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    • Point of View
    Quarterly Newsletter

    Business Financing: Raising Capital Through the Sale of Securities

    By Michael D. Sweet, Esq.
    The sale of securities is one of many vehicles for raising capital. For purposes of state and federal securities laws, the term "security" refers to any arrangement involving an investment in a common enterprise with profits to come solely from the efforts of others. For example, stocks, bonds, debentures, warrants and rights are all regulated as securities. In general, a company may choose to sell securities as a means of raising capital in order to avoid carrying additional debt or subjecting the assets of the company to security arrangements with lenders and the possibility of foreclosure.

    As with all other financing methods, it is important to consider relevant legal issues as well as the business factors that will impact the decision to sell securities. The sale of securities may subject a company to various contractual and regulatory requirements. The following is an overview of certain of these significant legal considerations and a summary of two common types of securities transactions.

    Unregistered Sales vs. Registered Sales of Securities

    From a legal standpoint, sales of securities can be grouped into two broad categories: unregistered sales of securities and registered sales. The federal Securities Act of 1933 prohibits the offer or sale of securities in interstate commerce unless the offer or sale is either (1) made in compliance with the registration process established by the Securities and Exchange Commission or (2) made pursuant to an exemption from the registration requirements. In addition to federal law, individual states, including Massachusetts, have similar laws and regulations with respect to the registration of securities and exemptions from registration requirements. The process of complying with the federal and state registration requirements can be long and costly, and the related public scrutiny and agency regulation may cause a dramatic change in the personality of a company. Qualifying for an exemption from federal and state registration requirements, therefore, is often an indispensable element of a plan for the sale of securities.

    Under both federal and Massachusetts law, an issuance of securities may qualify for an exemption from registration based upon either the nature of the securities offered or the structure of the issuing transaction. Exempt securities include those issued by the government and not-for-profit entities. The most common of the federal exemptions based on the structure of the transaction is known as the "private placement" exemption, which requires that the securities not be sold to the general public. The Securities and Exchange Commission has issued rules which create "safe harbors" for qualifying for the private placement exemption based on the size of the issuance and the sophistication of the investors. Companies often structure securities sales to take advantage of these safe harbors.

    Qualifying for an exemption from federal and state registration requirements . . . is often an indispensable element of a plan for the sale of securities.

    Venture Capital Transactions

    The sale of securities to a venture capital firm is one common form of unregistered sales of securities. In a venture capital transaction, a company issues securities and accompanying rights to a venture capital firm in exchange for its capital investment. Basic economic considerations include: (1) the amount of financing needed; (2) the valuation of the business; (3) the amount of control the company is willing to grant to the venture capital firm; (4) the type of securities to be sold; and (5) the rights accompanying the securities sold.

    Various documents establish the rights and obligations of the parties to a venture capital transaction. A Purchase Agreement includes the price for the securities being sold, representations and warranties made by both the venture capital firm and the company, and obligations as to the future conduct of the company, which may include restrictions on future mergers or sales of securities.

    A Certificate of Designations establishes the rights accompanying the securities being sold, which may include rights with respect to dividends, liquidation preference, redemption, conversion and voting. Also common to venture capital deals are Co-Sale Agreements, which grant to the venture capital firm the right to participate in certain significant sales of the company's securities, and Registration Rights Agreements, which grant to the venture capital firm certain rights with respect to future public sales of the company's securities.

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    		Initial Public Offerings

    Initial public offering is a registered sale of securities in which the Company sells its securities to the public for the first time. An initial public offering is perhaps the most dramatic of the methods for selling securities in terms of its potential for positive and negative effects on a company. Through an initial public offering, a company can obtain a substantial infusion of capital without incurring obligations to repay investors or to comply with burdensome financial covenants. An initial public offering is also costly, however, and the process is lengthy. In addition, once a company completes an initial public offering, it is subject to extensive ongoing reporting requirements and increased public visibility that may change the internal corporate culture that has contributed to its success.

    An initial public offering is perhaps the most dramatic of the methods for selling securities in terms of its potential for positive and negative effects on a company.

    The process of issuing securities for sale to the public includes the organization of the company's legal and financial affairs, the filing of a Registration Statement with the Securities and Exchange Commission and the issuance of a Prospectus to potential purchasers. Many contracts with lenders and vendors prohibit a company from selling securities.

    It is important, therefore, to review the company's legal documents before a sale of its securities so that any potential conflicts can be addressed. The Registration Statement and Prospectus describe the company and the rights accompanying the securities being sold. The Securities and Exchange Commission requires that these documents include certain financial data and other information about the company and its directors, officers, and shareholders.

    The drafting of a Registration Statement and Prospectus is a time-intensive process and the failure to include required information or the inclusion of misinformation may lead to legal claims by shareholders and government agencies.

    Anti-Fraud Rules Applicable to All Sales of Securities

    Federal and state anti-fraud rules apply to all sales of securities, regardless of whether the securities are sold pursuant to an unregistered sale or a registered sale. In general, a company may be liable to purchasers of its securities if it makes an untrue statement of a material fact or fails to state a material fact necessary to accurately and sufficiently explain the statements made. An investor who has been defrauded by a company in connection with the purchase of securities can recover from the company any losses resulting from the investment. In light of its potential liability, it is important that a company consult its legal counsel with respect to its disclosure obligations throughout the process of any sale of securities.

    Conclusion

    While not appropriate for all companies, the sale of securities can be an effective method of raising capital. In determining whether or not to sell its securities, a company will need to consider business factors such as the existence of a sufficient market for the company's securities and the willingness of the principals of the company to surrender a degree of control over the company to new shareholders that have not participated in the company's history. In addition to these business factors, the company will need to work closely with its legal counsel to determine the appropriate structure for a securities offering. The most basic decision to be made is whether or not the offering will be registered with the Securities and Exchange Commission and applicable state agencies. After this initial decision, the company must address the sophisticated regulatory scheme created by federal and state securities laws in order to determine the most appropriate structure for the specific needs of the company.

    Michael Sweet is an associate with Doherty, Wallace, Pillsbury and Murphy, P.C. He practices in the area of transactions, commercial real estate and general business law.



    DOHERTY, WALLACE, PILLSBURY & MURPHY
    ONE MONARCH PLACE, SUITE 1900
    1414 MAIN STREET
    SPRINGFIELD, MA 01144-1900
    TELEPHONE | 413-733-3111
    FAX | 413-734-3910

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