Friends and Family Investment Round of Funding

Can I Solicit in a Friends and Family Investment Round of Funding?

“A rising tide lifts all boats.” This is a common theme that is instilled into children in my extended family. When the sister who worked harder and smarter than her other siblings gets older she won’t forget her family and where she came from.  These values instilled at a young age create reflexes later on in life that one doesn’t even question. When someone creates an idea or opportunity they automatically turn to their family to help foster and invest in that idea without a second thought.

One would think to themselves, “If I have an opportunity to make my investors money on this idea or business opportunity, then why shouldn’t those investors be my family? After all, a rising tide lifts all boats.” So what can and should you do when you have an investment opportunity but you want to also comply with the securities laws?

Do you show up at your Aunt Janice’s Sunday dinner, with your business plan in your back pocket, and inform her about this amazing opportunity? After all, you are her favorite nephew!

Do you log into Facebook and message your entire family?

The answer to both of these questions is no. The following will explain why.

Taking investments from family members and promising returns can be seen as an investment contract or a profit sharing agreement. Either way it is structured the SEC would categorize this as a “security” because it fits the Howey Test: It is an investment of money into a common enterprise with the expectation of profits solely from the efforts of the promoter.[i]

This particular security falls under Regulation D. Regulation D contains rules that govern non-public offerings that private companies use to raise capital. These regulations help avoid paperwork but add multiple headaches and restrictions, along with civil monetary penalties for noncompliance. [ii] Regulation D has multiple exemptions but in a typical 506(b) private placement, by far the most common type of offering, there is no clear path to allowing family and friends to invest. Since Rule 504 and 505 do not allow for unaccredited investors, unless Aunt Janice is accredited, she’s out.

Rule 506, however, allows a company to have 35 unaccredited investors, but it requires that they are ‘sophisticated’ meaning they have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.[iii] Until recently, when the Rule 506(c) offering was allowed, none of these exemptions allowed for general solicitations. Rule 506(c) offerings are only offered to accredited investors.  And only 2% of offerings use Rule 506(c).

So what does this mean? It limits who can be an investor and how you inform them. A company cannot announce or offer investment opportunities over social media unless you use a Regulation A+ vehicle, a Title III Regulation Crowdfunding vehicle, or in some cases, use a Rule 506(c) offering.

Family members should be eliminated from consideration as investors in theory. A Private Placement Memorandum is often the best way to get around this restriction. A PPM allows a company to give its investors as much information as a company that is going public.

These documents can get unwieldy because there is a lot of due diligence and disclosure involved and in order to make sure you are fully compliant hire a trained securities lawyer. This is an extremely difficult process that should be done by someone familiar with the information, even licensed attorneys in other fields may find it difficult to produce a PPM that complies with all the regulations and produce disclosures that are not complaint and expose a company to liability.

So what should you do to start the process? Before you start circulating information at the family reunion, hire a securities attorney, and work with them on creating an exhaustive business plan.

“But I have a great business plan already!”

If your company believes that it has a great business plan already that tackles all of the information needed you should still have the attorney review it because it may be deficient and fail to adequately inform the investors of the risk involved with an investment. An attorney’s guidance is key in navigating the process of safely raising capital. Just because you are Aunt Janice’s favorite niece or nephew don’t think she won’t seek legal recourse if she feels her investment is mismanaged.

[i] John C. Coffee Jr., Hillary A. Sue, and M. Todd Henderson; Securities Regulations Cases and Material 13th edition 261-264

[ii] J. William Hicks; Limited Offering Exemptions: Regulation D 2007-2008 Edition 189-257

[iii] Id at 251 – 252

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