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Private Funding Guide

Private Funding Guide


Most small to medium-sized businesses are funded through private funding, which is a very complex area. There are many state and federal requirements that must be complied with during each stage of funding. This guide will review key concepts and steps to obtain private funding for a business.

STEP #1: Initial Funding.

At the initial funding stage, also known as an angel round of funding, a group of investors join together to form the corporation. This is usually a small number of investors (can be as small as 1, 2 or 3), but to qualify for the small business exemptions, generally, cannot exceed 35, as discussed below. These initial investors will contribute the initial amount of capital (money or assets) to start the corporation. In return, these investors receive shares in the corporation. These investors are referred to as the founders and generally receive shares of common stock with no preferential rights.

Buy-Sell Agreement
In addition, it is highly recommended, although not required, that the initial investors enter into a Buy-Sell Agreement.  A Buy-Sell Agreement is a contract between shareholders which governs the sale of their stock.  It is normally used a way to control who can become a shareholder of the company, or in the case of an initial round of investors, who will have the preferential rights, or have a majority shareholder status.  In this Agreement, certain “triggering” events are identified that would result in a buy-out of a shareholders stock.  The most common triggering event is the death of the shareholder.  Upon the death of a shareholder who is part of the Buy-Sell Agreement, the other shareholders will have the right to purchase the deceased shareholder’s shares.  This Agreement may be funded by life insurance, which will pay the cost to buy the deceased shareholder’s shares.  Other triggering events that may be found in a Buy-Sell Agreement include, attempts to sale to a third party, termination of employment and conviction of a crime.

STEP #2: Initial Securities Registration/Exemption.

Under both state and federal law, shares of stock in a corporation are considered to be securities.  Securities must either be registered in California and on the federal level through the Securities and Exchange Commission (“SEC”) or there must be an exemption from registration.  Registering securities is a complex, time consuming and expensive process, so it is best to find an exemption.

Federal Law
Under federal law, a commonly used exemption is found under Rule 147, the Intrastate Exemption.  As long as the corporation and all of its shareholders are in the same state, the securities are exempt from registration.  There is no limit as to the number of shareholders or the total amount of consideration to be paid.  Each purchaser must provide written representations as to the state of their residence to ensure compliance with this rule.  Each purchaser may not resell their shares for at least 9 months.  This exemption does not require a form to be filed!

If there are any out of state shareholders, then there are also exemptions available under Rules 504, 505 and 506, depending on the number of shareholders, the sophistication and relationship between the shareholders and the corporation, and the amount of money to be exchanged in the offering.

State Law
A commonly used exemption under California law is the limited offering exemption.  Under that exemption, there can be no more than 35 purchasers (although certain people are excluded from the count of 35 purchasers), and each purchaser must have a preexisting relationship with the company or have the ability to protect their financial interest in the transaction.  A preexisting relationship refers to a personal or business relationship with either the corporation or any of its officers, directors or controlling persons.  Protecting the financial interests means that the purchaser must have sufficient business or financial experience so that they could reasonably be assumed to have the capacity to protect their own interest.

There is no dollar limit for this exemption, but each purchaser must sign a representation that they are purchasing the stock for their own account and not with the intent to sell the same with any distribution of the security.  In addition, the corporation cannot make any public advertisement or general solicitation for purchasers during this initial round.  To utilize this exemption, a specific form is filed online with the Department of Corporations within 15 days of the first sale of the securities.

STEP #3: Subsequent Funding:  Securities Registration/Exemption.

After the initial round of funding, the corporation may decide to engage in larger offerings with numerous investors.  At this stage, the corporation may consider issuing stock with certain preferential rights, known as preferred stock.

Once it is determined that the corporation will seek additional funding, it needs to meet with counsel to re-evaluate the securities issues related to the subsequent rounds of funding.

Federal Law
If the subsequent rounds of funding will only be offered and sold to residents of the state in which the corporation is located, then it will likely be able to utilize the Intrastate Offering exemption.  However, if the subsequent rounds will be advertised to and/or offered to any of state resident, then the exemptions available under Regulation D needs to be evaluated to ensure compliance.  Otherwise, the corporation may have to do a “mini-registration” under Rule A or register the securities with the SEC.  If there is no exemption under the Intrastate Offering or Regulation D, the corporation cannot advertise, sell or offer to sell any stock until the SEC registers the securities.

State Law
Once the number of shareholders or persons offered shares exceeds 35 (with some exceptions), the corporation likely will not qualify for any of the exemptions under California law. Unless the securities were registered with the SEC, the corporation will need to obtain a permit to sell its securities in a process called qualification by permit. The corporation cannot advertise, sell or offer to sell any stock until the Department of Corporation issues the permit. Qualification by permit requires a length form concerning the finances of the business and the business background of all of the directors and officers of the corporation. It also requires a fair number of exhibits that the corporation must attach to the form, including corporate formation documents, the business plan and financials for the corporation. Given the backlog and ongoing furloughs of the Department of Corporations, it will take at least 90-120 days once the form is submitted for a permit to be issued.

STEP #4: Subsequent Funding: Finding Investors.

Once the California Department of Corporation issues a permit qualifying the corporation’s securities (and assuming there is still an exemption under federal law and registration with the SEC is not necessary), the corporation can then begin soliciting third parties to invest in the corporation.  This includes any advertising.  Any prospective purchasers must be provided with a PPM so that they can make a fully informed decision concerning their investment.

Preferred Stock/Preferential Rights
Preferred stock is a class of shares of stock in which certain preferential rights have been granted.  Some of those preferred rights may include priority to receipt of dividends, priority to distributions of money and/or assets when the corporation is dissolved, and the right to convert the stock into common stock.

Private Placement Memorandum
In conjunction with the initial funding, the corporation normally prepares a Private Placement Memorandum (“PPM”).  The PPM discloses all applicable facts about the transaction and the business such as the finances of the company, its business model, its business plan, and plans for future fundraising.  The PPM is distributed to all potential shareholders so that each person is fully informed about the company and the risks to his/her investment prior to investing any money in the company.