By Joseph J. Portale, Esq. California Licensed Attorney
Venture Capital Introduction
This informational article is intended for the venture capital regulation novice, building a foundational knowledge base. We all crave involvement in the venture capital world for its flashy reputation, life-changing profits, andprofessional stigma; we all could use a crash course on venture capital regulations as it pertains to our actions when raising any money promising profit. The reality is: if you are promising the return of profits in exchange for receiving money to grow a business, chances are good that you are attempting to sell “securities” as regulated and defined by the Securities and Exchange Commission (“SEC”). Venture capital as an industry, with regulations including Regulation D (“Reg. D”), allows exemptions to the SEC general rule requiring any sale of securities to be registered, allowing investors to make independent, quick, and efficient choices to invest their superfluous funds, growing new business ventures with added working capital for an eventual profit return, with some important regulations to keep in mind through the lifecycle.
Organic Venture Networks
The ellusive secret in venture networks is the uncanny organic nature of their existence. No singular person starts working in venture capital, and nobody can create a venture network out of thin air; venture network ecosystems exist irrespective of their singular participants. venture capital investments happen through the documents required in any sale of aprivately-offered-security and the people embodying the business’s team as a structural ecosystem connecting the invested money to the business’s goals through the people who run the business. When these investments take place, there are regulatory requirements that must be satisfied by those people, as detailed herein.
Areas Of Regulation
In general, venture capital is regulated by securities laws, because it typically involves the sale of securities. Securities laws govern the issuance, sale, or transfer of securities in order to protect investors from potentially harmful or fraudulent action. Compliance with securities laws is crucial and venture capitalists must obey laws guiding registration and disclosure of investment activities. Laws govern the creation and structuring of VC funds, including such considerations as the legal structure of the fund (LP, LLP, LLC, etc.) and the terms stated in the fund’s offering documents. The fund’s organizational documents, such as the LLC agreement, determine the rights and responsibilities of the general partner, limited partner, and other stakeholders. In the investment process, legal regulations often outline the due diligence process venture capitalists need to undertake before making an investment, including investigating the legal, financial and operational elements of potential companies to bring into the investment portfolio. The negotiation and documentation of investment agreements, including term sheets and definitive contracts are all subject to legalscrutiny in analyzing and regulating a given investment. Conflict of interest laws address any venture capital transactions involving loyalty, interest, and favoritism to parties with their interests conflicted between multiple parties, potentially including the venture capital firm and its
partners, conflicts among portfolio companies at a venture capital firm, or conflicts of interest between the fund and its investors – when a participant in the venture capital environment favors another party for some reason involving loyalty or preference, a conflict-of-interest issue arises. Depending on jurisdiction, venture capital firms may need to make certain regulatory filings, including registrations with securities regulators or notifications to relevant authorities. Laws often state corporate governance practices with portfolio companies, especially when VC firm holds a large stake of ownership in the business. Laws may influence the choice and execution of exit strategies, including initial public offerings (IPO’s), mergers and acquisitions (M&A), or other means of divesting from portfolio companies. Tax laws impact venture capital transactions significantly. Tax treatment of capital gains, carried interest, and other considerations can impact a venture capital fund’s overall state.
Compliance with data protection and privacy laws is crucial; venture capital firms must ensure that their portfolio companies handle personal data pursuant to applicable laws. Venture capital’s must stay informed and updated about any changes in the laws and regulations impacting their activities.
Reg. D primarily governs private placements, which are non-public offerings of securities to a limited number of accredited investors and a small number of non-accredited investors.
Private placements are exempt from the more arduous registration and reporting requirements that apply to publicofferings. Many Reg. D exemptions to the SEC requirement to register sales of securities only apply to accredited investors. Accredited investors are individuals or entities meeting specific financial criteria, demonstrating a certain level of financial sophistication, including high-net-worth individuals, institutions, and certain entities. Reg. D consistsof several rules: Rule 504, Rule 505, and Rule 506. Rule 504 provides exemption for offerings up to
$5million to an unlimited number of accredited investors and up to 35 non-accredited investors. Rule 506(b-c) is widely used for larger offerings. Rule 506(b) allows for offerings of an unlimited amount but limits the number of non-accredited investors to 35, while Rule 506(c) allows for general solicitation and advertising but requires that all investors be accredited. Reg. D is the primary focus of venture capital regulation and related informational sources because Reg. Dallows a sophisticated investor to make an investment in a business without the formality, inefficiency, and expense of retail investment in the public stock sphere. Compared to venture capitalists, retail investors buy pricier public shares of publicly-traded-stock, subject to extensive additional regulations (as are the businesses from which they buy the stock) and those investors typically retain much less control of the entity in which they invest. Reg. D allows new money to get invested into an early-stage business, to grow it efficiently. When sophisticated investors invest their money into a new business in order to grow the business, they complete a document called “Form D” in order to satisfy Reg. D. Reg. D defines a sophisticated investor to have $1,000,000 US Dollars of net worth besides the residential domicile in which they live. To claim Reg. D exemption, issuers are required to file a Form D with the SEC. Form D includes basic information about the offering, the issuer, and the type of exemption being claimed, typically done within 15 days of the first sale of securities. Although Reg. D exempts offerings from federal regulation, issuers still must obey state securities laws, or “Blue Sky Laws”. The local state requirements vary, and issuers may need to file notice filings or meet specific conditions to qualify for state exemptions. Securities sold under Reg. D are often subject to restrictions on resale to prevent the unregistered distribution of securities, called a “restricted securities” designation. Every issuer, VC firm, and other person involved should consult an attorney and do extensive research throughout this complicated and nuanced process, pursuant to local laws and guiding authorities in every applicable jurisdiction.
Legally Required Disclosures
Disclosures of risk are possibly the most important requirements for entrepreneurs and start-up team-members to remember when selling shares of their business, because they could eventually be held personally, financially liable, for any lies they tell inducing any investment. Lying is especially off-limits. If you are proven to lie inducinginvestment, it is at least fraudulent misrepresentation, and it is also probably securities fraud. Securities fraud occurs when people say untrue things in order to cause an investment in a business, and it is tightly regulated.
Material Information & The Total Mix Of Value
When is information “material”? When it matters. Material information is information that matters to areasonable investor considering the “total mix” of value when investing. In other words, if the claim, detail, or fact is “material” – then it’s important. Moreover, it is info that is important to an investor who knows what they are doing when analyzing a business. For example, it might very well be securities fraud for a business to misrepresent the structure of their board of directors, ownership interests, shareholder identities, or other important info, if it affects the total mix of an investment decision, if it causes a sale of shares in a business.
Broker-dealer licenses are often required in many circumstances selling business assets. Promoters of contracts are allowed to be compensated by a deal when they endorse contracts for a “finder’s fee” percentage of their business introduction’s value, without necessarily triggering the regulations requiring a broker-dealer license, due to efficiencyreasons on the smaller scale of early-stage ventures. In the practical reality of early-stage investment, many cannot afford the time, money, and energy required to pay brokers for their smaller scale venture capital opportunities; for those reasons and more, contract promoters, business introduction agreements, and registration exemptions are permitted following adequate disclosures of any transfer of interest or partial financial compensation to all parties involved, so long as any such agreements or resulting transactions do not violate any other relevant law.
A term sheet, sometimes called a ‘deal sheet’, is a list of basic terms inviting negotiation in a deal, laying theframework and structure of negotiation expectations for all parties involved. It is governed by all relevant laws;however, it is not a real contractual agreement. It should be a brief layout of the business entity, the amount or range of funds sought, intentions of the parties for the new capital invested into the venture, and any other effect or impact theVC contribution would have on the entity in any resulting investment following negotiations. The term sheet is specifically not a contract; it is a written, intentional invitation to reach an agreement following negotiations, laying out the circumstances and expectations for the negotiations and eventual agreement. With that said, any false claims about the business made throughout the process of
soliciting payment based on a promise of a profit, even in the term sheet, is at least fraudulent misrepresentation and it is also probably securities fraud. Throughout the entire lifecycle of an investment, from inception to dissolution or exit,all securities laws must be obeyed and satisfied while regulating the investment process and implementing any appropriate exemptions.
Private Placement Memorandum
A Private Placement Memorandum (“PPM”) is a type of document made by a business inviting an investment.In other words, the PPM document features all components of a business entity that might receive new capital, partners, or other assets or contributions to grow the business in exchange for partial ownership or an expectation of profit returns. The PPM goes deeply into the nitty gritty details of the given business depicted, including a brief summary of the business, its financial records/analysis, its intentions for its next steps of growth, future sales projections, and any other material information relevant to the total mix of value to any given potential investor. The PPM delivers thematerial information in a clear, organized way, for new people to understand the given venture prior to contributing their capital, so they can equip themselves with information, protecting them from potentially fraudulent businesses who lie in order to gain more capital. Venture capital regulations are intended to protect new investors from potentially false business-related claims causing financial losses to unaware victims of securities fraud. Any false claims about the business made throughout the process of soliciting payment based on a promise of a profit return, including in the PPM,is at least fraudulent misrepresentation and it is also most likely securities fraud. All securities laws must always be obeyed and satisfied while regulating the investment process and implementing any appropriate exemptions.
Of course, much more information and research would be required to obtain a full grasp on the entire venture capital regulatory framework; indeed, securities lawyers study the topic of venture capital for years and still fail to grapple with the fundamentals in their practical decision-making. Regulation D, Form D, material information, the total mix of value, adequate disclosures, and licensure to any given transaction guide the basic foundational framework of venture capital regulation as applied to any resulting term sheet, PPM, or other investment document or action inducing payment from an investorin exchange for a profit return from the given business. These general principles and guidelines govern and guide theventure capital ecosystem as our organic venture networks naturally develop and enrich one another, scaling in harmony.