Generally, to raise capital a company must register its stock or securities with the federal Securities and Exchange Commission (SEC), and with each state. Registration typically involves providing and obtaining approval from the federal and state governments for complex information about a company and its financing. Registration is time consuming and expensive. Most registration “exemptions” limit the number of investors, the dollar amount of the offering, and the manner in which money may be raised.

The most common exemption from registration is the private offering. Private offerings are generally sold through a legal disclosure document known as a private placement memorandum. Although private offerings are exempt from federal and state registration requirements, complex “notice” filing requirements still exist and many states further qualify a private offering. Finally, private offerings may not be sold by means of general advertising or solicitation. Normally a preexisting relationship between the company and the investor is required. Most entrepreneurs do not know enough qualified investors to finance a private offering. It is therefore easy to inadvertently turn a private offering into a public one, which then defeats the exemption and requires registration and/or return of investors’ money.

The SEC has created a “safe harbor” guideline to enable companies to stay within the private offering exemption. Regulation D (17 C.F.R. Sec. 230.500 et. seq.), Rule 506 allows a company to sell an unlimited dollar amount of securities to an unlimited number of “accredited” (generally wealthy investors and institutions, see Rule 501) investors, and to up to 35 nonaccredited investors. While Reg. D provides burdensome disclosure requirements for offerings over $7.5 million such as expensive and time consuming audited financial statements, these requirements are lessened if the offering is limited to accredited investors.

Reg. D offerings must still comply with state exemption filing and qualification requirements (“blue sky laws”). However, Rule 506 offerings are not subject to burdensome state qualifications, only to state notice filings and fee requirements. See 15 USC Sec. 77r.

For emerging as well as many established companies, the best way to raise capital is through a Reg. D, Rule 506, offering limited to accredited investors. The only remaining problem is Reg. D’s prohibition (see Rule 502) on Rule 506 offerings utilizing any form of “general solicitation or advertising”.

Of course, the questions are what is and what is not “general solicitation or advertising”, and whether or not it is possible to raise capital on the internet without violating this prohibition. A review of relevant SEC opinions on these matters is in order.

In H.B. Shaine & Co., Inc., No Action Letter dated May 1, 1987, the SEC staff indicated that the distribution by a securities dealer of questionnaires to prospective accredited investors to determine their suitability to participate in private offerings would not be a “general solicitation or advertisement”. This view was premised upon several factors, including the use of a generic questionnaire and upon the elapse of a sufficient period of time between the completion of the questionnaire and the contemplation or inception of any particular offering. 45 days has been held to be a “sufficient period of time”. See E.F. Hutton, SEC No-Action Letter (Dec. 3, 1985).

In IPONET, SEC No Action Letter (Division of Corporate Finance and Market Regulation Interpretive Letter dated July 26, 1996), the SEC staff indicated that a securities dealer and underwriter could distribute questionnaires to prospective accredited investors to determine their suitability to participate in private offerings, and that those investors may be invited to access a secured web-site to review private placement offerings not contemplated or commenced prior to the lapse of a sufficient period of time after completion of an investor’s questionnaire.

In SEC Interpretation: Use of Electronic Media (Securities Act Release No. 7856; Exchange Act Release No. 4278; Investment Company Release No. 24426—4/28/00), the SEC staff noted that “third party service providers who are neither registered broker-dealers nor affiliated with registered broker-dealers have established web-sites that generally invite prospective investors to qualify as accredited or sophisticated as a prelude to participation, on an access-restricted basis, in limited or private offerings transmitted on those web-site.” While the staff expressed some concern that certain sites have deviated from the format approved by IPONET, the staff went on to state that “the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case” (citing and quoting Securities Act Rel. No. 6825—March 15, 1989, at n. 12 “the staff has never suggested, and it is not the case, that prior relationship is the only way to show the absence of a general solicitation”). The conclusion was that “a third party, other than a registered broker-dealer, could establish a ‘pre-existing, substantive relationship’ sufficient to avoid a ‘general solicitation’”. While it is permissible for these web-sites to accept a fee for their listing services, these sites may not act as broker-dealers by attempting to induce sales of the securities of others without being licensed to do so.

There are many web-sites purporting to match entrepreneurs with accredited investors. Some of these sites may be found at http://www..wall-street.com/vcpp.html. While it is legally permissible to sell securities to accredited investors through properly structured on-line services, most of these sites do not provide enough accredited investor leads to properly capitalize many private offerings. A conservative rule of thumb is to contact 1000 accredited investors to raise $25,000. Because most of these sites do not have 1000 accredited investors, it is difficult to raise the amount of money needed solely from these sites.

A more effective alternative involves the purchase or rental of voluminous “accredited investor lists”. However, the mere fact that solicitations are directed solely to accredited investors may be insufficient to prove that solicitations are limited if no safeguards are taken to ensure that non-accredited offerees are not solicited. See In re CGI Capital Inc. Securities Act Release No. 33-7904 (9/29/00) (“CGI Capital”). In CGI Capital, the company sent e-mail messages to several thousand potential investors (some of whom the company did not have preexisting relationships with) regarding a private placement offering. Prospective investors were provided a “password” to a restricted web-site which contained the offering. However, offerees were not restricted from forwarding the password to others, nor otherwise advised that the password was restricted. Neither were offerees required to verify their accredited investor status prior to viewing the offering on the web-site. The SEC found CGI Capital had engaged in a general solicitation and advertisement because of a combination of three factors: (1) The e-mail was sent to thousands of offerees, many of whom lacked preexisting relationships with the company or its agents; (2) Offerees were not required to verify their accredited investor status prior to viewing the offering on the web-site; (3) There were inadequate restrictions on accessing the offering on the web-site—i.e., the password was not restricted from being forwarded and offerees were not advised the password was restricted to personal use. While it is important that the SEC found the lack of preexisting relationships a factor in finding CGI Capital had engaged in general advertising and solicitation, it is important to remember that the presence or absence of a general solicitation is always dependent upon the facts and circumstances of a particular case. As already mentioned, the SEC “staff has never suggested, and it is not the case, that prior relationship is the only way to show the absence of a general solicitation.” See Securities Act Release No. 6825 (3/15/89 at n. 12.

Secured third party web-sites matching entrepreneurs with accredited investors, where the site has established preexisting relationships with accredited investors, is generally permissible. Use of large accredited investor lists, such as e-mails or direct mailings, would be appropriate if the list owner has established preexisting relationships with accredited investors. The stronger the relationships established the better. For example, buying or renting a list from a company of its existing accredited investor-shareholders is preferable to purchasing a list derived from public property records. However, preexisting relationships are not determinative. The other factors cited in CGI Capital should be heeded: (1) Prior to viewing the offering prospective investors should verify their accredited status; (2) Safeguards should be in place to ensure only those to whom the solicitation is sent are able to view the offering.

506D offerings have the advantages of allowing a company to raise an unlimited amount of funds without the headaches of registration or burdensome blue sky compliances (beyond notice filings and fees). By limiting investors to those who are “accredited”, burdensome disclosure requirements are greatly lessened. The problem has been compliance with the ban on “general solicitation and advertising”. In light of recent SEC releases, it is possible to target large accredited investor databases provided those databases were properly generated, prospective investors verify their accreditation prior to viewing the offering, and safeguards are in place to ensure those not solicited do not view the offering. Legal counsel is advisable not only to ensure compliance with 506D offering requirements, but to assist in maximizing the number of investors to whom an offering may legally be targeted.