Small Business and Capital Raising

One of the greatest challenges small businesses and entrepreneurs face is accessing capital. Access to capital is oftentimes limited to those who are well connected and have a proven track record of sustainable business growth. For some small businesses and startup companies, securing debt financing options (i.e., raising capital through borrowing money from a bank or lender) may not be a viable option for a myriad of reasons, including lack of business revenue or cash flow, credit history, and no collateral. Despite these challenges, small businesses and entrepreneurs can explore capital raising options through a different lens—that of raising capital through equity financing.

How can Equity Financing help me raise funds?

Raising capital through equity financing entails selling shares of your business to investors. There are two main methods for equity financing a company may consider: (1) initial public offering and (2) private placement offering. The initial public offering process or “going public” is costly and more frequently associated with seasoned companies. Companies that seek to sell shares to the public are at a later business development stage and can incur the cost of regulatory compliance and subsequent public reporting requirements. Although this advisory post mainly covers private placement offerings, companies exploring equity financing through an initial public offering (“IPO”) should carefully consider both the costs and benefits of an IPO. 

Private placements may be a cost-effective and viable option for some small businesses and entrepreneurs seeking to raise capital. Private placements involve an offering to a small pool of investors. In a private placement, a company seeking to raise cash may offer stock in the company or another interest, such as bonds or warrants. Private placement offerings are regulated by the Securities Exchange Commission (“SEC”) under Regulation D. Regulation D is a series of rules that govern certain exempt offerings including: 1) Rule 504, 2) Rule 506(b), and 3) Rule 506(c). An offering in compliance with Regulation D is exempt from the federal registration requirements under the Securities Act of 1933. Nevertheless, small companies and entrepreneurs should be wary of state securities laws, which may impose notice filing requirements or qualification requirements depending on the offering type. 

Federal and State Securities Compliance

Under the Corporate Securities Law of 1968, the offer or sale of securities[1] in California requires the person or company issuing (“issuer”) the securities to have an effective qualification or exemption from qualification. A small business or entrepreneur seeking to raise capital through the issuance of securities in California should explore exemption options or if exemptions are not available given the type of offering and investors, then the small business should qualify the offering. Keep in mind that the securities regulatory framework operates under a dual system in which an offering of securities must be registered or exempted under both the federal Securities Act of 1933 and state securities laws. In certain cases, securities transactions are entirely excluded from the qualification requirements of the California state securities laws if the offering is subject to federal preemption. In other words, for certain issuers or securities transactions federal law prohibits state regulatory action.

Exemptions

As previously stated, any issuer offering or selling securities must ensure that the securities transaction is compliant with both the federal securities laws and state securities laws. For a small business, undergoing a qualification process at the state level and registration at the federal level may be cost prohibitive, but not all hope is lost because there may be exemptions applicable to the securities transaction. Please read below for more information on commonly used federal and state exemptions.

Exemptions from Registration under the Securities Act of 1933

There are various exemptions from the registration requirements under the Securities Act of 1933.  A small business issuing securities should familiarize itself with those exemptions to determine whether it is eligible for any.  Exempted transactions from the federal registration requirements are set forth under Section 4 of the Securities Act of 1933.  Also, the following are some exemptions from the federal registration requirements:

Regulation D

There are various exemptions from the registration requirements under the Securities Act of 1933. A small business issuing securities should familiarize itself with those exemptions to determine whether it is eligible for any. Exempted transactions from the federal registration requirements are set forth under Section 4 of the Securities Act of 1933. Also, the following are some exemptions from the federal registration requirements:

Unregistered securities offerings under Regulation D include Rule 504 and Rule 506 although most private placement offerings are conducted pursuant to Rule 506. 

Rule 504 Limited Offerings

Rule 504 is also an exemption from the registration requirements of the Securities Act of 1933. This rule allows certain companies (excluding investment companies and blind pool companies with no specific plan of business or purpose) to offer and sell up to $10 million of their securities in a 12-month period. In contrast with Rule 506(b) and Rule 506(c), Rule 504 is only an exemption from federal securities laws and an issuer relying on Rule 504 must comply with state securities laws. Therefore, an issuer must ensure that their offering is either qualified in California or exempted under the state securities laws. 

Rule 506(b) Private Placements

Private placements play a significant role in raising capital for small businesses. A company conducting an offering under Rule 506(b) can sell securities to an unlimited number of accredited investors and can raise an unlimited amount of money provided that the company does not conduct general solicitation or advertising to market the securities and the securities may not be sold to more than 35 non-accredited investors. An accredited investor is defined under Rule 501 of Regulation D, and the rule sets forth objective standards to determine whether an investor fits the definition. For example, an accredited investor may be an individual with a net worth or joint net worth with a spouse or spousal equivalent of at least $1 million, not including the value of his or her primary residence. 

An important point to note is that securities offered under Rule 506(b) of Regulation D are “covered securities” and thus not subject to the state qualification requirements. Therefore, if you are issuing securities pursuant to Rule 506(b) of Regulation D, and have duly filed a Form D with the SEC you are not subject to the state securities qualification requirements provided that you comply with all of the requirements of the rule. Although you may not be subject to state qualification requirements, states may impose notice filing requirements and the issuer will be subject to the state’s antifraud provisions. In California, issuers relying on Rule 506(b) of Regulation D must file a Form D and pay a filing fee. (See Commissioner’s Release 120-C).  

Rule 506(c) General Solicitation Offerings

Unlike the Rule 506(b) exemption, the Rule 506(c) exemption permits the issuer to engage in general solicitation of its offering. If an issuer generally solicits its offering, only accredited investors are allowed to purchase, and the issuer must take reasonable steps to ensure that the investors are accredited investors. An unlimited number of accredited investors may invest in the offering. Securities offered under Rule 506(c) are also not subject to the state qualification requirements, but an issuer must file a Form D and pay a filing fee as noted in Commissioner’s Release 120-C.

Regulation Crowdfunding (CF)

The primary purpose behind Regulation Crowdfunding (“Regulation CF”) was to help small businesses and startups raise capital through crowdfunding on the internet.  Regulation CF allows certain companies to raise up to $5 million in a 12-month period.  Each offering must be conducted through a single intermediary that is an SEC registered broker-dealer or a registered funding portal.   Additionally, the amount an individual non-accredited investors can invest across all crowdfunding offerings in a 12-month period is limited by the rules though an accredited investor is not subject to the limitations.  Although securities offered pursuant to Regulation CF are not subject to federal securities registration requirements nor state securities laws (i.e., blue sky laws), companies using Regulation CF are subject to the anti-fraud provisions and ongoing reporting obligations.  (See the SEC’s Investor Bulletin: Regulation Crowdfunding for Investors).

Regulation A

Regulation A is another exemption from the federal securities registration requirements.  The primary intent behind Regulation A is to provide capital raising alternatives for businesses.  An issuer offering securities under Regulation A must nevertheless comply with certain SEC filing requirements, such as filing the issuer’s offering circular.  Depending on the offering amount, an offering made pursuant to Regulation A is treated differently at the state level and a company offering securities under Regulation A must understand the implications of each tier. 

Regulation A established the following two tiers:

Tier 1

A company offering securities under Tier 1 can raise up to $20 million in a 12-month period.  Also, the company must submit its offering circular to the SEC for review and qualification. The issuer is permitted to engage in test-the-waters communication before and after the offering circular has been filed.  Offerings pursuant to Tier 1 are subject to state securities laws and qualification requirements.  To facilitate filings for multiple states, an issuer may use NASAA’s multi-state coordinated review program for Regulation A offerings.  

Tier 2

Under Tier 2, a company offering securities can raise up to $75 million in a 12-month period.  Like Tier 1, the company must submit its offering circular to the SEC for review and qualification.  The issuer is permitted to engage in test-the-waters communication before and after the offering circular has been filed.  There are investor limitations for non-accredited investors.  Offerings pursuant to Tier 2 are not subject to state securities laws and qualification requirements, but states may require issuers to submit notice filings and pay a filing fee.  In California, issuers relying on Tier 2 must submit their notice filing and pay the required filing fee.  (See Commissioner’s Release 122-C for more information on notice filing requirements for Regulation A Tier 2). 

Exemptions from Qualification under the Corporate Securities Law of 1968

The dual system for compliance requires an issuer to comply with both the federal securities laws and the state securities laws. California securities laws include various exemptions from qualification. Here are some popular exemptions for small companies raising capital: 

Limited Offering Exemption

The limited offering exemption is an exemption from the state qualification requirements available to an issuer who has complied with the requirements set forth in section 25102(f) of the California Corporations Code. Under the exemption, (1) the number of purchasers is limited to 35 persons, (2) all purchasers must have a preexisting person or business relationship with the offeror or its principals or investment sophistication adequate to the transactions, (3) all purchasers must purchase for investment and not for resale, and (4) no advertising may be published. The issuer must file a Limited Offering Exemption Notice and pay a filing fee via the Department’s self-service portal, DocQnet.

California Crowdfunding Exemption

An entrepreneur or small business can raise up to $300,000 in a 12-month period by offering to sell securities to investors. The offering must be conducted in accordance with the federal intrastate offering exemption, and it eliminates the federal requirement to obtain a financial statement review by an independent certified public accountant. An issuer relying on the California crowdfunding exemption must file a notice and pay the required fee at least 15 days before the initial offer.

Qualifications

If you are an issuer whose securities or transaction are ineligible for an exemption, you must qualify your offering before you offer or sell any security in California.  Securities offered or sold in California are subject to the merit standard requiring the offering to be fair, just, and equitable.  The qualification of the offering can be effected through qualification by coordination, qualification by notification or qualification by permit.  Any offering registered under the Federal Securities Act of 1933 may be qualified by coordination.  Any nonregistered offering by a company which has any security registered under Section 12 of the Securities Exchange Act of 1934 or which is an investment company registered under the Investment Company Act of 1940 may be qualified by notification.  For all other offerings, the issuer must qualify the offering by permit. 

The Small Corporate Offering Registration (“SCOR”) also provides certain small companies with a process for qualifying their securities offerings of up to $1,000,000 in a 12-month period. (See the NASAA SCOR Form).

DFPI is Available to Take Your Questions

Did you know that the Department of Financial Protection and Innovation provides a free service for anyone inquiring about compliance with the California Corporate Securities Laws of 1968?  If you have general questions or need guidance on compliance issues, you may contact a Customer Service Representative at the Department’s toll-free number 1-866-275-2677 and ask for the Securities Regulation staff member on phone duty or you may email the Department Counsel at ASK.DFPI@dfpi.ca.gov.  Please note that the Department staff are not authorized to provide you with legal advice, and you will need to seek independent legal counsel for legal advice.

FAQs for Securities

For general information about compliance questions under the Corporate Securities Law of 1968, please review the Department’s frequently asked questions for Securities (Securities FAQs).


[1]Section 25019 of the Cal. Corp. Code defines security as follows: “Security” means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest), except a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees’ pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. “Security” does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section 31100 or 31101.

Help us improve the DFPI website! Share your feedback.

 

Last updated: Jun 13, 2023 @ 4:28 pm