“Notable By Their Absence: Finders And Other Financial Intermediaries In Small Business Capital Formation”

Shumaker, Loop & Kendrick, LLP
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Small businesses are often regarded as the catalyst for economic growth in the United States. Small businesses account for the creation of two-thirds of all new jobs, and are the incubators of innovation. The majority of new jobs in the U.S. are from companies less than five years old. Raising capital is a never-ending imperative for small businesses at every turn: to explore new ideas, to exploit a new development, to expand the scope of research, to move from concept to prototype to marketable product, for manufacturing, distribution and marketing. At some point, financial institution financing and capital market funding provide the monetary resources for the growth of the business – but not at the beginning and, often, not for a great many years. In the interim, funding is provided by private money – initially from friends and family, then from a wider circle of acquaintances, later, perhaps, from angel investors and, ultimately, venture capitalists and private equity groups. Angel investors, for example, provide approximately 90% of outside equity raised by start-up companies, and are virtually the only source of seed funding. In 2013, angels invested $25 billion in 71,000 companies.

Early stage capital is raised exclusively through offerings that qualify for exemption under the registration provisions of the Securities Act of 1933 and the “blue sky” laws of the various states. The SEC’s Regulation D,and particularly Rule 506 thereunder, is the Holy Grail, providing two paths for companies to raise unlimited amounts of money with a minimum of filings, mandated disclosure and other regulatory burdens. Rule 506(b) exempts offerings from registration where “private” sales are limited to accredited investors and up to 35 non-accredited investors. In 2011, the estimated amount of capital raised in Regulation D offerings (overwhelmingly under the Rule 506 exemption) was more than $1 trillion, about the same as was raised in that year in public offerings. In the 12 month period, September 23, 2013September 22, 2014, there were almost 15,000 new Regulation D offerings, nearly all under the Rule 506 exemption. Beginning in late 2013, with the amendments to Regulation D mandated by the “JOBS Act,” new SEC Rule 506(c) exempts offerings from registration in “public” sales to accredited investors where the issuer has taken reasonable steps to verify such accredited status. Significantly, only 13% of Regulation D offerings between 2009 and 2012 reported using a financial intermediary, such as abroker-dealer or finder. There are several explanations as to why this is the case. However, for most start-up and early stage businesses, the primary reasons are the lack of interest from registered broker-dealers and the danger of using unregistered firms that might identify and solicit potential investors for these businesses.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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