Fundraising is a very important step in the life cycle of a startup. While Initial Public Offering (IPO) is the ultimate exit and fundraising strategy for many companies, it is a cumbersome and excessively expensive process for small but thriving companies. Thus, recently startups can grow as much as $100 billion in market cap simply by raising the funds they need from wealthy individual investors and institutional Venture Capital firms. However, unlike the common sense, those specific transactions are not exempt from the ambit of Securities Law and Regulation. Raising funds is necessarily exchanging capital for securities and specifically for ownership interest in the company. Simply by creating and delivering stocks or other securities representing current ownership or a future promise of ownership, companies assume the status of “issuer” which makes them subject to Securities Regulation and Capital Markets Law. However, Many jurisdictions have special rules for different types of fundraising activities that don’t reach up to the level of public offering.
The matter is of utmost importance for Turkish startup companies given that most of the US investors except those companies to be registered as Delaware Companies before investing in them, navigating through the US system without violating Security Regulations also bears utmost importance. Fortunately, there are ways both in US and Turkish systems that startups and alike companies can use to raise funds without doing public offering or registering securities with the relevant regulatory institutions: Securities Exchange Commission (“SEC”) and Capital Markets Board of Turkey. (the “Board”).
1. Fundraising for Startups under US Law
There are 5 principal ways in US Law, under which companies can raise funding by issuing securities without having to register those securities with the SEC. The economic consideration behind allowing such transactions is that in such types of small offerings investor protection is less critical because not many individual people have access to those offerings but still more funds were raised through exempt offerings than public offerings, making them an important driver of economic growth.
A) Private Offerings
Section 4(a)(2) of the Securities Act of 1933 writes as follows, “The provisions of Section 5 shall not apply to …. transactions by an issuer not involving any public offering.”
The provision requires us to determine what offerings are not public offerings that escape from the ambit of Section 5 of the Securities Act. SEC Release No. 285 provides us with guidance on this. According to the release indicative factors of non-public offerings are as follows:
- Pre-existing relationship between the issuer and the offerees
- Low number of offerees and units offered
- Small amount raised
- No public advertisement.
Above principles were materialized in a famous case: Securities and Exchange Commission v. Ralston Purina Co., 346 U.S. 119 (1953), where the Court held that an offer is private if the offerees:
- Are sophisticated, which means they can fend for themselves, and
- Have access to information, and the information should be more or less similar to what the company would provide to SEC in the form of registration statement if was doing an IPO.
In the case the Court didn’t provide a bright line rule as to how many investors is the upper limit to not implicate a public offering.
Legislators are less worried about these transactions simply because they are of limited magnitude in terms of ability to inflict harm to the capital markets. It flows naturally from the pre-existing relationship requirement and no-public advertisement condition that general solicitation is also not allowed in these offerings. Companies may approach investors to secure a connection, but they can’t reach investors for the first time with a purpose to induce them into investing in the offering.
Another reason limiting these offerings’ ability to plague the market is that investors in the private offering are limited in their ability to resell securities that they bought in the private placement. This restriction is also providing an additional layer of security for unsophisticated investors, because they can’t simply obtain these securities.
B) Regulation D
There are two types of Regulation D offerings: Rule 504 offerings and Rule 506 offerings.
Rule 504 Offerings:
These offerings are limited to $10 million, though there are no limits on the number of investors that can participate in the offering. This type of offering is not available to reporting companies, which are companies having registered securities with the SEC beforehand. General solicitation is not allowed unless the issuer complies with the state registration requirements. If the state law requires registration for these securities, the offering should be registered in at least one state. If the offering is exempt from state registration requirements, only accredited investors can participate in the offering. As you can see, this offering may seem as providing a significant length of freedom initially, but this is not the case at all. Given that a company considering using one of the exempt offerings wouldn’t want to take on the burden of filing registration in the first place, it would be able to offer securities only to accredited investors. Flows naturally from here, resales of those securities are restricted to the extent they were offered to accredited investors.
Rule 506 Offerings:
Unlike 504 offerings, there is no limit on the amount raised under this offering. However, again unlike 504 offering, there are limits on how many investors can participate. There two routes under this offering:
- Limit of 35 purchasers in any 90-day period if there are
unaccredited investors – and accredited investors (and parties
related to purchasers) don’t count toward the limit.
- Non-accredited buyers must meet sophistication standards (or at
least the issuer must reasonably believe that they do).
Route #2: Accredited investors only
As you can see, under Rule 506 the tradeoff is there is no limit on the amount raised but number of investors is restricted, and general solicitation is not allowed under Route 1. Again, the restriction on the number of participating investors significantly limits the potential magnitude of misuse, thus this offering is allowed both for registered and non-registered companies. Given that the preliminary assumption is securities will be held mostly by accredited or at least sophisticated investors under both prongs, it is also logical for legislators to restrict resales, as it did. After above explanations, general structure of the Rule 506 offerings looks like as follows:
- General solicitation is not permitted
- There can be non-accredited investors, on the condition that they are sophisticated.
- Cannot have more than 35 purchasers in any 90-day period.
- General solicitation is permitted
- All buyers are accredited
- The issuer should verify accreditation of the investors.
Who are the accredited investors?
Those are mostly institutional investors and high net-worth individuals.
*Any other business association, if: (1) it’s fully owned by accredited investors; or (2) has assets over a certain threshold and was not formed for the purpose of investing in the offering.
- Insiders: directors and officers with policy-making authority
- Minimum net worth or income conditions (minimum net worth of $1,000,000 or income of $200,000)
- Professional certification accepted by the SEC (e.g., certain FINRA licenses).
Who are the sophisticated investors?
If a purchaser is not an accredited investor, he is counted as a “sophisticated investor” if, either alone or with his representative, has knowledge and experience in financial and business matters and he is capable of evaluating risks and merits of the potential investment or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within the description.
In crowdfunding offerings, the issuer must be a non-reporting company since this vehicle was primarily intended to meet startups with retail investors. Issuers cannot raise more than $5 Million during any 12-month period and the offering should have a predetermined deadline attached. There is no limit for the number of accredited investors but the amount anyone investor can contribute is restricted.
Crowdfunding should be conducted through intermediary institutions approved by the SEC to ensure that investors understand risks and the issuer complies with the terms of the offering. Securities obtained from these offerings cannot be resold quickly.
D) Local Offerings
Local offerings are regulated in the section 3(a)(11) of the Securities Act. It exempts from registration securities that are offered and sold only to residents within a single state, if the issuer is a resident doing business in such state. Rule 147A sets out the condition of local offerings.
According to the Rule 147A, all the time of any offers and sales, the issuer must be a resident and must be doing business within the state.
- Where the issuer has its “principal place of business” – i.e., where its activities are directed. Unlike § 3(a)(11) (and Rule 147), Rule 147A does not require incorporation in the state or territory.
“Doing business” in the state. The condition is met if one of the following is met:
- A significant part of the revenues comes from operations in the state;
- A significant part of the assets are in the state;
- The issuer intends to use and uses a significant fraction of the proceeds from the offering for business purposes in the state; or most of the issuer’s employees are based in the state.
On top of above requirements, sales can only be made to the residents of the state of the issuer. (Rule 147(d)). General solicitation is allowed but eventually all of the sales should be made to the residents of the state of the issuer and until after 6 months of the offering, resales can only be made from a resident to a resident.
E) Regulation A
Regulation A (Rules 251-263) is essentially a simplified public offering but exempt under section 3(b).
The offering can be considered as public in the sense that there is no limit on the type or number of offerees involved and the offer can be promoted by general solicitation and shares issued for the offering are not subject to resale restrictions. The main difference between registered offerings is that disclosure requirements are lighter in this one. There are two types of Reg A offerings: Tier 1 and Tier 2.
- Low offering limit ($20 million in 12 months)
- No purchase limit for investor
- Must comply with state law registration
- High offering limit ($75 million in 12 months)
- Purchase limits for unaccredited investors based on income
- Doesn’t require state registration
** General solicitation is allowed in both ways and there is no resale restriction.
Companies in Regulation A offering should file an offering statement called (Form 1-A) that is like the registration statement but is less demanding; and they have to provide an offering circular that is similar to prospectus in public offerings. Further, those companies are also subject to periodic disclosure requirements. They have to file annual reports and semiannual reports, but these don’t need to be audited.
2. Fundraising for Startups under Turkish Law
In Turkey, offering securities is regulated under the Capital Markets Act Numbered 6362 (“Act”). For startups and similarly situated small companies, conducting public offering in Turkey is nearly as cumbersome and expensive as it is in the US. In any event, it’s a tool that startups don’t need to use because their capital requirement is generally sufficiently small to be covered by wealthy individual and institutional investors.
Under Turkish Law, companies conducting private offerings don’t need to file a registration statement with the Capital Markets Board, but they have to submit an offering statement, that is similar to Reg A statement in US Law, for the approval of the Board. Pursuant to the Article 11/2 of the Act, the Board may require a statement to be announced publicly, however, in the regular course of the transactions, it doesn’t need to be publicly announced. Communique II-5.1 Article 7 requires investors to sign a statement that includes representations and warranties as to how they understand the risks in investing such securities.
There are two types of private offerings under Turkish Law: Private Placements and Offerings to Sophisticated Investors.
A) Private Placements
Securities issued to be sold in a private placement should be issued in that nature in the first place. Issuing such securities in this nature brings substantial restrictions with it. Such offerings are also regulated in the Communique II-5.1.
Article 8 of the Communique requires that the number of investors holding such securities at any time cannot breach 150, including real and legal persons. All such securities are attached with ISIN codes thereby securities are tracked. Only the number of people holding securities at the end of the day is considered which means that number of people holding securities may breach 150 during day trade.
B) Offerings to Sophisticated Investors
Article 4 of the Communique stimulates that institutions that are included in the Board’s definition of Capital Market Actors and those who demanded to be considered as such are sophisticated investors.
In the case of individuals, when an individual demands to be considered as a sophisticated investor, he should be registered as one in central records by the capital market actor helping him. Article 9 of the Communique stimulates that this record is sufficient for an investor to be considered as a sophisticated investor. When a person loses minimum qualities to be counted as a sophisticated investor, he should also inform the capital market actor helping him and he should be subsequently delisted from the central records.
Unlike regular private offerings, the Communique doesn’t bring any limit on the number of sophisticated investors that can participate in the offering. Only condition is that all participants should be sophisticated investors in this case. Article 7 of the Communique also allows resales among sophisticated investors. In this case, another exclusive over-the-counter market is created for exchange of such securities among sophisticated investors.
As you can see, Turkish Law is relatively easier to navigate compared to US Law due to less stringent standards. This is perhaps because the Capital Markets activity in Turkey isn’t as strong as that of the US. However, recent development in startup fundraising may largely obviate the need of navigating these convoluted structures for fledgling companies.
3. SAFE (Simple Agreement for Future Equity)
SAFE is a novelty in startup fundraising and perhaps it is primarily responsible for the increasing ease of startup financing lately. They are essentially contracts through which new company owners may escape from being subject to Securities Law until a triggering event happens. SAFE is not a contract where the company issues securities to investors in exchange of money, but they simply are contracts that promise future issuance of securities and a corresponding percentage of ownership in the company. Since those are simply contracts including promises, they aren't subject to Securities Law, taking off huge burdens from new companies that don’t have financial resources to deal with exacting standards of the regulatory bodies. SAFE works through two simple but important mechanisms: Valuation caps and pre/post money valuation.
- Valuation Cap
Valuation cap is simply what makes the transaction more predictable on the part of the investor. Since the company doesn’t issue securities in this round, it doesn’t attach any value on the stocks. However, this is highly undesirable for investors because they don’t know approximately what portion of the company they are going to own after the triggering event which is a priced round where you are essentially putting value on the shares. This is why there is a valuation cap.
Valuation cap is simply the maximum valuation on which initial investor’s percent of ownership will be determined. If investor A invests $1M into the company on a $5M valuation cap this means that he will have 20% of the company no matter how the company is valued in later priced rounds. Assume that investor B invests $1M in the company in a priced round on negotiated value of $10 million where each share is valued at $1. In this case, investor B will own 1 million shares and 10% of the company. What about investor A? Since he has a valuation cap at $5 million, he will receive shares as if the company was valued at $5 million. He would own 20% of the company if the valuation was $5 million, so he will end up owning 20% of the company which corresponds to 2 million shares. He essentially got shares at $0.50 which is a 50% discount on the face value of shares. This the risk premium he gets for jumping in before priced-round investors.
- Pre/post Money Valuations
When a company raises funds, it essentially increases its value. Assume that company is worth $4 million, if it raises additional $1 million, it is now worth $5 million. This makes a substantial difference in ownership.
- Current Value: $4M
- Investment: $1M
- Investor ownership: %25
- Current Value: $4M
- Investment: $1M
- Value after investment: $5M
- Investor ownership: %20
Investors generally prefer the post-money valuation standard because it offers better predictability of their ownership interest in the company. It's also more advantageous for founders because they get to know how much of their equity is going to be diluted.
Despite all the advantages offered by SAFE, founders should be cautious using it because usually there is more than one Seed investor and essentially, in the end of the round, their contracts are matched through so called most favored nation clause which allows all investors in the round to have the most advantageous terms offered to an investor in the round. In this case, use of a post-money valuation cap may significantly dilute founder’s equity since post-money valuation locks ownership interest of investors.
Because of the reasons above, seeking attorney advice is recommended even in SAFE transactions despite their initial ease of use. Otherwise, both founders and investors may find themselves in an undesirable clash with each other.