Integration is not Just About a Race

Integration is not Just About a Race

We find that early-stage startup companies often sprint from one fundraising round to another in their quest to raise the necessary capital to build a growing enterprise. The problem for fundraising law compliance is that it becomes difficult to tell when one offering ends and another begins. The U.S. Securities and Exchange Commission historically has considered two securities offerings to be separate if the end of the first offering is at least six months before the start of the next offering. The regulators presume that offerings that end and start within six months of each other are “integrated,” in that they really comprise a single offering.

This can be a real world problem for startup entrepreneurs who can’t wait a full half year between equity financings.

In November 2020, the SEC adopted new Rule 152(b)(1) which, when it becomes effective on March 15, 2021, changes the six-month rule. The new Rule will generally provide that two offerings are considered separate and not integrated if the end of the first offering is at least 30 calendar days before the start of the second offering.

Most entrepreneurs can wait at least 30 calendar days between equity financings. But why should you care, anyway?

Assume that a startup raises its first round of capital from friends and family, including less wealthy individuals that don’t qualify as “accredited investors” under federal securities laws. Within six months of completing this round, the company starts raising additional funds, but this time, targets solely “accredited investors.”

As a reminder, a person is considered “accredited” if:

  1. alone or with his or her spouse the person has a net worth, exclusive of the value of his or her principal residence, of at least $1,000,000,
  2. the person had individual income in the past two years of at least $200,000 and expects to achieve that milestone in the current year or
  3. the person had joint income with his or her spouse in the past two years of at least $300,000 and expects to achieve that milestone in the current year.

For the second, solely “accredited investor” fundraising round, we would typically expect the company to rely on SEC Rule 506 as the exemption under federal securities laws. This Rule allows a company to raise an unlimited amount of funds from an unlimited number of
“accredited investors” (the prospects with the most investible capital) and from up to 35 investors who don’t qualify as “accredited.” Using Rule 506 simplifies compliance on a state-by-state basis where the company is selling its securities. Rule 506 also simplifies the disclosure requirements by excusing the company from providing to “accredited investors” any specifically mandated business or financial information as a condition to investment (though risk factor disclosure is still good practice).

But, Rule 506 does require a company to provide specific business and financial information, usually in the form of private placement memorandum, to each non-accredited investor before taking in his or her funds.

In our example, the company has started Fundraising Round 2 within six months of Fundraising Round 1. Unless the presumption is defeated, the regulators may consider the two rounds “integrated” as a single offering. This means that for the Rule 506 exemption to apply, the non-accredited investors in Fundraising Round 1 had to receive a private placement memorandum before investing. They may well have not. Thus, the integrated Fundraising Round 2 becomes non-compliant. This could give all investors in Fundraising Round 2 the right for several years to rescind their securities purchases and receive a refund, potentially from directors and officers of the company if the company cannot afford to make the refund.

That’s a real world problem under current law.

Thankfully, the SEC rules historically have allowed a company to overcome the presumption that two offerings within six months of each other should be integrated as a single offering. The Rules set out fact-specific factors to ascertain whether two such offerings are integrated together. These factors are:

  1. Are the sales part of a single plan of financing;
  2. Do the sales involve issuance of the same class of securities;
  3. Are the sales made at or about the same time;
  4. Is the same type of consideration being received; and
  5. Are the sales being made for the same general purpose.

As an example, if Fundraising Round 1 was a sale of straight debt and Fundraising Round 2, started five months after the end of Fundraising Round 1, was a sale of common stock, factors 2 and 3 would lean toward not integrating the two rounds together. In any case, you can see that ending one fundraising round less than six months before starting the next round does complicate matters.

By changing the safe harbor generally to require only a 30 calendar day break between two offerings to avoid integration, the SEC has done a service to startup companies.

We would be pleased to discuss your startup’s proposed financing plans to help keep you compliant with the integration rules and other federal and state securities laws and regulations.


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Jeffrey Robbins

Jeffrey Robbins

For over 35 years, I have represented entrepreneurs who start and grow technology-based enterprises and angel and venture investors who target those companies. Clients seek my assistance in strategic business plan development; entity selection and formation; private and public fundraising (including crowdfunding) and securities law compliance; employment and compensation plans and agreements; and merger and acquisition activities. Read Jeff's Bio.

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