The perils of fundraising: tales from the US

As the Scottish startup ecosystem continues to grow and strengthen its international recognition as a centre of innovation, it is not surprising to find more and more international investment directed into Scottish companies. Scottish technology companies are drawn to the likes of Silicon Valley and the venture capital firms investing in technology there, and medical and life sciences companies see the United States as a key market supported by investors that understand the industry well. In addition, increasingly we see successful Scottish ex-pat entrepreneurs looking to invest back into the ecosystem in which they began their careers. 

The result is more and more Scottish companies issuing shares to US persons, and not always with an awareness of the need to observe US securities laws. Legal firms should be aware of the application of US regulation where their client might be issuing shares to a US person.

Requirement to register shares

Section 5 of the Securities Act of 1933 sets out that all securities sold in the US must be registered with the Securities & Exchange Commission (“SEC”) or be exempt from registration. To avoid the burden and associated costs of registering securities with the SEC for a public offering, companies raising investment will often seek to carry out a private offering of shares under one of the many exemptions provided in the Securities Act. 

The most commonly used exemptions for offerings of securities by early stage companies fall under Regulation D of the Securities Act, which, for example, allows for private placements under rule 506(b). Among other things, Regulation D has historically prohibited general advertising and solicitation in the offering of securities. However, the Jumpstart Our Business Startups Act 2012 (“JOBS Act”) introduced a new rule 506(c) allowing companies to engage in general advertising and solicitation for the purposes of fundraising. 

In order to qualify for the Regulation D exemptions, companies must comply with certain limitations and requirements related to the persons to whom an offering is made (such as whether those persons are “accredited investors”), and the amount of investment being raised. 

A company undertaking a private offering typically uses investor questionnaires to help collect and verify information about potential investors’ suitability to participate in a rule 506(b) or rule 506(c) offering and whether or not any such investor is “accredited”. It is the company making the offering that carries the burden of determining the status of potential investors. If a company sells unregistered securities to an unqualified investor, such company may not be able to rely on the private placement exemption in question. 

Selling securities without a registration statement or valid registration exemption gives each investor (not just the unqualified investor) the right to rescind or cancel its investment and recover the investment (plus interest) from the company for up to one year following the investment. To avoid this liability, companies are recommended to require investors to complete questionnaires so that the investee company may be reasonably certain of the investor’s status.

Compliance for early stage companies: accredited investors

Individual angel investors are the most likely sources of venture funding for most early stage companies. In the UK, founders and companies may already be familiar with the concept of the high net worth individual to whom shares may be sold in compliance with the UK financial promotion regulations, provided certain criteria are met. In the US, in accordance with the Regulation D exemption, investors can participate in an offering provided they meet the criteria for being “accredited”.

Under rule 506(b) of Regulation D, securities can be offered to an unlimited number of accredited investors and up to 35 non-accredited investors (more on those below). Rule 506(c) allows for general solicitation, but only accredited investors may participate and there is an increased level of scrutiny of whether investors meet “accredited” criteria. Accredited investors are a limited group, and include (among others) the officers of the company offering the shares, individuals with a net worth of $1 million (excluding the value of their primary residence), and individuals with income in excess of $200,000 in each of the last two calendar years.

What about family companies or trusts?

Individuals and families with wealth in the US tend to make more use of family trusts and investment companies than their UK counterparts. It is not unusual to find that an investor wishes to invest through their family trust or investment company. Such investment companies will often be a limited liability company (“LLC”).

An LLC or trust is not automatically recognised as an accredited investor. The principal way to qualify a trust or LLC as an accredited investor is to meet an assets test of $5 million. Certain other enumerated entities with over $5 million in assets qualify as accredited investors, while others, including regulated entities such as banks and registered investment companies, are not subject to the assets test. The result is that the LLC or trust will need to have $5 million in assets or confirm that all of its members are individual accredited investors, to be able to qualify as an accredited investor.

Non-accredited investors

Recognising that many startups seek investment from friends and family who may not meet the accredited investor test, companies may offer securities to non-accredited investors, but only if such investors, either on their own or relying on a purchaser representative, have sufficient knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the proposed investment; and the company must satisfy an additional information requirement. This requirement is to provide disclosure documents that are generally the same as those used in registered offerings, which is a very high standard. The cost of such work and the advice needed may put some startups off seeking investment from those friends and family that are not accredited investors.

Documentation

Whether an investee company is signing up to an investment by way of a simple subscription letter or an investment agreement, companies selling shares to US persons should obtain certain representations and warranties from the investor to comply with the securities laws, confirming, among other things, that the investor is aware that the shares are not registered shares, that the investor is buying them for its own account and that certain restrictions apply to the resale of such shares. Additionally, US investors, particularly funds and family trusts, will seek certain confirmations from investee companies relating to information to be provided to the investor in order for it to comply with passive foreign investment company regulation in the United States.

Filings

The Securities Act is a federal statute, but most states have enacted what are known as “blue sky” laws that deal with the offer of securities in that state and offer exemptions to certain registration requirements. The federal law pre-empts the state law in addressing registration of securities, but companies will have to comply with any requirement to notify a state of having completed an offering into that state and having done so by way of an exemption under the Securities Act. As such, companies selling securities into the US should comply with both federal and local state securities laws (and their respective filing requirements), as discussed below.

A Form D must be filed with the SEC within 15 days after the first sale of securities in the offering (which will usually be the completion date). With the excitement of closing out the funding round, the investee company (and its counsel) should not forget to make the appropriate filings. A company may add to its defence against an accredited investor seeking a refund by evidencing that it has confirmed the accredited status of the investor and filed a Form D with the SEC to comply with federal law. The investee company should then file the Form D in each state in which the company has sold shares (i.e. where the investors are located). Filing requirements differ from state to state, and online filings, while making things easier in some regards, often require layers of identity validation and can take time to set up, so getting on top of the filing requirements early is a great recipe for an easier life.

Firms working in this space

Firms should continue to ensure that they have in place adequate terms of engagement that clearly set out the jurisdictional limit of advice. The Securities Act applies to companies outside of the United States if such companies are selling securities into the United States. As noted, fundraising in the US by Scottish companies is becoming increasingly commonplace. Where firms are assisting companies with raising funding and US investors are participating, appropriate US advice should be sought by the investee company.