually that easy to qualify for a 506(b) exemption. However, all is not lost if you do not have pre-existing, substantive relationships with accredited angel investors eager to invest in early stage companies.
If you don’t, or if there is some other reason you do not think the 506(b) rules work for you, then since 2012 you have had another approach – a 506(c) offering.
The JOBS Act of 2012 required the SEC to create a path to allowing issuers to use general solicitation but also remain exempt from registration. The result was Rule 506(c) and the associated rules that were finalized in 2015.
Rule 506(c) says you can raise money via general solicitation (advertising to anyone) as long as you only take money from accredited investors, and that you take “reasonable steps” to verify that everyone who invests is, in fact, accredited.
This is a trade-off: you can advertise, including to people you do not know (or with whom you only have a new, recent, and/or tenuous relationship); in return, you need to be certain that whoever buys the securities are accredited.
What are those “reasonable steps”?
Unfortunately, a form where investors can check a box to declare they are accredited (called self-certification) is not enough. (For example, in the enforcement example we will discuss later, “Despite collecting accredited investor questionnaires and representations from investors certifying to their accredited investor status, Respondent did not take reasonable steps to verify that investors in the Fund were accredited investors.”)
The SEC outlines are a few acceptable “reasonable steps” verification:
Collect and review the investor’s tax documents to verify the income for the last two years – and get a written representation from them that they have a reasonable expectation of reaching the required income this year too
Review both a credit report for liabilities and bank, brokerage, or other statements for assets – to verify the overall net worth requirement
Get a letter written by a professional that knows the investor well – a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a registered CPA – that says the investor is accredited
Use a third-party platform that does this work for you.
506(c) trade offs
As we said, using 506(c) involves trade-offs.
For us, it was fun to be able to advertise the fund, expand our relationships, and generate some buzz and interest in the fund; articles in the local press like this one definitely helped provide momentum to a first-time fund.
But…it was not fun collecting brokerage account statements and credit reports to verify net worth, or reviewing historical tax returns and W2s to verify net income.
It was not just the administrative labor involved in seeking and analyzing the documents. Several of the people who wanted to invest passed once they understood the invasive (from their perspective) disclosures needed to prove their accreditation. Potential investors were, and are, reluctant to provide this information, and do not necessarily understand that this process is set by the SEC and not the person fundraising.
These trade-offs apply equally to companies raising money: you have to do all this work. It’s hard enough to convince someone to invest $25,000 in your company. It’s certainly not easier to ask them also to share enough documents for you to verify their net worth.
Another trade-off is that using 506(c) might limit, potentially dramatically, your ability to raise capital from the more traditional sources. It might be helpful to get an investment from an Angellist rolling fund manager. But a traditional angel group, like VentureSouth, is going to pass immediately once we realize you are raising under 506(c).
What is an offer of securities?
Is publicly saying “we are raising money” the same as publicly soliciting a sale of securities?
Well, if you really are not selling securities, you are free to say “we are raising money” without falling under the scope of these regulations. This might be a donation crowdfunding platform, a Gofundme campaign, any kind of charitable donation, or many other things.
But if you are raising money by selling securities, then simply saying “we are raising capital” is the same as making an offer of securities (even if you include disclaimers like “this is not an offer to sell securities” in your documents!).
Debt very often counts as selling securities. Convertible notes, a popular option for early stage fundraising, is definitely a security. So are warrants that might go alongside debt. So is a SAFE.
Areas get grayer depending on how you phrase things: “here’s a link to my investor presentation”; “we are looking for partners to help grow our business”; “we are seeking a lead”; “here are our financial projections for the next three years”. You might not explicitly say “here is an offer of securities”, but it is pretty obvious you are making one.
Another related popular way companies and funds seem to skirt the general solicitation rules is when publicizing the “first closing” of their investment round or fund. Saying you’ve had a first closing of a round again does not explicitly say “You are selling securities”…but you obviously are. In our opinion you are blowing the 506(b) exemption.
As we frequently are lead investors in investment rounds, we always suggest our new portfolio companies avoid any public comment on fundraising – definitely not sending out a press release, but in fact not speaking to the press AT ALL while you are fundraising. An enterprising reporter might combine your Form D information (which we’ll discuss later) with the more general comments you made, and it will look a lot like you are trying to get fundraising advantages that are not permitted. Our companies listen once they understand who cares about this stuff.
Who cares about this stuff?
Assume you are raising money and you generally solicit investors when you should not. Who cares?
Here are three groups that do.
1) Financial regulators. The SEC and FINRA keep a close eye on issuers of securities; that’s their job. If you mess up the rules, they should notice – and if they do the investigation process can be significant and the penalties if you have violated the rules can be worse.
This page on the SEC website contains dozens of litigation actions that resulted from investigations by the SEC.
Not all of these are because of general solicitation violations, of course, but there are plenty of those in there. General solicitation is an area of particular focus for the SEC, because it goes to the heart of their mission of preventing inappropriate transactions. When the JOBS Act was being discussed, the SEC was definitively and publicly against permitting general solicitation: “general solicitation and advertising can all too readily become a tool for deception and misinformation.” It remains a focus and where, they say, there is zero tolerance for violations.
Suspected violations result in investigations (outlined here). The SEC has strong investigative and subpoena powers, and can pursue remedies – both administrative actions (presided over by an administrative law judge – so an SEC judge judging an SEC case!) or civil actions (from which the accused can end up in jail). We’ll review the penalties in more depth soon, but for now let’s just say they can be substantial – even existential.
2) Informed investors. If you approach VentureSouth to ask for investment and we suspect you are generally soliciting investors, we will pass – no matter how attractive the opportunity sounds. This happens every few weeks: a company approaches VentureSouth and says “you can download our pitchdeck from our website page” or includes a press release about the first closing of their fundraising in their email introduction. We pass immediately.
In case it is not totally clear by now, this is why:
(A) If the company is raising capital under the 506(c) exemption, we will pass because VentureSouth is not going to be sharing our members’ financial information – which would be needed to prove accreditation of all investors.
(B) If the company is supposedly raising privately under the 506(b) exemption, but is so obviously violating the general solicitation prohibition that we notice it immediately, the issuer should be heading to an appearance on the SEC’s litigation page – probably turning our investment into a fine paid to the SEC. Hard pass.
And yet…Once you are looking out for people declaring they are raising money, you see questionable material ALL THE TIME. Just google “in process of raising”, “first closing”, or anything similar and you’ll see what we mean. There are so many companies (and funds) raising money, and posting on Twitter about it, that you probably get away with it. But is it really worth the risk?
3) Disgruntled investors. A third group of people that care are your own disgruntled investors.
No startup company goes according to plan, and so (almost) every company has some investors that wish they could take back their investment.
Fortunately for them, one of the remedies to investors that get swept up in fundraisings that violate the Securities Act is a “right of rescission” – the ability to require the company to buy back their position (plus interest).
Later in the life of the company, a disgruntled shareholder hoping to force you to buy it out (or seek revenge) could look back to the original offering, and if it can identify violations of securities law it would have a very good case. A general solicitation is pretty easy to find because the internet does not forget, and form Ds are public – so finding violations, if you make them, is generally not hard.
So between regulators, potential investors, and your own investors: everyone cares!
Blowing the exemption
If you undertake general solicitation, you cannot rely on Rule 506(b) to give you an exemption from registration. It does not matter if a sale results from the general solicitation; all that matters is an offer was made by general solicitation. If you lose your exemption, you now find yourself selling unregistered securities – which is something you really do not want to be doing.
This is bad news for someone raising capital. Best case is that you have to stop fundraising – and if you need to raise money, that could spell the end of your business.
And the worst case is a lot worse. There are plenty of examples of enforcement actions by the SEC and FINRA against people selling unregistered securities. As one well-known example, in 2017 the SEC published this opinion (pdf will download) which confirmed a disciplinary proceeding that FINRA held against an issuer of securities – and upheld a fine of $73,000 that the issuer had to pay.
In another example (pdf will download), a crypto investment fund being formed had raised over $600k from 22 investors, supposedly under a 506(b) offering. However, it had obviously been generally soliciting investment – publishing information about the new fund on its website, among other things. The fund had to be unwound, the work cancelled, and the principals had to pay a $50,000 fine even though ultimately investors received their capital back.
The SEC can charge larger fines, suspend management teams, strip brokers of their licenses, and impose other punishments if they find the Securities Act or related rules are being violated. Not to mention all the energy dedicated to responding to their requests, the negative press, and the enduring infamy of being in an SEC opinion letter or listed on their litigation page.
Do these rules apply to people raising investment funds, like venture capital funds?
Yes, they absolutely do. The rules we have outlined apply to anyone selling securities. This is typically companies, but can also be investment funds (which are generally Limited Partnerships or Limited Liability Companies – basically companies). The SEC opinion letter we linked to before was about a broker-dealer raising capital on behalf of a residential real estate fund. So anyone out there raising capital for a micro venture capital fund, SBIC fund, mezzanine debt fund, PE fund, or any other kind of fund has to follow these rules.
Most professional investors are acutely aware of these rules, for many reasons – not least because if we violate them we jeopardize our careers and reputations! Even if we happen to forget temporarily, the next set of deal documents we review will have representations from the company that they have not done any general soliciting, and we will have to self-certify that we are accredited investors.
No-one heard (publicly) about the VentureSouth Angel Fund III until it was fully raised and all the securities (in this case, LP interests) were sold, because it was raised while relying on the 506(b) exemption – so we could not discuss it publicly until the fundraising was over, and it was raised exclusively from VentureSouth members or people we knew. As probably the most successful venture capitalist around today noted, you can’t find out about his latest fund because “some laws from the 1930’s [mean] we won’t be able to tell you about that until after the fact.” And it explains why this goal is amusingly perplexing.
Of course, not everyone is quite as focused on this though, and so your search results when you were looking for “first closes” very likely included investment funds being raised. For some of those, it was probably fine; perhaps they were based outside the US and not selling to US investors, or maybe they were deliberately using general solicitation under 506(c). But if you are considering investing with any fund, you need to do your research to make sure they are following the rules – because the penalties are no less unpleasant if a fund sells unregistered securities.
Reverse solicitations: Can I respond when someone solicits my solicitation?
If someone publicly asks entrepreneurs to send them investment opportunities, but the entrepreneur doesn’t know them already, would replying blow the entrepreneur’s 506(b) exemption?
As one example, we read recently a tweet that said:
“If you’re currently in the process of raising $1 to $1.5M & have a Product live, I’d love to see your deck. Send me a DM.”
If an entrepreneur replied to that tweet, could they have shown a pre-existing, substantive relationship?
If an entrepreneur publicly replied by saying “Sent” (as many entrepreneurs raising money in fact did), how could they argue that was not publicly announcing (to the twitterati, at least) an active fund raising and therefore offer of securities?
Both seem unlikely to be compliant with a 506(b) exemption, so let’s hope everyone was raising under 506(c)!
Even more blatant were several tweet threads that read:
Raising money? Reply with
· company name
· one-line pitch
· how much you are raising
Many dozens of people did, across several threads. Seems pretty clear that they generally solicited a purchaser of securities, which would not be compliant with Rule 506(b)! Seems a risky approach to finding an investor.
So our suggestion is that if you see reverse solicitations like this that you don’t respond. Or at the very least you document your legitimate knowledge of the investors before responding – and you keep the communications private.
Other things you cannot do:
Regardless of the fundraising rules you choose to operate under, there are a few things that you absolutely cannot do when selling securities. Here are a few:
Say that anything is “risk-free” or “guaranteed”.
You can provide facts (like the security is secured against the assets of the company) but subjective language, especially about risk, is dangerous. An attorney ought to review all your securities offering documents, and your advertising, press releases, and anything else you release before they become public, to make sure the risks are described reasonably.
Provide any kind of advice or recommendations, like telling a potential investor that this security is a suitable one for its situation.
Generally speaking, pay other people to raise money for you. You can if (a) the payment is a flat fee paid regardless of how much is raised (e.g. paying a PR firm to write press releases if you are doing a 506(c)) or (b) the payment is to a registered broker-deal, because they are allowed (after a thorough licensing process) to receive commission for selling securities. No-one else can. One of things you have to attest to in most deals is that you didn’t pay anyone – so don’t.
Lie, mislead, exaggerate, deceive, don’t intend to return the investment some day, …
Hopefully some of that is fairly obvious!
Congratulations: you made it to the end. Hopefully now you know more than us about the fundraising regulations you can operate under (506(b) vs. 506(c) and others), who really cares, what can happen when the SEC finds you are fundraising improperly, how these rules apply to venture capital funds, how informed investors watch out for the fundraising techniques being used by companies seeking funding from them, and some further perils, pitfalls, and prohibitions when fundraising.
If you are fundraising, or considering selling securities later, we strongly encourage you to engage with attorneys experienced in securities laws to keep you on the right track from the beginning. If you accidentally blow your exemption before you even speak to an attorney, you are not going to succeed.