I hear clients often discuss raising money from friends and family to finance their business. There is a common misunderstanding that you can take on investment from friends and family without having to comply with securities laws. This type of misunderstanding regarding securities laws can lead to serious consequences for the owners of the business. And I wanted to set the record straight so you can avoid unnecessary liabilities when raising money for your business.
What is a security?
To begin, it is important to understand what a security is to understand why this all matters at all. There’s a lengthy definition for what a security is, and boiled down to its essence a security is any contract, transaction or scheme where a person invests his money in a third party and expects to receive profits solely from the efforts of the third party. If you’re giving another person or company an ownership interest in your business, then you are likely selling a “security.” You can read more about the background of securities and how this definition came about here. To protect the public from phony investments and scammers, the SEC developed a long list of securities regulations that require companies to register any offering of securities with the SEC unless an exemption from registration exists.
There are a number of exemptions that allow businesses to sell securities without registering the sale with the SEC, but there are none that say you can raise money from friends and family without registering the offering.
There is no “Friends and Family” exemption, but there is Rule 506(b)
Sorry folks, despite what you may have heard or read on someone’s blog, there is no exemption strictly for “friends and family.” There are exemptions that allow you to raise money from friends and family, and the most common of these exemptions is under Rule 506(b). Under this rule, you can raise an unlimited amount of money for your business from “accredited investors”—this means all of the investors must have a net worth of $1M or an annual income over $200K or $300K with their spouse—as long as you have a pre-existing relationship with the investors (read= you aren’t cold calling investors or advertising the offering to the public). Rule 506(b) allows you to take money from up to 35 unaccredited investors, but I wouldn’t advise it (if I were advising), as it triggers additional disclosure requirements and ultimately increases risk. So if your friends and family are all accredited investors, then you can use Rule 506(b) as your “Friends and Family” exemption. But if any of your friends and family that want to invest are unaccredited, I’d think twice about taking their money.
There are also filing requirements whenever you raise money from investors, and it’s always best to consult with counsel before selling securities in your business. Here’s a recap of the information above:
- If you sell securities, you need to register the offering or find an exemption to fit within (and comply with filing requirements);
- There is no “Friends and Family” exemption that allows you to sell securities to your close friends and family without complying with securities laws;
- Rule 506(b) allows businesses to sell securities without registering the offering;
- If you use Rule 506(b), you should only take money from accredited investors that you have some form of pre-existing relationship with; and
- Talk with an attorney before you start raising money from investors!
It is important to note that there is a new way of raising money for your business under Rule 506(c). Under Rule 506(c), you can advertise your securities offering to the public, which is what is known as “crowdfunding”—as long as every investor you are selling to is an accredited investor. Here’s an article I wrote on the iVLG blog about Rule 506(c) and crowdfunding that will give a primer on the subject.
Please feel free to contact me at firstname.lastname@example.org or comment below if you have any questions about raising money for your small business or the new changes to securities laws.
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