Information for the Small Businessperson Considering Selling Securities

Information for the Small Businessperson
Considering Selling Securities
By John A. Eckstein

Introduction

This information has been prepared by the law firm of Fairfield & Woods, P.C., Denver, Colorado, for the purpose of assisting a businessperson who wants to raise capital by selling securities to others. The information includes a discussion of federal and state securities laws and various practical matters. In order to keep legal costs to a minimum, we ask that, before your first conference with a lawyer in this firm, you do the following:

1. Skim this material so that you will know generally what it contains.

2. Thereafter read each section carefully and underline any parts concerning which you have questions or comments so that you can discuss them with the lawyer during your first conference.

3. Complete the questionnaire and assemble the requested information. Once we are retained to represent you, you will then be able to return the questionnaire and information to the lawyer who is handling your matter prior to your first appointment.

Separate Laws

The federal government, the several states and the Financial Industry Regulatory Authority ("FINRA")(formerly known as the National Association of Securities Dealers, Inc. or the "NASD") each have separate securities laws and regulations. Foreign countries often also have such laws. A person selling securities must comply with the securities laws and regulations of each separate securities authority. Compliance with the laws and rules of one securities authority does not constitute compliance with the laws and regulations of any other securities authorities. If securities are to be sold in every state, one must comply with the laws and regulations of approximately 52 separate securities authorities, i.e., the United States Securities and Exchange Commission (the "SEC"), the securities authority in each of the 50 states and the FINRA (if the sales are to be made through a member of the investment industry). At a minimum one must comply with at least two separate laws, i.e., the federal law and the law of the state in which the securities are to be sold if sold in only one state. If one complies with federal law, compliance with the securities laws in many of the states is often relatively simple because many states permit what are known as "coordination filings." However, several states have statutes which permit a state official to judge the merits of an offering. In these "merit states," even though one complies with the registration or filing procedures, the state may still prohibit the offering because the particular state official does not consider the offering to be "fair, just and equitable" for purchase by residents of his particular state. Although the remainder of this material deals primarily with federal laws and regulations, one must remember to make sure that there also is compliance with all applicable laws of the interested states and foreign countries.

Federal Law

Instead of permitting a government official to decide whether a particular securities offering is "good" or "bad," the theory of the federal law is "full disclosure," i.e., the seller must tell everything. Most people want to tell the truth. However, the difficulty with the federal law is the significant amount of work involved in trying to identify matters which should be disclosed to tell the whole story and then describing each matter in writing in such a way so that the matter will be understood by prospective investors. It sometimes is said, "In most commercial transactions the rule is that the buyer should beware. Under the federal securities law the rule is that the seller should beware." This fundamental difference between securities transactions and other commercial transactions must be thoroughly understood and accepted and never forgotten. If an investor might reasonably consider a matter to be material, the matter must be disclosed to the investor in such a way that disclosure can be proved.

Securities

Most people think of stocks and bonds when thinking of securities. However, partnership interests, passive interests in oil and gas wells or programs, interests in some condominiums, promissory notes, mutual funds, or insurance policies, or any arrangement which one commonly would consider to be an investment may involve a security.

Registration

It may be an oversimplification, but for purposes of this discussion, the federal securities laws will be divided into two parts: (i) the "anti-fraud" provisions requiring full disclosure as discussed above, and (ii) "registration" which is designed to establish procedures and guides for accomplishing full disclosure. There are no exemptions from the anti-fraud requirements.

The Securities Act of 1933 ("1933 Act") technically provides in Section 5 that there must be an effective registration statement pertaining to the security every time a security is sold. However, the Act goes on to provide for several exemptions from the registration requirements. The principal exemption is Section 4(1) which exempts transactions by all persons other than (i) issuers, (ii) underwriters, or (iii) dealers. In other words, the registration requirements only apply to sales by issuers, underwriters or dealers. Trading transactions, which constitute by far the greatest number of securities transactions, are exempt because of the Section 4(1) exemption. Most small businesspeople do not need to be concerned about being a "dealer", but a corporation or other entity in which securities are sold by a small businessperson usually is an issuer and often the small businessperson herself or himself will be liable for sales of securities by the issuer because either heor she is classified as an underwriter or is in control of the issuer. As a consequence, a small businessperson wanting to sell securities must either register the securities offering pursuant to the 1933 Act or sell in reliance upon an exemption from registration other than the Section 4(1) exemption.

Spectrum of Offerings

One of the first things which a small businessperson should do after deciding to sell securities is to tailor his or her securities offering to fit a particular (i) form of registration or (ii) procedure to bring the offering within an exemption from registration. The following categorization of offerings is arbitrary and each category may involve variations. Still, it is hoped the following discussion of each of the different categories of offerings will help in tailoring a proposed securities offering. Some securities authorities may argue that one or more of the following types of offerings is not in technical compliance with the securities laws. Consequently, it is not always practical to obtain a legal opinion that a procedure is in compliance with all securities laws. Often a legal opinion cannot be obtained because the procedure involves future activities which cannot be the basis for a formal legal opinion. Therefore, everyone should understand that he or she will be assuming certain business risks in pursuing one or more of the following procedures. Further, a lawyer is not in a position to guarantee to anyone selling securities that he or she will not be accused of violating the law. The best a lawyer can do is to try to keep the opportunities for such accusations to a minimum.

Subject to the above, we suggest that a small businessperson wanting to raise capital by selling equity securities to others has the following alternatives:

1. File a full Registration Statement with the SEC in Washington, D.C.

2. File an SB-2 Registration Statement in the regional office of the SEC - for companies with annual revenues of less than $25 million whose voting stock does not have a public float of $25 million or more.

3. File a notification pursuant to Regulation A with the regional office of the SEC for offerings of up to $5,000,000 in any 12 month period. Prior to August 13, 1992, this firm discouraged the use of Regulation A; however, the SEC then changed the requirements for the use of "Reg A" and it should now be seriously considered for use by small business persons. For example, Reg A offerors may now "test the waters" with a simple flyer or alternative media message soliciting interest in a offering prior to filing a preliminary "registration-type" statement with the SEC.

4. Rely on the Section 4(2) nonpublic offering exemption under the 1933 Act and Rule 506 permitting an offering of restricted securities with no dollar limit to an unlimited number of "accredited investors" and not more than 35 sophisticated investors.

5. Rely on Rule 505 for limited offerings up to $5,000,000 in any 12 month period of restricted securities to "accredited investors" in unlimited number and 35 other investors.

6. Rely on Rule 147 which is an interpretation of the intrastate offering exemption under Section 3(a)(11) under the 1933 Act. This exemption should be used only for local offerings and must be limited to residents of a single state. Usually there is no significant aftermarket opportunity to be developed for securities sold in these offerings.

7. Rely on Rule 504 which permits offerings of securities totaling no more than $1,000,000 during any 12 month period by non-public companies. If one is selling securities totaling more than $1,000,000, Rule 504 can still apply to the first $1,000,000. (The SEC proposed in August 2007 amendments affecting Regulation D, Rule 504, 505, and 506, and also proposed a new rule 507 exemption; as of February 14, 2008, these rule changes were still proposed.)

8. Arrange a true non-public transaction relying on Section 4(2) above involving persons who are members of management or who negotiate the transaction.

9. Conduct an offering to employees of the company only relying upon Rule 701.

10. In the sale of securities exclusively to residents of foreign countries, rely upon the provisions of SEC Regulation S.

Full Registration

A full registration statement must be filed with the Securities and Exchange Commission in Washington. The attorney's work for the issuing company involves:

1. A review of the issuer's structure.

2. Often times making amendments to the articles of incorporation and bylaws and drafting corporate minutes.

3. Collecting information pertinent to the issuer.

4. Drafting and editing the registration statement including the prospectus.

5. Negotiating the underwriting agreement with the underwriter, if any.

6. Handling the filing of the registration statement with the SEC.

7. Responding to comments from the SEC.

8. Advising the issuer during the offering process.

9. Handling the closing of the underwriting agreement.

There is no dollar limit on the amount which can be offered. Unless the securities are by their nature nontradable, they usually are traded in an aftermarket by members of the investment industry. Generally it takes from 60 to 90 days to prepare the filing for the SEC and another 30 to 60 days for the SEC to comment, the comments to be answered and the registration statement declared effective. Depending upon the type of underwriting, the funds may be received within a matter of a few days after effectiveness or not received until after an escrow amount is reached within a given period of time (which may vary but often is 60 to 90 days).

Although the time involved for a fully registered securities offering can be considerably shorter for an issuer which is already "public", a first-time registrant should expect that it will take at least six months from the time work is started on the registration statement until funds are received. Often the time is considerably longer. The estimated legal costs for a full registration range between $100,000 and $200,000, and are often higher. In addition, the registrant must pay accounting fees, printing costs, blue sky fees and often, if an underwriter is involved, an underwriter's expense allowance. Consequently, the total cost of full registration (other than underwriting commissions) usually exceeds $125,000 and often totals $250,000 or more. Obviously this process involves a significant gamble by a small businessman because even though the registration statement is declared effective by the SEC and in various states, the small businessman cannot be assured that the offering will be sold even if an underwriter is involved.

SB-2 Registration Statement

The SB-2 Registration Statement was adopted specifically to help small business. It takes the place previously held by S-18 Registration Statements in the SEC's format. The principal advantages over the other full registration statements required by the SEC is that SB-2 Registration Statements require less specific disclosure and may be filed in the SEC regional offices (and processed by examiners who may be more sensitive to local conditions). Therefore if a "small business" wants to sell a stock offering and is not already public, this type of registration is preferable to full registration because both the time and cost should be less than for a full registration. Many of the requirements for an SB-2 Registration Statement are the same as for a full registration. However, only two (2) years rather than three (3) years of audited financial statements are required and many of the other requirements are simplified.

As with any public offering, care should be taken to provide an adequate quantity of securities held by members of the public so that there is adequate float for market makers to maintain an orderly aftermarket in the company's securities. One clear advantage to the use of Form SB-2 over its predecessors is that users of an SB-2 Registration Statement may take advantage of a new forms for registration and periodic reporting pursuant to the Securities Exchange Act of 1934 (the "1934 Act"), using simplified annual and quarterly reporting forms.

The minimum time from the date work is started until the effective date for an SB-2 probably is three (3) months rather than the estimated five (5) months for a full registration. As always, if problems are encountered, the time can be longer. An estimate of the legal costs is $65,000 to $95,000. There are additional costs of accounting, printing, blue sky fees and similar costs but hopefully the total costs for an SB-2 would not exceed $100,000.

Regulation A Filings

Regulation A filings are made pursuant to the Section 3(b) exemption from registration under the 1933 Act. A notification including an offering circular (similar to a prospectus) is filed in the home office of the SEC for offerings of up to $5,000,000. If submitted to the SEC prior to the time of first use, Regulation A now allows an issuer to distribute a "freely written" document generally (so long as it does not make offers, the issuer does not accept money, and certain required information is provided) in order to "test the waters" for indications of interest in the formal offering to come. This information may be published in print or broadcast. After its use, however, certain time periods are delineated during which sales cannot be made (i.e. a "cooling off" period is prescribed). The SEC also permits the use of a modified question-and-answer format for the disclosure document. However, the format is not used in any other SEC disclosure document and it is presently unclear to us the extent to which simply following the "Q&A" format proposed by the SEC will result in both an effective selling document and compliance with the antifraud rules in the securities laws.

Generally, with a Regulation A filing the process appears to involve the same type of legal work as is involved in an SB-2 filing (formerly, the process also involved considerable effort in determining sales of other securities which might be counted - "integrated" - in determining the ceiling requirement which if exceeded destroyed the exemption; however, the SEC significantly reduced this problem effective August 13, 1992). Regulation A permits the issuance of tradable stock and thus the existence of an aftermarket. The time and legal costs for a Reg A offering probably would be less than for an SB-2, i.e., a minimum of three months and $45,000 to $80,000. Also, there are accounting, printing and other costs so the total cost could be in the neighborhood of $95,000.

Limited Offerings

Rule 506

Rule 506 technically is a set of guidelines, which, if met, create a presumption that the nonpublic offering exemption in Section 4(2) of the 1933 Act is available. Actually Rule 506 placements are private offerings of restricted securities to an unlimited number of accredited investors (see below) and not more than 35 non-accredited purchasers. Unfortunately, for many years neither the securities laws nor the SEC regulations provided any private offering procedures. As a result, pressure built up to expand the Section 4(2) nonpublic offering exemption beyond its intended purpose. Because of this historical accident, Rule 506 technically is an interpretation of the nonpublic offering exemption and consequently is subject to many of the uncertainties which surround the use of the Section 4(2) nonpublic offering exemption. A small businessman using Rule 506 must realize that it entails risk, but the risk should usually be acceptable from a practical standpoint.

There is no dollar limit on the use of Rule 506, but instead, the limit is on the number of non-accredited investors which is limited to 35. If the issuer is not a reporting company under the 1934 Act, these investors (i) must be provided information substantially equivalent to the information which they would receive if furnished an offering circular prepared pursuant to Reg A, (ii) must be sophisticated in commercial matters (e.g. they must be able to understand the information furnished to them), and (iii) usually must be wealthy. The offering may also be made to an unlimited number of "accredited" investors which are essentially institutions, including savings and loan associations and similar institutions such as credit unions, whether acting for their own accounts or as fiduciaries, and broker-dealers if registered under the 1934 Act and purchasing for their own accounts; any partnership, corporation, or business trust with total assets in excess of $5 million; trusts with at least $5 million in assets as long as the trust was not formed solely to make the investment; any directors, executive officers or general partners of the issuer; any person who has a net worth of $1,000,000; and any person with an income in excess of $200,000, or has an annual income jointly with that person's spouse of $300,000, for the last two (2) years and who reasonably expects an income in excess of $200,000/$300,000 for the current year. Although the number of offerees (as distinguished from investors) is not limited, the offering cannot be advertised. The work involved in doing a Rule 506 private placement includes the preparation of an offering memorandum which involves much the same work as drafting a prospectus for a registration statement. However, because the offering memorandum is not reviewed by the SEC or (in most states) by any securities authority, the time and money costs resulting from the review procedure are eliminated.

Rule 506 also may be used by public companies which can incorporate by reference the reports required under the "1934 Act". Thus, costs and preparation time for public companies often are less than for a nonpublic company. For a nonpublic company, legal costs should range between $7,500 and $17,500, depending upon the number of states involved and the quality of the company's existing written business plan, if any. There may be some accounting costs but other costs should be minimal. Consequently the total cost for doing a typical Rule 506 private placement should be between $10,000 and $20,000. Although a Form D notice is filed with the SEC and certain states require other filings, Rule 506 filings normally are not reviewed by a securities authority and therefore the private placement normally can commence as soon as the offering memorandum has been completed. Usually it takes from 30 to 60 days to do the preliminary work (similar to that described under "Full Registration" above) and prepare the offering memorandum.

Rule 505

Rule 505 was adopted by the SEC pursuant to Section 3(b) of the 1933 Act and relates to the sale of "restricted securities" in limited offerings. It is generally quite similar to Rule 506. However, the amount of this offering is limited to $5,000,000. Further, Rule 505 is not available to an issuer that is an investment company. Sales may be made to up to 35 persons plus an unlimited number of "accredited investors." If a small businessman is able to fit a limited offering within the existing restrictions of Rule 505, consideration should be given to doing so rather than using Rule 506 and Section 4(2).

Intrastate Offerings Pursuant to Rule 147

Section 3(a)(11) of the 1933 Act as interpreted by Rule 147 provides an exemption from the Section 5 registration requirements for an offering of securities sold to residents of only one state which also is the state in which the issuer is incorporated and conducts its principal business. Although no filing is made with the SEC, usually it is necessary to file a registration statement by qualification in the state in which the offering will be sold. In these offerings it is necessary for the state to assume review responsibility which in other offerings is assumed primarily by the SEC. The extent of such review depends upon the practice in each state. Consequently, until a particular state is designated, it is impractical to predict the time or costs involved in an intrastate offering. In some states the review essentially is the same as the review by the SEC of a full registration statement while in other states the review is limited and the issuer has almost the same flexibility as it would have in preparing a Rule 506 private placement memorandum.

The problem with relying upon the Section 3(a)(11) exemption is that historically this exemption was abused and used for large public offerings. The SEC enforcement division responded, a number of indictments were returned and as a result, such offerings have a poor reputation within the securities industry. Further, under Rule 147, aftermarket trading must be limited to residents of the particular state for a period of nine months following the offering and as a result, it is difficult to establish any aftermarket. Because of these difficulties, we discourage reliance upon this exemption except for small local offerings. Even in such instances, an SB-2 Registration Statement, a Reg A offering circular, a Rule 506 private placement or a Rule 504 Notice filing often is more appropriate.

Rule 504

Rule 504 permits the sale of up to $1 million of securities in any 12 month period and is available to companies not subject to the reporting requirements of Sections 13 or 15(d) of the 1934 Act and companies that are not investment companies. The exemption, like Rule 505, is based upon Section 3(b) of the Securities Act and thus has the advantage of not being subject to the uncertainties associated with the Section 4(2) nonpublic offering exemption. Within 15 days after the first sale is made pursuant to Rule 504, a Form D notice must be filed with the regional office of the SEC. Under Rule 504, the issuer still has a burden of full disclosure under the antifraud provisions of the Securities Act and state securities laws; therefore it is often necessary to prepare an extensive disclosure document similar to a private offering memorandum used in connection with Rule 506. As a practical matter, however, small offerings which come within the criteria of Rule 504 usually can be described in a simple disclosure document, often a thoughtfully composed letter. Although a lawyer normally would not give an opinion as to the availability of Rule 504, in the best of circumstances, the lawyer should be able to assist a small businessman during a period of two or three days in drafting a document which tells the story of the small businessman's business. If each investor acknowledges in writing receipt of such a document, a Rule 504 notice is filed with the SEC and appropriate state filings are made, the business risks which must be assumed by the small businessman in connection with such an offering should be acceptable. In this situation, legal costs should be significantly less than $7,500 and there should not be other significant costs.

Nonpublic Transactions

The Section 4(2) nonpublic offering exemption was included in the 1933 Act to exempt the great majority of business investments which truly are private in the sense that only those participating in the business venture are permitted to invest. Usually, instead of being offered an investment on a "take-it-or-leave-it" basis, as is the situation in a public offering, private investors are in a position to negotiate the terms of the securities transaction. Such investors do not need to devote a significant amount of time (or even any time) to the business venture. However, a truly private investor is one who has a real say-so in how the business venture is structured. Often a private investor negotiates the transaction by requiring that the business venture be structured in a particular way. "Venture capital" deals are often structured under this non-public exemption. Such transactions are exempt from registration under the non-public offering exemption found in Section 4(2) of the 1933 Act.

The arrangements and relationships in a truly private transaction often are documented by carefully drafted consent minutes which are signed by each investor and each director. The use of consent minutes or making a person a director does not assure the availability of the Section 4(2) non-public offering exemption. Further, if one is appointed as a director, that person must act as a director and not be a director in name only. Also, just because an investor signs consent minutes, if it otherwise can be established that such person had no voice as to the contents of the minutes or the structuring of the business venture, then the exemption might not be available. On the other hand, most small businessmen who in good faith sell securities to persons who in fact negotiate a securities transaction or who are significantly involved in the management of the business venture, are willing to accept the business risk involved in relying upon the non-public offering exemption.

Regulation S

It should also be noted that the SEC permits an offering to non-residents of the United States through compliance with its Regulation S. The SEC does not review the documents used in such offerings, although the antifraud rules probably still apply. Such offerings are relatively inexpensive in terms of the legal fees involved in complying with federal law, although one must also explore the compliance issues involved with the law of the foreign jurisdiction. In the event that the small businessman believes that he or she is capable of selling all the securities in the offering to non-residents, please do not hesitate to ask us about this option.

Small Offering Exemption: Employee Benefit Plans

For purposes of completeness, we note that under Rule 701, offers and sales of securities by issuers who are not yet "public" may be exempt from the securities registration requirements if made pursuant to a written compensatory benefit plan and interests in such a plan are pursuant to a written contract of compensation. Plans that qualify for the exemption are purchase, savings, option, bonus, stock appreciation, profit sharing, thrift, incentive, pension, or similar plans. Only the issuer, its parent or majority owned subsidiary may establish the plan. Participants in the plan are limited to employees of the issuer, directors, general partners, trustees (if the issuer is a business trust) officers and its consultants or advisers if they are rendering bona-fide services.

It is important to note that the exemption does not apply if the primary purpose of the plan is to "raise capital." Additionally, Rule 701 was adopted pursuant to Section 3(b) of the 1933 Act, and there are limits on the total amount of securities that may be offered in a twelve-month period when this exemption is in place.

Restricted Securities

Restricted securities are securities which cannot be sold freely into the public market. However, this does not mean that restricted securities may not be sold under any circumstances whatsoever. Restricted securities may be sold in what are commonly known as "negotiated transactions" to sophisticated investors who are willing to accept the securities as restricted securities. Although such transactions should be made only with the advice and assistance of a securities lawyer, negotiated transactions can usually be successfully accomplished.

Rule 144

Rule 144, the "safe harbor" exemption for resales of restricted securities, waas amended effective February 15, 2008. Pursuant to Rule 144 as amended, after restricted securities have been held for six (6) months, if there is a public market in the securities, usually a person who is an "affiliate" of the issuer (see below) may sell up to 5,000 shares or $50,000, which ever is greater, of the outstanding shares of the issuer into the market in any three-month period by complying with the conditions of Rule 144. In addition to (i) the 5,000 shares or $50,000 requirement, and (ii) the three-month requirement, Rule 144 requires that there must be (iii) current information available concerning the issuer at the time of the sale, (iv) in most instances, a Form 144 must be filed with the SEC, (v) there can be no solicitation of the order to buy, and (vi) the transaction must be handled as a broker's transaction or directly with a market maker. Thus, if a company goes public after securities are received in a Rule 506 transaction, a Rule 504 transaction or a nonpublic offering transaction, the securities which originally were restricted securities normally may be sold after six (6) months into the public market under Rule 144.

Pursuant to the provisions under paragraph (k) of Rule 144, a non-affiliate beneficial owner of restricted securities who has owned the securities of reporting issuers for a period of at least six (6) months prior to sale will be exempt from (i) the 5,000 shares or $50,000 volume limitation, (ii) the manner of sale requirement, and (iii) the Form 144 filing requirement. Furthermore, once the six (6) month period has passed, the non-affiliate owner of these securities may have the restrictive legend and stop transfer instructions deleted from the securities. An "affiliate" is a person that directly or indirectly controls or is controlled by the company.

Under amended Rule 144, owners of shares of non reporting issuers who have held their shares for less than twelve (12) months may not resell their securities. Thereafter non-affiliates are permitted unlimited resales, but affiliates must sell in compliance with the volume limitations of Rule 144.

An "affiliate" is a person that directly or indirectly controls or is controlled by the issuer or is under common control with the issuer.

Underwriting

A small businessman may sell securities himself in a limited offering, a Rule 504 offering or in a nonpublic transaction but usually it is necessary to engage an underwriter if securities are to be sold to the public under a registration statement. Essentially there are two types of underwriting agreements: (i) "firm" and (ii) "best efforts." Firm underwriting agreements are preferable. In the past, many of the small offerings were done on a best efforts basis but recently even small offerings have been done on a firm basis.

The term "firm" is misleading because usually a firm underwriting agreement is not signed (thus there is no firm contract) until the registration statement is declared effective by the SEC. Consequently, the small businessman in a firm underwriting bears the risk of incurring all of the structuring and registration expense on the basis of only a letter of intent. When the firm underwriting agreement is signed at the time the SEC declares the registration statement effective, the underwriters (usually there is a syndicate or group of forty or fifty underwriters) agree to buy all of the securities offered at a discount (usually less than ten percent (10%)) from the price at which the underwriters will sell the securities to the public.

What happens in a firm underwriting is that the group or syndicate of underwriters will have distributed preliminary "red herring" prospectuses to customers, both directly and through participating dealers, prior to the time the registration statement is declared effective and will have obtained "indications of interest" from customers. The "indications of interest" are tabulated by each underwriter who in turn gives the information to the managing underwriter who allocates the securities among the various members of the underwriting syndicate and who maintains the distribution list which commonly is known as the "book." As a result, when the registration statement is declared effective by the SEC, confirmations are mailed with copies of the final or definitive prospectus to persons who have given "indications of interest." Consequently, in a well-managed firm underwriting, the entire offering often is sold within a matter of minutes after the registration statement is declared effective. During the next several days, the money is collected from the customers by the underwriters. Typically, the underwriting agreement is closed and the proceeds paid to the company within a week to ten (10) days after the signing of the underwriting agreement.

A "best efforts" underwriting agreement is simply an agreement by an underwriter to use its best efforts to sell the securities. Although a "red herring" prospectus can be used to obtain indications of interest prior to the effective date of the registration statement, often the selling effort is postponed until the registration statement is declared effective and the selling is done on the basis of the final or definitive prospectus during the thirty- to sixty-day period following effectiveness. Usually an escrow agreement is entered into with a bank so that as funds are collected by the underwriter from the sale of securities, the funds are deposited in the bank until all (or at least a substantial percentage) of the offering amount is on deposit in the bank. When the escrow amount is reached, the funds are paid to the company less commissions which are paid to the underwriter. Best effort underwriting agreements usually are used by small underwriters who, because of limited capital, are unable to incur the liability which exists for a period of a few days under a firm underwriting agreement. Further, small underwriters often are unable to assemble a group or syndicate of underwriters to help sell the offering and thus are willing to contract to buy the securities even after the effective date as in a firm underwriting.

The underwriting agreement is simply a contract between the company and the underwriter and can have various provisions. Typically it sets the price, number of shares, registration procedure and indemnification arrangements. Usually in a firm underwriting agreement the underwriter obtains an overallotment option which permits the underwriters to buy an additional percentage of the offering so that securities are available for use in stabilizing the market price immediately following the offering. Smaller underwriters sometimes insist upon obtaining as additional compensation from the company an option permitting the underwriter to purchase five percent (5%) or ten percent (10%) of the amount of the offering for a period of up to five (5) years following the offering. Additionally, smaller underwriters often require the company to advance $10,000 or $15,000 to pay the underwriter's costs during the registration process.

Satisfactory underwriting arrangements are essential to a successful public offering. Until a letter of intent is obtained from an underwriter, a small businessman should not engage lawyers, accountants and other professionals to commence the registration process because if there is no arrangement for the sale of the securities, there is no purpose in incurring the significant expense of registration. For this reason, many small businessmen conclude that they are at the mercy of underwriters and must agree to anything which the underwriter requests. However, one should remember that underwriters also compete for business. Thus, if the proposed offering is well conceived, the underwriting negotiations should be on a fair basis.

Costs

The legal costs mentioned above are rough estimates given solely for the purpose of alerting a small businessman to the magnitude of the costs pertaining to the different alternatives. The actual charges for legal services will be based on the time devoted to the project by lawyers, paralegals and secretaries, the out-of-pocket expense incurred such as travel, photocopying and telephone charges and the result achieved. Usually, a retainer equal to the minimum estimate is paid before any work is commenced. Thereafter statements are rendered periodically. If the project is terminated or concluded, any previously paid retainer will be returned after submission and payment of a final statement.

In addition to legal fees and expenses, a small businessman should obtain estimates of accounting fees, printing costs, SEC, FINRA and state filing fees, fees of other professionals such as engineers and underwriters expense allowances. One should make sure that satisfactory arrangements have been made to pay such "front-end costs" before engaging anyone to start work on a project.

Often times a small businessman does not have sufficient money or credit through conventional sources to pay the "front-end costs." Although risky to small businessmen and often more expensive, if no funds can otherwise be obtained to pay the front-end costs, sometimes nontransferable, convertible, subordinated promissory notes personally guaranteed by the small businessman are sold to a few sophisticated investors. The notes are (i) made nontransferable to avoid distribution problems under the securities laws, (ii) convertible so that the investor has an opportunity to profit from the venture, (iii) subordinated to avoid the possibility of precluding loans from banks and other financial institutions and (iv) personally guaranteed to provide by contract essentially the same liability against the issuer's organizers as the payee could obtain by suit under Section 12 of the Securities Act based on a theory that the promissory notes were sold in violation of either the registration or anti-fraud provisions of the Act. Of course, every effort should be made to avoid violating any securities laws and regulations. If complete and accurate disclosure in a letter or other written document similar to the type of document used in connection with a Rule 504 offering is used and if the nontransferable convertible subordinated promissory notes are sold to only a few sophisticated investors who have complete and accurate information concerning the issuer, the sale of notes should not be held to be in violation of the securities laws.

Attorneys' Stock

Small businessmen often ask the attorneys to buy stock in their venture thinking that (i) proceeds from the sale of the stock are available to pay part of the front end costs and (ii) the attorneys will have a proprietary interest in the business. Securities lawyers must remain objective and therefore, if asked to do so, lawyers in this firm will normally not buy stock.

Continuing Obligations

Once securities are sold to others, the company has a continuing obligation to keep those who own securities informed concerning the company's affairs. This is especially important for companies which have securities which are actively traded in the market. Companies having more than 500 shareholders and $10,000,000 in assets are required to register under Section 12 of the Securities Exchange Act of 1934. If we represent a company at the time it is required to so register, we typically provide to the company at that time a detailed written summary of its obligations under the 1934 Act. In general, such a registration is not difficult, but once registered a company has several continuing obligations including, but in no way limited to, the following:

1. Reports. Generally, a company registered under the 1934 Act must file 10-K reports annually, 10-Q reports quarterly and 8-K reports following the happening of specified important events (a "small business" issuer, as defined above, will use simplified disclosure forms 10-KSB and 10-QSB). The 10-Q reports, containing primarily unaudited quarterly financial information, customarily are prepared in-house and merely reviewed by counsel. However, 10-K annual reports require audited financial information and the narrative parts customarily are prepared by counsel. If the company's securities are quoted on NASDAQ, copies of the reports must be filed with the FINRA. A $250 filing fee must be paid to the Securities and Exchange Commission each year when the 10-K report is filed.

2. Proxy Material. A company registered under the 1934 Act must file its proxy material with the Securities and Exchange Commission and as a practical matter receive clearance (or not receive comments within 10 days after the filing) before mailing the proxy material to its shareholders in advance of a shareholders meeting. There must be included within the proxy material a description of management's remuneration, shareholdings and transactions with the company and other information which the SEC considers should be disclosed to shareholders on an annual basis. Proxy material customarily is prepared and filed with the SEC by the company's attorneys. A $125 filing fee must be paid to the SEC each year when proxy material is filed.

3. Insider Trading. Officers, directors and ten percent (10%) shareholders of a company registered under the 1934 Act are prohibited from profiting by making short-term trades in the company's stock. Section 16(b) requires any such person to pay any profits realized from trades within a six-month period to the company even though there was no intentional wrongdoing. So that there will be a record of such trades, officers, directors and ten percent shareholders are required to file Forms 3 and 4 with the Securities and Exchange Commission following such trades. In addition, the anti-fraud provisions of the 1933 and 1934 Acts can create other insider trading liabilities.

4. Tender Offers. A company registered under the 1934 Act is subject to the tender offer rules which are a mixed blessing. If a corporate raider is attempting to take over a company, the company must be notified under the tender offer rules. On the other hand, the SEC has adopted rules under Section 13(d) of the 1934 Act which require the filing of Schedules 13D or 13G by all persons owning more than five percent of the company's outstanding stock. Further, such reports must be kept current by amendment. Although the reports appear simple, the preparation of such reports involves difficult questions and consequently the costs in both time and money are significant.

Time and money must be devoted to both (i) the foregoing specific requirements and (ii) the fundamental obligation of a company to keep its shareholders and the public informed. Thus, before deciding to "go public," one should be prepared to accept a "fishbowl existence" and incur the annual cost for accountants and lawyers. Such costs for some very small companies have been as low as $15,000 per year but for most small businesses the cost, including the cost of the annual audit, will exceed $45,000 per year and may be considerably more.

Conclusion

In addition to the foregoing, the ability of the businessman to successfully raise sufficient monies (in compliance with the federal and state securities laws) is measured by a myriad of additional legal and non-legal factors and concerns. Lawyers in this firm have participated in thousands of business financings. We can help identify and deal with many of these factors and concerns based upon our experience and that of your other advisors and we look forward to working with you.

QUESTIONNAIRE

1. Issuer. Please give the name, address and telephone number of the corporation (or other issuer):

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2. Management. Please list on a separate sheet of paper the (i) name, (ii) home address and phone number, (iii) business address and phone number, (iv) social security number, (v) date and place of birth, (vi) number of shares or percentage of issuer's securities owned, and (vii) principal occupation during the last five years for each person who is now or who is proposed to be an officer, director or 5% shareholder of the issuer. If conveniently available, attach a biographical sketch of each such person.

3. Amount. How much money do you want to raise in the sale of securities? _____________________________________________

4. Use of Proceeds. Specify in as much detail as possible how you propose to use the proceeds of the offering?

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5. Security to be Sold. Describe the security to be sold. And, if stock, what percentage of the outstanding stock following the offering will be held by those purchasing the offering?

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6. Underwriter. Has an underwriter agreed to sell the offering? If so, give the name and address of the underwriter and the terms of the underwriting (i.e., percentage commission, firm or best efforts, all or none underwriting, amount of expense allowance, and warrants, if any).________________________________

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7. Other Public Companies. Is any officer, director or 5% shareholder a director or officer of any other corporation which is required to file 10-K, 10-Q, and 8-K reports or 10-KSB, 10-QSB and 8-K reports with the Securities and Exchange Commission? If so, please give the name of such person and the name and address of the corporation(s) with which each person is affiliated.

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8. Auditors. Give the name and address of the independent accountant that audits your financial information.

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9. Financial Statements. Attach copies of your financial statements for the last five years (or, if sooner formed, since inception) together with auditor's reports (if available) and notes.

10. Management Letters. Have you received within the last five years a letter from your auditors commenting on your company's operations? If so, please attach copies of all letters.

11. Articles of Incorporation. Attach a copy of the Articles of Incorporation, as amended, of your corporation (or similar documents such as partnership agreement).

12. Minutes. Please attach copies of the bylaws and all corporate minutes (or similar documents) pertaining to meetings during the past 12 months.

13. Litigation. Please describe all pending or threatened litigation or administrative proceedings in which the issuer or any member of management is involved. _________________________________________________________________

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14. Insider Contracts. Please list and briefly describe all contracts between the issuer and any officer, director or 5% shareholder entered into within the last five years or which have not been completely performed.___________________________________

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15. Business. Please describe the business and properties of the issuer. Please include value totals for the issuer's assets and revenues over the last three years, if available.

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16. Recent Securities Sales. Please describe all securities sold by the issuer within the last 12 months, giving the name and address of each purchaser, a description of the securities sold and the amount paid for the security.

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17. Material Contracts. Please list, give the dates and briefly describe all contracts entered into other than in the ordinary course of the business. If conveniently available, please attach copies of all such contracts.

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18. Employee Commitments. Please describe all executive employment contracts, union contracts, profit sharing plans, savings plans, incentive plans, bonus plans, pension plans, medical and hospitalization plans, and similar type contracts and arrangements.

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This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

Copyright © 2000, Fairfield and Woods, P.C.,
ALL RIGHTS RESERVED.

Comments or inquiries may be directed to:
John A. Eckstein.