Raising Capital Through Online Social Networking – A Violation of Securities Laws?
By: TODD A. TAYLOR
October 2009
Online social networks such as LinkedIn, Facebook, MySpace, and Twitter provide great tools for meeting potential business partners, discussing industry and business trends, and for networking. Given the potential to reach so many prospective investors, entrepreneurs may find such forums tempting in raising money for their companies. For the same reason, however, using online social networking sites to raise money may violate federal and state securities laws and create serious risks for both the company and the person who posts the message. Experience indicates that LinkedIn users extensively and frequently come across messages from business developers seeking investors, and similar opportunities are presented through Facebook, MySpace, and Twitter. While addressing the risks in more detail, this article strongly advises against such use.
Every offer and sale of a security—including stock, limited liability company membership interests, promissory notes, options, and warrants—must be registered with the Securities and Exchange Commission (SEC) (and comply with applicable state securities law requirements) or the sale must qualify for an exemption from registration. Since registration involves an expensive and time-consuming process including the SEC’s review of the offering materials, most start-up and developing companies avoid this process and try to raise money through an applicable exemption. Being unaware of the existence of applicable securities laws, many companies and their representatives may unknowingly violate securities laws while raising money.
If a company is not registering its securities, typically through an initial public offering, company representatives must ensure that the offer and sale of the securities is exempt from registration. The most commonly used exemptions fall within the umbrella of private placement exemptions under federal and state laws. One common, specific exemption is found in SEC Regulation D, Rule 506. Subject to certain limitations, Rule 506 allows a company to offer and sell securities to private investors without SEC review. One such limitation, however, states that companies conducting a private placement under Rule 506 and other exemptions cannot engage in general solicitation to attract investors. If a company does not comply with the exemption provisions and did not register the securities, then the SEC or state securities authorities can force the company to rescind the investment (returning the money to investors), pay fines, and possibly face more serious consequences for securities violations.
While general solicitation is dependent on facts and circumstances and is not well-defined, it generally refers to using a method of communications that indiscriminately reaches a broad audience. Whether a particular action is considered general solicitation depends in large part on whether a significant relationship predated the offering and whether the solicitation intended a sale of securities.
If no significant relationship exists, the company representative is exposed to considerable risk if he or she shares information about an investment opportunity. A significant relationship means more than simply being linked to someone on LinkedIn or being a friend on Facebook. Whether a solicitation intended a sale of securities requires examining the sender’s intent when making the contact. Sending an email to MySpace friends, Twittering, or posting a discussion on LinkedIn talking about a great new company while trying to raise related funds provide obvious examples of intending a sale of securities and should be avoided.
If a company representative cannot ask for investors or post a private placement memorandum, what is allowed? Online networking sites and other, more traditional means can be used to establish a significant relationship with people, and after the relationship is firmly established (separate from any company or investment discussions), company representatives can talk with such contacts about an offering. Discussing the company and its goals with others is also generally allowed, but if there’s an offering that is open at the same time or will be in the near future, he or she should take care not to use this approach to lure people to his or her company and then asking them to invest. Such actions could constitute another securities law violation termed “conditioning the market.”
Used wisely, online networking sites can significantly increase one’s network and potential for success, but one needs to avoid actions that could hurt his or her company in the long run. Companies and investors alike are obviously best served by avoiding potential securities law violation investigations.
Takeaway
Posting investment opportunities or company information while raising funds presents significant potential for securities law violations.