Raising Capital For Your Business & The SEC

Chris: Thank you. Thanks for having me.

Toby: First off, he’s my personal counsel when it comes to working on SCC matters—oversight, fundraising—just because he’s an expert in the area. We’ll kind of go over that. He’s going to go over the basics of what you should know if you’re thinking about raising money for a project, whether it be for your business, for an apartment complex that you’ve got your eye on, or if you have other investors that you want to work with. He’s absolutely fantastic. Again, welcome, Chris and thanks for being with us.

Chris: Thank you.

Toby: Let’s go over some of your background. I know the background, and it’s pretty darn impressive. Chris has actually worked for FINRA Way back when, right? How long ago is that?

Chris: Yeah, I worked there when I was getting a Master of Laws in Business Law with a focus on Securities Regulation. I spent a year there, one semester. I interned there during the master’s program. It was great. Some tremendously smart, caring people there. It was just a unique insight into the FINRA world, into the great nation.

Toby: He’s been on that side. He coupled it up by working with the Nevada Secretary of State Securities Division, right?

Chris: Yeah. That was my first job after law school. I practice law here in the great State of Nevada. My first entree into a full-time working world was with the securities division. I served in the capacity as a securities examiner. Essentially what that was, is I reviewed all securities offerings that were being qualified, and oversaw licensing of investment advisors, broker, dealers, and uniquely athletes’ agents, which was a fun change every once in a while.

Toby: I could imagine that you saw a few things there.

Chris: Yeah. It’s our rules here in Nevada, contrary to popular belief, that not everything goes maybe down the strip; but in the securities world, there is certainly a state dedicated to protecting your investors.

Toby: Then you went right over to probably one of the most aggressive states, California. You worked with the Department of Oversight, then the Securities Division?

Chris: Yeah, essentially, my wife and I were both from Southern California. We were expecting our first child and desired to be a bit closer to family. Back in California, I worked for the Securities Regulation Division within the Department of Business oversight, a much larger organization, obviously much larger state. One of the largest economies in the world. It was fun. I spent about a year there, working with some very smart people. Again, I was in a role where I oversaw securities offerings, and then I was de facto counsel to our broker-dealer in investment advisor regulation unit. I got to help out on some unique stuff but again, a tremendously passionate group of folks that make sure they protect the residents of the State of California.

Toby: When you say security, we’re throwing around some phrases, but anybody who has a corporation and LLC, you’re dealing with securities. The interest there is a security, right? So, when you’re talking about offerings and things like that, these are the people that are actually putting together both public and private offerings, right?

Chris: Correct. Unfortunately, there is a tremendous knowledge gap and understandably so. With folks trying to raise money, start a business, grow their business, and say, “Hey, the stock is what I see in the New York Stock Exchange, right? Well, I’m just raising money for my business, debt or equity.”

I think what’s crucial to understand and put it into the most easily understandable terms is if someone gives you money, you’re going to take that money and build your business, expand your business, acquire an asset—do anything where that person expects that money back plus some or expects their money back or hopes they get anything back—you may be involved in a securities transaction.

Importantly, there are a wide range of laws, both at the federal and at the state level, that apply to anybody engaged in that activity. It’s crucial before anybody takes money from another person to understand compliance is going to be necessary both at the federal and at the state level.

Some folks say “Well, I’m based in California, I only have to worry about California.” I tell folks, “Actually, patchwork is a little bit broader. It’s going to be California, in any state that you offer into, in any state where you have an investor base.” It’s very important for folks to understand there is a price associated with helping to raise money and grow your business. Often in counsel, the law can absolutely be complied with. It’s just you want to do it beforehand and have a plan versus get to the end and go, “I hope I didn’t step out of bounds because it’s easy to do.”

Toby: There are a few things I want to unpack there. Before I jump into that, you’re now in private practice. You work with NRI, right?

Chris: Correct. Yeah, I spent two years as a securities regulator. After that, I really had a desire to help small business owners, entrepreneurs, and raise money. I saw so a lot of the pitfalls that folks stepped into. I think something crucial for a lot of folks to understand is I think a securities regulator is only out there to get the Bernie Madoffs of the world, people intentionally committing fraud.

Unfortunately, that’s not really the majority of the issues that I saw as a securities regulator. A lot of times, it’s entrepreneurs that just have unknowingly engaged in a securities transaction without an exemption. They say, “Hey, I’m raising money from a handful of rich people. How is that a securities offering? They invested in my LLC, they helped me go buy that apartment building over there, or unity. How’s that a securities transaction?”

Toby: That’s not just them putting money in for equity. That’s also if you’re borrowing from them, correct?

Chris: Correct. There are certain types of debt instruments that can be considered a security. I think the safest place to start an assumption on an entrepreneur/business owner’s standpoint is to assume anytime you take money—debt or equity—that you’re considered to be engaging in a securities transaction. From there, we can look for exemptions or exclusions.

Exclusion is, “What I’m doing, the nature of it, how it’s structured is not considered to be a security,” which is great. The second is. “What I’m selling—debt or equity—is in fact a security. Maybe there’s an exemption that applies to me.”

There’s both, what are called transactional exemptions, which is based on the SEC and state regulators saying, “Based on the nature of the people involved in this transaction, we don’t need to regulate it. Either because the offering is small and localized to a group of very sophisticated wealthy investors.” There are also certain things that securities that are exempt but usually that’s applies to bank stocks and certain things the average entrepreneur is not going to be selling.

Toby: What would be an example of an exclusion? Something that may—contrary to popular belief—not be a security transaction?

Chris: There are some things where it technically can be a security that the SEC says, “Listen, this is just going to be excluded from us regulating it based on the nature of the offering.” They’re usually things like bank stocks, or things that the average entrepreneur is just not going to be engaged in doing.

By and large, for the most part, the focus for entrepreneurs or anyone raising money is going to be focused on what are called transactional exemptions, which are, “Hey, I’m selling a security, but based on the nature of the people, I’m going to let participate in this offering investment. I don’t need securities oversight.” I don’t think you’re registered with the SEC or estate. I can be exempt.”

Toby: Can you give me some examples of some exemptions that people would have?

Chris: From a starting point, at the federal level is something called Section 4(a)(2) of the Securities Act of 1933. Section 4(a)(2) essentially is an exemption that says, “You don’t have to qualify a non-public offering.” How that’s defined is through a variety of case law and interpreted letters from the SEC. It’s a very broad exemption. However, in practice, it can be a little bit narrower than people think.

So, folks that say, “Hey, can you provide me any real guidance on this?” The SEC long time ago came out with something called Regulation D. Regulation D is a safe harbor underneath 4(a)(2) that say, “Hey, if you can comply with a specific set of rules, your transaction will be exempt.” 

Traditionally, the primary exemption under Regulation D was rule 506. Rule 506 allows you to—through non-general solicitation—raise money from no more than 35 non-accredited investors. An unlimited number of accredited investors in theory, but there’s a point you have to become a reporting company.

That allows you to raise money from accredited and non-accredited folks as long as you comply with a laundry list of requirements. When you look back, you say, “Wow, I had to jump through all these hoops. I’ve certainly done enough to either add value to the company, audit financials, disclosure items,” things that will inform an investor. However, traditionally that was done through non-general solicitation.

During President Obama’s administration, he passed—with Congress’s help—something called the JOBS Act, which is an acronym for Jumpstart Our Business Startups Act. It was a response to one of the worst recessions this country has ever seen. What it did was it passed a tremendously powerful exemption for entrepreneurs and business owners. That’s something called 506(c).

506(c) is a transaction exemption that allows you to rely on this Regulation D exemption, but generally solicits your offering to anyone. So long as your investors prove their accredited, which people with net worth over a million dollars exclusive of their primary residence and anything. It’s tremendously powerful because there were a lot of entrepreneurs and business owners that said, “Hey, I’m willing to only have accredited investors and invest in my offering. I just don’t know any rich people.”

Toby: When you say general solicitation, this is really important for people to understand. If you have a pre-existing relationship with somebody, is that an exemption from the general solicitation rules?

Chris: Yes. General solicitation has not been specifically defined by the SEC, but through guidance, case law, interpretive letters, there’s some general parameters or guardrails. The focus in the general solicitation is, “Do you have a substantive pre-existing relationship with this person?” more than just, “I know their name, I know their address.” It’s, “I know their background, I know their middle name. I know they’re financially sophisticated. They’re a CPA. They’re a doctor, an architect. They have a level of sophistication that bypasses the average American and understands stocks generally, but they’re a person that understands investments and private deals, has an income that’s relatively substantial.” You know all about a person, you’re getting to the realm of, “I have a substantive, pre-existing relationship with this person.”

Unfortunately, that limited your ability to raise money to the people that you knew. […] If you know enough people that could finance your venture, you’re in a realm of, “What exemption can I rely on to raise the rest of this money?”

The Jumpstart Our Business Startups Act when it went into effect said, “Well, you don’t have to have that level of knowledge of all the people you offer to. You can go out. As long as all the people that actually give you money are accredited and there are certain things they have to provide as proof that they’re accredited.” The SEC will now exempt that transaction and what entrepreneurs raise money from folks that they may not have a pre-existing relationship with.

Toby: Are there dollar limits to that? How much can you raise?

Chris: No, 506(c) is unlimited in the amount of money that can be raised. There are certain thresholds where if you have more than a certain number of stockholders, you can eventually become a reporting company. That’s not a concern for the average business owner.

One of the things that I counsel folks on is, yes, you may have an exemption that allows you to solicit an unlimited number of people, but you don’t necessarily want an unlimited number of people to come into your business. […] you’re selling equity because there’s the exemption, but there’s also the practicalities of having these people own equity in your business. They’re going to have expectations. They’re going to want reports. Particularly sophisticated investors or wealthy investors will oftentimes demand things that match almost having a registered offering.

To be candid, I tell a lot of folks “Having 50 investors that you’ve never met before, that are now essentially your boss because you have to report to them can be a big burden for a startup business.” So 506(c) I think is a tool to be in a founder’s or our entrepreneur’s tool chest, but it has to be used in connection with practicalities of, “Do I really want investors I’ve never met to own a part of my business?”

Toby: You’re discussing this as per accredited investors, what if it’s just family members or my friend across the street, and we decide to do something together?

Chris: Yeah, Regulation D Rule 506 is a federal exemption. That’s the starting point. If you do a 506 offering, you can offer in states and you make a notice filing. Along […] your Regulation D for when they’re going to be raising money from either people they don’t know or a larger offering. There are, however, state exemptions that people can rely on in addition to the large federal exemption, which is Section 4(a)(2).

For example, we have an exemption that if you offer to a limited number of people, and you raise less than a certain dollar amount, that offering can be exempt from registration at the state level. You still have to look at the applicable federal exemptions, but Section 4(a)(2) is oftentimes an exemption people rely on in connection with what’s usually a small localized offering to friends and family.

Toby: Friends and family, right?

Chris: Correct.

Toby: What’s typical? Is it like 15 people or 10 people?

Chris: It depends on the state you’re in. There’s a lot of states that have adopted something called the uniform limited offering exemption. Depending on what state you’re in, that number can range from you raise no more money from no more than 15 people. Some states, it’s no more than 25. There’s usually a dollar amount associated with that. In some states, it can be as little as a million. I’ve seen it at $5 million in some jurisdictions.

The crucial thing to understand in the friends and family around is yes, they’re friends and family, but they may be buying a security from you. Whether they’re friends and family or not, that transaction must be exempt if it’s not registered. A lot of folks come to me and say, “Well, I don’t care. What do I need to document this for?

For a lot of entrepreneurs, the big thing is corporate diligence down the line is going to pick up a non-compliant securities offering. A lot of folks are worried about the SEC or state securities regulator, they think, “Well, they’re not going to know.” Even if a regulator doesn’t come in and identify your offering as non-compliant, you still run the risk of later-stage investors saying, “Hey, you did a non-exempt transaction where you didn’t pay for this transaction appropriately. I don’t want to invest in a deal that has risk unrelated to the project or business.”

It can be difficult to clean up after the fact, if it, in fact, can be. It’s something that I think entrepreneurs, you want to be in a position where you’re either explaining your project, you’re explaining your business, not trying to clean up this paperwork.

Toby: This is one of the hardest parts for people to really get their minds around. You set up an LLC. Even if it’s with your buddy and your partner, and you’re going to buy this. He’s the person you buy real estate with and you’re buying houses, or apartments. That’s still a security. It’s just because you guys are both partners in it, you’re probably going to be exempt here. It’s a small amount. You’re both the principal’s in it, you’re both running it. The second you start going out saying, “Hey, we need extra money.” You start reaching out to people, “Hey, let me talk to my uncle,” or, “Let me talk to this guy I know in town who’s pretty wealthy.” You’re just asking even for a loan, you’re still under the securities realm, and you got to make sure you don’t step on a landmine. Is that essentially—

Chris: Yes, correct. Friends and family are great until a dispute arises. I have seen clients that are going out and taking money from immediate family, but not done it in a compliant way. Unfortunately, sometimes there’s falling out with family. A business venture doesn’t turn out the way everybody thought. It […] slided. They can report. They can call their local securities division. They can try and call the SEC. They can call someone and say, “Hey, I put money into this deal. I don’t think it was done right. Is there anything you can do?” That’s just not something that you want to have to deal with in addition to the business for sure, is a call from a regulator trying to find out, “Hey, have you done something nefarious here?”

With proper planning, it can easily be addressed upfront. It’s just crucial for a lot of business owners to understand that these laws do apply. Even if you have an exemption, the laws still apply. You just need to make sure you either pay for that exemption, or tailor your offering in a way that qualifies for an exemption.

Toby: Do you remember any cases that you ran across where the person did not mean to step on a landmine but when they do step on it, you were like, “I feel kind of bad.”

Chris: Yeah, there’s a handful of examples that I see or cases I hear about. One is engaging in general solicitation without a proper exemption. Folks will say, “Well, I only sold to 10 people.” Well, if you offer to people you didn’t know or didn’t have a substantive pre-existing relationship with, you (in fact) engage in general solicitation.

Folks sometimes go, “Well, I didn’t offer a security. I just said I was raising money.” Well, anything that primes the markets for purities transactions can be considered an offer of a security. I’ve been at startup events where I hear entrepreneurs say, “Hey, I’m selling stock at this price and at this valuation,” and they don’t know that they’ve just generally solicited an entire room full of people.

Toby: What’s the […] that they do it?

Chris: Correct. Sometimes those folks will have exemptions in place, and they say, “Hey, no, I’m allowed to do this. I’m relying on 506(c). I’m only going to take money from people that prove they’re accredited.” Sometimes I see it in the context of, “Hey, all I did was I engaged in general solicitation. That’s fine. I was going to rely on rule 506,” but they didn’t take proper steps to verify that investors were accredited.

The SEC has come out and said, “Even if people ultimately wind up to be accredited, like assuming a person raises money, they generally solicit, send out a blast email, something to that effect, but they only take money from 10 people, those people wind up being accredited. Even if those folks are (in fact) ultimately determined to be accredited, if you didn’t take the proper steps to verify that those folks were in fact accredited at the time they gave their money, that’s a non-compliant 506 offering. And because you engaged in general solicitation, now you don’t have an exemption.” Those folks are in a very tough spot, were not asking for one or two more pieces of documentation could have exempted their offering. Now they’re in a non-compliant space.

Toby: Now, if you’re non-compliant, is it disgorgement? Is it penalties? Is it jail time? What is it if you’re non-compliant?

Chris: The penalties for non-compliance can range broadly depending upon the regulator you’re dealing with. Whether you’re dealing with an investor that’s suing you, the SEC, the penalties can be broad. A lot of folks think, “Well, I didn’t take their money and keep it. This wasn’t a Ponzi scheme. The business just went down,” or, “Hey, the business actually made money and everybody’s really happy.” A baseline remedy will be a securities regulator saying, “Hey, you need to register this transaction.” With a lot of folks, that’s not going to be possible. In those moments, regulators will sometimes say, “Okay, well, they need to offer everybody their money back.” What’s called the rescission offer.

A lot of folks that are startup founders, where they are trying to buy a real estate asset. They’re in the early years of either rehabbing the project where it’s not stabilized, it’s not rented out. Coming back to an investor and saying, “Hey, do you want all your money back?” Give me a very enticing person that says, “Well, what’s the company worth? What’s the project?” You’re sitting there saying, “Well, we’re in that down period where we raise money. All the cash is out.” Technically if you got all your money back right now as of today, it’d be a better return. It really kills a business to have to go through that.

Toby: If they have a regulator involved, I mean, somebody probably blew the whistle on it, right? Probably bad stuff’s going on and you’re in a precarious position. All of a sudden, they come in and say, “You got to give everybody back their money.” You’re like, “We don’t have their money.”

Chris: Correct. Regulators can learn of a busted offering in a handful of ways. One can be someone’s told. Sometimes it’s an investor that’s frustrated. Sometimes it’s a securities broker or to be often sometimes a competitor says, “Hey, I learned that this person was raising money. You should go check it out because I don’t think they’re doing it in a compliant way.”

Another can be folks, just not knowing what they’re doing as a securities transaction, can sometimes send out fliers. I see advertisements in newspapers that are securities offerings. Again, there can be exemptions for some of that activity, but quite often, when I was a regulator, we would reach out to people and say, “Hey, we saw that you’re doing this activity, can you please confirm what exemption you’re relying on?” Oftentimes people would say, “I don’t have a lawyer. I didn’t know what I was doing was a securities transaction. What do you recommend that I do?”

So, if you’re asking for securities advice from a securities regulator, you’ve probably done something wrong. It’s not the securities regulator’s job to help you comply or plan your offering. It’s their job to protect their citizens. If you’re raising money in a non-compliant way, you violated a law that they’re sworn to enforce. If you get to that point with the regulator, it’s not because they’re notorious. It’s not because they’re out to get anybody. It’s because they have a set of laws they have to enforce. If you violate it and they know about it, they have to take action against you.

Toby: Can they throw you in jail for doing stuff like that?

Chris: Depending on the nature of the violation. There are certain securities crimes that are punishable by imprisonment. You look at Mr. Madoff, currently a resident of the federal correctional system. That’s certainly a very egregious activity. Lots of activity that can get folks in trouble criminally as well. Sometimes what can take an action from civil to criminal is either repeated offenses, an intent to defraud investors, or actions that can only be interpreted as an intent to defraud investors.

Toby: So, assuming that all of our people listening, they just want to do things right. In fact, a lot of them are just scared to death of even going out and raising money because they know these rules exist, but they don’t know what they are. How do you do it right? Let’s say that I have a great apartment building that I got my eye on. I know that we can run it and make a good chunk of money, leverage it up, fix it up, and possibly sell it in two or three years, and really make a killing. I’m thinking, “Boy, I would really love to go see if there’s somebody that wants to do this with me.” What would be my steps?”

Chris: I think step one is looking at the process of raising money like a road trip. You need to know where want to end up, and you need to know where you’re starting. I often tell folks, “Do you plug in the MapQuest directions before you get in the car, or do you do it when you’re already on the freeway, hoping you’re going in the right direction?”

What I recommend to folks, using the MapQuest example, is plug in the destination before you get in the car. Know where you’re going, know where you want to be, and really just look at the roadmap of how you’re going to have to get there.

I strongly encourage investors or anybody trying to raise money, don’t do that on your own. Don’t try and take out the map and think you know the best route. Contact a securities attorney. Contact someone that can help you through that entire process. I think the key is vetting the person a bit, making sure you truly believe that they have the skill set to assist you.

Unfortunately, I run into folks that have gone out and they’ve engaged either legal counsel or someone that purported to be an expert. The advice they’ve gotten is either incorrect, not complete, or just, completely wrong. You have an entrepreneur that gone the route of trying to get advice, and they just didn’t get it correctly. The starting point is knowing where you want to wind up and identifying someone to help you get there.

Toby: Assume that I’m going to raise $2 million to do this apartment. I sit down with you and I say, “These are people that I actually know exactly who I’m going to talk to. It’s a bunch of investors that I work with.” What’s typical? I’m going to do a 506(c), […], or something along those lines.

Chris: Any number of facts can defer the advice that attorney would give in a situation like that, but I think the crucial analysis is for the person trying to raise the money to look with their counsel both at federal exemption and a state exemption, in order to understand “Okay, I know these people, have I done business with them before. Are they sophisticated? What’s their net worth?”

I think that helps to answer the federal and state securities law questions. From a state standpoint, it’s crucial to understand where are these folks? Where do they actually live? Because I’ve dealt with entrepreneurs before they’ll say, “Well, hey, this person is in Washington State.” We’ll look at the securities laws in Washington because it’s crucial to understand that all offers and sales must be exempt.

So, before you can approach that person about investing, you need to have a securities exempt exemption identified, you can even approach them about the offering. I’ve had instances where a person comes back and says, “Well, I moved. I’m not in Washington anymore. I’m now in Illinois.” Now you’re in a moment where you go, “Uh-oh.” What does the law of Illinois say?” 

Depending on the nature of the prospective investors, if you know that in advance, identifying the federal and state laws that you can rely on. If a person raising money says, “Hey, I don’t know who the investors are going to be.” Then we’re looking at exemptions where we can, what’s called preempt state law. That’s a moment where rule 506, which is a federal exemption that preempts the application of registration requirements, not the fraud requirements or notices filing requirements. 506 can say “Hey, as long as you comply with this federal rule, you can file a notice with these state securities regulators and that’s efficient.” You’re still subject to prosecution for things like fraud, but you can now focus on one set of laws from the upfront compliance standpoint.

Toby: That sounds pretty tasty for somebody who’s going to raise money and you might have 20 people all across the country. That sounds like it’s pretty good.

Chris: Yeah, Regulation D Rule 506 is a very popular exemption with entrepreneurs. Again, one of the big things there is, “Hey, I don’t know who all my investors are going to be.” Then you get into an analysis of, “Will do I do a 506(b) offering? Or do I do a 506(c) offering? How do they differ? What are the pluses and minuses associated with each one?”

I encourage entrepreneurs, if they are in a position where they truly do not know who their investors are going to be, they’re going to have a lot of conversations or conversations with people that they don’t know. They’re going to ask their friends and family for referrals of people that you’re starting to get one or two concentric circles outside of your direct contact base. I’m really encouraging folks to look at rule 506(c) because again, it is an exemption from registration that allows you to engage in general solicitation without having to be looking over your shoulder.

Toby: You’re actually registering your offering as a Regulation D offering. You’re letting the SEC and the state know, “Hey, I’m out here raising money.”

Chris: Regulation D, it’s not registration. It is a notice filing that you’ve engaged in an exempt transaction, and then […] on what an entrepreneur needs to know. Yes, you file what’s called a Form D with the US Securities and Exchange Commission, then you will provide that same filing to the states in which you sell securities in.

A person that is getting ready to conduct a securities offering says, “Here’s the nature of my investors. Here are the major people I’m targeting.” They ultimately determine if their counsel’s a reliable 506. That person would then look at the 506 notice filing requirements. That’s in the states they want to sell into. Then they would (with their counsel) file a Form D with the SEC or file a Form D in the states where they have investors.

Toby: Are there people that just skip that? That says, “Hey, I’m going to deal with accredited investors. I know that I’m meeting all the requirements. If a regulator ever comes in, I’ll just file it then.” Do people do that?

Chris: There are absolutely people that do that. That’s never something that I recommend because unfortunately, there are some states or the SEC will say, “A willful failure to file a Form D can vitiate your ability to claim that exemption.”

Toby: Yup, then all of a sudden, you’re in hot water again. So, we’ll do it right. Do it right from the get-go.

Chris: Right. You’re back in hot water. You’re scrambling to see, “Do I have a securities exemption that I can fall back on to?” What I told folks is you always want to have a fallback point where you can say, “If I somehow didn’t qualify with this exemption, I have another one that I can probably rely on.” It’s a very narrow-focused exemption with a lot of requirements to comply with it. There are some broader, more lax exemptions around Regulation D. However, the ability to rely on those really goes out the window with things like general solicitation, taking money from people you don’t know, raising over a certain dollar amount, or raising money from more than a certain number of people.

Toby: Let’s assume that we’re going to do it right. We actually filed our notice or Form D. We always hear about accredited investors. How do I verify and do I have to verify that they’re accredited? What about this whole thing called an offering memorandum? What are the next steps that I have to worry about?

Chris: There are folks that say “Okay, Well, I know I want to comply with securities laws. What do I do?” If they’re going to rely on Rule 506, as an example, Rule 506 has two avenues. There’s the 506(b) avenue, which is no general solicitation. There’s the 506(c) avenue, which is general solicitation. On a 506(b) approach, folks are not required to have definitive proof that a person is in fact accredited. They can rely on what’s called self-certification.

That will be in the form of an accredited investor questionnaire, where the issuer or the entrepreneur whoever’s raising money, will send out a questionnaire that says, “Check this box how you’re accredited. You have a net worth over a million dollars. You have a household income of over $300,000 annually.” Tell me how you’re accredited. That person will just check a box, sign it, and say, “I promise that I’m accredited this way.”

In contrast, Rule 506(c) offerings, because you’re engaging in general solicitation and your offering is being sent out to people you don’t know, there’s a higher threshold there. In those situations, the SEC is going to make you have proof that you prove these people were accredited.

There’s a handful of ways that the SEC has come out and presented as methods that you can use to verify a person is accredited. One is getting a letter from their accountant or a CPA or an attorney saying, “This person is in fact accredited.” Another is to start asking things like W-2 tax returns, but they have to be current. A W-2 from a […] is not sufficient. There’s a handful of other approaches. The SEC has said, “If you rely on one of these methods to prove people are accredited, we’ll deem it to be you proving that they’re accredited.”

Toby: There are some online services too. You go and they plug it in.

Chris: There’s a variety of these certification firms that have popped up. I say you always want to vet those. I think you want to have what I call the quarterback on the transaction. Someone that’s going to focus on helping you comply with all securities laws, making sure you select proper vendors to help with certification compliance.

[…] were really focused on the business, the interaction with investors, explaining their concept, their proposal to the folks, and letting people that specialize in securities clients take over that approach. I kind of look at it as I’m going to go do surgery or I need surgery on my knee. I’m not going to go out of the Home Depot and buy an X-ACTO knife and try and figure it out. That’s what they do.

Toby: That’s just gross. Pick up some screws, put them on it, get a drill.

Chris: Correct. Maybe poke around long enough you find the ACL, maybe you duct tape it. For folks, though, in the security space, what they need to understand though is that they are not taking a risk, their investors are taking a risk. People are giving you money. It must be done in a compliant way. If you can go out and you can comply with the requirements that are 506(b), 506(c), or some other exemption you’re relying on, now you could just focus on the core business.

Toby: We see this all the time and it drives me absolutely crazy. They offer a memorandum. That’s almost where everybody starts. We’re into this conversation now. We’re finally to the point where we actually have the offering memorandum and that’s where most people start. The offering memorandum is where you’re like, “Oh, I’m going to entice all these people. It’s going to be so great.” Basically, you could lose all your money together, or you could lose all your money statements right at the beginning of like, “Hey this is for sophisticated investors. This is for credit investors,” and all that good stuff.

Chris: The offering memorandum can be tough. There are some folks that say “Hey, I’m raising money from friends and family, immediate people that I know. What do I really have to tell them?” I think disclosure of certain key risk factors in a moment where it’s friends have a very limited offering. I’ve seen folks say, “Do I really need a full-blown 60-page offering memorandum when I’m taking a limited amount of money from people that I ordered a substance a preexisting relationship with? This is my tribe, right? I know them. I know everything about them.” That’s a moment we’re working with securities counsel. Folks may be able to say, “I’m going to take a different approach. I’m going to disclose risk factors in a certain way. I’m going to have a reduced set of subscription documents, but I’m still going to pay for the transaction, disclose material risks.”

When folks go out to people they either don’t know or they start to go out to a larger group of investors, an offer memorandum becomes crucial, both for purposes of qualifying for certain exemptions, some in general. Certain exemptions require investors to receive a certain set of disclosures, risk factors, a summary of management, what they’re up to. It’s really important to use the proceeds. What’s the money going to be spent on? Who’s going to get what fees or conflicts of interest? Really explaining an investment to your investors.

A lot of folks look at it as, “It’s just an expense I don’t need.” I really look at it’s just awesome doing business. If you want to do it out, you want to flip it up, you want to buy an apartment complex, you’re going to have to pull permits. You’re going to have the city come inspect different phases of construction and offer memorandum for folks that are looking to invest in real estate. I look out to the entrepreneurs, “This is one more permit you have to pull.” It’s an expense where maybe you don’t do it. Maybe nothing comes of it but if it does, it’s something you wish you would have done, 9 out of 10 times.

Toby: It’s a complete cover your backside. It’s disclosing everything so somebody can come to you and say, “You enticed me and you misrepresented.” It’s almost like the fraud defense just kind of throws them. You know this was all disclosed to you right at the very beginning. So, you put all the horrible stuff that could happen there, right?

Chris: Correct. Yeah, unfortunately, a lot of disputes that I see both in private practice and when I was a securities regulator, are based around a misunderstanding of the offering. Either people not understanding the nature of their investment, which is a red flag from the beginning of, is this person really as sophisticated as I think they are? Or it’s not understanding how to use the proceeds appropriately.

There are certain folks that will say, “Well, I’m going to go buy a fourplex. I’m going to fix it up and I’m going to flip it. It’s going to take me six to nine months to do that. Obviously, I’m going to be compensated for my time in the form of a development fee, a management fee, a salary, some kind of expense like that.”

However, an investor will sometimes come back and say,” Hey, you never told me you were going to take a management fee or a development fee. You just said that you were going to go buy the apartment building and flip it. Had I known you were going to take a development fee or some type of fee, I wouldn’t have invested.”

It’s crucial for folks to explain basically, as much as they can about the project, as much as they can about the use of proceeds. If you can cut off at the beginning any argument that a person can have, “I didn’t know X, Y or Z,” you’re in a much better position to hopefully defend any type of claim that may come. Hopefully cut off the desire of a person to bring a claim. That’s both for information and for making sure that your investors are right for the product. I have folks that will say, “Well, I complied with all the exemptions. I had a PPM offer memorandum. I’m doing a 506. I filed with the SEC. I filed in the state with these investors are. I’m free and clear.”

I think there’s compliance with a rule, but there’s also really understanding the practical nature of taking money from people. A big rule of thumb that I have—some states will actually impose; FINRA has rules like this with their brokers—is don’t take more than a certain percentage of a person’s liquid net worth. If a person writes you a check and says “I’m all in. I like the investment. I like the product,” what do you mean all in? Sometimes, an all-in is, “I gave you all the money in my bank account. If this doesn’t pay off, I’m bankrupt.” In my opinion, that is never an investor that you want.

As a rule of thumb that I have for folks—again, this is my rule of thumb, not my firm’s or any of my colleagues—is a 10% test. If you’re going to take more than 10% of a person’s net worth, I think you really need to evaluate, “Is this the appropriate person for me? Or do I want to count against me to win?” because what happens after investments are made […] recession’s hit, people need cash for unexpected emergencies, health issues come up, and you’re sitting there and you’ve taken half their savings account or a large portion of their net worth.

That person, notwithstanding the project performing well, notwithstanding that person set to receive a large return on the back end is going to become difficult because they just need the cash now. The entity is either not able to make that distribution, not able to give that investor money back. You could have an issue where a person is starting to either make claims, call regulators, do something because they’re desperate to get their cash back.

Toby: I just show you one interesting scenario. It was a private placement back in 2000, early 2001. It involved some banking. It was some money transfer technology. 9/11 happened and it made it virtually worthless at the time. The intellectual property ended up still being somewhat valuable and the company ended up doing a merger with another company. Literally, you fast-forward 19 years and the investment group bore fruit. Actually, the company went public and the initial investors ended up with shares in that company, ended up with restricted shares, but they ended up doing quite well after the case because they were able to weather that storm.

During that same period of time, the original folks that had started the money raise were settling out disputes. I don’t think they went to lawsuits, but the people that were hurting for cash, (a) lost the opportunity to participate in that growth, and (b) were the ones that squawked the loudest. I always just keep that in the back of my head, is that it’s not good for them. It’s not good for you. It’s not good for the person who comes in.

If you want to be dealing with adults that understand this is a risk and are able to weather that storm, that this isn’t the money that they need to live off of in two years. They’re not banking on you returning their investment plus this so that they could make their living, or they can retire or something. You need to make it to where this is actually an investment.

That’s just from my standpoint. I’m not a securities attorney. I don’t pretend to be. I always look at this and say I like to kick them over to you, Chris, because you’re very non-promotion about it. Some of these folks, they go in and sell the PPM. They’re saying “Hey, we can go out and raise money.” They skip the whole registration part, and they skip the whole, “Here’s how you can solicit and here’s the rules.” They go right to the, “Let’s do this enticing salesy business plan, private placement memorandum that we can pitch to people. You can raise a whole bunch of money.” I just think that that’s buying people a lot of trouble.

Chris: Yeah, I call it the furniture without the instructions. I recently bought an end table from a retail outlet here. I dropped all the pieces out and I said, “Oh my gosh, I don’t have the instructions. What am I going to do?”

Toby: Was it Swedish?

Chris: Maybe, I don’t know. I don’t want to violate copyright or trademark.

Toby: You’re such a lawyer.

Chris: I got $160 pile of wood here. Lucky for me, I just missed the instructions inside the box. The product without the instructions can be difficult. I think entrepreneurs need to really make sure that they understand not just the rules, but the spirit behind them. Again, having been a securities regulator, I can assure you that folks are not out to make entrepreneurs difficult. They are not out to have a “gotcha” moment with folks. They are really out to help preserve the integrity of the securities marketplace so that entrepreneurs can continue to raise money.

If you look at the integrity of our financial system here in the United States, we have one of the more transparent securities markets. People are comfortable putting their money to work in the United States because we have securities regulators that are making sure folks are not doing nefarious things. They have rules to help them do that. Workers that can come to understand, regulators are people to work with, be prepared for, and understand where they’re coming from are going to be in a much better position than folks that take the ostrich in the sand approach. “I’m just not going to worry about it because everybody else I know doesn’t get caught.”

Toby: When it’s sunny, you don’t need a roof. Don’t want to build your house without a roof because ultimately, it’s going to rain. You just want to be prepared for that. This is how you prepare. This is your roof. It sucks that you have to go through the expense. I know we’d all love to be able to ignore that aspect of it and say, “We’re not going to be in that scenario. We’re not going to lose money. We’re not going to have rough times. There’s never going to be a situation where somebody’s cash poor and needs their money back, we’re not able to provide it.” But it happens all the time. I’m sure you’ve seen it.

Chris: Correct. It happens all the time. You never want to be in a position where something you could have an ounce of preventative maintenance now, […] cure later. Businesses fail all the time. Ventures fail all the time. Real estate markets, securities markets go up and down. If you can be in a position where you say, “Hey, I fully complied with both federal and state securities laws. I did exactly what I said I was going to do with your money. I told you about the risks inherent in an investment like this. I didn’t take too much of your money. So, you shouldn’t be upset.” If you can do all those things, all of which are 100% in the control of the entrepreneur, if the unexpected happens with respect to the marketplace, a project, the investment, that happens. If you can have controlled everything you can, you’re going to be in a much better deal with that potential downside.

Toby: Well, I really appreciate it. We went way over, but I love talking with you, so I don’t care. Could you give them a phone number where if somebody wanted to reach out to, or somebody’s a little bit worried, or somebody is in a situation where they’re trying to raise money that they could actually get ahold of you?

Chris: Yeah, my number is (702) 669-4621. I’m an attorney at the law firm of Holland & Hart.

Toby: I’ll put your information up as well, but some of these folks listen to it on a podcast where they don’t see and they’re not looking at it on the internet. They’re just listening. This is one of the most important phone calls you can make. I’m sitting here as a tax guy, as a licensed attorney, but I don’t pretend to be a securities attorney to any extent. I’m just saying, the second somebody says, “I’m raising money,” or, “I’m getting money from other people,” what I usually say is you really need a securities lawyer to look at it. Make sure you don’t step on a landmine. I always say that

Chris: Absolutely. Whether it’s me or someone else, as long as it’s someone that knows what they’re doing, that’s absolutely a tremendously important call to make. And vice-versa. Once you get past the security space—unfortunately, there are all kinds of others—to actually take the whole nine yards. Again, when you’re dealing with other people’s money, it’s important to make sure you’re shepherding it well.

Toby: I really appreciate it, Chris. Thanks for joining us.

Chris: Thanks for having me.

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