How to Raise Capital Without Running Afoul of the SEC

Columns - Hemp Law

Understanding the basics of securities law and knowing what risks you need to disclose to investors is essential when obtaining the funding necessary to establish your hemp business.

December 1, 2020

Raising capital in any industry is difficult. Simply convincing people to part with their money can be a daunting task. However, raising funds while maintaining compliance with securities regulations is the real challenge.

The wrong steps can lead to costly litigation with civil or even criminal charges. At the very least, they can amount to immense and expensive setbacks for companies eager to build products and gain market share.

Given the nature of hemp and the cannabinoid industries, ensuring strict compliance with these securities regulations is vital. Before you can understand why it’s helpful first to understand securities law.

Securities Laws at a Glance

Securities regulations do not apply to all new ventures. A group of friends forming a company by pooling resources generally doesn’t come with many investment-oriented regulatory strings attached.

But as soon as a company starts seeking investment capital from investors outside of the organization, it is considered to be selling securities. That is where the Securities and Exchange Commission (SEC) and various state securities regulators get involved.

When most people think of securities, they think of stocks and bonds. However, what does and doesn’t constitute a security is far broader than that, in the 1946 landmark case Securities and Exchange Commission v. W. J. Howey Co., the U.S. Supreme Court created a test to determine what is and isn’t a security. The court held that a security must meet all of the following criteria:

  • An investment of money is made into a common enterprise.
  • The investment is made in the expectation of profits.
  • Those profits are derived from others' efforts (i.e., not the efforts of the person investing).

Before the Securities Act of 1933 (the Act), finding investors for commercial enterprises did not satisfy many regulatory requirements. As the SEC states on its website: “In the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits and without disclosing meaningful information to investors.”

When the 1920s stock market house of cards came tumbling down—on Oct. 29, 1929, aka Black Tuesday—it wiped out the life savings of enormous swaths of Americans who believed investing in the stock market would bring a guaranteed profit.

The Act’s current registration requirements make it much more difficult for companies seeking investors. Just going public today can cost companies tens of millions of dollars in legal fees alone. Much of the work associated with going public revolves around complying with SEC regulations.

If companies don’t comply with those requirements when raising capital, they are guilty of selling unregistered securities. Many small businesses, however, have no idea they are violating securities laws.

You might be thinking, “If this is such a problem, why don’t we hear about it in the news?” The answer is that the SEC is not a police force and generally isn’t actively patrolling the non-public markets. Many businesses avoid ill effects.

Businesses do feel the consequences of illegally selling securities (again, simply raising money) when they run into some trouble with their investors—the investors disapprove of how management handles an issue, for example, or individual investors feel they are being mistreated. The most common problem? When the company fails to live up to its projected performance.

Failure to observe the rules when securing capital can lead to costly, sometimes devastating, legal proceedings. Since the scenario arises when companies are trying to raise money, it often coincides with fragile times for a business.

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Exemptions From The Act

Companies do, however, have the option to safely raise money without incurring the steep cost of registration under the Act or following its stringent requirements by making use of one of several exemptions, including Rule 144, Rule 144A, Regulation A, Regulation A+, and Regulation D (Reg D).

The vast majority of capital raised in the U.S. is done through one of these exemptions. Each exemption has its strengths and weaknesses, but given its flexibility and popularity among companies raising money, Reg D is where we will focus our attention.

Reg D allows companies to access capital markets without spending enormous amounts of time and money to comply with the Act’s registration requirements as long as they comply with certain other restrictions.

Reg D has several subsections called “rules.” The two most commonly used rules are 506(b) and 506(c). An investment under either rule is usually referred to as a “private placement.”

Under 506(b), a company can raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non-accredited investors, as long as the company doesn’t use general solicitation or advertising for marketing the securities. Companies that issue securities through 506(c) may engage in general solicitation and advertising, but all investors must be accredited.

An “accredited investor” is a person or legal entity that falls into 15 defined categories. The most pertinent of those are:

  • A person who has an individual net worth, or joint net worth with said person’s spouse, that exceeds $1 million at the time of the purchase or has assets under management of $1 million or more, excluding the value of the individual’s primary residence, or has an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000;
  • A business in which all the equity owners are accredited investors; and
  • A charitable organization, corporation, or partnership with assets exceeding $5 million.

There are some common mistakes people make when it comes to these exemptions. One common mistake involves 506(b) non-accredited investors and “general solicitation.”


Pre-existing Relationships are Key

If the person or entity invests in the opportunity but was unknown to the company or its principals before investing, how did they hear about it? Under such circumstances, it is highly likely that stranger would have received some general solicitation, and under 506(b), all types of advertising and general solicitations are prohibited.

We also see the opposite scenario, where a non-accredited investor is included in what the company intended to be a 506(c) offering. But since these offerings do not permit non-accredited investors, they cannot be considered 506(c) offerings. This causes the offering to instead be deemed a 506(b), which means that the general solicitation(s) the company believed it engaged in legally were actually illegal.

Other issues involve the Private Placement Memorandum (PPM), a requirement in both 506(b) and 506(c) offerings. A PPM is a document in which the company clearly delineates all the risks associated with the investment. This document is probably the most important thing for a company raising money through either rule 506(b) or 506(c). Solid PPMs discuss the risks associated with: the industry in which the company operates; the experience level of the founders; and the company itself. (See the sidebar below for more details.)

Why are failures to disclose risks critical? We have seen numerous companies solicit investment without properly disclosing the offering's risks in a PPM, opting instead for a simple document with minimal risk disclosures (if any). Time passes. The company is successful. But a dispute about divvying up funds arises. One of the investors starts casting around for a bargaining chip to either get a better deal or a refund of their investment. The investor realizes that, way back on day one, the company didn’t follow the proper formula for laying out risk.

There’s the bargaining chip.

Any company looking for outside investment, even if it’s from just a handful of friends and family who will not be actively involved with the business, should reject moving forward until the company’s principals have carefully reviewed their SEC exemption options, filed the proper forms with the SEC, hewed to rules about non-accredited investors, and offered detailed and exhaustive PPMs to investors.

Dave Rodman is the founder and managing partner of The Rodman Law Group, a full-service law firm based in Denver.

Note: Nothing contained in this article creates any kind of attorney-client relationship. The contents of this article do not, and are not intended to, constitute legal advice. The information, content, and opinions are the authors’ own and have been provided for general informational purposes only.