What is and is not general solicitation can get tricky!  Especially if you decide to make your private offering of securities using a third party web-based platform.  Beware!  Don’t assume that these services know what they are doing and are in compliance with the law.  If they screw up, you could be on the hook to return the money you raised using their platform.

What questions should you ask before deciding whether to use one of these platforms?

1. Is the operator of the platform a licensed broker-dealer?  If not, it can be risky to post your private placement on their site.

Section 15 of the 1934 Exchange Act requires persons that effect securities transactions on behalf of others to register as broker-dealers.  However, if the web-based platform is merely serving as a passive intermediary that facilitates the introduction of buyers and sellers, it may be able to operate legally without a broker-dealer license.  The types of activities to watch out for if the platform does not have a license include offering advice and information, handling funds, assisting with negotiations, and receiving fees based on a percentage of the purchase price.

2. How is the operator of the platform finding investors for the site?  Is it being done in a way that could look like general solicitation?  For example if the public web site invites potential investors to view specific offerings, this could be a general solicitation and all un-registered offerings on the site would be illegal.

3. Is access limited to accredited investors?  If not, it is necessary to provide an extensive private placement memorandum to potential investors and there is more risk of runnning afoul of the law.

4. How are investors screened?  How does the platform ensure that investors are really accredited and are making other required representations such as a statement that they are not purchasing for re-sale?  Generally speaking a lengthy questionnaire is required to determine whether the potential investor is suitable – having them check a box stating that they are accredited is not enough.

5. Once investors are given access to the site, are they allowed to view offerings that were already listed?  If so, this could be deemed general solicitation.

6. Are detailed records kept to ensure that the requisite pre-existing relationships can be documented if necessary?

7. Has the platform secured a “no action letter” from state and/or federal regulators assuring that the regulators will not bring an action against them?

Under the intrastate exemption (Section 3(a)(11) of the Securities Act of 1933), an issuer is exempt from the federal securities registration requirements.  To be eligible for the exemption, all investors must reside in a single state and the issuer must be incorporated in and doing most of its business in that state.

If the securities are offered, sold, or re-sold within nine months of the initial offering to even one out-of-state investor, the exemption may be lost.  Losing the exemption means the issuer could be required to return all the investors’ money.

The best way to ensure compliance with Section 3(a)(11) is to take advantage of the safe harbor provision in SEC Rule 147.  A safe harbor is a set of conditions that, if you comply with them, you can be assured that you will meet the requirements of an exemption.  However, it is not necessary to comply with the safe harbor conditions to comply with the exemption.  The conditions required to meet the safe harbor are as follows:

1. 80% of the company’s assets are located in the state in which the offering is made;
2. 80% of the company’s revenue comes from the state in which the offering is made; and
3. 80% of the proceeds from the offering will be used within the state in which the offering is made.

The intrastate exemption is self-executing.  The issuer is not required to file any paperwork with the SEC.

To prevent the inadvertent loss of the exemption, the issuer should do the following:

1. Place a legend on the certificate evidencing the security stating that the securities have not been registered under the Act and setting forth the limitations on resale;
2. Issue stop transfer instructions to the issuer’s transfer agent or make a notation in the appropriate records of the issuer; and
3. Obtain a written representation from each purchaser as to his residence.

Even if an offering qualifies for the intrastate exemption to federal registration, it is still necessary to comply with the securities regulations of the state in which the offering is made.

Example of the Use of the Intrastate Offering Exemption

Saranac Lake Community Store

After the town’s general store closed, members of the Saranac Lake community decided to open their own store.  They are offering shares to the public using the federal intrastate exemption and a special New York state registration process designed for issuers using the federal intrastate exemption.

Investors can purchase as little as one share for $100, with a maximum purchase of 100 shares. As of June 24, 2010, the Community Store has raised $442,900 from over 400 investors all over the state of New York.  The offering will close when $500,000 has been raised.  The Community Store organization has engaged the local community by holding “share parties” – small gatherings in homes and other intimate venues where potential investors can discuss the business plan with the interim Board of Directors and invest in shares if they choose.

Equal Exchange purchases coffee and cacao from farmer cooperatives throughout the world and processes it into products that it sells to retailers.  All products meet rigorous standards for fairness and sustainability.

All of the employees of Equal Exchange (with the exception of new employees that have not completed an initial probationary period) own voting shares in the business.  Only employees may own voting shares.  The employees elect the board, with each employee having one vote.

To become a worker-owner at Equal Exchange, you are required to buy your ownership share, which currently costs $3,250 (the amount is adjusted for inflation each year).  To ensure that all employees can afford to buy their share, Equal Exchange offers a four-year no-interest loan for share purchase.  When employees leave, they must sell their share back to the cooperative.

In addition to voting rights, the employees are entitled to a share of the profits.  At the end of each year, 40% of the after-tax profits (or losses) are allocated to the workers.  Last year, each worker’s share was approximately $5,000.  The remaining profits stay in the company as retained earnings.

The company has been profitable every year but one for the last twenty years.

When the company needed to bring in outside capital, it created a second class of shares – a non-voting share.  These shares were originally priced at $25 (the price was increased to $27.50 after demonstrating a track record for paying reasonable returns).  After an initial offering to friends and family, the company sought out accredited investors to purchase shares in private offerings.

In exchange for their investment, the non-voting shareholders receive an annual preferred dividend (paid before the workers receive their patronage dividend).  The board decides each year how much the dividend will be, with a target of 5%.  Most investors choose to reinvest their dividend in non-voting shares.  The investors may redeem their shares after five years.  The shares are non-transferrable.

The following chart shows the performance of the Equal Exchange non-voting shares compared to the S&P 500 over the last 10 years.

Equal Exchange set up its financial model so that, while workers and investors can benefit from company profits, no one can benefit from increases in share prices.  This brilliant innovation ensures that none of the company’s stakeholders will ever be tempted to sell out to Starbucks or Hersheys.  The way this was accomplished was to prohibit the transfer of shares and to include a “sellout protection clause” in the company’s formation documents.  This clause requires that if the company is ever sold, all of the capital gains will be donated to fair trade organizations.  The workers and investors cannot receive capital gains on sale.

Many cooperatives have a great deal of difficulty raising outside capital because few investors are willing to purchase non-voting shares.  Yet Equal Exchange has raised over $8 million by selling non-voting shares.  How did they do it?  A number of mechanisms give non-voting investors comfort that the interests of the voting shareholders (the employees) are aligned with their interests.

These mechanisms include the following:

• The highest paid employee at Equal Exchange can never be paid more than four times what the lowest paid employee receives – this ensures that Equal Exchange’s profits will not be diverted to pay outrageous salaries
• The worker-owners receive half of their patronage dividends in non-voting shares so they have an interest in paying a fair return to the non-voting investors
• The workers are required to invest their own capital in the company and share in profits as well as losses, giving them a meaningful stake in the success of the company
• The workers spend time visiting the farmers and learning about how the company operates, putting them in the best position to make decisions about how the company is run.

The only thing that was missing from the model was a way for the public to invest in Equal Exchange.  The cost to sell shares to the public is prohibitive (as discussed at length in previous blog posts).  To remedy this problem, Equal Exchange partnered with a bank to create a company-specific certificate of deposit.  Investments in the CD go to a line of credit that can be used by Equal Exchange as working capital.

For more information, see Equal Exchange’s web site (http://www.equalexchange.coop/index.php) and blog (http://eeinvest.wordpress.com/).

One of the questions asked of the entrepreneur when completing the form for a capital raise on 40billion.com is “What incentive will funders get for funding your business? E.g., customer discounts, free items or services, financial return, progress updates?”  This invites a user of 40billion.com to promise a financial return to an investor.  Doesn’t that sound a lot like a security?  The web site’s terms of use document disclaims all liability and responsibility for the actions of the entrepreneurs that use the web site to raise funds and reserves the right to remove any content that might violate the law.  I wonder if a raise promising a return would be removed?

Whether this is a brilliant innovation or a risky gambit is difficult to say.  According to an article in The Oregonian, Oregon securities regulators are investigating 40billion.com.

40billion.com is part of a growing phenomenon called crowdfunding — the use of the internet to raise funding for various causes.  40billion.com is similar to ChipIn.com and micropledge.com, except that 40billion.com is focused exclusively on funding for business.  Other crowdfunding sites are used for things like anniversary presents and car repairs.

I recently saw an article about a company called Sellaband based in Amsterdam.  The company provides fans the opportunity to contribute to the making of an album.  If the funding target is reached, the fans and the artist share in the proceeds.  If the target is not reached, the funds are returned.  According to one commenter on the article, this is not a security, it is a pre-selling of a product.

Another interesting strategy can be found at beerbankroll.com.  This is a crowdfunding platform that sells $50 memberships that will ultimately be used to open a brewpub.  The idea is that this is not a security because it is a membership which brings with it some benefits – a t-shirt, a chance to win prizes, and the opportunity to participate in a community-managed brewpub!

Here are some more interesting articles on crowdfunding:

http://filmmakeriq.com/development/investors/crowdfunding-for-film.html

http://elr.lls.edu/issues/v29-issue3/documents/08.Kappel.pdf

http://www.businessweek.com/smallbiz/running_small_business/archives/2008/07/crowdfunding_yo.html

The 2009 forum is being held on November 19 in Washington DC.  It will be available as a webcast.

At the 2008 forum, SEC Chairman Christopher Cox acknowledged the following in his opening remarks:

• For at least the past two decades, small businesses, which are 99% of all businesses, have bailed us out of every recession
• Small businesses have generated between two-thirds and three-quarters of all net new jobs, year-end and year-out
• Firms with fewer than 20 employees spend 45% more per employee on complying with federal regulations.

The following are some of the recommendations that came out of the 2008 forum:

• Adopt a new private offering exemption from the registration requirements of the Securities Act that does not prohibit general solicitation and advertising for transactions with purchasers who do not need all the protections of the Securities Act’s registration requirements.
• Currently, under Section 12(g) of the Securities Exchange Act of 1934, a company with 500 or more shareholders of record must register as a public company which triggers extensive reporting and other obligations – Exclude accredited investors from the 500 shareholders of record calculation.
• Establish a new system of scaled or proportional securities regulation for smaller public companies (recommendation from the Advisory Committee on Smaller Public Companies).
• Simplify the registration requirements for broker-dealers selling investments in small private companies (recommendation from the ABA Task Force on Private Placement Broker Dealers).

• One easy reform would be for the SEC to exempt from its usual expensive disclosure requirements any low-risk public ownership of locally owned microbusinesses. By low-risk, I mean that no person can hold more than $100 worth of any one stock—which means that we’re freeing up people to engage in the risk equivalent of a nice dinner for two. By local ownership, I mean that only residents within a state can buy, hold, and sell stock shares. And by microbusinesses, I mean any business with a total stock valuation on issuance of less than $250,000.  A related reform would be for the SEC to set simple rules for the setting up of internet platforms for trading the exempt securities above.
• Let’s allow small investors to pool their money in backyard investment funds (again, up to $100 per person) that in turn invest in diverse portfolios of local stocks. (Only the super rich can invest in such funds now.)
• Let’s allow any pension fund that places as much as 5 percent in local securities, either directly or through microbusiness investment funds, to meet legal standards of “fiduciary responsibility.” (Current regulations define the term in a way that directs virtually all such investments must go to global companies.)

• unaccredited investors would have to be residents of the state in which the offering was made; and
• at least 10% of the total funds would have to come from institutional investors whose minimum net worth is $100,000,000 each and/or from approved Small Business Investment Companies (SBICs).

The rationale is that the involvement of institutional investors would ensure oversight of the Community Fund by a sophisticated watchdog that would protect the interests of the rest of the investors.

The proposed legislation also authorizes the trading of shares issued by a Community Fund on an exchange or over-the-counter listing service.

• specifically allow cooperatives to receive Small Business Administration loans
• raise caps on SBA loans
• create the Small Business Early Stage Investment (SBESI) program, which would provide matching grant funding for venture capital investments in early-stage small businesses in targeted industries including agricultural technology, energy technology, environmental technology, life science, information technology, digital media, and clean technology
• make several other changes to SBA programs intended to improve them and make them more accessible.

The bill has been referred to the Senate Committee on Small Business and Entrepreneurship.