Banking & Finance  April 17, 2015

Firms seeking capital may hit snag with SEC

Investors found by crowdfunding must meet legal criteria

Startup companies that hope to raise cash under a new state crowdfunding law may be at risk of running afoul of the U.S. Securities and Exchange Commission by not adhering to a rule that requires them to verify whether or not an investor is accredited.

The new state law was signed by Gov. John Hickenlooper April 13. It is designed to make it easier to raise capital by allowing startups and other small businesses to seek funding without registering with the SEC.

But the SEC still requires startups and small businesses to verify if an investor is accredited, a daunting task that is time consuming and costly for many small businesses, experts said.

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An accredited investor has a net worth of more than $1 million, not counting a person’s primary residence, and has an individual income in excess of $200,000 in each of the two most recent years, or joint income with that person’s spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year.

John Eckstein, a transactional, finance and securities lawyer with Fairfield and Woods PC in Denver, said startups have a couple of options on how to file with the SEC when they start a fundraising campaign. One allows them to forego verifying investors’ financial strength if they solicit from a pool of 35 or fewer people. This is known as rule 506 (B).

“That usually works if a company is trying to raise less than $1 million, but if it wants to raise more than that it should file under the 506 (C) rule,” Eckstein said. Under the 506 (C) rule, a company can raise an unlimited amount of money from an unlimited number of accredited investors, but it also must have a way to verify that the investors are accredited.

Eckstein
Sarmo

The SEC does not provide a specific checklist on verification, saying only that the business must take “reasonable steps” to verify an investor’s status, and must retain adequate records regarding those steps.

According to SEC documents, taking an investor’s word that he or she is accredited, called self-verification, is not acceptable. A business will need to use public information filed with a federal, state or local regulatory body to prove the investor meets the criteria, or the issuer can verify an investor’s status using a third-party such as a broker-dealer, attorney or accountant.

Jillian Sarmo, investor education and public affairs coordinator for the Colorado Division of Securities, said most of the issues that come before the securities division involve businesses that are not complying with the requirements to obtain the federal exemption from Regulation D requirements. “They simply aren’t registering for the 506 exemption,” she said.

For example, last year the securities division issued two cease-and-desist orders to companies that had not followed the proper channels to register for the 506 exemption, and simply had posted their offerings to Craigslist.

“With one instance it was because the issuer knew ahead of time that he would not meet the Regulation D requirements for exemption, but he elected to proceed anyway,” she said.

“It’s our hope with crowdfunding some of the companies that may not currently meet the Regulation D standards may be able to solicit investors through the new rules,” she said.

Sarmo wants small businesses to be mindful of disclosure requirements.

“As with all offerings, even under Reg D and crowdfunding, disclosure of risk level (which is generally high for new, small businesses) will be extremely important for unaccredited investors, who may not be fully aware of what they are really doing.”
She also cautions that unlike the federal Regulation D offerings, under which securities can be sold across state lines, the new crowdfunding rules passed by the Colorado Legislature this spring and waiting for Hickenlooper’s signature will allow crowdfunding campaigns only within state lines. The SEC has yet to legalize interstate crowdfunding.

“If small businesses use crowdfunding to solicit or accept investments from outside Colorado they will run afoul of the SEC,” she said. “They need to be particularly careful as most of their efforts will utilize the Internet.  This part will be tricky at least until the SEC catches up with individual states regarding crowdfunding requirements.”


How to verify accredited investors

The Angel Capital Association, a Kansas City, Mo.-based alliance of more than 100 of the largest angel investor groups in the United States, has published guidance to help companies better understand and comply with the requirements of rule 506 (C) that applies to raising capital. The association explains how startups can go about meeting verification requirements.

• Income test

Review of Internal Revenue Service forms that report income for the most recent two years, and written representation from the purchaser that he or she has a reasonable expectation of reaching an income level necessary to qualify as an accredited investor for the current year.

• Net worth test

Review of documentation dated within the prior three months detailing assets, report from a national credit reporting agency, and written representation from the purchaser that all liabilities necessary to make a net-worth determination are disclosed.

• Third-party verification

Written confirmation from a qualified third party that has taken reasonable steps to verify within the prior three months that the purchaser is an accredited investor. Allowed third parties include registered broker-dealers, registered investment advisers, licensed attorneys or certified public accountants.


Doug Storum can be reached at 303-630-1959, 970-416-7369 or dstorum@bizwestmedia.com.

Startup companies that hope to raise cash under a new state crowdfunding law may be at risk of running afoul of the U.S. Securities and Exchange Commission by not adhering to a rule that requires them to verify whether or not an investor is accredited.

The new state law was signed by Gov. John Hickenlooper April 13. It is designed to make it easier to raise capital by allowing startups and other small businesses to seek funding without registering with the SEC.

But the SEC still requires startups and small businesses to verify if an investor is accredited, a…

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