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Now let’s talk about raising funds for that great business idea that you have. Spend a few minutes on any startup finance website, and a term you will run across almost immediately is the “Friends and Family Round.” As the name implies, this is when the business owner hits the Family and Class Reunion circuits – looking for blood relatives, in-laws, and old roommates with money.
Let me be very clear here – there is no “Family and Friends Securities Exemption.” It simply doesn’t exist under either federal or state law. Now, there absolutely are times where a “substantial pre-existing relationship” can help make someone an eligible investor under a securities law exemption that has several other requirements.
When you raise capital from friends and family, and those folks aren’t either:
1) Participating in the business in a material way; or
2) Giving you an “adequately” secured or collateralized loan
Then you are selling them a security (just like you would be if you raised capital from someone you don’t have to see at Thanksgiving Dinner every year). As such, in order to stay off the enforcement radar of the Securities and Exchange Commission (“SEC”) and state securities regulators (which I highly recommend), you will either need to register those securities with the SEC (an exercise that will cost you multiple hundreds of thousands of dollars in legal and accounting fees), or find and qualify for an exemption from the requirement that you register such securities before you sell them.
Let’s take a quick look the most common of these exemptions:
Regulation D – Rule 506
1) Allows you to raise an unlimited amount of funds from an unlimited number of “Accredited Investors”;
2) Allows the participation of up to 35 Non-Accredited Investors;
3) May allow you to “generally solicit” your offering in whatever way you see fit;
4) State law compliance is very simple if you comply with federal law (because Rule 506 “preempts” state registration requirements).
1) It’s likely most of your friends and family won’t qualify as Accredited Investors (unless their annual income is north of $200k or their net worth is north of $1 million);
2) If you want to include Non-Accredited Investors in the offering, then you’ll need to provide them with very expensive disclosures (to the point where my blanket advice is not to include Non-Accredited Investors when using Rule 506).
Regulation D – Rule 504
1) Allows you to raise up to $5 million (up from a cap of $1 million as of October 2016) over a 12-month period from an unlimited number of Accredited Investors;
2) Allows the participation of up to 35 Non-Accredited Investors (and unlike Rule 506, no pesky additional disclosures are required).
1) No general solicitation is permitted, unless you jump through some pretty draconian hoops;
2) Unlike Rule 506, Rule 504 doesn’t preempt state registration requirements. This means you have to make sure your offering complies with “Blue Sky” requirements of every state where your investors live. Some states are cheap (or even free) and easy. Some states will be expensive and difficult (or even impossible). You have to do your state-level homework before you get too far down this path.
Rules 147 and 147A – Intrastate Offering Exemptions
1) At the federal level, these exemptions don’t put a limit on the amount of money that can be raised, or who it can be raised from;
2) No federal filing is required.
1) You’d better hope your friends and family are concentrated in one state, because all your investors have to be from the same state (and sign a written representation that they reside in that state);
2) That state also needs to be the same one where you primarily direct, control and coordinate the company’s activities;
3) You must meet one of three tests to be considered as “doing business” in that same state (based on revenues, assets or use of offering proceeds in the state);
4) You have to comply with the laws of the state where you are making the offering when it comes to things like who can participate (or even be solicited) in the offering, how the offering can be marketed, and what has to be filed with the state securities regulator.
As you can see, the Friends and Family Round is a bit more complicated than just convincing Uncle Joe and Aunt Josephine to cut you a check in exchange for a piece of the company. If you are embarking on your Friends and Family Round journey, please reach out to a competent attorney