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Raising Capital 101 Episode 3: What Makes it a Securities Offering?

by | Oct 14, 2022

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Does it matter who invests in my company? Does it matter where the funds come from geographically?  Does an investor’s intent change it? We’re going through real-life examples of what may or not be securities offerings.

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Episode Transcript:

Tom Voekler:

Hello and welcome to Raising Capital 101. We’ve learned the in and outs of raising capital, what to do and what not to do. This is KVCF, I am Tom Voekler, along with my colleagues, Rhys James, Mike Beville and John Watson. Today we’re going to cover what is a securities offering, which is an interesting concept because most people don’t realize that 99% of what they do when they take in money is securities offering. There may be ways to get around it, but that is the reality of the world. So we’re going to go through a couple real life examples and talk through why we think it could be, or maybe is not, a securities offering and then we’ll talk about some more detailed legalese around the definitions of securities offerings and the like.

All right, so guys, we got a couple friends, put money together to start a landscape business. They all got a couple dollars, they throw in some machines, they may buy some machines, who knows? But they are all operating it together. They’re all going to be equal partners. What do we think?

Mike Beville:

Yeah, I’ll jump in. I think this is going to be entertaining Tom, because you’re going to have four attorneys giving opinions on scenarios and it might be a good lesson learned in and of itself that people can differ in opinion. I do think this is a pretty easy one, so I definitely will take this one. I think this is a classic example of people entering into a business enterprise where there is no actual offering of securities. The purpose of this is for people to come together, join forces. Again, I use the word business enterprise, where the purpose is not to use the money to create something new, the purpose is to come together as a business, as an agreement, to then create capital or create the business that they’re hoping to do.

Tom Voekler:

So it’s the classic partnership idea, like you getting together as partners. Rhys, what do you think?

Rhys James:

Yeah, I think that Mike is on point here. You do not have a security here because all of the participants are active in managing the business and were engaged in its formation.

Tom Voekler:

So John, does it matter that three friends have been talking about this for a couple years and then the fourth friend came along and his dad had all the machines in the backyard and he gave it all? Last minute, he was like, “I’m going to part of this.”

John Watson:

His involvement in the business could certainly matter. If he’s an active participant in the business, that makes it less likely to be a securities offering. If he were to use the assets or offer the assets without participating in the business and they were to make some sort of offer to him to provide a return for his investment on the asset, I do think you’re getting much more close to a securities offering.

Tom Voekler:

That’s a perfect tie in to my next example. So the landscaping business takes off, guys all buy new, shiny, new trucks. Everybody starts noticing this, and so another friend comes along and says, “Well, I want a new truck. How do I get involved? I’ve got some money to put in here.” So the logical question I think you guys are going to ask me is, does he participate in the business or not and why does that matter?

Mike Beville:

Yeah, and I think it goes into how does that communication progress with that person? Is it, “Hey, you can provide X, Y, Z to the company, and we think that the value you bring is worth equity, using that term lightly, in the company,” that then you start getting into the analysis of, okay, well is this just another partner joining the partnership? I think if the communication is more towards, “Thank you for your money, we think we can produce this return, which is going to help you buy your new truck, here’s our prior performance, this is what we think we could get you,” things like that. Where, this is turning into more of the classic securities tests of benefiting from the efforts of others, then I think you’re starting to get more into the securities offering territory.

Tom Voekler:

So John, he’s just coming in and he’s saying, “I’m going to work alongside you guys. Instead of being five partners, it’s now six partners. Put in the same amount you guys did,” whether that’s, money or equipment or whatever.

John Watson:

To the extent that he’s participating in the partnership and is not a passive investor, I think that helps to avoid the issues of having a securities offering. The less he is involved in the business, the more he puts up assets or capital for a return. Again, you’re going back into the area of a securities offering.

Tom Voekler:

So they’re doing great. They’re getting asked by a lot of people, “Hey, you’re taking care of our lawns, you’re doing all that stuff. What about some landscape design? Like backyard build out?” Now people want the built in barbecues and all that stuff and they’re like, “Yeah, we can do that. We’ve got the expertise, we got some of the guys that can do that, but we need new equipment. We need some inventory.” So they go to their parents, all five partners now go to their parents and say, “Hey, we need some money to do this. We’re tapped out. We bought our trucks.” “Probably should have put it in the business,” but that’s probably what the parents will say. What do you think, Rhys, if they go to the parents and say, “We need money.” We know the parents are not going to be actively involved from a day to day basis. What are some of the things you got to look for when you think this is going to be more likely a security offering than not?

Rhys James:

Well, I think, first off, you’re looking at what is the form of investment that the parents are making. If it is going to be equity, then there’s a strong likelihood that they’re making a securities offering to these parents because they’re going to be buying into the business, where they’ll be passive investors and will be relying on the efforts of the five partners to produce a return for them. That’s both going to fall into the statutory definitions of a security and an offering, since that equity interest will be offered for money. And as well as into the analysis that Mike alluded to relative to an investment contract where you’re putting in money in receipt of a security that relies on the efforts of others to generate the return. If the investment that the parents make is indebtedness, then the analysis is a little broader, as while notes are typically considered securities under the definitions, there’s some greater leeway on indebtedness as to whether you’re actually engaged in the securities offering or not.

Tom Voekler:

So Mike, what about if the parent, or maybe one or two of the parents, maybe not all of them, say, “Here’s some capital, I’m not really looking for anything in return?”

Mike Beville:

I don’t know that that intent in and of itself is completely dispositive of whether or not this is a securities offering. It still goes back to the fundamentals that we’ve been covering, I won’t rehash. I do think you’d still land in the securities offering territory that we’ve covered and Tom, I think this is where you’re going with all this analysis is, even if you’re in the securities offering territory, how scary of a land is that? How much do you worry about it? Just because it’s your parents, does that change the analysis? If it’s someone on your kickball team, does that change it? If it’s a guy on the corner of the street, does that change it? Of course the answer is yes. So just because your parents are being nice does not necessarily change the initial analysis, I don’t think.

Rhys James:

Let me jump in real quick there because one thing I do want to say is that if it is in fact a true gift, then that is not a securities offering. You’re not delivering a security to your parents there for value. They’re simply giving you or the business the money. You might have some tax issues you got to deal with, but that’s taking it out of the realm of securities at that point.

Tom Voekler:

Yeah, I think intent is really important. Even if at a later date they pay that back, again as a gift back, I think the intent and how it was raised and how it was communicated is very important on both sides. I think the involvement of the parents in the negotiation of what they get for this, control rights, I think, if they now gain some duties, partnership duties, where they are now involved in the business, I think you’d have to consider that. One of the dads is a CBA, one’s a lawyer, they start doing work. Is that a different analysis than just, “We gave cash? And I think it is.

I think what we’re getting here is that there are so many different fact patterns and so many different facets that it may be very hard to have a bright line of, this is a security and this is not. So you have to almost approach each of these scenarios as it could be, and let’s see what the consequences are like Mike said. If it’s your parents, what is the likelihood of them suing you? In this litigious day and age, I don’t know that that’s as clear as it used to be, but the high likelihood is friends, family are not likely to trigger regulatory oversight or litigation.

All right, so landscape design’s going well. Backyard build outs, obvious progression. We got to build pools. That takes some money right? Now you got specialized people, specialized equipment. One of the dads, actively involved with the boys says, “No problem. All these guys at the country club have seen what you guys are doing, they love it. If I went to them with this, I think we could definitely get some money for the business.” Now what do you think, John?

John Watson:

Now you have passive investors who are seeking return on the capital they invested in the business, and I think you find yourself pretty squarely in a securities offering under those.

Tom Voekler:

Yeah, I think now we’re getting into a realm where it’s getting easier to say, “Look, you are bringing in money that has no say in the business and is solely looking to the friends to generate some type of return,” whether that’s in the form of equity or note, all that would have to be considered. The last one I had just to take it to the complete last step is this business has really taken off. It’s now going outside the geographic realm of where they originally were. We’re even talking about, potentially, another friend lives out of state, lives in Raleigh, and says, “Hey, I want to do exactly what you guys are doing here, help me do it, but we need cash.” So that friend in Raleigh says, “But I’ve got some buddies over here that would give me the cash,” so now we’re getting into extra complexities of going outside of the state. What does that immediately make us look at?

Mike Beville:

Obvious answer is you’re still subject to all of the federal securities offering regulations, which is the tip of the iceberg, so to speak. But now, not only are you subject to two different states securities laws, the idea, and Tom, if I’m assuming correctly, you were saying that potentially, we’ll assume that original company was in Virginia, if they were providing capital to this North Carolina company, for example, the foot falls now grow exponentially because you’re moving money across lines, you’re potentially purchasing securities across state lines. I mean, it opens up the next Pandora’s box for sure.

Tom Voekler:

Much greater regulation. I think we all have stories like this. Years ago, I had person where I live come and say, “Hey, want to raise some money for a restaurant,” and he was floored when I said, “Well, can’t really do what you want to do because you’ve got to look at what…” And we’ll go into this in further podcasts, “These people, are they accredited? Can you even do this type of offering? Can you do it in Virginia?” And he said, “Well, some of these people are outside Virginia.” And that opens up, like you said, a different analysis, and so I think it’s important for people to realize that this shouldn’t be a limitation on doing business, but you have to take into account that almost everything related to business has some type of investment to it.

That doesn’t mean it’s automatically a securities offering, but we covered it here. It can quickly get into that realm and you just have to be aware of that and make sure you have somebody knowledgeable on how to, as we’ll talk in further podcasts, do that the right way and successfully, so you limit or reduce the liability involved. Anybody want to tell us what the actual definition of a securities offering is? Rhys, you probably know that.

Rhys James:

Sure. Well, you’re looking under the federal law, which is the Securities Act of 1933, is the big one, governing companies offering securities under federal law. You’re really looking at two different definitions. There’s a definition of security and then there’s a definition of offer. Both of those are about 20, 30 lines long.

Tom Voekler:

And as broad as you could possibly imagine, right?

Rhys James:

They’re very broad. The definition of security encompasses all of the types of investment that are typical. Stock, bond, note, other equity interests, but that it has also been interpreted, as we were alluding earlier by federal court system, relative to the concept of whether the investment is actually investment contract, which is the investment for value for return that depends on the efforts of others. And so while you may see note, for example, in the definition of security, that doesn’t necessarily mean that every single promissory note under the sun is a security.

The definition of offer is similarly broad, but at its base, it is the offering of, or the solicitation of an offer to buy, or an offer to sell, any security for value. An offer is interpreted very broadly, unlike definition of security though, the courts have actually broadened the interpretation of offer, such that you may not think you are offering a security. For example, if you are simply discussing your security publicly. Let’s say you’re doing a newspaper article about your growing business and you referenced that your business needs capital, you’re thinking about selling 30% of the company to try to fundraise for your new pool business, well, that may be interpreted as an offer. So it’s important for folks to be careful when discussing capital raising outside the context of the boardroom or whatever governance vehicle you have for your business.

Tom Voekler:

That’s great, Rhys. I think you can tell from the regulatory side and the courts, again, this is not a black and white type analysis. This is extremely gray. There are a lot of factors that go into it. How much involvement do you have in the business? How much say do you have in the initial negotiation of that insertion of capital, whatever that is, the ongoing expectation of a return? How much are you involved in creating that return? There are a lot of things that need to be considered, and even if it is an offering, we’ll talk about in future podcasts, what do you do? That’s not the end of the game, right?

There’s ways to go forward and try to make this as cost effective as possible. And hopefully, the real life examples gave us some idea what we deal with on a daily basis when we have clients come in and say or, mostly it’s friends who are like, “Hey, I want to do this,” and you’re like, “I got to put my lawyer hat and explain to you that there’s some ramifications for doing that, and sometimes you can get away with it and sometimes you probably cannot.”

Mike Beville:

I think you actually, middle of this episode, you said something that was extremely important, that obviously, we’re doing these episodes and we’re trying to raise the issues that maybe people aren’t thinking about, but at its core, nothing we’re saying should prevent someone who’s made a business decision that raising capital is the best thing for the business. Nothing we’re saying should prevent them from doing it. I think the point is that we think those people should surround themselves with proper advisors, whether legal or otherwise, to make sure that you don’t make that decision, something that ends up biting you more than it should in the end. But otherwise, it’s very possible to raise money. You just have to do it correct.

Tom Voekler:

Awesome. Next time, we’re going to talk about some of the basic laws that are involved in securities offerings. We really appreciate you listening. Raising Capital 101 by KVCF. Thank you.

This podcast is provided by KVCF, PLC for informational purposes only and should not be considered legal or investment advice. The transmission of the information in the podcast is not intended to establish, and the receipt of such information does not establish or constitute an attorney-client relationship. The listener should not act on information contained in any of the materials on this podcast without first consulting legal counsel. The podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.