About the author: Bart Dillashaw is an attorney at the Scudder Law Firm in Lincoln, Neb. where he represents companies in formation, financing transactions, mergers and acquisitions and corporate governance matters.
The topic of Form D filings has come up a few times in recent weeks in conversations with clients and in a few blog posts by folks like Brad Feld and Jason Mendelson of Foundry Group, so I thought this might be a topic worth providing a little more background about. This may get a little deeper into legal nuances than the average post, but I’m a lawyer, so indulge me.
There is a basic premise underlying the laws and regulations covering the purchase and sale of interests in companies that states that you should not sell these interests, or securities, without telling the truth about your business and disclosing all of the risks involved with investing in your company. In order to ensure that appropriate disclosure is provided, these laws generally require a company to register its securities with an agency, such as the Securities and Exchange Commission and/or state securities agencies, and publicly provide some information about the company before it can offer to sell its securities to anyone. The registration process is complicated, expensive and usually requires a lot of accountants and lawyers to get you through the process. When you hear about Facebook’s IPO, or the fact that it is “going public” people are referring to this registration process, and this is an example of the level of disclosure that is required. These securities laws apply to every company and every sale of securities, so each time a company sells its shares it has to either register the securities or qualify for an applicable exemption to this rule.
Luckily, there are quite a few exemptions. The most popular exemption that investors such as venture capital firms and angel investors use is Rule 506 of Regulation D of the Securities Exchange Act of 1933. One of the key criteria for this exemption is that companies only raise money from “Accredited Investors,” which are basically individuals that have a net worth of over $1 million, or that have consistently made over $200,000 per year in income, or companies that have over $5 million in assets. This is the main reason the general public cannot buy shares of private companies, although there will be some exciting changes to this rule in the next year or so. Rule 506 has other requirements as well, one of which is that you have to file a Form D with the Securities and Exchange Commission. A Form D requires you to publicly provide certain information about the offering and your company, such as the company’s name, address, executive officers, directors, and the size of the offering. The Form D filings are now easily accessible through the SEC’s Edgar database.
The public nature of the Form D filings has led to some concern for companies that want to remain in “stealth” mode. To take a local example, if an enterprising reporter had gotten wind that Dwolla had done some sort of financing a few months back, she might decide to go to the SEC’s website and find this (right). That reporter might see that Albert Wenger is now on the board and surmise that Union Square Ventures might have just led a $5 million investment into the company. If Dwolla had wanted that information kept secret, it might not be so happy with the article that reporter is about to write.
This is what led to some companies wanting to avoid the Form D filing when raising money. From a securities law perspective, Regulation D is not the only alternative for securing a valid securities exemption, so companies can go with other avenues, and this is the issue that Brad and Jason blogged about. As they noted, I think the stealth issue is a little overblown and that any company that feels that public disclosure about their financing is going to cause them competitive harm probably needs to find a better competitive edge.
I will be the first to admit that a Form D filing is not appropriate for all occasions, but it is usually the best exemption available as Regulation D provides broad, clear exemptions with ample guidance about what works and what does not. In addition, the Rule 506 exemption’s best feature is that it works not just at the federal level, but also for each state. If an offering spans multiple states, a company would otherwise have to dig through the individual securities laws of every state it is offering securities in. The state laws are far less clear, more varied, and more likely to be enforced. This ability to avoid the complexity of dealing with multiple state’s laws makes the Form D filing worth the increased exposure in most cases. Failure to qualify for a valid securities exemption can present several problems, including that the company could face significant liabilities for breaking these laws. In addition, and perhaps more importantly, consider the message that running afoul of securities laws sends about the level of organization and responsibility of the company and the effect that will have on any potential investor or acquirer.
This is a very brief review of a complex issue, and I’ve glossed over a lot of the details and intricacies, so for any individual or company that is actually considering any sale of securities, please be sure to talk with your own counsel.
Credits: Photo of Bart Dillashaw courtesy of Dillashaw. Screenshot of Dwolla Form D from sec.gov.