Digital Angels, Analog Rules

Before I get accused of trying to rain on someone else's parade, let me just say, I've overcome my initial shock, and I think AngelList and the whole idea of AngelList is cool.

Social networks match minds and reduce inefficiencies in the unearthing and exchange of information. That should be part of how startups meet investors. Moreover, the transparency of an open, socially networked financing system promises health and wholesomeness, both for the angels and startups participating, and for the seed financing ecosystem in general. (More of this: publish valuations and deal terms as well!)

But the lawyer in me can't easily reconstruct how the securities registration exemption requirements of Reg D are being met for the deals being put together this way.

You remember Reg D. It is the federal rule that most startups rely on when raising startup seed and subsequent equity financing. It's important because it provides a path to preempt state securities agency review of startup financing. Recently, in the course of the debate before the passage of the Dodd-Frank Act, many angels and a handful of entrepreneurs and startup lawyers fought successfully to preserve the essential framework of Rule 506 under Reg D.

Compliance is not a mere technicality. Seed financings should be clearly covered by an exemption from registration requirements. Startups that cannot trace the path backwards to clear exemptions may later have trouble getting through due diligence before subsequent offerings can close. Sometimes, rescission offers have to be made. Problems can even make potential acquirers move on to alternative targets with less hair.

Reg D has a "limitation on manner of offering" condition. Unless you are relying on Rule 504 (not desirable, as it lets the states back in the door), Reg D requires that:

"neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising . . . "

Let's take a tweet from an AngelList-listed angel soliciting pitches from startups. Let's concede the tweet is an "other communication," for purposes of the rule.

But the communication is not "in any newspaper, magazine, or similar media." Or is it? What about where the tweet gets pulled into Flipboard?

There might be a temptation to concede that the tweet is "broadcast," but really there is too much context in the rule to make that leap. I think the right analysis is that the rule is inapposite to our tweet. The ways tweets are distributed and accessed are qualitatively different from the indiscriminate way ads in newspapers or magazines reach audiences. "Broadcast" as used by the rule means indifferent dissemination to a general, passive public.

Another way to satisfy the rule might be to take the position that VentureHacks is a finder for the startups soliciting investment.

Because of a series of SEC "no-action" letters, which say that "general solicitation" does not occur if the startup or those acting on the startup's behalf have a "substantial preexisting relationship" or a "preexisting business relationship" with each investor, there is a good argument that VentureHacks is simply supplying startups with angels with whom VentureHacks has a pre-existing relationship. (For this analysis, I am assuming that VentureHacks is clearing applications from angels before it lists them, and listing them without reference to any given offering. I am also assuming that VentureHacks is vetting the sophistication of the angels and their status as accredited investors.)

Yet another position to take -- a sound one -- is to say that there is nothing preventing an angel from engaging in general solicitation to find good deals. On the face of it, that's what's going on in the tweet linked to above, and the prohibition on general solicitation applies only to the startup and those acting on behalf of the startup. More conservative lawyers (and those tend to be the sort who sit on law firm opinion writing committees), however, might tend to want to look at the entire thread of tweets of which that solicitation is a part.

Bottom line: the scaffolding for a Reg D exemption may be there, but it's rickety.

We're yet living with securities offering exemptions built for an analog era. We're going to need new exemptions that let the angel and startup community innovate and self-police, without risking raising unnecessary compliance issues down the road.


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