Many start-up ventures raise money from friends and family without regard to compliance with federal or state securities laws.  Many believe that compliance is unnecessary (the company is too small), is too expensive (why should I pay money to a lawyer, when I can put it to work in the company—money is a valuable and scarce resource, after all) or that the offering will fly under regulators’ radar.

This is a mistake.

There are registration (or similar qualification, under state law) requirements and antifraud provisions in securities laws that affect friends and family offerings.  An excellent article by Alexander Davie discusses, in plain English, the foregoing requirements and civil and criminal penalties for non compliance.  I would only add the following.

To comply with the anti fraud provisions of federal and state securities laws, the company must carefully determine what it discloses to potential investors.  It must appraise potential investors of the risks of investing in the company.  These risks are not always obvious.  I recommend that a private placement memorandum (“PPM”) be used.  The PPM describes, among other things, the company, its officers and directors, the use of proceeds of the offering and its risk factors.  The PPM is then given to each of the potential investors.  I, and many corporate lawyers have done a number of these and, except for information peculiar to an offering and to the company, the prior deal can be marked up.  The expense is not  significant, especially considering the risks.  This is especially so as many friends and family offerings often proceed to friends of friends of friends offerings.  In addition to reducing risk the PPM should be a selling document.

As to registration (qualification) requirements, a non-compliant offering could impair further rounds of financing.  At the closing of institutional financings the company’s lawyer will be required to give an opinion that all prior sales of the company’s securities were in compliance with federal and state securities laws.  If the past financings were not compliant, the financing might not take place or a rescission offer (an offer to buy back the securities) to the friends and family might be required.  In any event, the financing, if it took place at all would be messy and expensive.  Where future financings are planned, I recommend that the offering comply with the requirements of Regulation D under the federal Securities Act.  All that is required is a simple filing with the SEC and state securities laws (New York’s filing is a little more difficult) and compliance with certain other requirements.  Properly done, that assures compliance with the registration or qualification requirements.

Posted August 8, 2011 by Edmund Polubinski, Jr.