Rules & Regulations Regarding Getting Startup Investment From The Not-So-Rich

I have been told a number of times by potential clients, “I have my investors in place.” My heart drops when I hear this, because it often means that a resourceful creative (and usually young) entrepreneur has gone about fundraising improperly. The minute founders of a company seek outside investment (which is NOT the same as donation-based crowdfunding such as Kickstarter or Indiegogo), those founders are dealing with the exchange of “securities,” and must conform to certain rules, or face potentially painful penalties.

It is unlikely that a small business startup has any interest in registering with the SEC as a traditional publicly-held company, preparing for a full-blown IPO. Therefore, unless that startup seeks investment solely in the state in which the company operates–purely intra-state commerce cannot be regulated by the SEC–the company will have to fill out an SEC Exemption Notice known as Form D, as well as any forms required in the state in which investment is sought.

In New York, for example, a company seeking investment would fill out Form 99. Different states have different “Blue Sky” laws and regulations that dictate how to seek investment in that state. Even if all of the investors and the company itself were only in New York, an intrastate offering would still need to register with New York prior to seeking investment. New York State General Business Law § 359-ff begins by stating:

 “It is unlawful for any person, directly or indirectly, to offer or sell any security which is part of an issue offered and sold only to persons resident within this state unless an offering prospectus which makes full and fair disclosure of all material facts is first filed by the issuer of such security with the department of law.”

The “private” offering that qualifies for the “Regulation D” SEC exemption comes in a variety of choices, but the traditional route for investment in privately-held startups is a “Rule 506” offering. In the past, investment in private companies was limited to wealthy investors. Today, it is possible for less wealthy (“non-accredited”) investors to invest in a private company, but there are a number of limitations, thresholds, and requirements for each Reg D exemption. A Rule 504 exemption allows for a private company to raise in a one-year span no more than $1 million from any type of investor without real financial disclosures, but state regulations and Blue Sky laws may make a 504 exemption financially onerous. A Rule 505 exemption increases the raise to $5 million, but will not allow more than 35 non-accredited investors to invest, and require detailed financial and risk disclosures to those non-accredited investors. Again, Rule 505 may be subject to onerous Blue Sky laws.  In 2013, Rule 506 “split” into 506(b) and 506(c); Rule 506(b) allows for up to 35 non-accredited but self-identified as sophisticated investors, while 506(c) only allows for accredited investors (individual annual income of $200,000 or combined annual household income of $300,000 or net worth of $1 million). 506(c) allows for certain general solicitation and advertising. In the event there are non-accredited investors as part of a 506(b) offering, the offering paperwork must have full disclosures similar to those for a Securities Act registration statement, usually in the form of a detailed Private Placement Memorandum.


“If I only have them invest $1000 each, it’s no big deal.”

Founders of small businesses often think that the amount per person raised is the issue when collecting money from friends and family; they often think more along the lines of “If I only have them invest $1000 each, it’s no big deal.”  The truth is, collecting any amount of investment from outside investors without paying attention to state and federal laws can be disastrous. Donation-based crowdfunding can come with its liabilities, too, including tax implications and civil litigation for failing to deliver on backers’ rewards, but is often the most prudent option for those not willing to navigate statutory waters.

Attorneys often do not like to advise clients about major recent changes in SEC policies–the tried and true Rule 506(b) offering to accredited investors only is often regarded as the safer route. But startups, including the likes of larger independent media ventures such as independent film and video games, have got to be excited by the possibilities of Regulation Crowdfunding–instead of Kickstarter-style donation in exchange for “rewards,” investors’ money goes towards an equity investment–often referred to as “Title III” for a crowdfunded raise up to $1 million from accredited and non-accredited investors. Per Obama’s JOBS (Jumpstart Our Business Startups) Act of 2012, on October 30, 2015, the SEC adopted final rules for Regulation Crowdfunding, and they will be fully implemented in May 2016. Equity crowdfunding has been around for a long time, but for accredited investors only; soon, non-accredited investors will be able to participate, too.

Related Post:  A Compliance Checklist for American Apparel Startups

There is also the “mini-IPO,” Regulation A, Tier 2 (affectionately known as Reg A+ or “Title IV”) for an up to a $50 million capital raise–a reality created by the JOBS Act which went into effect on June 19, 2015. This is an opportunity for small businesses to raise money publicly with a less stringent SEC approval process and investment allowed to non-accredited investors limited to the greater of 10% of their annual income, or their net worth, excluding their principal residence. Unlike the original Regulation A, state Blue Sky laws are exempted by the SEC filing.

Recently, I met Ron Miller, the CEO of StartEngine, one Reg A+ platform that I found intriguing. He sent me an email that said, “If you or someone you know are currently in need of raising $2 to $50 million we would love to talk to you.  Please reach out to my Director of Business Development, Dana Weiss, at; she would be happy to hop on a call to answer any questions you have.” So, even though Reg A+ is not even six months old, it’s clear that entrepreneurs are already on board for an entirely new approach to raising capital investment.

Cover picture taken by Pavan Bahl of @OSFashion at the Bushwick Collective; Brooklyn, NYC.  Artwork by: @MRPRVRT


Pavan Bahl

Pavan founded Open Source Fashion (OSF) in 2011. He has since emerged as a connector between innovators working in fashion, retail, and related technologies. He's a strong advocate for startups and entrepreneurship, focusing his efforts on uncovering opportunities for the OSF membership base between New York City and Washington, DC.