JOBS Act Secretly Cramps Friends-and-Family Funding

Tell Cousin Phil to put away his checkbook. By opening up solicitation, the government also limited who can fund your business for equity in certain cases.

Natalie Gordon was two years into bootstrapping her online baby-gear registry start-up, BabyList, when she was accepted into the 500 Startups accelerator. 500 Startups encouraged her to raise funding to speed up growth, and she did so with considerable success: She put together a first funding round amounting to $120,000.

That allowed her to hire three employees and rent office space in San Francisco, and, she says, gave her the credibility that led rapidly to another half-million dollars in investment. "Thanks to that money, I've been able to grow the company a lot since then,” Gordon says.

It's a classic story, including this element: of that $120,00, more than half ($70,000) came from family members and assorted friends. Today, Gordon couldn't do that. It is no longer legal for a start-up to take money from both friends-and-family investors, as they are called, and professionals. It's one or the other. That's because of a little-noted side effect of a provision of 2012's Jumpstart Our Business Startups Act, or JOBS Act, which went into effect last week.

You've probably heard about the new ability of start-ups to do equity-based crowdfunding, based on last week's lifting of the 80-year-old ban on general solicitation. It's that same provision that blocks friends and family who are not "accredited" investors (any individual with, basically, an annual income of more than $200,000 or non-home net worth of more than $1 million) from such funding rounds. The JOBS Act, which on its surface is a sweeping attempt to simplify the funding process for start-ups, is actually limiting funding options for the scrappiest companies in the United States.

Once you start talking openly about your fundraising, you relinquish the right to include your very interested but not very wealthy Uncle Pennybags in your funding round. "The letter of the law is that if you are generally soliciting your round, you have to go to accredited investors only," says Chance Barnett, a serial entrepreneur, start-up adviser, and CEO of Crowfunder.com, a platform for equity-based investment.

And if you're determined to involve Uncle Pennybags? You relinquish the right to involve accredited investors.

That's not all. Let's say your friends and family assure you that they do qualify as accredited investors. According to the Securities and Exchange Commission, you--the issuer--must also take "reasonable steps to verify that such purchasers are accredited investors." Meaning: You may need to prove your kin or pals chipping in for funding are actually as financially fit as they claim. And that might just be a position you don't want to put yourself in, notes William Carleton, a Seattle-based startup lawyer who has written extensively about the new rules on his popular legal blog.

"What I've been telling clients is that there is no friends-and-family exemption," Carleton says. "There's no easy way to raise money from grandma, even if she is an accredited investor, because you have to be willing to take reasonable steps to verify that."

I know what you're thinking: Surely there's a way to take a small amount of money from dear old granny without looking deeply into her finances.

"You can do a deal that is not general solicitation--but good luck figuring out the definition of 'general solicitation' alone," said Peggy Wallage, managing director of Golden Seeds, a firm that's invested $60 million in companies, at the WomanCon conference in New York City in late September, where she was speaking about funding options before an audience of female entrepreneurs. "It's not simple. You need to talk to lawyers."

Before you even seek legal help, tread lightly: If your friends or family--anyone with whom you are in regular and close contact with--want to chip in for a small round of funding, the new laws require you to stay tight-lipped about it to everyone else. That includes private communication online, or alluding to the fundraising, say, on Facebook, because that could be construed as "general solicitation."

"It's still somewhat gray, but if you are communicating with anyone who you don't have a significant existing relationship with, you can't mention it," Barnett says. "People should just be careful to not use any Twitter, Facebook, or email to discuss the deal."

San Francisco-based start-up lawyer Andre Gharakhanian, a partner at Silicon Legal, says he doesn't expect friends-and-family rounds to disappear. They will, however, come much earlier in a company's existence, with a general-solicitation round following. The classic story, is appears, is going to have to change.

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