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Some Points for Professional Consideration

Since it is only quite recently that universities awoke to the reality that most of their graduates were not going to work for a Fortune 500 company, a big five accounting or a big law firm, there is very little in the standard syllabus that pertains to small companies. While that situation is changing rapidly, the attorney, accountant or MBA dealing with small companies attempting to raise capital has very little to go on but his own experiences.

In the case of attorneys, that experience is usually quite limited, since small companies and startups usually draw the most junior attorney in the practice. This blind and blind coalition may be guided by a more experienced attorney, but chances are, his experience is limited to private placements (Sect 4(2), 4(6) and Rule 505 of Sect 3(b) of the Securities Act), a fund raising technique in which the entrepreneur can only approach a handful of people he knows (in the case of 4(2)), but can approach any number of millionaires or businesses which invest in risky undertakings. Since the entrepreneur cannot advertise, he must also know these potential investors as well. In the all too likely event that the entrepreneur does not know enough so-called accredited investors, the deal will fail. The entrepreneur won't get the money he needs and another idea will starve to death.

There are alternatives to private placements (see table of exemptions). Some, like the Intrastate Offering Exemption (Sect 3(a)(11)) are heavily used in some states, while the Rule 504 and Regulation A exemptions in Sect 3(b) are not used as often as they should be. Since 1990, fewer than 2,000 companies have attempted to raise money through the direct sale of securities to investors under an exemption from federal registration. Of the 2,000 that attempted to raise money, about one-third succeeded, which is about the success rate for all businesses with less than $2.5 million in revenue. Of the 670 or so companies that raised money, about 166 have gone on to list on some form of secondary market.

In our conversations with attorneys over the years, it has become apparent that they see the requirement to register in each state in which the securities are to be offered as a drawback. Such a concern overlooks the true nature of the small corporate offering. Even in this era of the Internet, very few small companies reach beyond a short radius of their headquarters. Since they are only likely to sell securities to people who know the company or its product, most small companies need register in one or two states at most. With the regional review processes most states have adopted, it is no more trouble to register in one state than it is to do so in two, or three or four, if necessary. The issuer deals with only one comment letter.

The other often heard problem is that many states impose "merit review." While it is true that the majority of states require more than straight disclosure, those standards are not generally as onerous as the uninitiated might think. (It should be noted that Florida's merit standards do make it impossible for any small company to become registered, but it is the only state in which this is true. The problem in Florida is a very narrow interpretation of the amount of risk the company's founders and promoters should bear. In most merit states the founders and promoters are expected to have some of their own hide at risk. The general rule of thumb is 10 percent of the offering (no figure is actually sited in most state statutes or regulations). Thus, if the company is trying to raise $1 million, the founders and promoters should have at least $100,000 of their own money in the deal. Florida looks for an equity position of 10 percent of the entire company's worth. Thus, if a company is selling 10 percent of itself for $1 million, the value of the company is $10 million and the founders and promoters are expected to have $1 million of their money invested before the offer can be registered in Florida.

A list of web sites with state statutes, rules and regulations is found in the Resources section of this web. See State Securities Laws.

Contrary to uninformed opinion, merit review has nothing to do with the quality of the deal. The state does not claim any clairvoyance as to which companies will succeed or fail. The state does require that the investor be given a shot at making some money. Thus, the state requires that a goodly portion of the investor's money actually be used to advance the business. The state also requires the founders and promoters to permit the investor to participate in the profits, if profits there be, and that the investor pay a fair price, vis-à-vis the price the insiders paid, for stock in the company.

Perhaps this is not an ideal situation for the issuer, but money has a value and the issuer must be prepared to pay that value or forego the money. Since a number of companies have succeeded under these conditions, there is no reason to believe that others won't as well.

A common problem is that by the time the entrepreneur tells his attorney that the money is running out, there isn't enough money to keep the company going while a small corporate offering is drafted, registered and sold.

Accountants are generally interested in doing the review or the audit required by the state as part of the registration process until they talk to their insurance carrier. Because small corporation offerings are rare, insurance underwriters tend to equate them with IPOs and adjudge risk accordingly. Because of this, a number of accountants have told us they can not afford to work on small corporate offerings. A number of others, however, have found a way to do them.

Stewart-Gordon Associates, Inc.
P.O. Box 781992
Dallas TX 75378-1992
voice (972) 620-2489
fax (972) 406-0213
e-mail Tom Stewart-Gordon