Formalizing Equity Investment

Where an entrepreneur feels that a venture might have wide public appeal, or that some group of investors might be more comfortable with a formal division of ownership, the decision may be made to distribute stock in the corporation in proportion to ownership. For the protection of investors, this process is more tightly regulated than direct sales of ownership interest.

Simply stated, it is against the law to sell stock unless you are licensed to do so or can qualify for an exemption from the Securities and Exchange Commission (SEC) and the various states securities commissions\' rules. Let us take a look at some of the exemptions.

Regulation D

For some entrepreneurs, the best vehicle to accomplish initial equity financing under an exemption is through the use of Regulation D, which is a limited offer and sale of their company\'s stock, or securities, without registration under the Federal Securities Act of 1933. Some risks continue under \D,\ but compliance is significantly easier than before it existed. Under Regulation D, Rule 504 generally pertains to securities sales up to $1 million, and this is the rule most applicable to the ventures we are considering.

Rule 504

This rule is considered by many as the perfect answer for the company just starting out that needs to raise less than $1 million but cannot afford to go through the whole SEC registration process. Rule 504 offers such companies an alternative:

An exemption to raise up to $1 million, with no disclosure criteria

The total offering amount under Rule 504 can be up to $1 million in a 12-month period, less the aggregate offering of all securities sold within 12 months before the start of the offering. So, if a company has raised $100,000 in private money in the 12 months preceding qualification under this rule, it can still raise an additional $900,000.

Few general solicitation and resale restrictions

Generally, under Rule 504 there are no specific disclosure requirements, unless the state of issue imposes them. Theoretically, an issuer can have a purchaser sign a subscription agreement and purchase stock without any information about the company being disclosed.

Regardless of the amount of disclosure the issuer is willing to provide, Rule 504 does not dismiss the issuer from federal requirements, nor is there an exemption from fraud provisions, including the areas of material omissions or misstatements. The penalties for noncompliance are severe, including monetary fines and mandatory jail sentences.

Rule 504 allows the issuer to generally solicit, or advertise, for subscribers to an offering. Some states have been quite lenient in allowing it. However, in practice, very few issuers have advertised their offerings in newspapers or through other common media as was expected.

No limit as to the number or type of investors

Rule 504 is the only rule under D that permits an unlimited number of investors.

Regulation A Offerings

Under Regulation A, a company may also publicly offer its securities without registration under the 1933 Act. Instead, an offering statement (Form 1-A) is filed and \qualified\ with the SEC. A principal attraction of \A\ is that only two years of financial statements are required and they may be unaudited if audited information is not readily available. The limit of an A offering is $5 million in any 12 month period. Also, Form 1-A has been revised to allow the optional use of a \user-friendly\ question and answer form.

Small Company Offering Registration (SCOR)

Form U-7, the basic registration/information form used in the Small Corporate Offering Registration (SCOR) was adopted by the Securities and Exchange Commission in 1992. In some states, this is called Uniform Limited Offering Registration or ULOR. It allows a company to raise up to $1 million by selling securities. The disclosure statement (Form U-7) is considerably less complicated than standard disclosure forms and is constructed in question and answer form; the SCOR/ULOR process is considered by many to be the simplest paper-work process used to complete an exempted offering ever.

The major drawback to the exempted processes is the complexity of the regulations, and the courts have shown a willingness to rule against the entrepreneur in their interpretations. The entrepreneur should not proceed without first seeking the advice of qualified legal counsel to determine the best form of exemption to apply for.

John B. Vinturella, Ph.D. has almost 40 years experience as a management and strategic consultant, entrepreneur, author, and college professor. For 20 of those years, Dr. Vinturella was owner/president of a distribution company that he founded. He is a principal in business opportunity sites jbv.com and muddledconcept.com, and maintains business and political blogs.