Raising private capital for early-stage businesses has its place online

Finance

By Michael T. Raymond, Esq.

Businesses in their infancy often turn to private individuals to raise their start-up and early-stage growth capital by offering equity interests in their company. In most instances, the instrument delivered to the private investor constitutes a "security," thereby invoking the need to comply with federal and state securities laws. Among other things, legal compliance requires registration of the offering with appropriate regulators or adherence to strict requirements for an exemption from registration.

While a comprehensive summary of these securities laws is outside the scope of this piece, a general familiarity with some of the basic tenants is essential to lawfully undertaking a private offering.

Here, I will focus on the Internet, which has surfaced as a potentially attractive means to raise early-stage capital.

Regulation D offerings on the Internet

As noted before, raising private capital predominantly involves an offering of "securities" and the resulting need to comply with rigorous registration and disclosure obligations or, instead, qualify for an exemption from registration.

With respect to the latter, Regulation D, an integrated series of rules promulgated by the Securities and Exchange Commission (SEC), provides a safe harbor exemption for "limited" offerings of securities.

One of the criteria for obtaining Regulation D exemption is that the offering must not involve a "general solicitation." Basically, this means that the capital-raising company and its representatives must refrain from locating and propositioning investors through any form of broad-based or "blind" solicitation techniques or advertising.

The use of the Internet as an attractive means to conduct offerings under Regulation D has intrigued capital-raising firms for a number of years. Unfortunately, there is an inherent tension between Regulation D's prohibition on "general solicitation" and the use of the Internet.

In response to the growing public interest in utilizing the "real time" efficiencies of the Internet to make private securities offerings, the SEC and many state regulators have begun to explore various ways to permit Internet offerings without them constituting a "general solicitation."

The SEC has maintained a long-standing position that a general solicitation will not be found when a pre-existing, substantive relationship between the issuer (or its broker-dealer) and an offeree exists.

A 1996 SEC No-Action Letter applied this principle to private offerings posted on the Internet. The SEC concluded that Internet access to private offering material would be permitted if the prospective investor was pre-qualified (by completing a questionnaire) and was issued a password which enabled secure access to a Web site page containing private offering material.

In addition, the SEC required a suitable "cooling-off" period between the time the questionnaire was submitted and access to the private offering material was granted. In approving this Web site, the SEC concluded that the company had taken sufficient steps to establish a "pre-existing, substantive" relationship before an "offer" to invest was made.

A similar 1997 No-Action Letter involved a broker-dealer firm that administered a Web site containing certain hedge fund investment offerings. The SEC determined that the proposed operation of the Web site would not involve a "general solicitation," since it was password-protected and access was granted only to members who had been pre-qualified as "accredited investors" (e.g., high net worth individuals). These investors were also subject to a 30 day "waiting period" before they were allowed to invest.

Based upon increasing concerns that certain other Web site operators attempting to conduct lawful online private offerings may have been overzealous or incorrect in their interpretations of these 1996 and 1997 No-Action Letters, the SEC issued a clarifying Release in April 2000. In this Release, the SEC expressed its general concern that certain entities (notably those who were not broker-dealers or affiliated with broker-dealers) may have engaged in practices that deviated substantially from the underlying facts and intent of the two No-Action Letters.

For example, the SEC noted that certain unregulated parties had set up Web sites that invited prospective investors to respond to a questionnaire, ostensibly for the purpose of qualifying them as an "accredited investor." Completion of the questionnaire immediately permitted access to private offerings displayed on those Web sites.

Some of the Web sites did not even require the completion of a questionnaire; instead, they simply invited the user to check a box as a means of self-accreditation and immediate access. The SEC staff expressed their view that these types of Web sites raised significant concerns that an unlawful offering was being conducted via a general solicitation.

Angel networks and online matching services

The SEC has generally approved broker-dealer-operated Web sites provided they prequalify their customers. However, the SEC has routinely resisted granting the same approval to non-broker-dealer Web site operators.

One reason is, the SEC gains a higher comfort level with broker-dealer firms, as they are required to maintain customer intake procedures designed to establish a "pre-existing, substantive" relationship with prospective investors. This is because broker-dealers are required, under their self-governing NASD rules, to "deal fairly with" and make "suitable recommendations" to their customers.

The SEC has stated, however, on numerous occasions that the absence or presence of a general solicitation is determined on a case-by-case basis, taking into account all relevant facts and circumstances. In so commenting, the SEC has at least left open the slight possibility that a non-broker-dealer may lawfully conduct an online private offering.

Two examples of a non-broker-dealer-operated Web site are found with angel networks and so-called online matching services. Angel investors are typically high-net worth, business-savvy individuals willing to invest "patient" capital in early stage, high-risk companies.

Angel networks essentially provide a convenient forum (either real or virtual) for pre-screened, qualified angels to assemble, evaluate, collaborate among themselves, and actually invest in emerging businesses.

In addition to live presentations, investment opportunities are often presented to angels through access restricted/password protected private offering materials discretely displayed to them on an angel network Web site. Companies afforded the lucrative opportunity to present their offering materials to investors are often invited by a "sponsoring" angel and are typically pre-screened from a large group of companies which have previously submitted their business plans.

Angel networks (especially Internet-enhanced ones) and online matching services bear a strong resemblance to one another. Online matching services attempt to join companies in search of capital with people looking to invest their capital. The capital seekers are typically earlier stage companies. The capital spenders are typically angels, venture capitalists and, on occasion, other institutional-type investors.

There are three primary regulatory considerations introduced by the operation of Internet-enhanced angel networks and online matching services. First, and most importantly, due to the inherent nature of their activities, both of these operations may require licensing as a broker-dealer. As noted, the SEC has routinely denied no action relief from the broker-dealer registration requirements for unlicensed persons that sponsor angel networks or provide matching services for profit (See Progressive Technology Inc., SEC No-Action Letter, Oct. 11, 2000, and Oil-N-Gas, Inc., SEC No-Action Letter, June 8, 2000).

Second, regulatory concerns stem from the fact that certain state private offering exemptions are expressly conditioned upon the issuer not paying "commissions" to any unlicensed persons (e.g., MCL 451.802(a)(8)(B); MCL 451.802(b)(9)(C)). If the angel network sponsor or matching service provider is not registered as a broker-dealer (or at least affiliated with a registered broker-dealer), payment of a transaction-based fee to such operator could render the private offering exemption unavailable to the issuer utilizing such services.

Finally, based upon the SEC No-Action Letters and Interpretive Releases discussed above, the means by which investors are accessed through an online angel network or matching service may involve a "general solicitation," thereby defeating an issuer's claimed private offering exemption. As noted, however, by taking certain precautions, the issuer may avoid the characterization of its offering as one involving a general solicitation.

In conclusion

Based on available SEC No-Action Letters and other commentary, it appears that the safest online private offerings under Regulation D will involve: