Linked, Out

The other day, a fellow with a startup wanted to know if he could raise money by soliciting investors through a closed LinkedIn, invite-only group and still escape close regulation by the SEC.

Interesting question.

When you sell shares of your company, you are selling a security and you fall under regulation by the SEC and the state.  Usually you have to register the security with the SEC, a process that can burn up some pricey lawyer hours.

Startups are usually strapped for cash, though, so the securities laws (1933 Act Section 4(2) and Rule 502 of Regulation D) exempt small offerings from registration – so long as the startup avoids making general solicitations of its securities.

Fine, you say, this will be easy.  So what’s a “general solicitation”?  And that’s where things get interesting.

The SEC doesn’t say.

Instead of giving a hard and fast defintion of general solicitation, the SEC states that it will evaluate on a case-by-case basis.  See Interpretive Release on Regulation D, Securities Act Release No. 33-6455, 17 C.F.R. Pt. 231, 1983 SEC LEXIS 2288 (March 3, 1983).

But there are some clues as to how the SEC would come out.  For starters, the Supreme Court said in the famous SEC v. Ralton-Purina case, 346 U.S. 119 (1953), that “the focus of inquiry should be on the need of the offerees for the protections afforded by registration”, namely where the offerees ”have access to the kind of information which registration would disclose.”

LinkedIn has the advantage of allowing a startup to be able to see the backgrounds of the people they intend to solicit for investment.  But that does not mean that the solicitees, in turn, will have full access to your information without registration.

Second, if you look at how the SEC comes out in their no-action letters, you can make out the outlines of how they would come out on this idea. It appears the SEC bases its decisions on whether there is already a significant relationship that predates the offering (friends or family, for instance), whether the offerees share a common interest, whether a third-party communication has been made on behalf of the issuer or whether a sale of securities was intended.

Since these are LinkedIn invitations, we can scratch the first category – there is not a pre-existing relationship.  The second category could work, depending on the screening done.  But the common interest cannot be something like “red hair,” or “fellow South End resident.”  The common interest must be enough that it allows the offeror to evaluate the suitability of the security for the offeree.

For that reason, the SEC has granted no-action status to a proposal to hand out questionnaires to potential investors and, based on the outcome, solicit the responder.  The SEC has also allowed an on-line version of this scheme.

So if the LinkedIn scheme allows the startup to gather enough information about the potential investor that they can be screened and evaluated before the pitch, the chances are the SEC would not stand in the way.

But since the SEC says it wants to evaluate on a case-by-case basis, a no-action letter would seem to be the way to go here.