Introduction

Businesses in their infancy often turn to private individuals to raise start-up and early stage capital, often by offering equity interests and/or incurring non-bank debt.  In most instances, the instrument delivered to the private investors meets the definition of a "security".  Therefore, early stage businesses must comply with federal and state securities laws in raising capital through these means.  Typically, this would require registration of an offering or compliance with the requirements of an exemption from registration.  While a summary of applicable securities laws is outside the scope of this article, suffice it to say that a well-experienced guide is absolutely necessary if one is to properly navigate the registration and exemption requirements of applicable securities laws.

The internet has placed its mark on securities offerings in recent years, including those offerings which aim to raise start-up and early stage capital.  Amidst the myriad regulations, requirements and exemptions of securities law, a movement toward offering securities for sale via the internet has occurred.  The following article focuses on developments in this area.

Regulation D Offerings on the Internet

As noted, the raising of private capital for early stage businesses most often involves the issuance of securities, and the issuer must comply with certain registration and disclosure obligations, or qualify for an exemption from registration under applicable securities laws.  These requirements are relaxed, however, in certain cases.  For example, Regulation D (an integrated series of rules promulgated by the Securities and Exchange Commission (the SEC)) provides "safe harbor" exemptive relief for "limited" offerings of securities.  The establishment of a Regulation D exemption generally requires, among other things, that the offering not involve a "general solicitation".  Essentially, this means that the capital-raising firm must refrain from prospecting for investors through any form of broad-based or blind solicitation techniques or advertising.

The use of the internet to conduct offerings of securities under Regulation D has intrigued capital-raising firms for a number of years.  However, there is an inherent tension between Regulation D's prohibition of general solicitations and the use of a public, broad-based medium such as the internet to offer securities.  In response to the growing public interest in utilizing the efficiency of the internet to make securities offerings, the SEC and many states have explored ways to permit internet solicitations without such actions constituting a general solicitation.

As a matter of background, a general solicitation (which, as noted, is prohibited by Rule 502(c) of Regulation D) is typically not found when a pre-existing, substantive relationship between an issuer (or its broker-dealer) and an offeree exists.  A 1996 SEC No-Action Letter (IPOnet, SEC No-Action Letter (July 26, 1996)) extended this principle to private offerings posted on the internet.  In that case, access to private offering material was granted only after a "member" had been pre-qualified as an "accredited investor" by completing a generic questionnaire.  Once qualified, the member was issued a password which enabled access to a website page containing a notice of a private offering.  In addition, the operator imposed a suitable "cooling off" period before the qualified member was granted access to the private offering material.  The SEC approved the operation of this website.  In doing so, the SEC found that the website operator had taken sufficient steps to allow a "pre-existing, substantive" relationship to be established between the issuer/broker-dealer and the offerees.

A similar 1997 No-Action Letter (Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1997)) involved a company that administered a website containing certain hedge funds offered on a semi-continuous basis.  The SEC staff determined that the proposed operation of the website would not involve a general solicitation since it was password-protected and accessible only to members who had been pre-qualified as accredited investors.  The investors were also subject to a 30-day "waiting" period before investments could be made.

Based upon concerns that certain website operators conducting online private offerings may have been overly zealous in their interpretations of the IPOnet and Lamp Technologies No-Action Letters, the SEC issued a clarifying release in April, 2000 (Release No. 33-7856 (April 28, 2000)).  The SEC expressed its concern that certain entities (notably those who were not broker-dealers or affiliated with broker-dealers) may have engaged in practices that deviated substantially from the facts set forth in the IPOnet and Lamp Technologies No-Action Letters in offering private placements over the internet.

For example, some third party service providers had set up websites that invited prospective investors to respond to a questionnaire, ostensibly for the purpose of qualifying them as an "accredited investor".  Completion of the questionnaire permitted access to private offerings displayed on those websites.  Some of the websites did not even require the completion of a questionnaire; instead, they simply invited the user to check a box as a means of self-accreditation and immediate access.  The SEC staff expressed their view that these types of websites raise significant concerns that a general solicitation is occurring.

Angel Networks and Online Matching Services

In approaching the general solicitation question as it relates to online offerings, the SEC has focused on broker-dealer operated websites and the method by which they pre-qualify their customers.  As noted, it appears that the SEC has demonstrated considerable acceptance of online offerings operated by broker-dealers.  However, the SEC has routinely resisted providing no-action relief to non-broker-dealer website operators.  In doing so, the SEC has repeatedly relied upon its high comfort level with the traditional methods of broker-dealer firms designed to establish a "pre-existing, substantive" relationship with prospective investors.  This is because broker-dealers are required under their self-governing NASD rules to deal fairly with, and make suitable recommendations to, their customers.  The SEC has noted, however, that the absence or presence of a general solicitation is always determined on a case-by-case basis, taking into account all relevant facts and circumstances.  In so commenting, the SEC left open the slight possibility that third party (i.e. non-broker-dealers) service providers may obtain no-action relief.

Possible examples of non-broker-dealer website operators include unregistered angel networks and online matching services.  Angel investors are typically high net worth, business-savvy individuals willing to invest patient capital in early stage, high-risk companies.  Angel networks essentially provide a convenient forum (either real or virtual) for pre-screened, qualified angels to assemble, evaluate, collaborate among themselves and actually invest in emerging businesses.  In addition to live presentations, investment opportunities are often presented to angels through access restricted/password protected private offering materials discretely displayed to them on an angel network website.  Companies afforded the lucrative opportunity to present their offering materials to investors are often invited by a "sponsoring" angel and are typically pre-screened from a large group of companies which have previously submitted their business plans.

Angel networks (especially internet-enhanced ones) and online matching services bear a strong resemblance to one another.  Online matching services attempt to join companies in search of capital with people looking to invest their capital.  The capital seekers are typically earlier stage companies.  The capital spenders are typically angels, venture capitalists and, on occasion, other institutional-type investors.

There are three primary regulatory considerations introduced by the operation of internet-enhanced angel networks and online matching services.  First, and most importantly, due to the inherent nature of their activities, both of these operations may require licensing as a broker-dealer.  As noted, the SEC has routinely denied no action relief from the broker-dealer registration requirements for unlicensed persons that sponsor angel networks or provide matching services for profit.  See Progressive Technology Inc., SEC No-Action Letter (October 11, 2000) and Oil-N-Gas, Inc., SEC No-Action Letter (June 8, 2000).

Second, regulatory concerns stem from the fact that certain state private offering exemptions are expressly conditioned upon the issuer not paying "commissions" to any unlicensed persons (e.g. MCL 451.802(a)(8)(B); MCL 451.802(b)(9)(C)).  If the angel network sponsor or matching service provider is not registered as a broker-dealer (or, at least, affiliated with a registered broker-dealer), payment of a transaction-based fee to such operator could render the private offering exemption unavailable to the issuer utilizing such services.

Finally, based upon the SEC No-Action Letters and Interpretive Releases discussed above, the means by which investors are accessed through an online angel network or matching service may involve a "general solicitation", thereby defeating an issuer's claimed private offering exemption.  As noted, however, by taking certain precautions, the issuer may avoid the characterization of its offering as one involving a general solicitation.

Conclusion

Based on available SEC No-Action Letters and other commentary, it appears that the safest online private offerings under Regulation D will involve: (a) a password-protected website directly operated by an issuer or its broker-dealer firm (as opposed to an unlicensed third party), (b) use of a comprehensive, generic (non-offering specific) questionnaire that elicits sufficient information to permit a thorough evaluation of the prospective investor's financial standing and sophistication level, and (c) a requirement that a sufficient amount of time lapse between the response to the questionnaire and actual participation in a private offering.  While the time may come when the SEC will truly embrace an online Regulation D offering sponsored by a non-broker-dealer, currently the SEC has shown practically no support for such offerings.  Accordingly, start-up and early stage business seeking to utilize online angel investor networks or matching services to raise capital should ensure that these service providers have been registered as broker-dealers, and that they follow at least the "general solicitation" precautions noted above.

Michael T. Raymond is a partner in the Ann Arbor office of the law firm Dickinson Wright PLLC.  Mr. Raymond gratefully acknowledges the assistance of James L. Carey, Assistant Professor at Thomas M. Cooley Law School, and Anthony P. Ferman, Associate, of Dickinson Wright PLLC.