The Secrets of Wall Street

A Person Who Won’t Read Has No Advantage Over A Person Who Can’t Read. ~Mark Twain Table of Contents

FOREWORD ...... - 4 - Chapter 1: An Introduction to Raising Capital in the United States ...... - 8 - Chapter 2: The Perfect Storm: Are you Ready? ...... - 28 - Chapter 3: Capitalizing On the Winds of Change ...... - 41 - Chapter 4: Knowledge is Power: The Power-Play ...... - 45 - Chapter 5: Conduct a Series of Related Securities Offerings ...... - 58 - Chapter 6: Why Entrepreneurs Fail to Raise Capital...... - 67 - Chapter 7: The Four Professional Functions of a Securities Offering ...... - 76 - Chapter 8: Organizational Structures & Management Mindsets ...... - 82 - Chapter 9: Deal Structuring ...... - 91 - DEAL STRUCTURES FOR OPERATING COMPANIES ...... - 94 - DEAL STRUCTURES FOR FUNDS ...... - 98 - Chapter 10: Company Valuation and Securities Pricing ...... - 109 - Chapter 11: Attracting Capital: Warping the Risk - Return Continuum ...... - 120 - OPERATIONAL RISK ...... - 121 - FINANCIAL RISK ...... - 121 - LITIGATION/REGULATORY RISK ...... - 123 - Chapter 12: The Two Most Popular Deal Structures for Start-Ups ...... - 127 - Chapter 13: Testing the Waters ...... - 135 - THE R&D OF DEBT CAPITAL ...... - 136 - THE R&D OF EQUITY CAPITAL ...... - 138 - Chapter 14: Making Structural Changes ...... - 144 - Chapter 15: Securities-Offering-Document Production ...... - 148 - Chapter 16: US Securities Laws ...... - 153 - EXEMPTION DECISION MATRIX ...... - 156 - Chapter 17: Crowdfunding ...... - 165 - I. DONATION-BASED CROWDFUNDING ...... - 165 - II. CAPITAL-BASED, REGULATION CROWDFUNDING ...... - 166 - Issuers of Securities ...... - 166 - Qualification ...... - 166 - - 1 - Copyright © Commonwealth Capital, LLC 2003-2019

Limitation on Investment Amounts ...... - 167 - Disclosure Requirements ...... - 168 - Intermediaries – Crowdfunding Portals ...... - 170 - Non-Integration with Concurrent Offerings ...... - 174 - Advertising the Offering ...... - 175 - Oversubscription and Offering Price ...... - 176 - Restrictions on Resales ...... - 176 - Relationship with State Law ...... - 176 - Exemption from Section 12(g) - Becoming an SEC Reporting Co...... - 177 - Chapter 18: Soliciting & Selling Securities to Raise Capital ...... - 178 - Chapter 19: Compliance with Federal and State Securities Laws ...... - 195 - About the Authors: ...... - 201 - TIMOTHY DANIEL HOGAN ...... - 201 - RUSSELL C. WEIGEL III, ESQ...... - 201 -

Dedications

Financial Architect™ is dedicated to my family, friends, and colleagues who tirelessly support my constant refining of Financial Architect™. Thanks to Nicole Ryan, Charles David Dreher, George D. Psoinos, Esq., Lynn Stedman, Esq., Bill Romanos, Esq., Ronald Alderman, CPA, and Carol Brubaker, CPA, for the enthusiastic support and assistance throughout the development of this system. Thanks to Scott J. McKinnon for the ongoing development of the Company’s international and domestic websites, and our e- commerce operations. Special thanks to Russell C. Weigel, III, for his legal perspectives.

Thanks to our Managing Directors and professional supporters who have been instrumental in the continued growth of the Company.

Special thanks to our current investors—Jeff H., Michael K., Johnny Z., Charles D., Charles N., David V., Roberto & Sine F., Bob & Joan D., Kip & Phelps E., Terry & Oliver H., and Tom & Margaret C. Kevin W. Steven R. David S. —who have placed their confidence in us, as well as their capital, in the very early stages of our Company.

Author: Timothy Daniel Hogan, Founder & CEO: Commonwealth Capital Advisors, LLC & Commonwealth Capital, LLC1

Disclaimer: THE INFORMATION CONTAINED IN THIS BOOK IS INTENDED FOR EDUCATIONAL PURPOSES ONLY, IS OF A GENERAL NATURE, AND IS NOT MEANT TO COUNSEL YOU ON YOUR INDIVIDUAL OR SPECIFIC CIRCUMSTANCES OR PLANS. THIS BOOK DOES NOT CONSTITUTE LEGAL ADVICE, NOR IS IT A SUBSTITUTE FOR LEGAL ADVICE. BY ACQUIRING, POSSESSING, OR READING THIS BOOK, YOU HAVE NOT BECOME A CLIENT OF THE AUTHOR OR ANY LAW FIRM IN WHICH THE AUTHOR IS ASSOCIATED, NOR DOES THE INFORMATION OR PROVISION OF INFORMATION TO YOU IN THIS BOOK CONSTITUTE AN ATTORNEY-CLIENT PRIVILEGED COMMUNICATION. YOU SHOULD CONSULT AN ATTORNEY LICENSED IN YOUR STATE BEFORE ENGAGING IN ANY ACTIVITY DISCUSSED IN THIS BOOK. YOU SHOULD CONTINUE TO CONSULT COMPETENT LEGAL COUNSEL THROUGHOUT ANY ATTEMPT ON YOUR PART TO IMPLEMENT ANY OF THE INFORMATION CONTAINED IN THIS BOOK.

THIS BOOK AND ITS CONTENTS ARE PROVIDED BY THE AUTHOR ON AN "AS IS" BASIS. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES OF ANY KIND, EXPRESSED OR IMPLIED, AS TO THE INFORMATION, CONTENT, MATERIALS, PRODUCTS, OR SERVICES INCLUDED IN THIS BOOK. TO THE FULL EXTENT PERMISSIBLE BY APPLICABLE LAW, THE AUTHOR DISCLAIMS ALL WARRANTIES, EXPRESSED OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE AND NON-INFRINGEMENT. THE AUTHOR FURTHER DOES NOT WARRANT THE ACCURACY OR COMPLETENESS OF THE INFORMATION CONTAINED WITHIN THIS BOOK. IN NO EVENT SHALL THE AUTHOR, ANY LAW FIRM OF WHICH THE AUTHOR IS ASSOCIATED OR WAS ASSOCIATED, OR THE PUBLISHER OF THIS BOOK BE LIABLE UNDER ANY THEORY OF LAW FOR ANY COMPENSATORY, DIRECT, INDIRECT, INCIDENTAL, EXEMPLARY, PUNITIVE, OR CONSEQUENTIAL DAMAGES. IN NO EVENT SHALL THE AUTHOR, ANY LAW FIRM OF WHICH THE AUTHOR IS ASSOCIATED OR WAS ASSOCIATED, OR THE PUBLISHER OF THIS BOOK BE LIABLE UNDER ANY THEORY OF LAW FOR INFORMATION PROVIDED THROUGH EXTERNAL LINKS TO WEB SITES.

1 Commonwealth Capital, LLC is a wholly owned subsidiary of Commonwealth Capital Advisors, LLC established April 9, 1998.

FOREWORD

By: Jeffrey H. Canfield, Esq.

I first became acquainted with Commonwealth Capital Advisors and their Financial Architect System™ in late 2003. At the time, I was a partner at a large general practice law firm (Bell, Boyd & Lloyd – Chicago) that had a substantial corporate practice. I was in the Intellectual Property Department. Inter-departmental cross selling was the watchword at the time, and I was often recruited by partners in our corporate department to develop intellectual property strategies for both newly formed start-up companies and established corporate clients.

Such was the case with Commonwealth Capital Advisors. One afternoon, I received an invitation to meet a new client who had developed some software for structuring deals for raising capital. I was to assess their technology and determine whether it might be patentable. The new client was Commonwealth Capital Advisors, and that day I met Tim Hogan. In short order, Tim launched into an enthusiastic description of Commonwealth Capital Advisors' new Financial Architect System™. As is often the case with new inventors, Tim was exuberant. It was clear that he was excited about Commonwealth Capital Advisors' new product, and he truly believed that Financial Architect™ would revolutionize the way start-up companies and entrepreneurs raise capital.

Tim related how many small businesses and entrepreneurs are denied access to capital because they can’t pay the price of admission. Private offerings, debt issues, and other instruments for raising capital require the hands of professionals. The lawyer and accountant fees associated with preparing SEC filings, pro forma financial projections, and the like, can push the costs of obtaining funding well beyond the reach of many promising start-ups. The idea was to reduce the cost of raising capital by reducing the professional fees associated with developing a capitalization plan and preparing the supporting documentation to implement the plan by teaching entrepreneurs to do the heavy lifting themselves and providing them with tools to get the job done.

In the quintessential American spirit of self-help and do-it-yourself-ism, why not teach entrepreneurs basic strategies, capital-raising deal structures, and give them the - 4 - Copyright © Commonwealth Capital, LLC 2003-2019

tools to start the process themselves? With a little effort and the right tools, there is no reason why ambitious hard-working entrepreneurs cannot put together their own capitalization plans complete with all the necessary financials and other supporting documentation. Taking care of these preliminaries on the entrepreneur’s time rather than the lawyer or accountant’s time could save thousands of dollars, even tens of thousands of dollars in attorney and accountant fees. Tim was not advocating bypassing the services of professionals all together, merely starting the billable clock much later in the process. By minimizing professional fees, start-ups and small businesses have a better opportunity to gain access to sources of capital from which their very lack of capital would otherwise exclude them.

All told, Tim’s presentation was impressive. The basic premise appeared sound; nonetheless, I was skeptical. I have worked with many, many inventors over the years. Most are enthusiastic about their ideas. Most are as enthusiastic as Tim was. Many inventors have very good ideas. Sometimes they have great ideas. Nevertheless, the task of turning a good idea into a tangible product or service that people will be willing to pay for is another thing entirely. Happily, my job does not require me to make judgments as to whether I think new inventions will sell or whether I think they are “a good idea.” My job is to assess whether an invention is patentable, and if so prepare a patent application and shepherd it through the Patent Office.

My initial assessment, with regard to Financial Architect™, was that various aspects of the system did appear to be appropriate subject matter for a patent. I committed to preparing an application. Shortly thereafter, I was supplied with all of the documentation and other resources that Commonwealth Capital Advisors had on hand to teach me about their invention. These included a draft copy of this book and the Securities-offering document Production Template Modules of Financial Architect™. They proved to be the only resources I would need.

At this point in the story, I should emphasize that I am not a finance person. I am a patent lawyer with an engineering background. Until I began working with Commonwealth Capital Advisors, my involvement with start-up companies had been limited to evaluating and protecting their intellectual property assets. Yet, to prepare a

patent application covering the novel aspects of Financial Architect™ I had to become thoroughly acquainted with the ins and outs of capital formation and deal structuring as well as all of the supporting documentation necessary to put together and implement an effective capitalization plan. Not only that, I had to learn these things quickly and on a budget.

The Secrets of Wall Street: Raising Capital for Start-Up and Early stage Companies and the document-production-template modules of Financial Architect™ were the perfect vehicles for bringing me up to speed. Within days I was acquainted with not only the various deal structures and financial arrangements that may be employed in developing a capitalization plan, I was running different scenarios, creating alternate deal structures and hybrid capitalization plans, changing deal structures, and evaluating which scenarios and capitalization plans would be best for my start-up business and my potential investors. I was able to view: how various deal structures played out over time; how they affected my bottom line; how they affected control of my company (I speak in the first person here because I literally felt as though I was setting up a capitalization plan for my own future business). In a very short time, I went from a clueless financing neophyte to a CEO with a plan. And not only did I have a plan, I had the pro forma financial projections compliant with GAAP (Generally Accepted Accounting Principles) standards to back it up!

Over the years I have worked with enough solo inventors and start-up companies to know that access to capital is the single greatest obstacle to bringing new ideas to market. Without adequate financial backing, even the most groundbreaking ideas will flounder. This book and Financial Architect™ have the power to prevent that from happening. When entrepreneurs are aware of the options open to them, when they have the tools to put a realistic, well-thought-out capitalization plan together by themselves, the cost of accessing the capital markets is significantly reduced. Armed with the insights gained from this book and the tools provided by Financial Architect™, entrepreneurs can tap pools of capital that, heretofore, were beyond their means to even consider.

So if you have an idea, if you have a plan, if your business has everything it needs—except the financial resources necessary to put your plan into action—start

reading. In short order, you will possess the knowledge and tools necessary to raise the needed capital to put your dreams into effect.

Jeffrey H. Canfield, Esq. Brinks Hofer Gilson & Lione www.usebrinks.com

Chapter 1: An Introduction to Raising Capital in the United States

“The truth is like poetry. Everyone says they appreciate it, but no one wants to hear it” ~Anonymous

The following stories are typical and problematic. These are the challenges and successes this book addresses.

****

Trevor, a newly hired apprentice in John and Steve’s start-up company, made haste as he nervously packed up the audio-visual equipment—Steve was about to launch into John once again how this all had been a complete waste of time. Lately, the tensions between the two men were becoming severe, palpable. John was clearly not in the mood to hear yet another lecture from Steve about the frustrations of “pounding the pavement,” seeking capital for their new company from venture capital and private-equity firms. Having spent his first twenty-three years as an US Air Force fighter pilot and hobby inventor, John had the discipline and tenacity (not to mention the intellectual prowess) to overcome almost any adversity. But his patience, too, was wearing thin. How many more false hopes and broken promises from these financial firms, which only sent “screeners” and never “decision makers” to these meetings, could he endure? After countless introductory and due-diligence meetings, they were exactly where they started five-and- a-half months ago—at square one. Having burnt through Steve’s inheritance and John’s savings, they were slowly going broke. Steve noticed something in John’s demeanor he was originally unaware of—a combination of fury with a much deeper pale of sadness (something was just not right). Was this slowly killing him? Steve decided to walk out of the room—the inevitable discussion of abandoning their dream could wait.2

****

Since childhood, Sue and Margo had always known they would have a place in each other’s lives. Best friends and entrepreneurs since Girl Scouts—laughter and inventiveness fueled this friendship. Once again, the national economy forced them to strike out on their own—because working at a coffee shop was not their idea of full-time employment. Having received “good advice” from her brother, a doctor, Margo convinced Sue they should seek to raise $1,000,000 through a crowdfunding web portal— Title III of the Jobs Act of 2012 enabled entrepreneurs to raise money through general solicitation. They went to a crowdfunding seminar, which was conducted by someone who claimed to be a pro on the subject. The advertisement referred to him as an “expert” in crowdfunding. Obviously, he must be—right?

Exhilarated to find investors, they signed up on one of the more popular, crowdfunding web portals, posting their company’s business plan without the proper guidance from legal counsel. Things started off great. In five months, they raised an average of $117,000 per month and were very prudent on how they employed those

funds. A few months later, they received news the web portal was seized by the SEC and seventeen state-securities administrators. Apparently, the regulators claimed the crowdfunding web portal Sue and Margo used was not properly registered. Further, because this portal enabled their client companies to simply post a business plan, the portal was charged with aiding and abetting fifty-seven companies in over 230 counts of various felonies—including securities fraud.

The SEC in turn seized the assets and forced liquidation of forty-three out of the fifty-seven companies, including Sue and Margo’s. Both women were banned from selling securities in the US for five years. Due to their lack of malice and intent, through plea-bargaining with the state and federal prosecutors, they survived any criminal convictions. Their investors, however, saw an open window to claim a breach of fiduciary duty on Sue and Margo’s part, citing lack of due diligence and proper legal counsel. This opened up their personal assets to attachment, voiding the limited-liability protection of their corporation. Their “American Dream” became a regulatory and litigation nightmare that started years ago and continues to this day.3

****

Darian and Kim’s social-media network had tens of thousands of followers and was growing daily. They just knew their first smart-phone application, would sell for ninety-nine cents to millions if they could only get it up and off the ground. They surmised they only needed $200,000 for launching their new company and releasing the application. Once this first app sold to the masses, they could create and sell more. They had tried the donation-based-crowdfunding platforms but only raised $11,454 in five months. Darian’s father, a CPA, suggested they speak with Ron, a good friend of his from college—a long-time SEC-enforcement attorney who now was running a private practice.

After their initial meeting with Ron, Kim and Darian were even more excited about the prospects of a successful venture, but realized just how much work was needed to prepare a business plan for Ron so he could produce the securities-offering documents. There’s lots of good news with Regulation Crowdfunding (aka Title III of the JOBS Act of 2012). An issuer of securities (the company seeking capital) through a Regulation Crowdfunding portal simply fills out Form C with the SEC before solicitation and sales can begin. The really good news is its being solicited to the general public. The bad news is an issuer of securities must use a crowdfunding portal exclusively [no other method of solicitation may be used] to offer and sell the securities. Even worse, they can only engage one crowdfunding portal to do so. That’s a lot of risk placing the ability to raise capital with one solitary effort and source. Regulation Crowdfunding also has a strict, relatively low, investment dollar limit per investor, thereby compounding that risk.

Although limited to a maximum offering amount of $5,000,000 per 12-month period, Regulation D - Rule 504 does not have a strict investment dollar limit per

3 This is a highly likely scenario in our current environment.

investor, so if one has friends, family, personal and professional contacts that would like to invest more than Regulation Crowdfunding allows, then they can simply invest using Regulation D - Rule 504 document.

Although the Regulation Crowdfunding Form C filed with the SEC doesn’t require a sophisticated securities-offering document, Ron thought it wise to produce a securities-offering document under Regulation D - Rule 504 because it would enable Kim & Darian to retain two critical elements he recognized as very important. First, due to the higher level of disclosure under Rule 504, the securities-offering document and elements of it included in Form C would protect Kim and Darian against any claims of securities fraud. Second and more importantly, it would allow them to avoid the singular dependence on the performance of just a crowdfunding effort with only one crowdfunding portal, as they now could sell securities concurrently to their friends, family, personal and professional contacts (with no dollar limit per investor), as well.

In other words, to properly sell securities concurrently directly to their friends, family, personal and professional contacts (with no dollar limit per investor), and through a crowdfunding platform, under “Title III” or “Regulation Crowdfunding” one needs to use the elements within the Regulation D - Rule 504 document to fill out Form C for the crowdfunding portal.

After researching successful securities offerings and the deal structures that made them so, they settled on a simple, three-year convertible-note structure to sell to investors. Ron suggested they move the size of the convertible-note offering to $1,000,000—just in case they needed more than originally thought. They could always close it early at a lesser amount, if necessary.

Once Ron was finished with their securities-offering documents he gave them the “thumbs-up.” He supplied them with a pdf copy of the Regulation D - Rule 504 document to send out to friends, family, personal and professional (pre-existing) investor contacts. Ron also gave them a MS Word copy to assist them in filling out (copy and pasting the elements in made easy) Form C with the SEC for the Crowdfunding effort. Darian and Kim used the business plan and disclosures in the Regulation D - Rule 504 document to fill out Form C with the SEC to qualify for Regulation Crowdfunding. Then they engaged a Crowdfunding portal to sell as much as it could, then went to work on selling the securities to friends, family, personal and professional (pre-existing) investor contacts under the exemption: Regulation D - Rule 504. Running with the “double- barreled shotgun” approach, they were able to further control the outcome and success of the capital-raising effort. Before engaging the crowdfunding portal and soliciting and selling securities under Regulation D - Rule 504 outside the crowdfunding portal, they obtained Ron’s blessing. (Early on in his college, business class, Darian learned an opinion of legal counsel is an affirmative defense in regulatory litigation.)

In addition, because they used Regulation D - Rule 504, Ron was easily and quickly able to file that document under their State’s Small Corporate Offering Registration (SCOR) allowing them to advertise the securities in their state and outside - 10 - Copyright © Commonwealth Capital, LLC 2003-2019

the crowdfunding portal. As some capital rolled in from friends and family, under SCOR they were able to advertise in the regional, financial publications. Although a little more expensive, that “triple-barreled shotgun” approach was highly effective. They learned quickly, when raising capital through public solicitation, using the general media, social media, and other means, you get what you pay for.

Ron oversaw all their regulatory requirements and was honored and excited to be a part of a real success story. Darian and Kim ended the offering early at $770,000; because they started to sell their app and unexpectedly received a significant, development contract from another company to design an app for them. Receiving outsourced app-design work was not part of their original business model; but after receiving support from their investor base, documented by Ron, they jumped at the opportunity. Funny how success breeds success!

****

Robert had met Kyle on the golf course at the invitation of his bother-in-law, Pete. Kyle, being a financial advisor for a large, New York investment bank and one of the leading advisors in the firm, was bored and quite frankly unfulfilled with his position in life. He used to say, “I often feel like a high-paid babysitter who shuffles paper and contributes nothing of any real value to society. I wish I had the passion of my youth in business and my life was an example to my kids.”

Robert, a savvy real estate investor and developer, had grown his business to the degree he could handle it with little effort. Having been fortunate to accrue some past successes in his field, by sharing some of the profits with his employees through an ESOP (employee stock-ownership plan), he was able to build a real estate-development firm successfully. His employees were loyal and took care of the company as if they owned it, which they kind of did, when Robert simply needed time to himself. He trusted them, as they did him. Trust…a lost commodity of sorts, he thought. He had choices— sometimes too many. He could either sell the company, continue as he had been, or expand to varying degrees. At fifty-five years old, what would Robert do if he sold it— continue as is? Sure, but he, too, was a bit bored. High achievers tend to get bored easily.

After the round of golf and over a couple of cold ones, Robert asked Kyle if he knew anything about how one would go about building a REIT (Real Estate Investment Trust). Kyle explained he knew enough to get in trouble but certainly could put Robert in touch with some experts in the field.

That was a little over five and a half years ago. Because the REIT concept was a completely new business model for Robert, it was structured as a start-up. That one, friendly question led to a dream come true for both of them. Robert was able to build a formidable real-estate empire from scratch in a niche market overlooked by the giant publicly traded REITs. Kyle came on as the new REIT management company’s CFO. He was the key in handling the securities-related aspects of building the firm. From individual investor contacts—through Kyle’s golden Rolodex, along with utilizing Title

II of the JOBS Act of 2012 (aka Regulation D – Rule 506(c)) with broker-dealer engagements, as well as in-house securities sales effort and with continued, good investor relations—they had more investment capital than they could employ. The good news is, under Title II of the JOBS Act of 2012, they were able to solicit accredited investors (only) for an unlimited amount of capital and they didn’t need to use a crowdfunding portal exclusively, to do it. The only bad news is that they had to obtain 3rd party verification of each investor’s accreditation prior to accepting an investment. To them, it seemed like an easy enough process to stay in compliance…and it was.

“It was simply the next level for both of us. The timing was perfect—two, successful fellas bored to death, needing the next level to grow personally, as well as professionally,” Kyle said.

Robert sought out the correct corporate and securities legal counsel, audit firm, and corporate financial-advisor firm and never looked back. Robert recently stated, “Once I knew how they did it on Wall Street, I wondered why none my old competitors did it. Today, I’m glad they didn’t because today they can’t compete with me…not even close.” ****

The first two of the previous four examples are not all that empowering are they? They’re meant to be what they are, a warning. The money game is the biggest game in town, and it’s also the roughest. If you’re a serious entrepreneur, brace yourself in this armor of knowledge. It’s meant to protect you from those who would take advantage of your naiveté, to whatever degree they believe it is. The contents of this book will enable you to do this right the first time whether you plan on simply sending business plans to venture capital firms or selling securities, such as; stock, bonds or cryptocurrency to individual and institutional investors to raise permanent or temporary capital.

This book is no substitute for proper legal counsel, accounting or corporate finance advice. It gives you the knowledge you need so that you can control the events and the professionals you hire throughout this process. The information in this book is designed to increase the probability of successfully raising capital in the United States to the highest degree possible. How can we (my senior management members and I) make such a claim? We can because these are the secrets of Wall Street in relation to funding start-up and early stage companies. We have simply brought the “Wall Street process” to “Main Street companies.”

This book was written as the precedent to a revolutionary change in the ability, not necessarily the way, to successfully raise capital. The fundamentals of the way to raise capital rarely change—if at all—however, the ability to perform the necessary tasks to ensure success has. However, as a treatise, we will also introduce you to complex processes that have been substantially streamlined and simplified for the benefit of your understanding of the way to raise capital successfully. We will also divulge numerous secrets, strategies, and techniques used to further your ability to successfully raise capital for your start-up, early stage, or later-stage Company. These are simplified versions of - 12 - Copyright © Commonwealth Capital, LLC 2003-2019

the practical applications used by Wall Street investment-banking firms. As it relates to raising capital for your company, our goal is to teach you how to deal from a relative position of strength throughout the life of your Company.

Most importantly, we want you to sell your company’s securities to us, as well as to and through our investor and broker dealer contacts.

The most challenging part of writing this book was to take an enormously complex set of processes and simplify them as much as possible—without degrading them. The true value of what you are about to discover herein is your ability to make a qualified decision if these processes are right for you and your Company. Only you and your team can make the qualified decision if your Company is ready (or not) to take on this challenge. The process of selling securities to capitalize a company is not for everyone. This is not child’s play. I often humorously refer to this book as a tool we use to scare away the few entrepreneurs who simply are at the “dreamer stage” in their journey. From decades of experience, we know these processes will work for those who are ready. Many entrepreneurs come back to us within a few months—when reality sets in, and only then are they ready for the challenge and opportunity for long-term success. When the student is ready…the teacher appears.

To be clear, the activation of the processes outlined and clarified in this book are for serious entrepreneurs only. This book is designed for those who need to raise substantial amounts of capital for start-up, early stage, or later-stage companies—or commercial projects—and want to maintain voting control and the vast majority of equity ownership. These processes are used by Wall Street investment banks to raise capital for their client companies. You can use them to capitalize your Company as well! Once you are able to successfully raise capital in the private markets, opportunities will abound. At that juncture, you may decide to take the Company public, sell it outright to a strategic acquirer, or remain private as your own personal, best investment. To raise capital, you do not have to take your Company public. These processes give you options, not restrictions.

A Few Definitions: The Language of “Wall Street.”

TYPES OF CAPITAL

“Capital” when referring to “raising capital,” we mean raising substantial amounts of capital for the traditional working capital needs of “for-profit companies.”

“Equity” can mean common equity or preferred equity.

“Common Equity” is voting (normally Class A) or non-voting (normally Class B) capital stock. Common shareholders (or members or unit-holders in an LLC) have the right to vote on matters as spelled out in the By-laws or Operating Agreement for LLCs. These rights normally extend to: 1.) The right to share in a prorated percentage of profits (and losses); 2.) The right to vote in elections of the Board of Directors, who - 13 - Copyright © Commonwealth Capital, LLC 2003-2019

in turn set policy and elect the Officers of a corporation, who implement policy and run the day-to-day operations of the business; and 3.) Common shareholders may also have preemptive rights according to the By-laws or Operating Agreement. Common shareholders are last in the chain of distribution rights in the course of liquidation, forced through bankruptcy or otherwise.

“Preferred Equity” is a non-voting form of capital stock. However, preferred shareholders (or preferred members or unit-holders in an LLC) normally do have limited right to vote on matters as spelled out in the By-laws or Operating Agreement for LLCs, such as; the right to alter, add or subtract the various attributes of the preferred equity. These rights normally require a unanimous vote of all preferred and possibly all common shareholders. Preferred shareholders may also have preemptive rights according to the By-laws or Operating Agreement. Preferred shareholders are normally the 2nd to the last in the chain of distribution rights in the course of liquidation, forced through bankruptcy or otherwise. The attributes of preferred equity are spelled out in By-laws or Operating Agreement. The following are examples of attributes of preferred equity, which could include, but necessarily be limited to:

a. “Stated Dividend” (or Cash Distributions for LLCs). Normally, holders of the Company’s Convertible Participating Preferred Units are entitled to receive “Stated Dividends” at a pre-set rate, such as; 8% per annum, payable quarterly, if and when declared at the discretion of the Board of Directors or Managing Member and out of funds legally available. Stated Dividends or Cash Distributions will depend upon, among other things, the operating results and financial condition of the Company, its present and future capital requirements, and general business conditions.

b. “Participating Dividend (or Cash Distributions for LLCs). The aggregate holders of 20,000 Convertible Participating Preferred Shares or Units could have the right to receive distributions from net income at a pre-set rate, such as; Twenty Percent (20%) (known as the Participation Rate) of the net after tax income. Participating dividends or distributions are typically paid annually within 60 days after the end of each calendar year.

c. “Conversion Privilege.” Holders of Participating Convertible Preferred Share or Units may have the right to convert into the Common Class A Voting Shares or Units at a pre-set pro-rated conversion ratio or price. Often the conversion ratio or price is commensurate with the participation rate any time until the Call date. The aggregate of the 20,000 Convertible Participating Preferred Share or Units may be converted, in whole or in part, into Twenty Percent (20%) on the total ownership of the company, on a fully diluted and on a pro rata ownership basis. Class A Voting Share or Units represent permanent equity in the company.

d. “Cumulative Dividends.” Convertible Participating Preferred Share or Unit Dividends are normally cumulative and are paid in arrears before any Common Class A Shareholders or Members receive dividends.

e. “Call Protection.” The Convertible Participating Preferred Units are typically callable at what is known as a pre-set “Call Price.” The Call price is pre-set with what is known as the “Call Premium” attached to it, to enhance the investors overall return. 110% or par value is typical for the Call Price. Normally, management may “Call” the Convertible Participating Preferred Shares or Units any time after the Call protection date has expired. Call periods typically run less than 5 years. Due to the call provision, the Convertible Participating Preferred Share or Units do not represent permanent equity capital in the Company.

f. “Forward Lien Position.” Convertible Participating Preferred Shareholders or Unit-holders shall have the right to receive distributions from liquidation of the Company’s assets, ahead of Common Class A Shareholders or Members, but behind any general creditors, such as; Note or Bond holders, secured credit lines from Banks, leasing companies , etc. if business failure were to occur.

“Common & Preferred” are “Types” of Equity.

“Traditional Debt.” We embrace reasonable amounts of debt as part of the overall capitalization mix—once a company has sufficient revenues to support the principal payments and accrued interest—because debt is the least expensive form of financing if one assumes success in the foreseeable future. However, too much debt can be dangerous in the early stages. Thus, before the entrepreneur obtains reasonable amounts of debt financing from banks, they normally must have a substantial amount of equity capital saved, raised, retained earnings, and or a combination from a sustained operating history. This often eliminates traditional debt structures for most start-up and early stage companies. It is important to keep in mind that financial structures need balance and that balance changes over time.

“Notes and Bonds” Commercial (as opposed to government) Notes and Bonds are typically priced at $1,000 each. However, one could price at any denomination for instance one bond for $10,000, $50,000 or a $100,000. Normally, one would issue 10 Notes or Bonds at a price of $1,000 for a $10,000 investment. The only real difference between the term “Bonds” versus “Notes” is the length of its maturity date from their issuance date. One would generally issue corporate notes with maturity dates ranging from ninety days to five years—corporate bonds 5–30 years (5, 10, & 30 year bonds are most common). Typically, one would issue notes and bonds in increments of $5,000 but can be any increment of $5,000, such as $10,000, $25,000, $50,000, etc. Notes and Bonds can be convertible into a pre-set amount of common stock or units at any time up to the maturity date.

OTHER TERMS REFERRING TO CAPITAL

“Class” is the “Designation” within the Type of Equity or Debt Capital.

“Series” in the “Order of Placement” i.e. timing relative to other offerings of the same Type of securities within the Designation of the Type of Equity or Debt Capital.

“Dilution” This is a phenomenon that few fully understand. It can be far more complicated given various conversion scenarios, so will keep it simple for the sake of understanding the principle. Dilution is the term used in the investment banking world in regards to the amount of the immediate value lost due to an investment in, primarily, common stock of a company with little or no marketable net assets. For instance, if an investor invests $1,000,000 in a young company that has no marketable net assets and receives 20% of the common stock (ownership) that investor just lost 80% ($800,000) of his or her investment, immediately. The company now has $1,000,000 in the bank (as its only net asset) and the investor only owns 20% of the company, or $200,000 of the $1,000,000 in the bank. Even if the investor owned 80% of the company, the investor would still lose the 20% or $200,000 immediately, which may take years to make up in value. With the inherent risks of investing in a start-up or early stage company, only a fool invests with any dilution present.

“Passive Capital” means attracting capital from investors who are not interested in any active management of a company but seek relative safety with a better-than-average rate of return on their investment. We refer to these investors as “True Angels.”

“Active Capital” means attracting capital from professional investors who seek active management, strategic support, or both—i.e., actual control of the company. These investors will structure the deal (e.g., offer terms of financing on a term sheet) to achieve relative safety while seeking a substantial return on their investment. In most professional circles, this type of capital is referred to as “high octane” capital because of the high- pressure demand for speed and performance often put on the recipient company’s management team. These investors are commonly referred to as “institutional” or “professional” investors; and this type of funding is more typically known as “venture capital.” Most Angel Groups are considered professional investors. Throughout this exercise we will address both types of investors (re: True Angels and institutional/professional investors), as both sources of capital have their place. In the early stages, passive capital is generally better for most companies, especially for entrepreneurs who seek the freedom of control without having to answer to another type of boss (e.g., Angel Groups or the institutional/professional investors). In other words, too many proverbial cooks in the kitchen can distract the entrepreneur from realizing their dream.

“Permanent Capital” means common equity. This normally is issued in the form of Common Class A Voting Stock or Common Class B Non-voting Stock for Corporations and Common Class A Voting Member(ship) Interests or Common Class B Non-voting

Member(ship) Interests for Limited Liability Companies (LLCs). Some states register an LLC as Member(ship) Interests and some as Member Interests.

“Semi-Permanent Capital” means hybrid securities convertible into common equity. This normally is issued in the form of Convertible Notes or Bonds; Convertible Preferred Class B Non-voting Stock for Corporations and Convertible Notes or Bonds; Convertible Preferred Class B Non-voting Member(ship) Interests for Limited Liability Companies (LLCs). These securities if paid off at maturity (Notes & Bonds) or are “Called” (Preferred Equity) become temporary forms of capital. If converted into common equity, become permanent forms of capital.

“Temporary Capital” means traditional lines of credit and or term debt, including mortgages with maturities of less than 10 years. This includes Non-convertible Notes or Bonds.

“Substantial Amounts” of “seed” capital could mean anywhere from $100,000 to $1 million. Substantial amounts of “development” capital could mean anywhere from $1 to $10 million. Substantial amounts of “expansion” capital could mean anywhere from $5 to $50 million.

“Pre-sales of Product or Services.” Although it generally lessens the amount of working capital necessary (a very good thing) franchise sales, pre-construction price for real estate or other asset sales, or the sale of other rights, are not considered raising capital; these are booked as sales and are finite in nature.

“Grant Money.” Although it is nice if you can get it, we also do not consider grant money from governmental or other organizations as a form of available, working capital for a start-up, early stage, or even seasoned companies. The availability of grant money is always shifting—the amounts are always too small—and the probability of attainment is generally very low. Grant money often comes with too many strings attached; nevertheless, we encourage pursuing such available funding (under the right circumstances) once a company is properly capitalized through the means illustrated in the Corporate Engineering Conservatory™.

“Government Assistance Loans.” We do consider any commercial lending activity as part of a capitalization plan or deal structure, which would include bank loans and lines of credit—US Small Business Administration (“SBA”) guaranteed or not—factoring of receivables, and purchase order financing. Like grants, Government Assistance Loans often come with too many strings attached; nevertheless, we encourage pursuing such available funding (under the right circumstances) once a company is properly capitalized through the means illustrated in the Corporate Engineering Conservatory™.

TYPES OF COMPANIES

“Start-Up.” A Start-Up Company is considered a company at the pre-revenue stage.

“Early Stage.” An Early Stage Company is considered a company at the post-revenue, pre-profit stage, with less than five years of operating history and less than $5 million in annual sales.

“Later Stage.” A Later Stage Company is considered a company at the post-revenue, post-profit stage, with more than five years of operating history and more than $5 million in annual sales.

TOOLS

“Corporate Engineering Conservatory.™” The private, invitation only, member area where young companies are re-engineered to mitigate risk and maximize returns, using standardized corporate engineering principles designed on Wall Street for Main Street companies.

“Financial Architect™.” The proprietary software based system, housed within the Corporate Engineering Conservatory™, used to design a securities offering with a marketable deal structure, compliant with federal and state(s) securities laws, rules and regulations.

“CapPro™.” The proprietary software based system, housed within Financial Architect™”, that is the engine that creates the company’s 5-year capitalization plan and pro forma financial projections, compliant with GAAP, to arrive at a marketable deal structure.

“GAAP” The acronym that stands for Generally Accepted Accounting Principles. If one is going to include pro forma financial projections in a securities offering document, those projections must be GAAP compliant.

“IRR” The acronym for Internal Rate of Return, which is calculated with the assumptions of dividends and or interest re-invested into the securities in question.

“ROI” The acronym for Return On Investment, which is calculated with the assumptions of dividends and or interest not re-invested into the securities in question.

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When speaking of raising capital for developing companies, our primary focus lies in how to raise “passive, semi-permanent” capital, as opposed to “active, permanent” capital. As a rule, sources of temporary capital are rarely active.

In order to increase your Company’s chance of successfully raising substantial amounts of capital, it will be to your advantage to know how other entrepreneurs are successfully raising capital in the marketplace. It is also important to know the current trends in the private, as well as the public capital markets, so that you are strategically positioned to take advantage of these trends and get ahead of them. More importantly, to

increase your Company’s chance of raising capital correctly and legally, you must understand the nature of the regulatory environment for issuing securities to capitalize your Company.

For most entrepreneurs, the wealth of information contained in Commonwealth Capital’s Corporate Engineering Conservatory™ is a lot to digest. To help you understand the full magnitude of the process, many concepts, techniques, strategies and tactics have been repeated and further clarified, with source data links, throughout the Financial Architect™ Educational Course located within the Corporate Engineering Conservatory™.

Our Corporate Engineering Conservatory™ has 3 inter-dependent components: 1.) Securities Industry Knowledge Primer—“The Secrets of Wall Street…” ; 2.) Deal Structure Creation & Securities Offering Document Production; and 3.) Execution—Selling Securities in Compliance with Federal & State Law.

There are Only 2 Ways to Legally Raise Capital in the United States.

Unless you have really wealthy relatives who like you an awful lot, for all practical purposes, there are only two ways to legally raise capital in the United States. To legally raise capital in the United States, you must engage in one of the two activities listed below:

1. Produce a Business Plan and submit it to Financial Institutions for Capital. After you’ve produced your company’s business plan or pitch deck submit it only to institutional sources of capital. Institutional sources of equity and/or debt capital would include venture-capital firms, commercial banks, private-equity firms, family offices, broker-dealers, pension funds, angel-groups and other similar financial institutions. When soliciting financial institutions for capital, the definition is essentially defined as: “any entity regulated as a financial institution and or any un-regulated organization of professional investors, e.g. hedge funds and angel groups. Submitting business plans for substantial amounts of funding to financial institutions simply does not work for most start-up, early stage, or later-stage companies—those companies with under $10 million in annual revenues, rarely works. When it does work, only 0.77%4 of companies seeking seed capital receive it and they only receive 1%5 of all venture capital available and it often requires sacrificing too much equity ownership and control to make the funding worth it.

Although securities may be involved in the transaction with a financial institution, when these institutions make the “offering of terms” by issuing a term sheet to your

4 This fairly well-known statistic in the investment-banking community is called a “venture-capital industry norm.” The National Venture Capital Association (NVCA) used to track this and similar statistics, but they now have either been restricted to members only or eliminated from public access. See Chapter 5 “The Secrets of Wall St…”for our calculations. 5 http://nvca.org/pressreleases/annual-venture-capital-investment-tops-48-billion-2014-reaching-highest-level-decade-according- moneytree-report/ - 19 - Copyright © Commonwealth Capital, LLC 2003-2019

Company, it is not considered a “securities-offering” because your Company did not making the offer. This is significant because in this scenario, you have no burden of regulatory compliance associated with a securities offering.

IMPORTANT: The business plan or pitch deck cannot offer ownership equity, debt or any other form of financing otherwise or it becomes an un-registered securities offering and exemptions from registration are most likely unavailable for any business plan. If you raise capital with a business plan from individual investors, without the proper disclosure as contained in a securities-offering document, the business plan could be used as a basis of securities fraud, a criminal offense punishable of up to 20 years in prison.6

Pitch Decks are normally the most dangerous item one can use to pitch an investor, due to the inability to provide proper disclaimers and the tendency to ask for capital with stated terms, making them an illegal offering of securities.

In addition, business plans or pitch decks are also are highly ineffective as documents used to raise capital, as they do not carry the “threat” of the “take away.” For instance, a business plan relies on any number of financial institutions to either accept or reject all of the financing. However, if you produce the required securities offering documents and advertise a securities offering in compliance with federal and state(s) laws, you can sell a little piece of your company to many individual investors, thereby eliminating the need to “beg” financial institutions to invest large amounts into your company. If you structure the deal where it’s extremely attractive to any investor, and your securities offering qualifies for general solicitation, and you have the advertising power to “by-pass” the financial institutions and go directly to passive investors, then you are dealing from a relative position of strength because you will have many opportunities to sell to many individual investors, and therefore you don’t need to “beg” and can pull it back or “take away” from any particular investor.

2. Conduct a Securities Offering in Compliance with U.S. Federal and State(s) Securities Laws, Rules and Regulations.

What does raising capital for your Company through a securities offering entail? The following will explain in detail the exact nature of a securities offering, as well as cite examples. First, we need to define what constitutes a security. The courts have generally interpreted the statutory definition of a security to include both traditional and nontraditional forms of investment. In Section 2(1) of the Securities Act of 1933, as amended, the SEC defines the term “security” to mean “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest, or participation in any profit-sharing agreement, collateral trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interests in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest

therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing” (1–2)7 (also see SEC v. W. J. Howey & Co., 328 US 293 (1946)).

In Landreth Timber Co. v. Landreth, the US Supreme Court adopted a two-tier analysis that basically further elaborates as follows: “For purposes of securities laws, a security in an investment of money, property or other valuable consideration made in the expectation of receiving a financial return from the efforts of others.”8

EXCERPT: “By and large, the structures of ICOs (initial coin offerings) that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws. Generally speaking, these laws provide that investors deserve to know what they are investing in and the relevant risks involved. I have asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the 9 federal securities laws” Jay Clayton-Chairman, Securities and Exchange Commission.

To summarize, anything—including cryptocurrencies, you trade an investor in exchange for an investment in your Company—where the investor expects a return on the investment—constitutes a security.

Now that we have made clear what constitutes a security, we need to define what constitutes an “offer” or “offering” of a security. Remember, presenting a business plan (without a specific deal structure or offer of terms) to a financial institution (i.e., venture- capital firm) to obtain capital will not constitute a securities offering—as long as the financial institution offers the terms of financing. The offer must come from the source of capital to avoid your Company inadvertently making an offering of securities. If your business plan requests or even suggests, giving up any amount of the company for any amount of money it will constitute an offering of securities. If your business plan requests or even suggests, loaning the company money (even personal promissory notes) at an interest rate and term, for any amount of money it will constitute an offering of securities. If your business plan requests or even suggests, issuing cryptocurrencies or tokens of the company, for any amount of money it will constitute an offering of securities. Selling any securities, cryptocurrencies or tokens of the company to non-US residences would be subject to Regulation S10 under US securities laws and therefore without the proper securities offering documentation and protocols in place, it would most likely be a violation of US, as well as various foreign countries’ securities laws.

7 Securities and Exchange Commission. Securities Act of 1933 [As Amended through P.L. 112–116, Approved April 5, 2012]. 8 US Supreme Court. Volume 471 2 US 681 (1985). 9 https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11#.WwBvflo8-lo.email 10 https://www.sec.gov/rules/final/33-7505.htm - 21 - Copyright © Commonwealth Capital, LLC 2003-2019

When the regulatory authorities consider the distribution of equity or debt a securities offering (even before the issuing entity actually exists), simple intrastate exemptions from registration of those securities are available. This is the reason why most start-up companies do not necessarily violate securities laws. Some states allow for as little as six (and up to fifteen) entities—consisting of either individual’s organizations or combinations of both that reside in that state—to form the issuing entity and distribute securities to the founders, without the need to register the securities or qualify for the exemptions from registration.

Every state has its own uniform offering exemption(s), and you must comply with each state's stipulations to qualify for claiming those exemptions. However, you cannot rely on the intrastate exemption if one founder is from another state. In this case, the issuing entity must qualify for federal exemptions from registration under Regulation D or the Accredited Investor Exemption 4(a) (5)—if all founders are accredited—to rely on the Accredited Investor Exemption from registration.

An offering of securities without the necessary legal documents, registration requirements being met or claiming and qualifying for an exemption from registration will constitute a violation of federal and or state(s) securities laws, rules and regulations. These violations can cause innumerable problems stemming from simple fines to banishment and moratorium from issuing securities to asset seizure and liquidation and re-compensation requirements to criminal charges and conviction. Simply make sure you do not offer anything for any money in your business plan and you should be fine. Consult with proper legal counsel prior to any issuance if you’re not 100% sure.

The production of securities-offering documents normally takes a great deal of time, cost, and effort. No matter who produces the securities-offering document(s), it will take some time and effort for you and your management team to create an attractive business plan and to accurately respond to questions regarding disclosures and disclaimers included in the securities-offering document(s); however, Financial Architect™, within the Corporate Engineering Conservatory,™ enables anyone to produce the required securities-offering documentation for a fraction of the time, cost, and effort otherwise typically involved.

Even when soliciting and selling exclusively to accredited investors, where technically no documentation is required to conduct a securities offering, according to the Accredited Investor Exemption—Section 4(a)(5) of the Securities Act of 1933, as amended—your offering may still be subject to the No General Solicitation rules and provide no protection from the anti-fraud provisions of the Securities Act of 1933 (and amendments thereto), irrespective of the degree of disclosure your documentation contains (or lack thereof).

Since the beginning of capitalism, there always seems to be someone or some various expert groups that proffer an easier, quicker way to raise capital correctly, but in reality you’re dealing with “other peoples’ money” and these quick fixes can easily and often do lead to class action lawsuits, as well as possibly jail time for securities fraud. - 22 - Copyright © Commonwealth Capital, LLC 2003-2019

Selling cryptocurrencies for block chain platform development with just an idea will become increasingly difficult as companies with real applications compete in this space. In addition, the foreign and domestic regulatory landscapes for Initial Cryptocurrency Offerings (ICOs) will continue to shift and the last thing you want is to be a regulatory “crash test dummy” or worse, be accused of securities fraud by investors, a criminal offense.

Some expert groups create other “types” of securities that appear simple and have acronyms like S.A.F.E., which stands for a Simple Agreement for Future Equity (SAFE).11 If that acronym isn’t begging for a class action suit, we don’t know what is. SAFEs are highly inappropriate for a securities offering by an issuer. SAFEs are normally offered by a single source of capital (one investor or financial institution, such as; Y Combinator) to a company. By doing so, the company isn’t making the offer of the security, thereby negating the need for securities-offering compliance requirements by the issuer. Hence, it’s an instrument best used for a single investor offer, not an issuer. Don’t get cute and think you can produce the SAFE document and have multiple investors “offer” your company the exact same structure. That’s not only a violation of federal and state securities laws, but most probably would be securities fraud, because you couldn’t disclose that you’re making an offer and collecting funds from other investors under the same terms without blowing you cover, and hence you’d inherently be committing securities fraud, a criminal offense.

Anyone choosing to pursue issuing and selling a SAFE as a security to multiple investors for any form of capital would inherently destroy any future capitalization efforts through a broker dealer, or any other professional investor.

To maintain the vast majority of equity interest and voting control in your company, you will need to construct a marketable deal structure, within properly constructed, securities-industry recognized hybrid securities and add the proper disclosures to create a securities-offering document and then offer it to investors.

Currently, there are only three ways to legally conduct a securities offering in the United States: 1. Register the securities on the federal and/or state level or file on Title IV (JOBS Act of 2012) Regulation A+ (a very expensive procedure). 2. Qualify for an exemption from registration, with the ability to advertise the offering with the use of the general media, e.g., Small Company Offering Registration (“SCOR”), California Corporation Code Section 25102(n). (A fairly expensive procedure.)

3. Claim an exemption from federal and/or state registration, with or without the ability to advertise the offering with the use of the general media, e.g.,

Title III -Regulation Crowdfunding, or Title II - Regulation D 506(c). (A relatively inexpensive procedure.)

NOTE: Title IV - Regulation A+ (Tier 1 or Tier 2) is highly inappropriate and impractical for most start-up or early stage companies. The initial burden of document production, registration and SEC approval, as well as ongoing filing and reporting is normally cost prohibitive for most start-up or early stage companies, as a general rule. See SEC Final Rules for Regulation A.12

Furthermore, there are only six (6) ways to effectively sell securities:

a. Engage SEC-registered broker-dealers to sell your Company’s securities. Note: Most BDs will not engage most start-up or early stage companies); b. Sell securities privately to your management team’s pre-existing relationships (personal and professional contacts) under Regulation D 506(b) (a relatively Inexpensive proposition), (Most practical for most start-up or early stage companies); c. Sell securities to investors, using public media sources under Title IV Regulation A+ (Tier 1 or Tier 2) for interstate offerings. (a relatively Expensive proposition); d. Sell securities to investors, using public media sources under Intrastate offerings would include SCOR Offerings or other intrastate registrations that allow for general solicitation (a relatively expensive proposition) ;) e. Sell securities to investors, using public media sources under Title III - Regulation Crowdfunding (a relatively Inexpensive proposition); f. Sell securities to accredited investors only, using public media sources under Title II - Regulation D, Rule 506(c). (A relatively Inexpensive proposition), (Most practical for most start-up or early stage companies).

Please remember submitting business plans for substantial amounts of funding to institutions, simply does not work for most start-up, early stage, or later-stage companies (under $10 million in annual revenues). When it does work for the unique few, it often requires sacrificing too much equity ownership and voting control to make the funding worth it. Nonetheless, the following three basic problem issues arise when it comes to the alternative—raising capital through the solicitation, sale, and issuing of securities.

The Three (3) Basic Problem Issues when Selling Securities to Raise Capital in the United States.

1. Affordability of the high cost of securities-offering-document production.

2. Deliverability of the securities offering, in compliance with federal and state(s) securities laws, to many investors. 3. Marketability of the proper deal structure to investors so they invest.

We will review the practical applications and processes that solve all three basic problem issues and enable your Company to legally sell securities to us and our co- investor contacts, as well as compete directly with qualified institutions for individual- investor capital through an offering of securities that is affordable and effective. Once you build your Company in the style proposed throughout this book, you will be able to negotiate with any and all sources of capital from a “relative position of strength,” which allows you to dictate the terms of future rounds of financing using a [suggested] series of securities offerings.

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.:

What does this have to do with a business or real estate entrepreneur seeking investors? Legally…everything. Unless you are [the Federal Government] of the United States of America and you are offering United States treasury or savings bonds, or you fit into one of ten other federal, special, statutory exemptions, all securities offers must be registered. The first registered offer of an issuer of securities is often referred to as its initial public offering (IPO). Because there are statutory exemptions for specific offering situations, most investment offerings are conducted as private offerings (also known as private placements) and are not registered. Generally speaking, private offerings are less expensive for companies to undertake because they do not undergo federal government review before being made available to prospective investors. Depending on the nature of the offering and the statutory exemption travelled under by the issuer, state-securities commission- registration may still be required for certain offerings. The primary distinction between a public offering and a private offering is public offerings are offered to the general public without regard for the knowledge level or sophistication of the prospective investors because they are receiving a disclosure document filed with the government. Whereas, until recently, federal law prohibited private (unregistered) offerings from being solicited or advertised because no disclosure document would have been filed or reviewed by the appropriate securities regulator—unless an applicable state statute authorized a local advertising. The failure of an issuer to comply with the exemption requirements always has meant that it conducted an illegal, unregistered offering. People have been jailed for such violations because the solicitation to sell an unregistered, non-exempt, security is punishable as a felony at the state and federal levels. Small companies face the possibility that their solicitations for investment funds must be registered at both the federal level and in each state: (i) where they propose to offer an investment, and (ii) where the offer originated. The exemptions are tricky; but in certain circumstances and in a few states, it is possible to advertise an investment solicitation if the offer is limited to the residents of a single state, and the solicitation is conducted in - 25 - Copyright © Commonwealth Capital, LLC 2003-2019

compliance with that state’s law. However, state-offering registration may be a requirement before in-state advertising is permissible. (See Chapter 18.) Here is a typical small-company example: Mary is the owner of a successful nail-care business. She believes she can expand her business to a couple of new locations but also may be able to acquire one or two of her competitors for the right amount of cash. However, Mary does not have the cash in her business to expand this quickly. Mary has seen some businesses that have advertised in local classifieds for investors. That gives her an idea. She knows many of her customers seem to be wealthy, so she puts a small flier by the cash register that states: “We are growing. Wouldn’t you like to be part of our future? Contact Mary for more information.” Can she legally seek capital this way? The answer is no, unless she is prepared to file the required government notices, pay required state fees, and verify that her “wealthy” customers are in fact sufficiently wealthy to meet the definition of “accredited investor.” Prior to September 23rd 2013, Mary’s method of seeking capital could have been perceived as a general solicitation or advertising – and therefore illegal -- because anyone walking into her store could see the flyer, not just those persons that already knew her. When Title II of the Jumpstart Our Business Startups Act of 2012 was implemented by the SEC (new Regulation D Rule 506(c) in September 2013, Mary’s method of general solicitation became legal, provided she complies with Rule 506(c)’s investor accreditation proof requirements and accepts only accredited investors. To be compliant with existing law (Regulation D Rule 506(b)), she could communicate with existing customers if she knew them well enough to know whether they were sophisticated about business matters - but not before they are personally known to her. Now that Titles III and IV of the Jumpstart Our Business Startups Act of 2012 are implemented by the SEC, Mary is able to raise capital in the manner she was using the crowdfunding exemption under Title III (regulation crowdfunding), provided that her advertising is limited to directing investors to contact only her investor portal or licensed securities broker dealer that has been engaged to sell her securities. Also, she will be able to raise capital under Title IV (Regulation A+), if she is conducting an offering in her state in compliance with Regulation A+’s requirements, which allow her to publicly offer and sell her securities, provided that her financial statements are annually audited, among other requirements. Hopefully, Mary seeks competent securities counsel before she makes a legal mistake that hurts her and her business. Ultimately, on the part of many people, it seems natural there would be an assumption that if everyone is doing it, it must be legal. Of course, without following the requirements of each registration exemption, general solicitation for investment capital is illegal. And although it’s a numbers game of getting caught by regulators or getting sued by one’s investors, the consequences of getting sued by a government, financial regulator or of having in the public record a private investor’s judgment for fraud against you can be destructive or fatal to one’s business and personal reputation. - 26 - Copyright © Commonwealth Capital, LLC 2003-2019

All of this is longhand for saying a prudent person should think hard about the risks of something going wrong in their offering, including the risks of bringing strangers into their company. The best time to think about these issues is before accepting their money. Assuming you are willing to move forward, let’s start to plan a capital raise with a view to keeping you and your company out of trouble.

Chapter 2: The Perfect Storm: Are you Ready?

Now it is time to discover how you can gain a substantial edge over all other entrepreneurs seeking capital. Specifically, you will learn how to issue privately placed or publicly placed private securities that can compete directly with other investments financial institutions may offer—i.e., bank certificates of deposit.

The good news is that you have a proverbial “perfect storm” in place for capitalizing your Company, which is based on a dramatic shift in the patterns of five (1–5 below) closely related segments of the securities industry.

1. The first part of the perfect storm is the present state of currently available cash and the publicly traded fixed-income markets, which includes (but is not necessarily limited to) notes, bonds, preferred stock, commercial paper, and CDs (certificates of deposit). The US fixed-income markets are a little larger than the US equity markets; however, the yield on these fixed-income securities is at a historical all- time low. (The demand for high-yielding investments is at a historical all-time high.) On May 7th 2018, the weeks average was 17.57+ trillion in US financial institutions (M1+M2)13 earning less than 2.5% per year; (M1+M2) is considered “cash available for investment” on Wall Street (see Federal Reserve Bulletin14 and Bank Rate™15).

2. The second part of the perfect storm is the current state of regulatory reform, since the Jumpstart Our Business Startups (JOBS) Act was signed into law on April 5, 2012. This act of Congress did many things to help stimulate the US economy, but the provision that is most important to capital-seeking entrepreneurs is that the ban on general solicitation, in force since 1933, has been lifted—with certain restrictions. Note: you can legally solicit and sell your Company’s securities to the general public in many ways. Aside from the more well-known IPO (Initial Public Offering), there are additional ways to legally promote your Company’s securities to the general public, thereby enabling you and your company to compete directly with financial institutions for individual investor funds.

3. The third part of the perfect storm rests in the amount of talent available to help you along your journey. Here, I am referring to already highly trained individuals in the securities industry who are finding it more difficult each year to make a decent living in their present positions in large securities-brokerage-and-investment-banking firms. Although highly trained in and mentally geared for their professions, you might be surprised how many of these financial professionals would love to be part of your Company at the senior-management level.

4. The fourth part of the perfect storm is the amount of acquisition opportunities available in increasingly shifting markets, industries, and the general US economy. Today, whole companies, management teams, and assets are moving at

13 For definition of M1 and M2, see http://www.federalreserve.gov/faqs/money_12845.htm 14 https://www.federalreserve.gov/RELEASES/h6/current/default.htm 15 https://www.bankrate.com/banking/money-market/rates/ - 28 - Copyright © Commonwealth Capital, LLC 2003-2019

incredible speeds. The demographic landscape of baby boomers nearing retirement is the primary catalyst for this phenomenon. Company founders nearing retirement must exit their companies through outright sale, leveraged-management buyouts, or divesting of individual assets. Growth through acquisitions has become a standard and the right securities can be used as currency to acquire companies, assets and entire management teams.

5. The fifth part of the perfect storm involves the technological innovations that enable you to be in control of the entire capital-raising process. Friction free capitalism has arrived and if you know what you’re doing you can take full advantage of this incredible phenomenon. More importantly, you will no longer need to rely on the expensive expertise of outsiders who profess to know what they are talking about. You will no longer be at the mercy of an uncompetitive market for investment banking, legal, and accounting services. You will rule with the knowledge you obtain here!

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The first part of the perfect storm includes recognizing the current state of available cash for investment, and why that availability will grow over the next decade. As aforementioned, at the end of January 2016, it was estimated that there is over $15.5 trillion in US financial institutions, which is considered investable cash or “cash available for investment” on Wall Street.

The amount of cash available for investment will grow over the next decade due to previously issued government, corporate, and municipal bonds maturing. Currently, individual investors are feverishly seeking high-yielding cash flow from their investments, because they are always in need of additional income to supplement their retirement lifestyle. From the late 1970s throughout the 1980s and into the 1990s, individual investors invested hundreds of billions of dollars in twenty- to thirty-year bonds issued by the US Treasury Department, US corporations (for taxable income), and municipalities (for tax-free income). The yields on these bonds at the time of their issuance were at all-time highs. US Treasuries sold with 14%, 16%, and even up to 17% interest rates, and corporations issued bonds at even higher rates. Municipalities issued bonds at 12%–14% because the interest is not taxable to investors at the federal level, and, furthermore, the interest is not taxable to investors at the state level—if the investors reside in the state that issues the municipal bonds. These bonds are now maturing and being refinanced at substantially lower rates. Investors are receiving very large lump-sum principal payments due to the maturation of these bonds, and they are zealously seeking higher yields than are currently being offered in the marketplace.

Imagine an investor who owned $1 million of tax-free AAA-rated municipal bonds with a 12% interest rate or “yield.” The investor was living on $120,000 in annual tax-free income until the bond matured, as well as received the $1 million principal back from the issuer. Now, the investor can buy the same bond with the same maturity—e.g., thirty years—and with the same quality rating but only with a 4.5% yield. Yes, the

investor just took a $75,000 hit on his or her annual tax-free income, or a drop from $10,000 to $3,575 a month (on average), which equates to a monthly loss of $6,250. This is not an unrecognized phenomenon; it is an economic reality based on obligations (bonds) created 20–30 years ago that are now maturing and will continue to do so for the next several years. By issuing competitive high-yielding securities, your Company is able to capitalize on this opportunity now. Knowledge is power. The average entrepreneur has little knowledge about what is happening in these fixed-income markets…but now you do. The question then becomes—what are you going to do about it?

Because financial institutions have market constraints, they cannot offer 7%–11% yields on investor funds by issuing notes or bonds. Banks cannot issue five-year CDs with an 8% yield if they’re lending at 3.5% on home mortgages or 5% on car loans; quite simply, they cannot make money this way. A healthy, publicly traded corporation cannot issue 10% bonds when it can issue them at 5%, as the board of directors would be in breach of their fiduciary duty to the company’s shareholders. Also, retiring baby boomers will be purchasing more and more of these fixed-income instruments—e.g., bonds, notes, CDs, and preferred stock—to supplement their retirement income stream. When this demand exceeds supply for these fixed-income instruments, which is already happening and will continue for some time, they will go on to bid up the prices of these securities, thereby inherently lowering the available yields.

Because your Company is privately held (or even for companies that are publicly traded), you have the ability to set the yield component on your securities in a private placement above the current public market rate; therefore, you will attract the multitude of investors who are hunting for yield, en masse.

In the past, if a management team of a start-up or early stage company attempted to sell and issue these types of fixed-income securities, they would be looked at as if they “need their collective heads examined.” Common equity was the only sensible form of a security to be issued. Yet, when the fixed-income-market demand became insatiable for high yield, issuing common equity became somewhat ridiculous—as it was less attractive to most passive investors. Thus, the dynamic shift in what type of securities you should be selling is revealed. Many entrepreneurs sell too much of their most precious element— common equity—too soon and for far too little, and end up running out of it during subsequent rounds of equity financing. Not only does this scenario defeat the entrepreneur’s goal of wealth attainment, it is unattractive to investors. [More on this topic is provided in Chapter 8]

Over the next several decades, millions of individual accredited investors16 will be receiving the principle back from high-yield bonds, and they will be seeking high- yielding investments to replace that high-yield income. They will be looking to invest hundreds of billions of dollars in the US economy. Yes, hundreds of billions of dollars— if not trillions; because in mid-1980, the US budget reached over $5 trillion in debt, most of which was financed with twenty- to thirty-year treasury bonds that are now coming due (note: this debt figure does not include corporate or municipal bonds). According to

one of our professional sources on Wall Street, as of May 2018, the US had over $17.5 trillion in US financial institutions earning less than 2.5% per year. So are you ready to compete for those funds?

*****

The second part of the perfect storm is the current state of regulatory reform since the passing of the JOBS Act of 2012. The JOBS Act of 2012 has many provisions, but Title II and Title III of the legislation effect entrepreneurs the most. Title III is official titled Regulation Crowdfunding but known simply as “crowd-funding,” and it was quoted by a former SEC-enforcement attorney at an investment-banking conference soon after the JOBS Act was passed into law as being “DOA” (Dead on Arrival). The reasoning for this contrite remark is the burden of compliance is so high it is essentially cost prohibitive.

Note: Although Regulation Crowdfunding is being conducted successfully by some in various stages of a company’s life cycle, it remains our position that the crowdfunding provision may become an administrative nightmare (for you the issuer) and an abused provision by unscrupulous (companies) issuers of securities. If this unfolds as such, issuers will become frustrated with the overburden of state and federal regulation. Investors will shy away from any offering under any provision that attracts bad press. Yes, we know many people currently appreciate the Regulation Crowdfunding provision but that, too, will likely change. We suggest you follow the guidelines and adopt the tactics laid out in the Chapter on Regulation Crowdfunding and be careful to not become the SEC’s crash-test dummy on this one—let others do that for a few years until the compliance burden either lessens through an act of Congress or the cost proves it is too prohibitive.

Not to worry…Title II of the JOBS Act—also known as Regulation D, Rule 506(c)—enables companies to legally advertise and solicit accredited investors nationally, using the general media by lifting the general-solicitation ban that has been in place since 1933. There are, however, hurdles to overcome with choosing this avenue, but they are certainly not insurmountable or cost prohibitive (see SEC Final Rules).

How does one market these securities? Consider two subsequent rounds, if necessary, for your Company’s total capitalization needs:

1. Round 1 is the “Seed Capital” Round. This round can easily be accomplished with use of either Regulation Crowdfunding, Regulation D, Rule 504, Rule 506, or Section 4(a)(5)—Securities Registration Exemptions (i.e., Accredited Investor Exemption)—depending on how well connected to potential investors you are at this time or a combination thereof. Although there are a myriad of choices, as a practical matter, we suggest the following options:

a. Private Solicitation up to $5 Million. Under Regulation D, Rule 504, you can issue securities through a private placement to pre-existing relationships, - 31 - Copyright © Commonwealth Capital, LLC 2003-2019

up to $5 million within a twelve-month period of time17. You can allow thirty- five (35) non-accredited investors and an unlimited18 number of accredited investors to purchase your Company’s securities. The offering must be private. You cannot use the general media or any other marketing efforts that are considered mass-marketing, such as direct mail or e-mail solicitation, for potential candidates.

b. Public Solicitation up to $1 Million. Regulation Crowdfunding under Title III of the Jobs Act of 2012 enables you to publicly solicit and sell up to $1,000,000 in a 12-month period, with various restrictions. In addition, Regulation D Rule 504, if constructed to a maximum offering of $1,000,000 in a 12-month period, (Rule 504 can be up to $5,000,000 by the way) can offered at the same time as the Regulation Crowdfunding offering is being conducted. Or the Regulation D Rule 504 private placement memorandum can be easily modified to register the offering at the state level under the Small Corporate Offering Registration (“SCOR”) exemption in various states, where available.19 Simply check with your secretary of state for SCOR availability. Under SCOR, you can issue up to $1 million in securities through a public placement to an unlimited number of both accredited and non- accredited investors within a twelve-month period of time. Some start-up, early stage, and even a few later-stage privately-held companies simply do not have the investor connections to raise the “seed capital.” If this is the case for your Company, consider registering the securities at the state level—e.g., SCOR—to attract and to build an entirely new pool of individual investors. This process involves submitting an application for registration with the state(s) regulatory authority where the securities will be solicited. By registering the securities at the state level, you will be allowed to advertise your securities offering through the general media within that state. Now you're in head-to-head competition with financial institutions for individual investors based on the ability to provide a higher “current yield” and a consistent cash flow to such investors. Regulation Crowdfunding and “SCOR offerings” enable you to advertise in your regional Wall Street Journal, Investors’ Business Daily, Barron’s, and local newspapers, as well as radio and direct-mail advertising. Imagine investors calling you to inquire about funding your Company. This is very positive. Although emails may be a legal means to solicit securities within your state, emails to stranger rarely, if ever, work.

17 Once the offering has been officially terminated, at any time within the twelve-month period by filing your final FORM D- Notice of Sales, you will need to wait six months from that termination date to be able to sell again claiming the exemption from registration under Regulation D or SCOR. 18 Although your Company has the ability for inclusion of an unlimited number of accredited investors, once you have passed the 2,000-investor mark, your Company becomes an SEC-Reporting Company, whether your Company’s securities are publicly traded or not 19 SCOR offerings are currently not available in Alabama, Delaware, Florida, Hawaii, Nebraska, and Washington D.C. - 32 - Copyright © Commonwealth Capital, LLC 2003-2019

2. Round 2 is the “Development Capital” Round. This round can be easily accomplished with the use of Regulation D, Rule 504, Rule 506, or Section 4(a)(5)—Securities Registration Exemptions (i.e., Accredited Investor Exemption)—depending on how well connected to potential investors you are at this time. Although there are a myriad of choices, as a practical matter, the following options are suggested:

a. Private Solicitation—Unlimited Amount—Nationally. Under Regulation D, Rule 506(b), you can issue securities and raise an unlimited amount of capital through a private placement to pre-existing relationships, within a twelve-month period of time. Additionally, you can allow thirty-five non- accredited investors and an unlimited number of accredited investors to purchase your Company’s securities—with no “accreditation verification” (hassle) necessary. The offering must be private. You cannot use the general media or any other marketing efforts that are considered mass-marketing, such as direct mail or e-mail to solicit potential candidates.

b. Public Solicitation–Unlimited Amount–Nationally (Not an IPO). Under Regulation D, Rule 506(c), you can issue securities through a public placement to an unlimited number of accredited investors within a twelve- month period of time. However, under Rule 506(c) you cannot allow any non-accredited investors to purchase your Company’s securities. By limiting the offering to accredited investors only, you can use the general media or any other marketing efforts that are considered mass marketing for solicitation, such as direct mail or e-mail. There are fairly stringent “accreditation verification procedures” that must be adhered to under this option; however, one can integrate a previous Rule 506 private placement into the Rule 506(c) offering as long as the accreditation verification procedures are first met under the previous Regulation D, Rule 506 offering. Note: Rule 506(c) is a new provision under Title II the JOBS Act of April 5, 2012 (see SEC Final Rules).

c. Public Solicitation—Unlimited Amount—within the state of California. Under California Corporation Code Section 25102(n), California corporations only can issue securities through a public placement to an unlimited number of investors who reside in the state of California using general solicitation through the general media within the state. However, we suggest limiting the offering to accredited investors only, as a practical matter, because it is better to have those who can sustain a loss—just in case your Company fails. In order to qualify, an entrepreneur can either form his/her corporation (“corp.”) in the state of California if he/she has yet to form the entity in another state or may register the corp. in the state of California as a “foreign corp.” if the entity is already formed in another state. You do not need to move yourself or your Company to California to use this exemption. You can use a Resident Agent—a person and place in the state of California.

It has always been our position that the allowance of non-accredited investors in purchasing securities be limited, if not entirely excluded, in the initial stages of a company’s existence. This is generally wise not only to reduce regulatory burdens but more importantly to relieve entrepreneurs of administrative headaches. This two-step approach is an extremely important strategy. Thus, the Financial Architect™ program product line has been styled in a progressive fashion in order to enable you to accomplish your overall capitalization goals with relative ease…and at a fraction of the normal cost involved.

*****

The third part of the perfect storm involves hiring professionals away from the securities industry as your company’s point person(s) to raise capital internally for your Company. Recognize the fact that, relative to the past, you can easily hire professionals from the securities industry who have investor contacts and skill sets to assist you in raising capital for your Company. As previously mentioned, this is not a prerequisite for raising substantial amounts of capital for your Company. This part of the process is generally reserved for the “post-seed-capital round” of financing for most companies. One should have ample seed capital on hand, sufficient cash flow from sustained operations, or both before considering this next step in building your Company. Remember this is an additional option, primarily for middle to later-stage companies and is not a requirement of the process. As a rule, this option is rarely used for start-up companies; nevertheless, there are exceptions to every rule.

At the end of 2017, there were 630,130 registered representatives (stockbrokers) of broker dealers in the U.S.20 There isn’t any easily accessible published data on the annual turnover rate for stockbrokers in the U.S., however, it is our experience that it is quite high in the earlier years of one’s career than in later years. Those in their early years of their career tend to have a very high attrition rate, upwards in the neighborhood of 80%. Those in their later years, tend to have a much lower rate in the area of 20%. Those with years of experience would be far more valuable for your Company to bring on as CFO or VP of Corp. Finance, a senior management position. Hence, there are probably over 120,000 viable candidates for you to choose from at any given time, giving you a superior edge in the capital raising process. [More information on this topic is provided in Chapter 19]

*****

The fourth part of the perfect storm lies in recognizing that currently more founders and owners of companies are looking to retire and must exit their companies through outright sale, leveraged-management buyouts, or divesting of individual assets. The demographic landscape of the baby boomers nearing retirement is the primary catalyst for this phenomenon. With the correct deal structure, one can find and acquire whole companies, individual assets, management teams, and properties—intellectual or otherwise. You can use your Company’s securities as currency to purchase these assets;

however, this strategy may only be effective if you are issuing hybrid securities you plan to list on a publicly traded securities exchange in the near future, normally within twelve months.

Think of it this way. Assume you want to buy a competitor or strategic-alliance company. Under most circumstances, a seller lists the asset(s) for sale at a certain price. Suppose the asking price of the acquisition target is $5 million. Well, if you raise capital (“cash”) to buy this asset company, and you happen to be a savvy entrepreneur and negotiator, you would probably offer something less than the asking price—much like an offer to purchase real estate. You may value the company at only $3 million…and if neither party is willing to negotiate on price then the transaction ends, which is most often the case.

Imagine an alternative to offering cash for less than the asking price as mentioned above. Imagine stylizing a preferred-equity round (you can refer to this new preferred- equity offering as “Series B”) specifically designed to purchase the company for the full asking price. You offer to “secure” the Series B preferred equity with the assets of the selling company to enhance the safety of the transaction for the seller. If the seller “balks at the offer” it may reveal that the assets may not be truly worth the asking price; therefore, you may then be in a powerful position for negotiation. To use the preferred equity as the currency to purchase (e.g., acquire) the assets or the whole company, simply state the benefits of the preferred-equity ownership. The benefits of preferred-equity ownership include the following: the Series B preferred equity is directly secured against the acquired assets; the preferred equity is an investment in a growing company in an industry the seller understands; the stated quarterly dividends are much higher than alternative fixed-income investments; the annual participation in net profits enhances the overall return; and the conversion option into the common equity is available to realize a potential capital gain if the acquiring company (e.g., the buyer) is ever sold.

*****

The fifth part of the perfect storm involves the technological innovations that enable you to be in control of the entire capital raising process. Note: the following three basic problem issues that arise when it comes to raising capital through the solicitation, sale, and issuance of securities:

1. Affordability of the high cost of securities-offering document production. 2. Deliverability of the offering to many investors, in compliance with federal and state(s) securities laws, rules, and regulations. 3. Marketability of the proper deal structure to investors so they invest.

One legally viable alternative to submitting business plans to financial institutions exists, which includes creating a securities offering—with a “marketable deal structure”—and selling it to individual investors in compliance with federal and state(s) securities laws. - 35 - Copyright © Commonwealth Capital, LLC 2003-2019

No matter how you look at it or what route you take, the capital-raising process takes time, money, and effort. You may be thinking that it would not cost much to send business plans to venture-capital firms. Yet, consider the cost of failure (e.g., you and your management team’s time and energy) to receive the funding from these sources—it takes 9–15 months (on average) to be turned down, and only 0.77%21 of entrepreneurs actually receive the funding they stipulate. The costs of this route could be extreme for your Company. In addition, if you receive funding from venture capital firm(s) it may be extremely costly long-term, because if your Company does become very successful, the venture-capital firm(s) may have taken more equity from you and your founders than you really needed to give up in the first place.

You may be asking, “Why does this need to be so complicated?” The regulators of federal and state securities are interested in mitigating securities fraud, so they set up hurdles one must surpass. Most entrepreneurs will not go through this process because they actually believe there must be an easier, softer way. The truth is there is not. Take heart—if this were easy, everyone would be doing it—you would have to work twice as hard for the same result.

I am often asked, “What are the common denominators that differentiate those who succeed in raising capital from those who do not.” Ironically, I wrestled with this question for some time. I’ve concluded that dedication, focused concentration, a take-no- prisoners attitude, as well as a total commitment to the process of a series of related securities offerings are the common denominators for those who succeed. Conversely, the common denominators for failure are self-entitled entrepreneurs who do not know what they are doing or expect someone to do this for them. In fact, this is true on all fronts for operating a successful business, not just for securing capital. As it happens, the answer to the aforementioned question is exactly the reason Financial Architect™ and the Corporate Engineering Conservatory™ was created in the first place! And yes, I’ve never been accused of being politically correct, the truth rarely is.

Unlike most venture-capital firms, we’ve taken the mystery out of the application and funding process. We’re upfront about what we want to invest in and why. Most of you will be able to understand our venture-capital-fund model and appreciate the innovative way we reduce risk for our investors. Without this model, there’s simply no way to justify the inherent risk with investing in start-up or early stage companies.

In addition, we won’t leave you hanging on and frustrated with endless due diligence. Our philosophy is simple. If you can do what we request of you through our process outlined below, there’s a very high probability that we’ll invest in your company or find a broker dealer who will. See Platinum Access under Venture Funding at the top of our website www.CommonwealthCapital.com.

21 This fairly well-known statistic in the investment-banking community is called a “venture-capital industry norm.” The National Venture Capital Association (NVCA) used to track this and similar statistics, but they now have either been restricted to members only or eliminated from public access. See Chapter 5 for our calculations. - 36 - Copyright © Commonwealth Capital, LLC 2003-2019

One final comment before we move onto the mechanical process of raising capital. You only get one first bite at the apple. If you do this without the proper deal structure, without the required disclosures within a securities-offering document that qualifies for the proper exemption from registration or without the marketing fire power to get the job done…you may ruin any chance you have to go back to the apple. Most securities-offering documents we see are not only a joke (deal structure-wise) but are also potentially illegal due to “boiler plate” documents that are highly insufficient—even when produced by an attorney—to claim an exemption from registration and, therefore, are dangerous from a regulatory standpoint. Your investment-in-time now—ensure you do this right the first time around—will enable you to take many more bites of the apple over time.

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.:

Limiting your litigation risk should start by taking inventory of your company’s people, your cash needs, and your friends. What does this mean?

You need to perform a simple self-analysis to determine what type of private offering you are eligible to conduct. When you know those answers, the direction of your planning can be focused. Starting first with the members of management and key employees, what are their backgrounds? I make the officers and directors of all of my corporate-finance clients complete a background questionnaire.22 Unless the enterprise is entirely owned and managed by a single family, chances are most or many of the responses to the questionnaires would be surprising to others in the company. What we are looking for are background issues we want to disclose to investors as material information before they make their investment decision. This is often a counter-intuitive process because I want you to tell me what you ordinarily would not tell me in casual conversation. Certainly, there is some information issuers may not want to disclose because it might make it harder for the issuer to raise funds. These are precisely the same issues that (if they are not disclosed at the outset) may later become central to any subsequent dispute between the company and investor. This scenario arises repeatedly because the issuer may be staring at an investor who wants to throw cash at the company and is afraid of losing the opportunity. If the issuer lets greed or desperation control its rational-thought process, it may be setting itself up for a very ugly future in the court system.

Thoroughly knowing management’s background is critical. Two of the exemptions from SEC securities-offering registration contain “bad boy” disqualification provisions. If the issuer, its officers, directors, significant shareholders, or persons participating in the offering have been the subjects of criminal proceedings, government financial regulatory proceedings, or have been sanctioned by a non-government regulatory authority such as NYSE or FINRA, the issuer may well be precluded from utilizing a Regulation A, A+, or

Regulation D Rule 506 private offering. Obviously, the issuer should want to know whether it is disqualified from certain types of offerings. In my view, being disqualified from a Rule 506 offering is a big deal because this is the offering with no dollar limit and not subject to concurrent state-securities-offering laws. It is the most-often utilized private-offering exemption. Another, major, deciding factor is how much cash you need. The federal offering exemptions have limits of $1,000,000 (Title III Crowdfunding & SCOR), $5,000,000 (Regulation D, Rule 504), $20,000,000-Tier 1 & $50,000,000-Tier 2 (Title IV, Regulation A+), and No Dollar Limit (Regulation D, Rules 506(b), 506(c), and Regulation S). Each exemption has specific limitations that must be complied with such as the number of unaccredited investors who can participate (which ranges from zero in a Regulation D, Rule 506(c) offering to no limit in a Title III crowdfunding or Title IV, Regulation A+ offering), the minimum information that must be disclosed to unaccredited investors, the knowledge and sophistication of unaccredited investors, the maximum amount of money each investor can invest, the possible need to verify the accredited status of investors claiming to be accredited, and in the case of offshore sales, the need to ensure no securities are sold back into the United States within a one-year period. Of course, there are pros and cons with each type of offering. One of the significant distinctions between offering types is Rule 506, Regulation A+23, and investment-crowdfunding offerings preempt state-securities-registration requirements. Thus, the states cannot assert their rules or review requirements as to the offering’s conduct. This aspect provides significant cost and time savings because compliance with each state’s securities requirements is cumbersome, expensive, and time-consuming. Regulation A and Rule 504 offerings are subject to state-offering regulations.

Along with these considerations is the question of what character of investor you are willing to accept. (Strangers or friends? Wealthy or not so wealthy?) If you are conducting a debt offering and have the ability to pay off the debt as agreed in the offering terms, the investors’ character in one sense may seem less important—you are going to get rid of them all with the last principal or interest payment. But don’t be lax with your applicable-exemption-requirements compliance because debt offerings all have the same registration-exemption restrictions as equity offerings. The point is investors in a debt offering can still sue you, so you should investigate their characters before agreeing to accept their funds.

With equity offerings, once you let the investors in, unless you have a built-in redemption right where you can purchase their interests back in the future, you might be stuck with them indefinitely. Investors hate redemption rights. Issuers love them. You should know who these folks are and ensure they can afford to be invested for the long haul. Some will have a public history of litigation. Try to avoid these toxic investors, if at all possible. In the publicly advertised offerings (crowdfunding, Regulation D, Rule 506(c), and Regulation A+), anyone can show up and buy their way into your enterprise if you are

23 For a Regulation A+ offering to preempt state registration requirements, the offering must be limited to qualified investors which may be defined by the SEC as one having at least $5 million in assets. - 38 - Copyright © Commonwealth Capital, LLC 2003-2019

not careful. Prudent entrepreneurs will let investors in their deals only if they know them. This policy is consistent with the SEC’s longstanding policy that only friends, family, and pre-existing business relations can be communicated with to maintain the private nature of the Regulation D offering (Rules 504 and 506(b)). Hopefully, your friends and family are wealthy and generous. Most entrepreneurs probably know only other starving entrepreneurs. This scenario led to the 2012 recession-driven legislation known as the Jumpstart Our Business Startups Act (JOBS Act), which reduced the SEC’s and states’ control of private-capital formation. Investment crowdfunding and advertised, Rule 506 offerings are some of this legislation’s hallmarks. I caution you to consider the merits of advertised Rule 506 and investment crowdfunded offerings because you will be letting strangers into your company.24 Crowdfunding means different things to different people; but in each category, it involves the solicitation of funds from strangers using the World Wide Web or social media as the primary means of solicitation. The JOBS Act’s investment-style of crowdfunding will become legal once the SEC promulgates rules to implement it. This type of crowdfunding is also known as equity (or debt) crowdfunding and is distinguished from donor, pre- purchase, and rewards crowdfunding. Donor crowdfunding essentially is the solicitation for gifts or donations from strangers for personal use or charitable causes. Pre-purchase crowdfunding is the solicitation for pre-production donations in exchange for a promise the donor will receive the produced product or a prototype of the company’s product. Rewards crowdfunding is the solicitation for contributions to a project such as a film production where the donors are promised public recognition or a small role in the film. Thus, issuers and entrepreneurs can utilize the non-investment crowdfunding types at the present time.

Investment crowdfunding will contain the limitation that issuers can solicit funds from potential investors nationwide, but the solicitations must direct prospective investors to a registered broker-dealer or a registered “portal” where offering information can be learned. Issuers will not be permitted to solicit and receive funds directly from investors. Issuers will have to wait until the SEC finalizes rules before investment crowdfunding will be legal.

Likewise, an advertised Rule 506(c) offering will carry with it a limitation where the issuer must take reasonable steps to verify the accredited status of each investor. This offering type will also carry with it the risk that if a single, unaccredited investor invests, and the issuer lacks adequate documentation of the investor’s qualifying assets or income, the entire exemption may be void. In that case, the issuer and affiliated participants in the offering may be jointly and severally liable for the full amount of the proceeds raised.

24 This is the case if you conducted a registered IPO as well. In an IPO, there is the possibility that a liquid market will develop that will enable investors to exit from your company and resell their investments publicly. This is not necessarily the same when a private offering is conducted. Investors in a private offering may have to wait indefinitely to realize a liquidity event. The company may never go public, or a secondary market for the company’s securities may not develop, or the expected revenue from the pooled asset vehicle may not materialize. In these circumstances, a probable way out of the company or the investment vehicle will be for the investors to sue for relief. - 39 - Copyright © Commonwealth Capital, LLC 2003-2019

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Remember, you can relax a bit now. Although this book contains a lot of information that may seem overwhelming at times, we assume you want to provide only excellence to the investor community. Thus, as you start to build your securities-offering documents with the use of one of the Financial Architect™ programs, you will be led down a path of relative ease. You will be in a position to make critical deal-structuring decisions easily and “on the fly.” In this book, we reference specific chapters you can refer to throughout the process if you want to explore alternatives to pre-determined deal structures and securities-offering exemptions within the Financial Architect™ programs. Again, we have done a ton of work for you already, so you can relax and get on with the business of raising capital and building your Company!

Chapter 3: Capitalizing On the Winds of Change

Our experience has taught me many things about raising capital. One of the main things I have learned is entrepreneurs have developed “belief systems” that are either entirely wrong or skewed enough to impede their success. If you can wrap your head around a few new concepts, which at first may challenge some of your deep-seated belief systems, you stand a far greater chance of successfully raising capital.

Accessing Capital.

Raising capital is like fishing. To illustrate, we must deal with two factors: the known and the unknown.

1. We know there are fish in the sea, and we know they eat. Similarly, we know there are investors in the world—and we know they invest. As a matter of fact, more do-it-yourself investors are swimming with more money and less choice of investment—with any real potential for return—than ever before.

2. What we do not know is: will they invest in your Company?

a. To legally “go fishing” for individual investors, you must have a securities-offering document—e.g., a Private Placement Memorandum (PPM), offering circular, or prospectus based on a qualified registration statement compliant with federal and state(s) securities law. We know about seeking indications of interest from individual investors with a “red herring” preliminary-prospectus document; but for all intents and purposes, one should actually produce the required securities-offering document prior to testing of the waters, in this case. Otherwise, if you do get a lot of positive indications of interest, it could be months before your securities-offering documents are ready, and that bad timing alone (investors will assume you don’t have your act together) could ruin your chance of “striking when the iron is hot.” b. To effectively attract investors, you must present the securities offering with a marketable deal structure investors are hungry for—the bait. c. To get investors to bite, the bait must be more appealing than other food (other offers or investment opportunities). To make your offer more appealing than others you need to shift the fear of perceived investment- capital loss to absolute opportunity lost. In order to do that, you must “mitigate” operational, financial and litigation/regulatory risk. d. To easily reel investors in, you need to get them to want to be in the boat.

When raising substantial amounts of capital, while maintaining the vast majority of equity ownership and voting control, everything starts with the production of a marketable deal structure. A marketable deal structure inherently mitigates both operational and investment risk. Through this Corporate Engineering Conservatory,™ you will create a marketable deal structure for your company soon enough, but for now - 41 - Copyright © Commonwealth Capital, LLC 2003-2019

we need to continue to address the remaining concepts to help you frame your mind on what constitutes a marketable deal structure that’s acceptable to you.

Capitalize to Compete. Most entrepreneurs are under the impression that technologies, inventions, patents, processes, or trade secrets that make up their company’s product or service line(s) offer investors the greatest opportunity ever, because nothing like their situation has ever occurred before—they have a lock on the marketplace. No entrepreneur can predict, with any real accuracy, when or if a competitor will introduce superior products, services, or technologies to the marketplace, thereby marginalizing said entrepreneur’s product or service line(s).

Once capitalized correctly, many opportunities abound, and you may need more capital to take full advantage of this situation. Every entrepreneur I’ve met wishes they had raised more capital than originally sought. Planning for a series of capital rounds accomplishes the goal of capital inflows to continue the expansion and growth of your Company.

Ask yourself the question: “Do I want my Company to be the first one in my competitive field to have the ability to quickly raise substantial amounts of capital— while maintaining the vast majority of equity ownership and voting control—or the last?”

In addition, most entrepreneurs believe investors want to see t entrepreneurs “boot-strapping their way” to success and great wealth for the future, by living like paupers now. This is a false belief, contrary to reality, as well as a foolish assumption. Any experienced investor, relying on that premise to provide the illustrated rates of returns on an investment in the company would run from the deal. What would happen to a company if one or more of the management team—eating ramen noodles and living below their means— needed to be replaced by experienced professionals who demand a real compensation package? Well, the illustrated budgets would not reflect the ability to pay a competitive, executive compensation package. The point being, think like an investor and give yourself a break by budgeting a competitive, executive compensation into your pro forma financial projections. How do you expect to attract a real management team without a healthy and attractive executive compensation package?

View the Effort as a Process, Not an Event. Most entrepreneurs are under the impression that technologies, inventions, patents, processes, or trade secrets that make up their company’s product or services will allow for sufficient net operating margins to expand the company’s growth with internally generated funds once they receive their initial funding. They, therefore, view the securities offering as a one-time event. In theory, only a true monopoly can achieve that feat. Any direct or indirect competition will eventually lower those margins. Outside capital must be employed to keep up with the competition, especially if the competition is formidably capitalized—i.e., publicly traded. Be sure to raise sufficient capital through a series of securities offerings, so your Company can stay ahead.

Sell Products, Services, and Securities. I often ask entrepreneurs if they can sell their product or service. Of course they look at me as if I may be an idiot—their answer is always a resounding “Heck, yeah!” I then ask, “Well, do you think you could sell a ‘piece of the action’ in your Company to investors?” They think a bit and say, “Well, I don’t see why not.” My response is always… “Exactly.” Think of a securities offering as a new product or service launch, where a research-and-development process precedes the actual production or assembly of the product. In this case, the securities-offering document is the product. Thus, as you and your management team go through your day, engaging prospective and current clients in the process of selling products and services, be mindful you also have “a piece of the action” to sell—your Company’s securities. The individual “passive” investor market is demanding high yield, with some upside participation of profits to enhance the yield relative to the risk involved with the security. If you compete—based on yield—by offering hybrid securities, such as; convertible notes, bonds, or preferred stock with higher-than-average yields, you will attract individual investors. Hybrid securities are considered fixed income securities, due to the stated interest rate or dividend. This fixed-income market—just over $40 trillion, which is 25% larger than the equity markets, which is just over $30 trillion according to Zack’s Research May, 201825. In theory, for every three investors who would buy stock in your Company, there are four investors who would buy notes, bonds, or preferred stock in your Company.

Treat Your Company’s Securities Offering as Your Most Important Client. The most important attitude one can adopt is that your Company’s securities offering is your newest and largest client or customer. Yes, get your head wrapped around this concept, and imagine your Company’s securities offering as your newest and largest client, customer, or distributor. That “new customer” is willing to pay you $1 million, $5 million, or more (based on the amount of the securities offering) for you to dedicate 70%–90% of your time to the client’s effort—e.g., your Company’s securities offering— for the next 6–12 months. Would you do this for a client if requested? If so, why not do it for yourself?

Mitigate Risk. If you want to attract serious capital, you must mitigate risk of an investment in your Company and its securities. There are three, critical types of risk you can mitigate or limit—operational risk, financial risk, and litigation risk. More on this in Chapter 10: Warping the Risk/Return Continuum.

Maintaining Control of your Company. Hybrid securities do not normally have voting rights. Most entrepreneurs can raise substantial amounts of capital without giving up any (or very little) of their companies’ voting rights. To ensure you maintain voting control—e.g., greater than 51%—plan for future rounds of financing and grow your own private pool of investors by selling a series of hybrid securities that give the investor— first or forward—lien on assets in liquation and short-term immediate returns, with no votes. Attract only passive investors in the early stages. Most passive investors couldn’t care less about voting rights. For start-up and early stage companies, it is usually better to have many individual (passive) investors in your Company with relatively small amounts

of capital, as opposed to a few professional (active) investors with large amounts of capital. Professional investors do care about and want voting rights. By selling hybrid only to passive investors in the first few rounds of financing, you will always control the terms of the deal, maintain voting control, and build a growing pool of private investor contacts, which you may need for additional future rounds of financing for your Company. You should always be dealing from a “relative position of strength” when seeking capital. Adopting these few belief systems and exercising these concepts as your primary discipline will further your Company’s relative position of strength.

Zen Finance. Picture the type of investor base you would like to have. Do you want to raise money quickly with “high-octane” venture capital? Then be prepared to live a high-octane work life—or would you rather have more easy-going investors who truly appreciate their interest, dividend checks, and seek to help their own Company’s investment by thinking how they can benefit your Company with their contacts? The point being, attract capital from investors who are like you if you want peace and fulfillment in your work life.

Chapter 4: Knowledge is Power: The Power-Play

Rule #1: Understand Institutional Sources. Substantial amounts of equity or debt capital, from financial institutions, is generally not available for the vast majority of start-up and early stage companies. Institutional equity or debt capital means capital secured primarily through professional investors, such as venture-capital firms (“VCs” or “VC firms”), angel groups, family offices, private-equity investment firms, retirement or pension funds, insurance companies, and capital secured through the sale of securities offered through investment banks and broker-dealers. Corporations, unless they have a specific venture capital division or subsidiary, are not considered financial institutions by regulatory authorities and hence by the securities industry, as well. Commercial, merchant and import / export banks are another subject entirely and are lenders, not investors. Although debt financing is the least expensive form of capital and we want you to get to that level eventually, without sufficient equity capital raised externally, there never seems to be enough debt capital obtainable to provide for development or expansion at the start-up and early stage.

Venture Capital Industry

“According to the National Venture Capital Association, first financings, defined as the first round of equity funding [Seed Stage] in a startup by an institutional venture investor, also took a hit in 2016, with just 2,340 companies receiving their first round of funding, amounting to $6.6 billion in total invested capital or an average of $2.82 million per company.26”

“Following the year 2016 that saw both capital invested and completed financings at the angel & seed stage drop around 20%, the market stabilized to some extent last year, 2017. What we continue to note, however, is the lower counts in completed financings. Today, more institutional investors are in the market looking to back early-stage startups. The number of companies competing for this capital has also grown considerably over the last few years. As a result, the bar has risen in terms of the Key Performance Indicators (KPIs) that investors will want to see before investing. This notion, along with the delayed entrance of companies into the traditional seed & angel space will continue to contain deal flow in the size bucket.27

While such a large pool of capital is available to the industry, investors are working to stay disciplined in their approach, translating into overall fewer deals taking place, though more capital is being deployed at higher valuations.

In many ways, 2017 can be characterized by the record amount of activity we saw involving unicorns. More than $19 billion was invested into such companies across 73 completed financings, reflecting a year-to-year increase of over 10% and nearly 49%, respectively. Further, investments in companies valued over $1 billion amounted to more than a fifth of all VC invested last year, yet less than 1% of total deal flow.”28

27 https://pitchbook.com/news/reports/4q-2017-pitchbook-nvca-venture-monitor

Stage of Development

A picture says a thousand words. VC interest in Seed Capital investing is and has always been anemic and Early Stage investing is not much better, unless of course your company is a hot software firm, on the east or west coast. Even then, you’ll most probably give up voting control to obtain all the capital you’ll eventually need.

The problem for start-up and early stage companies is there is more Venture Capital available and being invested but fewer deals are getting done. This is due to the drain of capital from a huge emphasis on financing larger ‘Unicorns.”

Even more revealing is where these deals are being funded. Silicon Valley leads the pack by a wide margin with NY Metro and New England coming in at a distant second, leaving all other areas of the U.S. virtually non-existent.29

It is also a common misperception that 85% of small businesses fail within the first five years. The statistics indicate approximately 50% survive past five years and 30% survive past ten30. The problem is that venture capital firms are not interested in simple survivors, but those who truly prosper. Now what’s the definition of prosper? One could use a “start-up to IPO” statistic to arrive at what a VC firm would consider a success, because IPOs or outright strategic sales are the primary exit strategy for a VC firm. “Out of approximately 17,500,000 employer companies31 only 275 IPOs were conducted in 2014”32. The acquisitions (outright strategic sales) number33 is skewed as the numbers are derived from large companies eating up other large companies ($10 billion or more in acquisition price)34 and the statistics are primarily based on the size of the deals not the number in the U.S. However, the number of total acquisitions in the U.S. was approximately 2,254 and worldwide was 16,77535 Therefore, based on those statistics one could surmise that very few small businesses actually prosper to the degree that warrants a venture capital investment.

The above figures show only a small relatively insignificant part of the equation. They only show the percentage of dollars received from the total dollars in venture capital actually invested. What’s missing is the percentage of all start-up or early stage companies seeking venture capital but not receiving it. These statistics vary and they’re hard to pin down, but according to the U.S. Small Business Administration36 the reality is that there are approximately 28,000,000 small businesses in the U.S. and 600,000 start- ups each year. We believe in the 80/20 rule, in that only 20% of those would be worthy of an outside venture capital investment, as 80% would be “mom and pop” type operations obtaining traditional bank and or lease financing to start and grow their companies. If that seems reasonable, then 120,000 of the start-up and 5,600,000 existing small businesses are those seeking venture capital from outside investors. If that seems reasonable, then we simply divide the total start-ups 2,340 plus early stage 2,065 companies, or the 4,405

29 http://nvca.org/research/venture-investment/ 30 https://www.sba.gov/sites/default/files/FAQ_March_2014_0.pdf 31 https://www.sba.gov/sites/default/files/FAQ_March_2014_0.pdf 32 http://www.renaissancecapital.com/ipohome/press/ipopricings.aspx 33 http://www.forbes.com/sites/alexadavis/2014/06/24/no-slowdown-in-sight-for-2014s-ma-frenzy/ 34 http://www.goldmansachs.com/our-thinking/trends-in-our-business/trends-in-mergers-and- acquisitions.html?cid=PS_01_87_07_00_00_01_01 35 http://www.forbes.com/sites/alexadavis/2014/06/24/no-slowdown-in-sight-for-2014s-ma-frenzy/ 36 https://www.sba.gov/managing-business/running-business/energy-efficiency/sustainable-business-practices/small-business-trends - 48 - Copyright © Commonwealth Capital, LLC 2003-2019

that were funded last year, by the total amount of 5,720,000 qualified companies seeking venture capital to arrive at that percentage of .077% (3/4th of 1%) of those actually receiving it.

If the simple analysis of the above-mentioned statistics is correct, then 20% of small businesses are in need of a venture capital investment but only 0.077% are actually receiving it. Hence, there is a high probability that 19.22% of potentially great companies are being ignored. We believe with the proper corporate engineering, 30 to 35% start-up and early stage companies would be worthy of venture capital and we intend to see that they get it.

The bottom line is the overall probability of your start-up and early stage company being funded by venture capital (including angel groups and private equity) is becoming lower each year. Hence the absolute need to an alternative and effective method of raising substantial amounts of seed, development and expansion capital through the legal solicitation and sales of hybrid securities to individual investors.

However, no matter what route an entrepreneur may take, the capital-raising process takes time, money, and effort. Consider the cost of failing (e.g., the entrepreneur’s management team’s time and energy) to receive VC funding. It takes 3–5 months (on average for due diligence review) to be turned down.

The following are statistics from 2014, one of the best years since 2008 for the venture capital industry. For previous, as well as future years the statistics change but the percentages stay within a narrow range. “According to the National Venture Capital Association, Seed Stage investments fell 29 percent in terms of dollars and 18 percent in deals with $719 million going into 192 companies in 2014, the lowest number of Seed deals since 2002. In the fourth quarter, venture capitalists invested $176 million into 39 Seed Stage deals. Seed Stage companies attracted 1 percent of dollars and 4 percent of deals in 2014 compared to 3 percent of dollars and 6 percent of deals in 2013. The average Seed Stage round in 2014 was $3.7 million, down from $4.3 million in 2013. Investments in Early Stage companies accounted for the most deals during 2014 with 2,165 deals capturing $15.8 billion, [less than 1/3rd of the $48 billion funded by venture capital in 2014.] While the number of deals remained relatively flat in 2014 compared to the prior year, the dollars invested rose 54 percent over the same time period. In the fourth quarter, $5.6 billion flowed into 576 Early Stage deals. Early Stage companies attracted 33 percent of dollars and 50 percent of deals in 2014 compared to 34 percent of dollars and 51 percent of deals in 2013. The average Early Stage deal in 2014 was $7.3 million, up notably from $4.8 million in 2013.”37 These and the following trends continue into 2015-16.

However, two questions that are not revealed in these figures is exactly who is getting the money and why. The vast majority of the venture capital money went into

37 http://nvca.org/pressreleases/annual-venture-capital-investment-tops-48-billion-2014-reaching-highest-level-decade- according-moneytree-report/ - 49 - Copyright © Commonwealth Capital, LLC 2003-2019

software, then by a much lower margin biotech, media and entertainment, IT services with most other industries left behind.

Sector and Industry Analysis “The Software industry maintained its status as the single largest investment sector for the year, with dollars rising 77 percent over 2013 to $19.8 billion, which was invested into 1,799 deals, a 10 percent rise in volume over the prior year. Software remained the number one sector in Q4 for both dollars invested and number of deals with $5.8 billion going into 461 deals, nearly four times the number of deals than the second highest volume sector, Media and Entertainment. Software has held the number one spot in terms of dollars invested for 21 straight quarters. Biotechnology investment dollars rose 29 percent while volume decreased 4 percent in 2014 to $6.0 billion going into 470 deals, placing it as the second largest investment sector for the year in terms of dollars invested. The Media and Entertainment sector accounted for the second largest number of deals in 2014 at 481, however it was third largest in terms of dollars invested with an annual total of $5.7 billion. Overall, investments in 2014 in the Life Sciences sector (Biotechnology and Medical Devices combined) rose to the highest level since 2008 with $8.6 billion invested into 789 deals, a 29 percent increase in dollars but a 3 percent drop in deals compared 2013. In Q4, the Life Sciences sector captured $2.8 billion going into 202 deals, a 62 percent increase in dollars invested while deal volume remained relatively flat compared to Q3 2014. Dollars invested into Life Sciences companies accounted for 18 percent of total venture capital investments in 2014. Internet-specific companies experienced a 68 percent increase in dollars but a 6 percent drop in deals for the full year 2014 with $11.9 billion going into 1,005 rounds compared to 2013 when $7.1 billion went into 1,074 deals. This marked the highest level of Internet-specific investment since 2000. For the fourth quarter, $3.0 billion went into 236 Internet-specific deals. ‘Internet-specific’ is a discrete classification assigned to a company whose business model is fundamentally dependent on the Internet, regardless of the company’s primary industry category. These companies accounted for 25 percent of all venture capital dollars in 2014. Fourteen of the 17 industry categories experienced increases in dollars invested for the year. Industry sectors experiencing some of the biggest dollar increases for 2014 included: Retailing/Distribution (265 percent); Computers and Peripherals (132 percent); Electronics/Instrumentation (128 percent); and Financial Services (109 percent).”38 Stage of Development “Expansion Stage investments captured the most investment dollars in 2014, increasing 102 percent to $19.8 billion which flowed into 1,156 deals, a 13 percent increase compared to the prior year. In the fourth quarter, 297 Expansion Stage companies captured $6.2 billion. Expansion Stage companies attracted 41 percent of

38 http://nvca.org/pressreleases/annual-venture-capital-investment-tops-48-billion-2014-reaching-highest-level-decade- according-moneytree-report/ - 50 - Copyright © Commonwealth Capital, LLC 2003-2019

dollars and 27 percent of deals in 2014 compared to 33 percent of dollars and 24 percent of deals in 2013. The average Expansion Stage deal in 2014 was $17.1 million compared to $9.6 million in 2013. Investments in Early Stage companies accounted for the most deals during 2014 with 2,165 deals capturing $15.8 billion. While the number of deals remained relatively flat in 2014 compared to the prior year, the dollars invested rose 54 percent over the same time period. In the fourth quarter, $5.6 billion flowed into 576 Early Stage deals. Early Stage companies attracted 33 percent of dollars and 50 percent of deals in 2014 compared to 34 percent of dollars and 51 percent of deals in 2013. The average Early Stage deal in 2014 was $7.3 million, up notably from $4.8 million in 2013. Seed Stage investments fell 29 percent in terms of dollars and 18 percent in deals with $719 million going into 192 companies in 2014, the lowest number of Seed deals since 2002. In the fourth quarter, venture capitalists invested $176 million into 39 Seed Stage deals. Seed Stage companies attracted 1 percent of dollars and 4 percent of deals in 2014 compared to 3 percent of dollars and 6 percent of deals in 2013. The average Seed Stage round in 2014 was $3.7 million, down from $4.3 million in 2013. In 2014, $12.0 billion was invested into 843 Later Stage deals, a 35 percent increase in dollars and a 6 percent increase in deals for the year. In the fourth quarter, $2.7 billion went into 197 deals. Later Stage companies attracted 25 percent of dollars and 19 percent of deals in 2014 compared to 30 percent of dollars and 19 percent of deals in 2013. The average size of a Later Stage deal rose from $11.2 million in 2013 to $14.3 million in 2014.”39

First-Time Financings40

“First-time financings in 2014 rose 47 percent in dollars while the number of deals was flat compared to 2013, with $7.4 billion going into 1,409 companies. Investments into companies receiving venture capital for the first time in Q4 increased 57 percent in dollars and 8 percent in deals when compared to the prior quarter. First-time financings accounted for 15 percent of dollars and 32 percent of deals in 2014 compared to 17 percent of dollars and 33 percent of deals in 2013.

Industries that captured the highest total of first-time dollars and deals in 2014 were Software, Media and Entertainment and Biotechnology. Sixty-eight percent of first- time deals in 2014 were in the Early Stage of development, followed by the Expansion Stage of development at 14 percent, Seed Stage companies at 11 percent and Later Stage companies at 7 percent.”41

39 http://nvca.org/pressreleases/annual-venture-capital-investment-tops-48-billion-2014-reaching-highest-level-decade- according-moneytree-report/ 40 To understand how our system operates, please see the schematic of our Corporate Engineering Conservatory™ at the end of this EBook. 41 http://nvca.org/pressreleases/annual-venture-capital-investment-tops-48-billion-2014-reaching-highest-level-decade- according-moneytree-report/ - 51 - Copyright © Commonwealth Capital, LLC 2003-2019

One issue should be explained here. Venture capital is almost always provided in stages, and therefore the number of first-time financings, may mean a combination of both first time for serial entrepreneurs for that particular company not in their history and first time for those who have never received financing before. Therefore, the statistics also leads us to believe that most start-ups being funded by venture capital are high-end deals that serial entrepreneurs who have built and sold more than two successful start-ups in the last ten to fifteen years are the only ones being funded, because they’re matching venture capital funding internally. In other words, these entrepreneurs have $20,000,000 $50,000,000 of their own money and they want the VCs to simply match them based on their terms of the deal. These entrepreneurs deal with the VCs from a serious relative position of financial strength. That’s who getting the most venture capital for start-ups and because they not only have a successful track record of being serial entrepreneurs but more importantly they have the funds to command venture capital attention.

Becoming quality deal flow for professional capital is just as important to attract passive investors as it is for professional investors. Professional capital sources would include investment banks (e.g., broker-dealers), angel-investor groups, hedge funds, private equity firms, family offices, venture capital funds and registered investment advisors. From their perspective, quality deal flow typically refers to a company with positive cash flow, an experienced management team with a unique, high-demand product or service in a growing market. Unfortunately, identifying quality deal flow is often an overly simplified, quantitative assessment that does not fully recognize the distinctive benefit and potential value of investing in a start-up or early stage company.

We believe that the reason for direct or in-direct failure or stagnant growth for so many small businesses is not due to lack of entrepreneurial vision or product/service need or demand, but due to the lack proper market positioning and sales execution, organizational communication with action item checks and balances; capitalization planning, internal accounting controls and corporate governance. However, the cornerstone to these problems is the lack of capital—and therefore the inability to hire the right management team and outside legal, accounting and other professionals to executed the entire business plan through to fruition. Without adequate access to substantial amounts of capital to hire the necessary management team to design and implement the proper product and service production protocols; execute the proper marketing and sales strategy; implement the proper internal accounting controls; and standard corporate- governance practices; and to survive general economic down cycles, business failure isn’t assured, but prosperity becomes a rarity indeed.

In our experience and analysis, less than 0.77% of all new, non-serial entrepreneur driven start-up and early stage companies searching for capital receive their needed funding through any institutional source—on average annually, in good or bad times. In good times, generally more money is available and there is more quality deal flow. In bad times, less money is available and there is less quality deal flow. It’s all relative. If your start-up or early stage Company is within the lucky 0.77%, the institutional, equity-capital source will most likely control the terms of the deal and [often] demand voting control. You may have to give up substantial equity and upside - 52 - Copyright © Commonwealth Capital, LLC 2003-2019

participation to “seal the deal.” On average, VC firms typically fund two, three, or possibly four companies out of the 1,500 [or more] deals they review each year.

“Why do most VC firms operate this way?”

They operate this way because they have no real choice—it is a matter of survival. True, more venture-capital money is currently available than at any other time in history; however, the money is not being invested due to a lack of quality deal flow. In the VC or Private Equity industry, this reality is called “Capital Overhang” or “Dry Powder.” The term Capital Overhang refers to the amount of capital committed by investors to venture capital and private equity firms for investing purposes. When VC and private equity funds are created, most have limited lifetimes. That means that fund managers typically have 5-7 years to invest the private equity overhang, or they have to send the capital back to their investors. Over the decade of 2007-2017 the Capital Overhang in the U.S. private equity markets have hovered around the $500 Billion dollar level in the U.S. and it’s getting close to $1 Trillion Globally.42 Yes, that means that the VC and private equity industry will give their U.S. investors back around $500 billion dollars each year, due to the lack of quality deal flow.

The VCs cannot lower their investment criteria—to fund the majority of start-up and early stage companies—primarily because they raised capital through a prospectus to individual and institutional investors, which limits their flexibility. Specifically, they raised capital for their Funds by selling shares and setting criteria within the prospectus (their securities-offering document) that limits their ability to invest in prospect companies. For example, they may have stated, “…the Fund will only invest in portfolio companies that are engaged in the medical-supply-and-health-care industries, nanotech (as it relates to medical supplies), surgical application or other related technologies [sector-positioning limitation]; with a minimum of seven years of operating history

[stage limitation]; annual sales of at least $15 million [size limitation]; and the average capital commitment of $20 million [capital-commitment limitation].” Essentially, they pin themselves into a corner through prospectus limitation. Granted, they believe this limitation protocol mitigates portfolio risk, which it does to one degree or another— depending, of course, on how one looks at it. More importantly, however, this limiting strategy mitigates capital-raising risk for the VCs. What do you think would happen if they took a prospectus with little or no limitation protocol to an institution looking to invest a couple hundred million dollars? They would be laughed out of the room.

“I only need $500,000.00. Why won’t a venture capitalist just cut me the check?”

Unless they make a radical departure from the “old school” position and protocol of investing and managing “portfolio companies” for their Funds, it is a mathematical certainty they will never be able to afford to simply “cut the check.” Not only is it commercial suicide for a VC firm to stray from investment-criteria protocol for attracting capital for their Funds, but they could not otherwise afford to manage the amounts invested in smaller companies.

For instance and as an example let’s run the numbers to discover why. Let’s say a VC firm was able to raise $10 million in a new Fund to invest only in start-up companies. Also assume the average amount to be invested is $500,000 per company, and the Fund plans on investing in twenty companies this year (for diversification) with the average holding period estimated to be five years. After making stated investments, the Fund has twenty portfolio companies it will then need to look after. The VC firm needs to employ professional managers (in-house within the VC firm) to look after these companies. How many companies can each manager reasonably look after—two, three, or possibly four? Remember, the VC firm has a fiduciary duty to its shareholders of the Fund, so it cannot skimp in this area. Let’s assume for this example that each manager looks after four companies (the high end of this estimate). In this scenario, the VC firm needs to employ five managers to look after all twenty portfolio companies. How much should the VC firm pay these managers in annual salaries? Should the VC pay $200,000, $250,000 or $300,000 each? Where is the line to further assure the Fund is hiring competent managers to protect the VC firm’s fiduciary duty? Let’s assume $200,000 is the line on salaries— the low end of the cost spectrum. That’s five managers at an annual cost of $200,000 each for a total annual cost of $1 million in salaries alone. Who is going to pay for these managers’ salaries? Typically, the portfolio companies need to provide immediate returns to the VC Fund to pay this cost. Most start-up companies would be hard-pressed to afford annual contributions to the VC Fund of $50,000 each year. However, let’s assume that each of these portfolio companies can make annual contributions to the Fund of $50,000 each year to enable the VC Fund to afford the managers to justify the capital invested. We do this to further define the next segment of this scenario.

After the average holding period of seven years, the total cost of managing the investments of the Fund in these start-ups is $7 million ($50,000.00 x 20 companies x 7 years) in salaries alone, which is now being funded by the companies within the investment portfolio. Add an extra $500,000 for other unforeseen costs, such as - 54 - Copyright © Commonwealth Capital, LLC 2003-2019

additional legal advisory, accounting services, etcetera, which will also be borne by the collective of all portfolio companies—for a total of $7.5 million over that seven-year period. That’s the VC Fund’s overhead commitment, whether or not these companies survive to the degree that they can cover these costs. Now the accepted truism in the industry is 50% of these portfolio companies will fail within the first five years, 30% will stagnate and or essentially breakeven, leaving 20% to succeed to a degree that should make up for the “capital losses” (and then some) of the other 80% (50% + 30%). Thus, we can assume that out of the twenty companies funded, ten companies (e.g., 50%) will fail—for a total capital loss of $5 million of the original total Fund value of $10 million and 6 companies (e.g. 30%) stagnate and breakeven for a $3,000,000 recapture. If we assume the 50% fail and the 30% are sold at breakeven during the 5th year, on average, the sixteen companies will not be able to cover 2 years of the $7,500,000 VC’s overhead commitment. This equates (16 x $50,000 x 2 = $1,600,000) to a VC overhead shortfall or loss. Let’s say the VC is willing to absorb the $1.6 million potential operating loss for the potential to offset those losses with capital gains. Note, if you knew any VCs, they would laugh at that last statement. Each of the four remaining portfolio companies with initial investments of $500,000 each ($2 million total) would need to be liquid—publicly traded or sold to a strategic buyer—with average values of at least $15.625 million per company (assuming an 80% ownership interest acquired in each portfolio company by the Fund, for a $12.5 million net value in each portfolio company to the Fund) to meet the “risk/return criteria” of five times the money in five years set by the Fund, e.g. $10 million dollars to $50 million—4 companies x $12,500,000 in Fund value each. That is a far reach. Furthermore, as an entrepreneur, if you had a company with the potential to be worth $15.125 million in five years, would you sell 80% of the ownership today for $500,000?

In the precious scenario, we’ve made some fairly unrealistic and aggressive assumptions to entice or motivate a VC firm to adopt a business model to fund start-up or early stage companies. First, we’ve asked the VC firm to demand $50,000 from each portfolio company for each year; we’ve asked the VC firm to shoulder an estimated $2 million in internal operating losses; and lastly, we expect the VC firm to grow 4 out of the 20 start-up or early stage companies with unproven business models, to grow and sell company for a minimum value of $15.125 million in five years with only $500,000 invested.

The point I’m trying to make here is the math simply does not make sense for a VC firm when one assumes the traditional VC Fund model is employed by competent managers.

You may be thinking, “But I’ve read in all the trade magazines that venture capital groups are springing up all over the country and are funding deals left and right.” Frankly, you are reading about the rare cases. Remember, the publishers of these magazines need to sell “hopes and dreams” and, ultimately, their publications. Consider the source before you jump to conclusions. They produce good stories that motivate and do have value. However, if you want to raise substantial amounts of capital while maintaining the vast majority of equity ownership and voting control, consider producing - 55 - Copyright © Commonwealth Capital, LLC 2003-2019

and executing a series of successful securities offerings to be effective in your capital- raising efforts—this strategy has far more value than simply being motivated by stories.

You could also be thinking, “But we’re different because we’re being romanced by a couple of VC firms right now.” Sorry, it is most likely a false romance. VCs must generate massive deal flow so they can “cherry pick.” It costs them virtually nothing to keep you and everyone else hanging on. You cannot blame them—this is the nature of the industry.

All VC firms are looking to invest in the “next big thing.” Yet, most of them will not know what the “next big thing” is until it is too late. That is why they have to “cherry pick” the top 0.77% of the deals they review. It is estimated that with approximately 600,000 startups each year along with 28,000,000 existing small businesses the U.S. venture capital simple isn’t interested in funding start-up or early stage companies. Nevertheless, the VC industry may need to adjust their investment criteria, or like any other industry that does not change to meet market demand…the industry may cease to exist.

With that all said we have access to many sources of capital for varying stages of a company’s existence. More importantly, we, too, are looking to invest in start-up and early stage companies through our own venture-capital fund.

Investment Banking.

There are two sides to the investment banking industry. Those two sides consist of: 1.) “Consumer Markets,” where financial advisors manage individual investment portfolios of their firm’s investor clients, and 2.) “Capital Markets,” where investment bankers raise capital for their firm’s issuer clients. We refer primarily to the Capital Markets side of the investment banking industry in the discussion below.

The investment banking industry is continuing to experience difficult times. Restrictive and suffocating laws have been passed, such as; the U.S. Patriot Act and Sarbanes Oxley, and the new FINRA replacing the NASD have put additional pressures on publicly traded companies and investment banks alike. What most people do not realize is that these laws have a negative effect on the ability of all companies, publicly, as well as privately held, to raise capital through a traditional investment-banking avenue. The attributes necessary for companies to qualify for an investment banking relationship, have always been high, but recently they have increased significantly due to the increase in regulations and the inherent general liability of compliance. Therefore, even companies that would have normally qualified for such investment banking relationships in the past, now find it difficult to qualify for the relationship, due to today’s regulatory environment.

The typical “boutique” investment bank – broker dealer must be extremely selective and protective of any capital raising effort they engage an issuer in. Broker dealers need investors more than they need quality companies to capitalize, aka quality

deal flow. One would be wise to budget marketing dollars, from the use of proceeds from the securities offerings, to provide to broker dealers so the broker dealers can attract new investors for your securities offering. This further justifies taking on the additional risk of capitalizing an early stage company. This is a tactic we’ve used successfully since 1998.

Boutique investment banks and broker-dealers (specifically those with less than 50 sales representatives) are finding it far more difficult to engage companies, at any stage of the companies’ life cycles, in an investment-banking securities-brokerage effort. The difficulty arises in the increasing compliance burden of the SEC, Financial Industry National Regulatory Authority (FINRA), and North American Securities Administrators Association (NASAA). In the compliance session at a capital conference we recently attended, a former SEC-enforcement attorney—on a panel of six securities attorneys— made the statement that FINRA has indicated in their internal documents that these small broker-dealers are to be sought after as the primary targets for assessing fines, because these smaller firms are the cause of the vast majority of the complaints and regulatory violations within the securities industry. For these reasons, the securities regulators are set out to destroy this portion of the industry. What FINRA recognizes is the more rules they make and enforce the more difficult and cost prohibitive it is for compliance to be met by these firms. Thus, small-boutique broker-dealers may be going the way of the dinosaurs.

In addition, the amount of quality deal-flow—e.g., companies that qualify for the investment-banking relationship—is far less than it used to be. The profit margins are simply too small to make it worth it anymore. Sadly, this portion of the industry may be doomed. In conjunction with this evolution, entrepreneurs may have no choice but to capitalize themselves “in-house” by conducting one or more securities offerings themselves.

To hedge your position and increase the probability of success, you must compete directly with financial institutions to attract capital from individual passive investors. Keep in mind those financial institutions need to attract capital from individual investors as well. Banks need depositors and venture capitalists need shareholders in their Funds. No matter how it looks, it boils down to attracting individual investors, because ultimately they own and control the money. Business plans and executive summaries do not meet the stringent legal requirements to raise capital from individual investors—only securities-offering documents do.

Crowdfunding Portals.

As previously stated in Chapter 4, the Sub-Chapter “Denying Access,” the Crowdfunding Portals for regulated equity or debt offerings will become more and more like investment banks / broker dealers. They’re a good avenue for start-ups as long as you really know what you’re up against when dealing with the increasingly risk-averse environment of this new sub-industry of financial institutions. Change is inevitable and we’ll bet it moves toward risk aversion, and if your company is not properly engineered you simply will be denied access. - 57 - Copyright © Commonwealth Capital, LLC 2003-2019

Chapter 5: Conduct a Series of Related Securities Offerings

Conduct a Series of Related Securities Offerings to Raise Capital—by Using Hybrid Securities to Maintain Voting Control and Equity Ownership. You can raise sufficient capital without giving up substantial common-equity interest through the issuance of hybrid securities. This includes—but is certainly not limited to—convertible preferred stock, convertible notes, convertible bonds, non-voting common stock with married put options, participating preferred stock, notes with equity kickers, cryptocurrencies, or through issuing royalty financing contracts. In the current market environment, convertible-participating-callable, preferred equity with an attractive— stated dividend, participative dividend (participation of net income), conversion ratio into the common voting equity, with a call protection date that is four to five years away from the date of issuance is very attractive to investors.

Selling common equity in the early stages of a company’s existence generally results in selling out the company’s most precious element—common-equity ownership—for too little, too soon. In the world of finance, there exists what is known as “cheap” money and “expensive” money. Nevertheless, it is relative and changes. For instance, bank debt with a high-interest rate seems like expensive money in the beginning. However, if your company is successful, bank debt becomes cheap money relative to selling common voting equity because that equity will become more valuable over time, and, inherently, it becomes the real expensive money. For example, if you borrowed $1 million at a 10% interest rate for five years, that is $100,000 a year in interest or a total of $500,000. In this scenario, bank debt seems expensive. Yet, if you sold 30% of your Company’s common stock for $1 million, and your Company's worth $5 million at the end of the fifth year, that is a value of—or a net expense difference of $1 million (the $1.5 million value of 30% of the Company versus $500,000 in bank interest equals $1 million net difference). The common stock is technically lost forever, so the net cost may be more as your Company continues to grow. That’s really expensive money.

Let’s look at it from an investor’s perspective. To reiterate the point, it is very difficult and expensive when attempting to sell common stock in a corporation or membership/partnership ownership interest in an LLC at the early stages of a company’s existence. It is difficult because most try to sell a small amount of equity ownership for a relatively large amount of money. If there is very little cash or marketable inventory in the company, and an investor purchases 30% of the total ownership equity for $1 million, that investor just lost $700,000 due to dilution. An extreme dilution factor is very unattractive to any investor. In addition, if you assume success in your venture, selling any common voting equity in the early stages generally results in selling too much of - 58 - Copyright © Commonwealth Capital, LLC 2003-2019

your Company’s most precious element—common voting equity…too soon, for too little—which is a critical mistake made by most entrepreneurs. There are service firms that will charge you an outrageous fee to take your start-up or early stage company public (pink sheets or OTC bulletin board), which is one of the biggest mistakes a start-up or early stage company can make. Repairing this mistake can be done, but for most…it is a death sentence.

If you want to control the terms of the deal and maintain the vast majority of equity ownership and voting control in your Company, while simultaneously increasing the probability of raising substantial amounts of capital, you must conduct a series of related securities offerings compliant with federal and state(s) securities laws, rules, and regulations. These offerings would include using hybrid securities (that have little or no dilutive repercussions for investors). Searching for capital in any other fashion generally results in everyone attempting to change the terms of the deal, which always results in loss of time and money. Thus, the alternative becomes an extremely frustrating endeavor.

The most successful capital-raising structure for start-up and early stage companies are illustrated as follows:

1. The process begins with conducting a “seed capital” round, ranging from $100,000–$1,000,000. An ample amount of seed capital is necessary to launch - 59 - Copyright © Commonwealth Capital, LLC 2003-2019

a successful development or expansion capital-raising effort. Seed capital is generally raised through the issuance of one-, two-, or three-year “seed capital- convertible bridge notes.” Producing this deal structure and the related securities- offering documents is relatively quick and inexpensive.

2. Seed capital is best used to protect investor interests by a. further protecting the company’s assets—i.e., intellectual property or “IP”; b. sustaining (not expanding) basic business operations; c. most importantly, A portion of the seed capital is used to produce and promote the next securities offering for “development capital.” Hiring the right professionals to continue the process of raising capital through a series of related securities offerings with the issuance of hybrid securities in compliance with federal and state(s) securities laws is often the only alternative to seeking substantial amounts of capital from financial institutions.

3. Development capital is best used for hiring employees, especially additional management- team members, capital expenditures, and (most importantly) for generating sales and increasing the revenue stream. For most entrepreneurs, development capital will be sought out in the local community using the general media to solicit the securities. You can qualify for public solicitation through the general media—under SCOR, through provisions in California Securities Code (Section 1001 or 25102(n)), Regulation D, Rule 506(c), or Regulation A or A+. Because of the issuance of convertible participating preferred equity, development capital should be kept at a minimum. If one assumes success, due to its income participation and conversion features, said form of capital could get expensive. A portion of development capital is often used to produce and promote the next securities offering for “expansion capital” for fast growing companies. Raising development capital is easily done through “public solicitation” of the private entity’s securities.

4. Expansion capital is best used for expanding sales and customer service operations; acquiring additional capital assets; expanding the administrative employee base; and executing acquisitions of entire companies or their assets. You can qualify for public solicitation through the general media, in the same manner as development capital (noted above). Additionally, expansion capital can be sought after in a few different ways. Due to the issuance of common or convertible preferred equity and/or traditional or convertible debt, expansion capital should be kept in balance, but be sufficient to expand your Company through acquisitions to increase market share and further profitability.

More on Expansion Capital.

Under Regulation D, Rule 506(b) private or Rule 506 (c) public, you can use expansion capital for the acquisition of other companies and/or assets to increase revenue, reduce cumulative overhead expenses through consolidation, or both. Using the convertible participating preferred equity deal structure, one can acquire assets or entire companies by issuing a specific “series”—i.e., Series B, C, or D—of preferred-equity - 60 - Copyright © Commonwealth Capital, LLC 2003-2019

offerings directed at that acquisition. Normally, assets are acquired, thereby relieving you of the acquired company liabilities—disclosed or otherwise. In addition, by acquiring all the assets of a company—as opposed to all the stock of a company—your Company can depreciate or amortize the acquisition thereby reducing taxation. That convertible participating preferred equity would be secured against the acquired assets, while allowing the previous owners to share in the profits of the [entire] newly created consolidated company. Furthermore, they will receive a stated dividend higher than they could get elsewhere. In addition, you can create the convertible participating preferred equity with a one-hundred-dollars-per-share par value price and discount it to defer capital-gains taxation to the previous owners. For instance, if the negotiated purchase price of the acquired assets is $10 million and the previous owners have a cost basis of $6 million, you could issue 100,000 shares of preferred stock at $100 per share, which equates to $10 million. However, you would price it at a sixty-dollar cost basis with forty dollars of unrealized appreciation per share (40% discount) on your Company’s—as well as the selling company’s—balance sheets (accounting records), as opposed to the $100 per share. Ultimately, this will defer the previous owners’ capital gain until they sell their newly acquired shares. By conducting your securities offering in this manner, you may be able to negotiate the acquisition price to a lesser amount because the discounted, preferred-security can defer capital gains, but more importantly it can provide far more net cash flow than many other competing investments in the public marketplace. Think about it. If you issue at 8% stated dividend at $100 per share and discount it to the assets’ cost basis, of say 60%, (40% discount) then the cash flow is a net 13.34% ($8.00 stated dividend / $60.00 share price) to that investor / seller of assets. Need more power in the negotiations? Consider listing the convertible preferred equity on a publicly traded securities exchange. Depending on the value of that acquisition deal, it may be worth spending the extra funds necessary for the exchange listing.

Additional Benefits of Issuing Hybrid Securities.

Other significant benefits of issuing (high-demand) hybrid securities include the following: (a) your common equity ownership and voting control is not diluted or lost; (b) hybrid securities are in high demand, so selling them to passive investor is relatively easy (preferred-stock dividends may qualify for the 50% to 65% “dividend exclusion allowance” essentially tax-free income on half the cash flow—for US corporate investors; (c) hybrid securities either mature or can be “called” or redeemed at a pre-set price, making this form of equity capital temporary (at your option) and, thus, the least- expensive form of equity; (d) hybrid securities can be used as currency for asset or company-acquisition purposes—this is very important; and (e) more importantly, if these hybrid securities are listed on a publicly traded securities exchange, offering them directly to market makers at a discount (from market price) makes raising additional rounds of capital very easy.

Note: listing “common stock” on a publicly traded securities exchange too early is a major mistake for most early stage companies. Most publicly traded, small companies initially went public because someone “sold them” on the concept that once their common stock was traded publicly, they would be able to raise capital. Although they do - 61 - Copyright © Commonwealth Capital, LLC 2003-2019

raise some capital, it never is what they expect; essentially, the stock becomes a penny stock. At this juncture, the trading volume dries up, and the stock falls further in price due to the illiquid nature of the decrease in volume. When attempting to “float” (sell as secondary public offerings) additional common shares into the public market to raise more capital, the stock becomes further diluted as does the owners’ equity and voting interest. The securities regulators despise penny stocks, because they are fundamentally part of abusive sales tactics for “boiler room” operations. What the difference here is to list “hybrid securities,” such as convertible notes or preferred stock that have stable price structures due to face or par values. Imagine listing preferred stock on an exchange with an initial listing par value price of $100 per share. The preferred stock with a reasonably high stated dividend, you will naturally stabilize that price, making it more attractive to institutional, as well as individual investors.

When you’re dealing with “liquid securities” on a publicly traded securities exchange it is like turning a faucet on and off again. If you need more capital, “float” or sell more securities to market makers and other institutional investors—“turn it on.” When your capital needs are satisfied, “turn it off.” Once you understand the process of operating with publicly traded securities, it is not that difficult to manage your ongoing capitalization needs.

You must have ample funds (seed capital) to support the related sales and marketing efforts, whether you are selling securities privately or publicly—e.g., limited public placements internally—or engaging in a selling effort involving a FINRA Member broker-dealer. Offering $50,000 to $100,000 in marketing support to a FINRA Member broker-dealer should get the broker-dealer’s attention. If you do not have a sufficient amount of seed capital, first raise it through a seed-capital securities offering. Depending on your Company’s situation, $50,000 to $100,000 of seed capital should be sufficient to obtain the larger $3 million to $5 million amounts of development or expansion capital.

You may be saying to yourself, “That’s expensive money!”—you’d be right. All “risk capital”—and all capital is “risk capital” when it involves an investment in a start- up or early stage company—is expensive, but consider the cost of not obtaining it. Selling securities to raise capital is like selling anything else—it takes time, money, and a concerted effort. You are simply marketing and selling an intangible asset in a highly competitive and a highly regulated environment. Ensure you only attempt to engage a broker-dealer when you need to raise a serious amount of capital; and your Company is producing enough cash flow that $50,000 to $100,000 for marketing support is not a big deal.

There are no guarantees when it comes to raising capital—only degrees of probability. The probabilities increase in direct correlation with the amount of seed capital available to promote expanded, capital-raising efforts. The more seed capital you have available, the higher the probability for a continued series of successful securities offerings. You are competing with financial institutions for individual investor funds. Therefore, you have to act like one.

Create a Finance Department

Seriously consider creating a Finance Department to Compete for Capital. If your Company is in the early or later-stage of development, and you are unable to engage a SEC-registered broker-dealer to sell your Company’s un-registered securities (private placement) consider creating an “in-house” finance department. Once you have raised sufficient seed capital or have ample cash flow from operations, a well-staffed finance department within your Company can compete with financial institutions for capital from individual investors. Staff it internally or hire someone from the securities industry with the skill set, investor contact, and ability to raise capital exclusively for your Company. This department is headed by your Chief Financial Officer (CFO) or vice president (VP) of finance. When working as a bona fide Officer or Director for your Company, no securities license is required for any executive to solicit and sell your company’s securities. How do you find these individuals? It is relatively easy, especially in today’s market, because of the securities industry’s high turnover rate and profit margin squeeze, due to online investing.

For start-up or early stage companies, hiring a CFO (or VP of Finance) from the securities/investment-banking industry that has a book of many qualified leads, (e. g. investors willing to invest in your company) would be appropriate and wise. To replace the VP of finance title, you may want to choose the title of CFO for the person you seek as long as it doesn’t create any ambiguity or resentment within your current management team—as the title and position of CFO has more cachet and power.

Remember, only SEC-registered FINRA Member broker-dealers or bona fide officers and directors of your Company can legally solicit and sell your Company’s securities. However, you cannot pay a bona fide officer or director a commission from the sale of securities. The beautiful thing here is, unlike an accountant or attorney, the CFO or VP of Finance is a self-funding expense with very little financial risk for your Company—if done correctly. The CFO or VP of Finance’s job description must be in the nature that raising capital is an incidental part of that position. It’s often wise to arrange an employment contract whereby this is stated specifically.

The reason this part of the process may seem obvious to some but foreign to others is most entrepreneurs come from large corporations where the company has various departments, such as; human resources, production, operations, administration, and so on. Most large corporations have an accounting department, but it does not serve as a finance department. Normally, the financing function easily is outsourced to (or handled by) commercial or large SEC-registered FINRA Member broker- dealer/investment banks, because mid-cap to large-cap corporations have the overall financial strength—to sustain interest and dividend payments and, therefore, inherently have less risk.

Only officers and directors authorized by their corporation may communicate with prospective investors. Lower-level employees, equity holders who are not officers,

directors, attorneys, or other corporation agents may not do so unless they are registered as securities broker-dealers. Indeed, no officer or director may be specially compensated directly or indirectly for communicating with prospective investors. They cannot receive commissions. They cannot receive success fees. No officer or director may have as his/her full- time job the position of communicating with prospective investors to obtain capital, unless that person is registered as a broker-dealer. Generally, the federal and state definitions of a “securities broker” are purposefully broad to include persons who are not compensated for introducing an investor to an investment opportunity. Anyone who engages in the activity of finding potential investors is a broker. Thus, corporate officers and directors who communicate with prospective investors are also brokers. Federal law, however, provides an issuer- employee exemption for participation in one offering per year. Also, most states exempt these persons from being required to register as securities brokers, provided they are not compensated for their services as securities brokers—and so long as it is not their full-time duty to raise funds for the corporation. Some people with histories of relevant, criminal convictions, injunctions, cease- and-desist orders, bars from the securities industry, or from being a public-corporation officer or director, or a penny-stock bar are automatically barred under federal law and the laws of most states from participating in some but not all categories of unregistered- securities offers. In the world of raising capital, there are many rules for securities compliance. It is well known and accepted that hiring the right professionals (in-house or out-sourced) is truly the key to overall success. This certainly would include hiring the right accountant, attorney, and a CFO or VP of Finance—from the securities industry.

There are additional benefits of establishing and building an in-house finance department. An in-house finance department can manage future capital-raising efforts in- house or in conjunction with your SEC-registered broker-dealer, as well as manage franchise operations, the relationships with commercial banks, supplier-creditors, lessees and lessors, product lease options, investor relations, and so on. An in-house finance department can function as the catalyst for an exit strategy for the owners’ shares, when they are ready to divest their ownership positions. The point being, an in-house finance department is not a temporary department and on the contrary, if built correctly, it can be a cornerstone of your Company.

NOTE: To identify the executive position within the start-up or early stage company, we use the term and title “VP of Finance” throughout this course. We do this because most small companies already have a CFO—by title. The term “by title” means just that. They’re really not true CFOs per se. Some are from the accounting or commercial- banking industry and therefore incorrectly titled. A true CFO is responsible for capital attainment and the maintenance of a company’s capitalization structure. One with an

accounting background should really be titled “controller” or “treasurer”—not CFO. For later-stage companies, where institutional financing (primarily bank debt) is an acceptable form of capital—e.g., real estate, hiring a CFO with a commercial banking background would be appropriate. However, start-up and early stage companies need someone as either a true CFO or VP of Finance, who can raise capital through a series of securities offerings compliant with state and federal securities laws, rules, and regulations to increase the degree of probability of successfully raising capital for their company. In our experience, every other effort is a complete waste of time, energy, and effort.

To attract a true CFO or VP of Finance you will need a final draft copy securities- offering document, just prior to completion to show these individuals so that they too have a clear understanding of the company’s plan and what types of securities they are going to be selling.

Do Not Rely on Others to Raise Capital.

Most entrepreneurs believe raising capital is like selling real estate. They think capital-raising commission-based entities exist for their start-up or early stage Company. Essentially, they are called SEC-registered investment banks or broker-dealers, which must also be FINRA Members. However, they will not raise capital for start-up or very early stage companies—there are many reasons why. The primary reason is most start-up and early stage companies are simply too risky.

History shows us 80%43 of all start-up and early stage companies fail or stagnate within their first five years primarily due to lack of sufficient capital reserves. In addition, there’s very little money in it for them because the deals are too small. If you want to pursue this route for your Company, be aware your Company may also need to invest in marketing support—approximately $50,000–$100,000 in additional cost—for a broker- dealer to be interested in an engagement contract with your early to later-stage Company. This is not mandatory; but without it, you stand very little chance of engagement. The expense associated with broker-dealer due diligence is separate. FINRA (the primary federal regulator for broker-dealers) mandates third-party due diligence be conducted prior to broker-dealer engagement. That due diligence process can be very expensive, depending on the nature of your Company and the dynamics of its operations. On top of those up-front out-of-pocket expenses, you will pay a generous commission—generally 5%–12% of monies raised—and depending on the market environment, you may also give up some equity through the issuance of warrants to the broker-dealer(s). In addition, you will be doing most of the work of actually selling the securities—through the proverbial “dog and pony shows.” There is nothing like the enthusiasm of company management-team members to garner investor interest—broker-dealers rely on that. This reality further justifies the hiring a VP of Finance...and conducting your securities offerings in-house.

WARNING! HIRING MONEY FINDERS AND PLACEMENT AGENTS CAN BE EXTREMELY DANGEROUS— AND IT RARELY WORKS. YOU SHOULD NOT PAY ANY UP-FRONT INVESTOR INTRODUCTORY FEES. YOU CANNOT PAY THEM A COMMISSION, PERFORMANCE OR SUCCESS FEE FOR OBTAINING CAPITAL IF AN OFFERING OF SECURITIES IS INVOLVED. IT IS YOUR RESPONSIBILITY TO COMPLY WITH FEDERAL AND STATE SECURITIES LAWS NOT THE MONEY FINDERS’ RESPONSIBILITY.

Keeping a Proper Perspective.

Raising capital for start-up and early stage companies in any economic environment can be difficult if not properly orchestrated. In good times, investors can expect good returns on their investment in the stock market, where the investment is easily accessible because one can sell (liquidate) their securities at any time. The resistance often lies in tying up money in an illiquid security in a private company. However, this can be overcome with a solid marketable deal structure along with proper securities marketing and selling techniques. In bad times, investors are always waiting for good times to reappear before they make any changes in their investment portfolio. When competing for capital in any market environment, simply compete on the basis of the following criteria:

1. Relative safety of principal. 2. Immediate return (yield). 3. Long-term return (profit participation/capital gains). 4. Liquidity

After you have beaten the competition from a deal-structuring standpoint, you simply need to maximize the number of investors you contact—legally. As with all sales, it becomes a numbers game. In any market environment, it is far more effective to raise small amounts from many investors by being able to compete directly with financial institutions in the fixed-income securities markets with high-yield securities.

In summary, consider creating hybrid securities, such as seed capital-convertible bridge notes or participating convertible-callable preferred stock (or Member Units for LLCs). Develop a five-year capitalization plan, which illustrates issuing one or more of a series of these types of securities over time. Oversee the training of personnel, to accomplish the task of raising the capital either “in-house” (with or without a Chief Financial Officer “CFO” or VP of Finance from the securities industry) or through a SEC-registered broker-dealer, when ready. By doing so, you further assure: 1. the capital structure does not become cost prohibitive—by implementing the rolling of re-financing techniques; 2. your Company maintains compliance with securities regulations and financial results are optimized; 3. you do not sell too much of your Company too early for too little; 4. more importantly, the capital is actually raised.

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Chapter 6: Why Entrepreneurs Fail to Raise Capital

The average entrepreneur fails to raise capital for their start-up or early stage company for any one of the following 15 reasons:

1. The entrepreneur does not properly assess his/her personal capital contact—e.g., investor—environment in the beginning stages, in order to tailor the securities offering to meet that particular market demand, i.e. doesn’t do his or her research.

We suggest you and your management team “test the waters” by contacting only potential investors with whom you have pre-existing relationships to see if they might be interested in your idea or company, before attempting a capital raise.

2. The entrepreneur spends too much time, money, and effort soliciting the wrong sources of capital.

At any stage of your Company’s existence, we suggest you only negotiate from a “relative position of strength.” In other words, ensure that any prospective investor, who you approach with the securities offering, needs the deal more than you need that particular individual’s capital investment. In the beginning stages of your Company’s existence, you are working from a relative position of weakness when approaching strangers (i.e., venture capitalists, angels or investment-banking firms) and a relative position of strength when approaching personal and professional contacts that already know and trust in your ability to get the job done. You should consider professional sources of capital only when your Company grows and expands through internally generated revenue…and only to the degree that you maintain a relative position of strength.

3. The entrepreneur seeks too much or too little capital for the company (or project) during the first round.

Your five-year operational plan should be geared toward raising the minimum amount of capital necessary for each step, in a series of subsequent financing rounds or securities offerings, but not so little that investors don’t take you seriously. There is an optimal capitalization amount that you can discover within the Corporate Engineering Conservatory™, but suffice it to say that $500,000 to $1,000,000 is normally an appropriate amount for seed capital followed by a $5,000,000 to $10,000,000 round of development capital for most operating companies. This strategy accomplishes two very important and strategic objectives: first, it increases the probability of obtaining the desired amount of capital. Second, it allows you to maintain the maximum amount of equity ownership and voting control.

4. The entrepreneur puts the proverbial “cart before the horse,” by failing to start the capital-raising effort early enough in the company’s existence.

More often than not, entrepreneurs spend considerable time building their company or developing their project—i.e., intellectual property—with little or no capital, when they should be concentrating on raising capital for future development. It is better to raise capital in the beginning stages, especially when you have your initial personal capital to do it right rather than waiting until you run out of capital.

5. The entrepreneur does not have enough personal capital committed to the project.

Most investors want to hear that you have your own money in the deal—i.e., “skin in the game” as the term goes. If you personally do not have considerable capital to contribute, one way to mitigate a possible objection is arranging for your management team to sign personal guarantees for debt financing or bank loans—if the company is bankable—or have friends and family members finance the deal. Somehow, you need to show investors that you have far more to lose than they do, if your Company fails.

6. The entrepreneur does not communicate a clear strategy or “game plan” for the use of proceeds of the capital raised.

This is solved when conducting a securities-offering to raise capital, as you must provide a detailed, GAAP compliant Sources and Uses statement as your required Estimated Use of Proceeds disclosure when conducting a securities offering. This is mandatory for Regulation D compliance (all subsections of this exemption from SEC registration), as well as all registered offerings.

7. The entrepreneur does not provide an estimated Internal Rate of Return (IRR) or Return of Investment (ROI) analysis for potential investors.

Most investors are already well aware of the possible downside, which is a 100% loss of their investment in your Company. That’s simple math. However, most investors want to know what their potential rate of return on investment (ROI) will be if things work out as planned. Rarely are these estimated ROI figures provided— i.e., an Internal Rate of Return analysis—in most business plans or securities- offering documents. If, on the rare occasion, the IRR & ROI figures are provided, the pro forma financial projections most often are not GAAP compliant, subjecting the estimated IRRs to gross errors. GAAP compliancy is a mandatory requirement if you are including pro forma financial projections in for your company’s securities-offering documents.

8. The entrepreneur does not provide a forward position on liquidation rights for investors…in case of business failure.

It’s wise to show investors that if your company fails, they come first on asset rights, or at least ahead of you and your company’s founders, in the event of bankruptcy and forced liquidation off assets, even though the assets may not be worth very much. The assets may grow in value mitigating financial risk over time - 68 - Copyright © Commonwealth Capital, LLC 2003-2019

as the original financial structure with lien rights would still be intact until the securities are payed off or redeemed. This is easily done with hybrid securities, such as; convertible notes, convertible bonds, and or convertible preferred equity.

9. The entrepreneur attempts to collect a capital investment from an investor, using only a business plan.

Using a business plan to attract individual investor capital rarely works and if done incorrectly, it can be very dangerous, as it may be in violation of US securities laws. This happens more often than you may think. You may ask, “But what are the consequences?” The consequences are far too numerous to mention, but suffice it to say you would have to refund the money to your investors (at a minimum), pay fees and fines, and most likely the entrepreneur would be prohibited from using securities to capitalize any company, as a principal, for a period of five years.

10. The entrepreneur does not assure or guarantee an exit strategy for the investor.

Although an IPO or an outright sale of the company (or its assets) may be a nice approach to an exit strategy, it certainly cannot be guaranteed or even remotely assured in most cases. Therefore, this approach is largely unrealistic and real investors know it. A structure must be put in place that allows investors to get their investment principal back—in a relatively short period of time with a strong probability of occurrence—while enjoying some upside potential over a longer period, if they so choose. This is easily done with hybrid securities, such as; convertible notes, convertible bonds, and or convertible preferred equity. Convertible notes work best or callable preferred equity as a close second choice. The exit strategy of the investment is the most important aspect for the investor, and it can easily be guaranteed due to the nature of the security that matures, such as; convertible notes or convertible bonds. Although a Call Protection Date ending in 4 or 5 years is not an assurance of investment principal return, with proper illustrations in GAAP compliant pro forma financial projections, one can pose the Call being exercised with the pay-off of convertible preferred equity at the end of the Call Protection Date.

Essentially, for any company, there are no guarantees on an effective exit strategy as a whole, so we use hybrid securities that enable an investor to exit from the investment without the need for an entire sale of the company.

11. The entrepreneur does not have a solid management team.

If you have yet to build your management team, do what you can to put together a contingent management team, if you have not already done so. In the securities- offering document, include the relevant biographies and designated responsibilities for each management-team member that has signed and dated and executive compensation agreement. This can be a bit of a catch 22. If the arrangement of your management team is contingent upon financing, it is wise to ensure it with signed - 69 - Copyright © Commonwealth Capital, LLC 2003-2019

contingent-commitments letters from each potential management team member before you include their backgrounds, biographies, and responsibility statements in a securities offering document.

Otherwise, it could be construed as securities fraud in a securities-offering document—a very bad thing, indeed.

12. The entrepreneur requires too large of a minimum initial investment per investor.

Consider allowing as many investors as possible into the deal, with relatively small amounts of capital per investor, without going to extremes. In most cases, it may be better to have 100 investors in your deal with a $5,000 investment per investor (totaling a $500,000 equity raise) than it is to have 5 investors in at $100,000 each. The reasoning for this is most investors can “take a flier”—e.g., risk a small amount of their investment portfolio—with a small amount of money. An additional benefit to this tactic is that rarely will an investor constantly bother you over a $5,000 or $10,000 investment, whereas a $100,000 investment may necessitate attending to constant inquiries, concerns or further unwanted investor involvement in your Company. In addition, today you can now have many more investors in your deal, with relatively small investment amounts, before you must report to the SEC as a publicly traded company. A provision within the JOBS Act of 2012 allows you to have up to 2,000 investors (plus the number acquired under Section 4(a)(6)- Regulation Crowdfunding) in your Company’s securities offering before you are required to become an SEC-reporting company. Previously, it was only 500 investors participating in your securities offering before you would be required to become an SEC-reporting company—so there is some relief here. Becoming as SEC-reporting company comes with many compliance issues that can become too burdensome and grossly cost prohibitive for most small companies, so it is best to stay under the two-thousand-investor limitation or delay the reporting process as long as possible.

13. The entrepreneur does not allow ample time for raising capital.

Like most business objectives, raising capital may take longer and cost more than you originally thought—no matter how you go about it. We advise our portfolio companies to plan on a minimum of six months to one year, depending on the following: the amount of capital sought; the history and general nature of their company; as well as the number of potential pre-existing-investor contacts of the company’s management team. I have yet to meet an entrepreneur who did not need all the capital they are seeking…“yesterday.” Almost all entrepreneurs state that if they “don’t have the money to act now, the opportunity will be lost.” Well, that’s life…and as an investor—if you approached us in that manner—we would run. Do yourself a favor; do not bind yourself or your Company to “an opportunity.” That is not a reliable plan for business rather a speculation in outcomes…and real investors do not speculate—they invest for the long haul, meaning 5 to 7 years. In addition,

many factors can affect the timing of a capital-raising effort, so plan on a longer time horizon than a shorter one.

14. The entrepreneur does not have enough seed capital dedicated to the capital-raising effort.

Like any type of product launch, it takes promotional dollars to raise capital effectively. You need seed capital to promote the attainment of your development capital. If you do not have seed capital, raise it through a seed-capital securities offering, first. The seed capital is riskier by design, so the structure of a first- or second-lien debt position with a two- or three-year maturity should mitigate some of that risk…and, therefore, attract seed capital.

15. The entrepreneur does not have the proper corporate governance in place.

It’s all about the legal and accounting paperwork that normally an attorney and CPA should be handling, but most entrepreneurs put it off or handle it themselves— incorrectly.

The vast majority of the entrepreneurs who contact us either: 1) want us to invest; or 2) want us to find investors who will fund their company or business project. We have two VC Funds specially created to fund start-ups and early stage companies. We also have many relationships with institutional investors who will have an interest in providing funding…when your Company is ready. However, for most start-up and early stage companies, it is futile to make an attempt at raising substantial amounts of capital from institutional, professional or even passive investors, until you’ve properly mitigated all risks through proper corporate engineering. Most entrepreneurs do not want to face this fact, and they continue to “bang their heads against the wall.” If you want to get serious and be ready to approach any investor, we have created the Corporate Engineering Conservatory™ as the utility for delivery.

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

Investment-funds solicitation is highly regulated at both state and federal levels. Federal law requires every investment-opportunity offer be registered with the US Securities & Exchange Commission, unless a registration exemption applies (meaning you can legally conduct an unregistered, securities offering). Thus, in practical effect, there are ways to structure a proposed, investment solicitation so the offer is exempt from registration under federal law and state law. Even if structured properly, the company’s offer execution must be compliant with the anti-fraud provisions of federal law and the anti-fraud laws of each applicable state. Anti-

fraud statutes and regulations make it illegal to commit fraud in the offer, purchase, or sale of a security. If you fail to comply with applicable registration and/or anti-fraud laws and regulations, it could result in lengthy imprisonment and fines. Most, if not all, federal and state securities laws are punishable both civilly and criminally. Under most state laws, investors have a right of rescission (meaning the purchaser can cancel the purchase and get a full refund) or a right to rescinding damages (meaning if the issuer cannot return all the investment-purchase money, the issuer and other liable persons will owe a debt to the purchaser) for an issuer’s non-compliance with registration or anti-fraud requirements. In some states, the issuer’s officers and directors must register as “brokers” before they can solicit investments in these states.

Unregistered Securities Sales

An unregistered, security offering made in reckless disregard for a regulatory requirement (such as a registration requirement) is a felony at both the federal and state level. The seller (issuer) has the burden of establishing as a matter of law it complied with at least one, applicable, registration exemption. For government civil prosecutions of unregistered securities sales, the seller is strictly liable for the failure to register. Additionally, as a matter of law, the seller has the burden of establishing that it complied with at least one, applicable, registration exemption. Demonstrating compliance with an exemption statute after one has been sued for failing to register usually is not a successful, defense strategy. This is because the government typically will have investigated and concluded that no registration exemption applied to the offering, and it will be prepared to demonstrate that any evidence you can muster in your defense will not be sufficient to prove your entitlement to an exemption. In addition, the prosecution will educate the court that a tie in the battle of proof should not result in victory for the defendant. The government will argue that the better policy is to favor a registration scheme and full disclosure than to reward issuers who take the unregistered route of presumptively inadequate and governmentally un-scrutinized disclosure. This is not to say you cannot claim an exemption. It is to say you have to demonstrate your compliance with the exemption. Also, remember the regulatory scheme mandates registration of all offerings and permits registration exemptions only if the exemption requirements have been complied with. Here is an example of the risk of non-compliance: A Connecticut court convicted Constance Andresen (her real name) of five counts of selling unregistered securities, although she was acquitted of five counts of securities fraud. The defendant claimed in her defense, among other arguments on appeal, that she relied on the advice of her lawyer in selling the unregistered securities. Approximately ninety people invested $1.3 million in her company that purportedly had a FDA-approved cancer-diagnosing device. The court noted that the corporation spent only $35,000 on research and development of the device and that the device was of little use in diagnosing cancer. Constance and her

husband received approximately $1 million of the $1.3 million raised. She was sentenced to ten years in prison, suspended after two years, five years of probation, and a $10,000 fine. Here, the client blamed her lawyer as her defense against the state’s accusation of selling unregistered securities. Reliance on legal counsel, the court held, was not a defense to the strict-liability crime of selling unregistered securities. In essence, strict liability means if you committed the prohibited act (in this case, selling securities without filing a registration statement for them), whether or not you intended to do wrong, you are liable. The permissible defense is the defendant’s activities qualified for an exemption from registration—i.e., sufficient evidence by the defense must be put forth to show an exemption (such as the maximum, dollar amount or the maximum number of offerees) was not exceeded. This court made clear that in Connecticut, as in most jurisdictions, the defendant has the burden to prove entitlement to a registration exemption; and the prosecutor does not have to disprove entitlement to any exemption to sustain a conviction. In other words, in this type of crime, it is constitutionally permissible to require the defendant to offer evidence of innocence to prevent a conviction. Lawyer or no lawyer, selling unregistered securities without taking the steps to qualify the offering under a registration exemption can seriously affect the quality of your life, the extent of your property, and your liberty.

Negligent or Fraudulent Misrepresentations

In most states, in criminal prosecutions, a negligent misrepresentation made in connection with the offer or investment sale is also punishable as a felony. A negligent misrepresentation is one meant to induce the buyer to accept the offer but is based on material facts the seller should have known were not true. A negligent misrepresentation of a material fact in a securities offer is punishable as a felony in almost every state. The only defense is the issuer did not make false statements. There is no “good faith” defense. At the federal level and in certain states, in a civil case, the government or the investor has a higher standard of proof—the issuer was at least reckless in its representations made in connection with its offered investments. Good faith of the issuer applies only as a defense to a claim the issuer knowingly or recklessly violated the fraud provisions. The defendant’s good faith is not a defense to a claim of negligent misrepresentation. A violation of anti-fraud provisions of the federal-securities laws can carry a twenty or twenty-five-year sentence since the Sarbanes-Oxley Act was enacted, and a federal conspiracy charge carries a five-year sentence. If securities fraud seems a little too difficult to prove, prosecutors routinely charge mail or wire fraud on the same fact pattern and get the same twenty-year jail threat against a potential defendant. In government civil-securities actions, the penalties and remedies are usually the same whether the government established a violation of the anti-fraud provisions or the registration provisions. Every defendant is likely to be required to “disgorge” all - 73 - Copyright © Commonwealth Capital, LLC 2003-2019

purportedly ill-gotten gain, pay a civil fine plus pre-judgment interest at the IRS underpayment rate, and receive an injunction against securities registration and fraud violations in the future. If fraud is charged, small-company executives may also be subject to a bar from serving as an officer or director for a public company. Small- company executives and entrepreneurs, whether involved in public-reporting companies or privately held enterprises, are likely also to receive a bar from participating in penny- stock offerings. What is penny stock? It is stock offered for less than five dollars per share, stock issued by a company that has net-tangible assets of less than $5,000,000, or has average revenues of less than $6,000,000 in the last three-year period. The asset- based qualification depends on how many years the company has been in operation, while the revenue-based qualification requires sustained revenues for three years. Consider that most small-company equity offerings are offered for less than five dollars per share, and even fewer issuers have net-tangible assets (i.e., total assets, less-intangible assets, and liabilities) in excess of $2,000,000 (if the issuer has been in continuous operation for at least three years) or $5,000,000 (if the issuer has been in continuous operation for less than three years), or average revenue of at least $6,000,000 for the last three years. A company that does not meet these standards is a penny-stock issuer if it issues equity or debt that is convertible into equity. Thus, most issuers and their equity- offering participants are at risk of being barred for life from raising capital if a federal- securities regulatory action is brought against them. Here is an example of what not to do—taken from a reported, appellate decision from an Illinois court: Emanuel Khan raised $1,465,200 from more than 35 people. He failed to register the stocks issued, or himself, as an agent as he was required to do under Illinois law. He also failed to inform prospective investors that he had a history of administrative and judicial securities proceedings brought against him. The court noted that for a three- year period money was raised from investors but that his company’s total gross sales were only $2,429. However, Khan paid himself $489,545 for his services to the issuer. Khan was convicted of selling unregistered securities, securities fraud, corrupt business influence, and failing to register as a securities sales agent. He was sentenced to ten years in prison. No mention was made in the opinion whether Khan had told the investors he would use nearly thirty percent of the total funds received to pay himself a salary. (To his credit, he only paid himself eleven percent of the gross proceeds per year, so maybe he didn’t set out to burn thirty-three percent of the proceeds on his salary.) Presumably, he did not tell the investors about his compensation expectations, and the investors must have been upset about that. [This is what “use of proceeds” is all about.] The opinion did not mention whether the balance of investors’ funds was saved or spent on legitimate, business expenses. Other takeaways from this case: the court did not believe it was okay for Mr. Khan, the entrepreneur, to receive approximately $1.5 million, spend a significant chunk on his compensation, and generate only token revenues. Legitimate start-up companies may never generate revenues. However, this is how the court system often operates when

business people are dragged into it. People with little or no business experience (e.g., typical government investigators, lawyers, judges, and juries) parse out select facts and hold them under a microscope and pass judgments against entrepreneurs and business executives—that is our system. The safest place for business people to be is away from this system. Minimizing litigation risk while raising capital is serious business. There are few “commercial” or “business-oriented” courts in the country, but there are lots of retired or unemployed people able to serve on juries and who may have an axe to grind against corporate America. To top this off, the laws in every state favor the investor over the capital raiser.

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If you want to effectively raise substantial amounts of capital and maintain the vast amount of equity ownership (e.g., wealth) and voting control (e.g., power), you must learn what is necessary to conduct an effective and legal offering of securities to obtain capital for your start-up or early stage company. You must “crawl before you walk…walk before you run…and run before you jump.”

Chapter 7: The Four Professional Functions of a Securities Offering

Before examining the mechanics of deal structuring, you need to understand the workings the 4 professional functions of a securities offering. These functions are in relation only to a securities-offering, as each professional has more to offer after the successful offering.

The investment banks, i.e. securities-brokerage firms, are the “real players” in small, medium and larger capital markets. Once you understand how the investment- banking divisions of Wall Street firms work, you will understand how they dominate the landscape and why they are the top of the food chain in the capital markets. They dictate to legal and accounting, how things are to be handled because they have immediate access to capital. They also employ the stockbrokers, directly with an in-house sales force or in-directly through syndicating deals with other broker dealers. By understanding each professional function you’ll be able to better relate their capital-raising techniques to your Company’s capital-raising efforts and needs. Further, this is part of building a functional finance department within your Company, which is a necessary step for any entrepreneur seeking to raise substantial amounts of capital in the post-seed-capital stage.

As a side note, venture capital firms feed investment banks quality deal flow from their portfolio of companies that they have invested in and benefit from the exit strategies investment banks provide, i.e. IPOs, mergers and acquisitions. They’re rarely, if ever, involved in a securities offerings of their portfolio companies.

We’re not attempting to teach you everything you need to know about conducting an effective offering of securities, with a marketable deal structure, compliant with federal and state(s) securities laws, rules and regulations, as that would be immensely impractical. What we hope to accomplish here is to give you enough knowledge so you and your management team can “run the table,” not your professional advisors. This is extremely important, as you go through this process. Investors want to invest in effective management teams that will execute with conviction, not management teams that rely on decisions from a collection of advisors that have no real skin in the game. You either dominate this process or you will be dominated by the other players in it.

The following fundamental, four professional functions are used by Wall Street firms in the process of raising capital in the United States:

1. The first function is that of the investment banker. The investment banker “runs the show” and has access to the institutional and individual capital markets through the firm’s sales force of Financial Consultants (stockbrokers). The investment banker inherently knows what the capital markets will and will not accept, as far as the size and types of companies and their related deal structures is concerned. The deal structure must be marketable and sold to the market of investors. The investment banker analyzes a company’s future valuation, establishes the current price of the company’s securities based on estimated rate of return, and then structures the capitalization plan (“deal structure”) so it is - 76 - Copyright © Commonwealth Capital, LLC 2003-2019

accepted by or fits the demand of the various private or public, capital markets— i.e., individual or institutional investors. The investment banker then tailors the securities offering(s) to meet or exceed that market demand. Next, the investment banker oversees, coordinates and essentially rules the other three, subsequent, professional functions.

2. The second function is that of the accountant, in the production of historical, financial statements in a year-to-year comparative-trend-line fashion for existing companies. With that information and management’s vision of the future with the influx of additional capital sought, the accountant can begin the process of producing the pro forma financial projections to GAAP compliancy. These projections analyze potential future sources of revenue, operational expenses, net- income potential, tax liability, cash flow, and capital budgets, normally over a 5 year period. The pro forma financial statements that the account produces illustrate the elements mentioned above and would include the pro forma Income Statements; the pro forma Statement of Operations; the pro forma Statement of Cash Flows, the pro forma Balance Sheets; the pro forma Sources and Uses Statement and Notes thereof, as appropriate. Although often44, but not always, derived from the pro forma financial statements the company valuation statement is normally a function of the accountant, as well but must be supervised by the investment banker to be germane to the capital markets and industry standards, as the company valuation statement will have an impact on the pricing of the securities. The pricing of the securities and calculating an estimated ROI, IRR, yield to maturity or yield to “call” also must be supervised by the investment banker for the same reasons. In the case of an existing company, the accountant would also produce compiled financial statements, which may need to be audited if necessary and depending on the circumstances of the size of the offering and the degree of access needed to solicit various, capital markets.

3. The third function is that of the attorney, in regards to start-up and early stage companies the production and filing of the legal documentation of the entity, such as; the Articles of Incorporation (for Corporations) or Articles of Organization (for LLCs); Tax Identification number with the IRS if the accountant hasn’t already done so. For companies deemed ready, the attorney completes the securities offering documents and files the necessary documentation with the SEC and state(s) FORM D- Notice of Sales, for instance, to comply with the various federal and state securities laws, rules, and regulations. The attorney is generally also retained to handle other administrative compliance follow up after the sale of securities, such as; the review of annual reports; acts as transfer agent; and maintains the registrar and securities ledger. Your legal counsel should structure the legal documents but not the deal—financing structure. Most attorneys claim to have expertise in this area, which requires company valuation and securities pricing, and some do when it comes to venture capital, but since 1985 I’ve never

44 Due to the nature of start-up and early stage companies’ limited operating histories, company valuation statements are normally derived from pro forma financial projections, as there isn’t enough historical operating or financial data to rely upon. - 77 - Copyright © Commonwealth Capital, LLC 2003-2019

seen a deal structure for a securities offering that was produced by legal counsel sell, ever.

4. The fourth function is that of the stockbroker, in the legal execution of the solicitation and sales of securities to raise capital for the client firm. As previously mentioned, the investment bankers also employ the stockbrokers, directly with an in-house sales force or in-directly through syndicating deals with other broker dealers. This is obviously an essential part of the process, because without the effective execution of a securities offering through a salesforce of professionals who know how to sell securities, it’s all academic.

Remember, all four functions are managed by the investment-banking divisions of Wall Street firms.

Here are a few realities you should know.

Most securities attorneys work for large law firms on Wall Street that only cater to publicly traded or larger, privately held companies because that is where the money is. The practice of securities law is a Wall Street industry in and of itself. It’s a fast paced, high octane environment that burns out most securities attorneys before they hit forty years of age. Former SEC enforcement attorneys are also in the same fast paced, high octane industry of Wall Street but aren’t compensated nearly as much as their Wall Street brethren for their early burnout rates. After their Wall Street “tour of duty,” these attorneys often choose private practice, which is certainly less money, but a lot let stress and we’re grateful for this. Most of these attorneys have earned their seat at your table, but you must remain at the head of that table, not matter what. Consider engaging an attorney of this caliber as In-house legal counsel. The attorney would practice law for your firm, but only be compensated as an officer and as per the executive compensation package you produce through your corporate engineering exercise. Or consider engaging an attorney of this caliber as a board member, as opposed as outside counsel. In such a position, the attorney would not practice law for your firm, but would oversee outside legal counsel’s activities and billing—thereby justifying the expense of that board seat.

Most accountants can produce pro forma financial projections, but rarely are they able to determine and formulate a marketable deal structure for a securities offering. Most accountants are hesitant to produce pro forma financial projections if they know they are to be used in a securities offering document. Their fear is not unfounded, as most start-up and early stage companies will fail within 5 years. If they produce pro forma financial projections for a start-up or early stage company and that company fails they could easily be called into a lawsuit by disgruntled investors. The return rarely justifies the risk.

Most investment bankers can determine and formulate a marketable deal structure, because they are in touch with the private and public securities markets on a daily basis. However, like securities attorneys, investment bankers deal primarily with larger companies…because it generally requires less time to place $100 million in securities for a well-seasoned company than it does to place $1 million in securities for a - 78 - Copyright © Commonwealth Capital, LLC 2003-2019

start-up or early stage company. Once again, they go where the money is and take the paths of least resistance.

Most stockbrokers can sell securities to raise capital, but they generally will not do so for start-up or early stage companies…because they do not want to tie up the funds—in a private placement—or risk losing their clients’ money due to the nature of start-up or early stage companies in general. Note: The traditional stockbroker has evolved into one of two distinct areas within the securities industry. The first and primary area is that of the Financial Consultant, which functions as a financial planner for the client and asset gatherer for the firm. The second is that of the professional trader, which rarely interacts with the client, unless working as an independent Financial Consultant with a clearing firm. The point is, if hiring a CFO or VP of Finance for your firm, look only to the Financial Consultants with pre-established trust relationships with many investor clients to assist you in raising capital from those contacts. Stockbrokers aka Financial Consultants face increased regulatory environment and ever decreasing commission payout structures. With securities industry attrition rates as high as ever, it should be relatively easy to hire one as your CFO.

In summary, you may surmise that hiring an attorney to either work as outside counsel, in-house counsel or as a board member overseeing outside legal counsel activities should be relatively easy. Hiring a CFO or VP of Finance from the securities industry should be relatively easy, as well, owing to the increased regulatory environment and the squeeze of commission payout structures. However, hiring accountants to produce GAAP complaint pro forma financial projections and investment bankers to valuate you company and price your securities is going to be next to impossible for most start-up and early stage companies. Not to worry, as we’ve enabled you to perform those tasks with our Corporate Engineering Conservatory™. We know where the gaps are so we filled them so you can engineer your company to the quality deal flow we, and other investors, seek.

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LEGAL PERSPECTIVE:

A CAUTIONARY TALE - by Russell C. Weigel, III, Esq.

Perhaps the most subtle and potentially devastating circumstance to the unwary entrepreneur is that she has unwittingly offered investors an “investment contract,” a type of security.

Here is an actual example of what can be at stake for offers of non-traditional investment opportunities—i.e., those encompassed by the definition of an “investment contract”: A prospective condominium buyer contacted a real estate agent in another state seeking assistance with purchasing a condominium unit. The agent located a condo unit, and the

investor purchased the unit from its owners who previously had purchased the unit from the condominium developer. Prior to the closing of the purchase and sale transaction, the buyer’s real estate agent advised her client that he is eligible to participate in a rental pool created by the condominium developer whereby absentee owners could place their units up for rental and share in the net profits generated by units participating in the rental pool. Participation in the rental pool was optional. The seller of the condo was not a rental pool participant. Also, a property management company offered rental management contracts to unit owners. The buyer subsequently opted into the rental pool and entered into the property management contract. Apparently, the buyer became unhappy with his “investment.” The buyer sued his real estate agent, claiming that she violated the antifraud provisions of the Securities Exchange Act of 1934 and SEC Rule 10b-5, and committed fraud, negligence, and breach of fiduciary duty in violation of state common law in the offer of an investment contract – a security. The buyer alleged various acts of fraud by the agent in inducing him to buy the unit and in the services she performed or failed to perform thereafter. A federal appeals court sustained the claims against the agent, holding that the rental pool arrangement was an investment contract and was therefore a security. As a result, the real estate agent was deemed to be a securities salesperson and implicitly was unlicensed. The security, which was not marketed as a security, legally resulted because each “investor buys one share — a condominium — in a common venture that pools the rents from all of the units.” The financial success of each participant's individual investment depended on a rental pool manager generating a return on investment for the entire rental pool’s success. These are factors that can determine whether an investment offering amounts to a securities offering.

In the above example, a real estate agent got sued for something she did not think she was involved in and for events that she had no control over. In fact, the developer was a large household name insurance company with plenty of legal counsel. Why had no one raised a red flag about the alternative legal perspective applicable to the rental pool? Doubtless the broker thought a security was a stock that you buy from a stock broker and never imagined it could be a contract related to a condominium purchase. How could she have avoided this issue? Here is how: any time the word “investment” is used in promotional materials where someone else will be doing the work and the investor will be earning a passive return, you should seek out competent securities law counsel to review the materials and analyze whether a security is being offered. Real estate lawyers, for example, often are not trained to recognize these issues.

When Does an Offer Typically Occur?

In the life of a corporate entity, an offer of securities typically occurs any time after the corporate entity has been formed and the round of founding shareholders or equity holders has been determined. Once the corporate entity has been formed and founders have been identified, each new investor brought in to provide financing on a passive basis is protected by the securities laws. Thereafter, from start-up stage all the way to the point of corporate dissolution, and even during a bankruptcy, it is possible legally to make an offer of investment. - 80 - Copyright © Commonwealth Capital, LLC 2003-2019

However, the security offer can also occur before the corporation is formed. The statutory definition of security includes a “preorganization certificate or subscription.” Thus, at any time prior to incorporation, a forthcoming-corporation organizer could solicit passive investments in the future enterprise and subject himself/herself to the jurisdiction of state- and federal-securities laws.

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By the end of this book, you should have an in-depth understanding of all four professional functions to the degree necessary to determine a proper deal structure for your Company’s securities offerings, price the securities, complete a securities-offering document for legal-counsel review, and effectively sell securities to raise capital for your Company.

Chapter 8: Organizational Structures & Management Mindsets

You can sell an ownership interest in the following three basic types of organizational structures: a partnership, an LLC (limited liability company), or a corporation. In a partnership (general or limited), you can sell general or limited partnership interests. In an LLC, you can sell membership interests and other securities, such as; notes, bonds, or hybrid securities like: royalty financing contracts; convertible preferred membership interests; or convertible notes/bonds. However, if you want to add hybrid securities to your firm’s capitalization structure, in order to specifically permit the type and amount of securities to be authorized, you may need to amend both your Operating Agreement—internally and or the Articles of Organization with the state. In a corporation, you can sell common stock and other securities, such as; notes, bonds, or hybrid securities like: royalty financing contracts; convertible preferred stock; or convertible notes/bonds. However, if you want to add hybrid securities to your firm’s capitalization structure, in order to specifically permit the type and amount of securities to be authorized, you may need to amend your By-laws—internally and or the Articles of Incorporation with the state.

Corporations

With corporations, there are two basic types of corporate tax structures. S Corp.s have an “S election” tax status (No corp. tax— single taxation pass-through to shareholders). C Corp.s have a “C election” or a full-corporate tax status. If you choose a corporation to use as the legal entity to build your company, to avoid unnecessary double taxation (corp. tax and tax on distributions to shareholders) of a C corporation, we suggest filing as an S election corporate tax structure at the beginning of a company’s existence. Attempting to change a C corporation into an S corporation at any stage, is a daunting task and it may not work for any one of the various reasons to follow.

Corp. Limitations

Number of Shareholders. S corporations cannot have more than 100 shareholders. Make sure there are no more than one hundred shareholders. Otherwise, your Company will not qualify for the non-taxable status of an S corporation. C corporations cannot have more than 2,000 shareholders and remain privately held. The C corporation becomes an SEC reporting company when the shareholder number is over 2,000 whether it’s publicly traded or not.

Types of Shares. Technically, an S corporation can only issue one class of stock—disregarding differences in voting rights, to maintain it “S” election tax status. Hence, for all practical purposes, in order to maintain the single taxation status, an S corporation is only allowed two classes of stock—Class A voting common stock and Class B non-voting common stock. If your Company issues any other type of equity security or a security convertible into equity, it will lose its non-taxable S corporation status. Thus, most S corporations will choose Class A voting or Class B non-voting common stock, notes, bonds, or royalty-financing contracts. If you wish to maintain your - 82 - Copyright © Commonwealth Capital, LLC 2003-2019

Company’s “S” election tax status, do not sell preferred stock or convertible securities— including warrants, rights, options, convertible notes, and subordinated debentures—as they constitute a third class of stock or equity.

Types of Shareholders. Only individuals and qualified S trusts can own Class A and B common-stock shares in an S corporation. You can sell royalty-financing contracts, notes, or bonds of an S corporation to any entity, though because it’s not equity. If any other entity, such as an LLC or other corporation (e.g., S or C corporations), purchases common stock (class A or B) in your S corporation then the corporation will automatically become a C corporation. In addition, S corporations’ securities cannot be held in qualified retirement accounts such as IRAs, SEPs, Keogh plans, etc.

Process.

If you have not already done so, or if you have not yet incorporated a company yourself in the past, you may want to hire an attorney to incorporate your business. If your Company is a start-up, we suggest you complete the following:

1) Have your attorney file your Company’s articles of incorporation with the state you have chosen to incorporate in. 2) When the state sends back a “filed date” copy of your articles of incorporation, get a copy of Form SS-4 from your accountant. 3) In the early stages of a corporation, you must file Form SS-4—Application for Employer Identification Number—with the IRS, per those instructions. 4) After you receive your employer identification number from the IRS, it is wise to file Form 2553—Election by a Small Business Corporation—for S corporation tax status with the IRS (there are time limits on these various procedures, so be aware that this process is time sensitive).

You will also need to register for a state tax number with your state’s Department of Treasury. Most states adopt the IRS’s tax ID number assigned to your Company. There is no federal corporate income tax on S corporations.

If you elect to conduct a preferred-stock offering, you will need to form a C corporation. If you plan on growing your Company very quickly and are planning to conduct an initial public offering (IPO) soon, it is best to form a C corporation (LLCs cannot currently trade in the public markets). To establish a C corporation, simply do not file a Form 2553 with the IRS. An S corporation will automatically become a C corporation once a security is issued that constitutes a third class of stock (or equity) or when you exceed the “one-hundred-shareholder limit,” according to the IRC 26 US CODE RULE 1361. Incidentally, the one-hundred-shareholder limit may change from time to time, so be sure to check the current rules with your accountant or attorney.

Although attorneys and CPAs generally suggest setting up an LLC for most new small businesses (and we agree), that may change if you plan to grow your Company quickly if you choose to go public (through either an IPO or a reverse merger into a - 83 - Copyright © Commonwealth Capital, LLC 2003-2019

public shell) within five years. There is value in setting up your organization as an LLC, partnership, or S corporation due to the distribution of losses, which “pass through” to the individual investors. You will need to discuss this strategy with your accountant. However, when producing pro forma financial projections we suggest one budget for paying federal and state tax, not to be paid directly to those government bodies, but as distributions to shareholders because the LLC or S Corp. will create a “pass through” tax obligation when it produces a profit. It’s wise to account for the tax distribution to shareholders, not only so that cash flow figures are correctly reflected, as if one is paying them directly to the government, but to keep shareholders happy.

Limited Liability Companies (LLCs)

It used to be easier to attract capital by selling shares in a corporation than by selling membership interests in an LLC or partnership interests in a limited partnership, because the term “membership interest” may remind most investors of the term “limited partnership interests” that imploded in the late 1980s. The large stock-brokerage firms in the mid-1980s to the late 1990s sold vast amounts of limited-partnership interests. Some of those limited partnerships were grossly mismanaged—in some cases, fraud was committed. Bankruptcies were declared, and investors lost fortunes. As a result, the term “membership interests” was closely associated with the term “limited-partnership interests,” which was associated with that situation. One way to circumvent that old issue is to amend your LLC’s Operating Agreement to substitute the term “membership interests” to “Units.” (See LLC Operating Agreement Templates in the Corporate Engineering Conservatory™ for examples.) And then define the number of Units authorized, like authorized shares in a corporation. This one change should allow you to avoid the need for any explanation or confusion of actual equity ownership and voting control. As you’ll soon discover, the LLC as an entity has evolved since the mid-1990s and is now one the very best entities for a start-up or early stage company to be organized as, legally.

For your information, most LLCs differ in form from a corporation because they are technically partnerships, managed either by managers or by members (limited partnerships are managed by the general partner, and general partnerships are managed by the general manager). In addition, an LLC differs because of its limited ability—as determined by the state—what type of securities it can issue. In general, if the LLC is managed by managers, the majority of members must vote for the manager(s) according to the LLC’s Operating Agreement. Operating Agreements can allow each member to have one vote per member, or many votes based on their capital contribution to the LLC. If a member has one vote, irrespective of that member’s capital contribution, it will differ substantially from the organizational structure of a corporation. Corporations must allow one vote per share of its Class A, voting, common stock; therefore, those investors who contribute the most amount of capital technically have more voting control over the corporation. It is extremely difficult to raise capital for LLCs that do not allow voting control to be established by the majority of those who contributed the capital. Thus, we strongly suggest that if you have yet to establish an LLC, ensure the LLC’s Operating Agreement allows for a majority of ownership interest to control the Company. And as - 84 - Copyright © Commonwealth Capital, LLC 2003-2019

just mentioned substitute the term “membership interests” to “units” and define the number of Units authorized, like authorized shares in a corporation. For instance, 1,000,000 membership units authorized—as opposed to percentage units.

However, only do this with a Regulation D offering. If your LLC or Partnership will be filing for a Regulation A or A+ offering at the federal level, registering for a SCOR at the state level, or registering for a CA 1001 or 25102(n) at the state level for California companies only, use the term “membership interest” or “partnership interest”—regulators may not understand what you are trying to convey with the term that is foreign to the entity.

If you already have an LLC that allows each member to have one vote per member—irrespective of that member’s capital contribution to the LLC—we suggest you amend the LLC’s Operating Agreement to reflect that the ownership control is constituted by a majority of ownership percentage interest in the Company. In addition, some LLCs are managed by its members, which are like Class A, voting, common-stock shareholders in a corporation. If you will have many members—e.g., more than five or seven…after the sale of securities—consider amending the LLC’s Operating Agreement to allow the Company to be managed by managers as opposed to the members, because you do not want “too many cooks in the kitchen.”

Corporations are controlled by Officers elected by its Board of Directors who are, in turn, elected by a majority vote of its Class A, voting, common-stock shareholders. That is why LLCs should be set up—through the Operating Agreement—to be controlled by capital-contribution-percentage-based managers elected by members.

The following terminology is still important for you to understand:

• Corporations have “Articles of Incorporation.” • Limited Liability Companies have “Articles of Organization.”

• Corporations have “By-laws.” • Limited Liability Companies have an “Operating Agreement.”

• Corporations have “Officers & Directors.” • Limited Liability Companies have “Managers, Managing Directors and or Managing Members”

• Corporations have “Shareholders (who own shares of stock).” • Limited Liability Companies have “Members (who own Ownership Interests).”

• Corporations have unlimited life spans. • Limited Liability Companies, like Partnerships, may have a pre-determined life span according to the Articles of Organization as mandated by the state of organization and or Operating Agreement.

• Corporations, Limited Liability Companies and Partnerships have “Subscription Agreements” for the purchase of securities. We have built the Admissions Agreements directly into the Subscription Agreements in our templates for your use. • Limited Liability Companies have Admissions Agreements, like Partnerships, which have Partnership Agreements.

Please remember, the threshold for automatically becoming an SEC-reporting company (with all its mandatory burdens of compliance—i.e., annual & quarterly audited financial statements, pre-filings for insider buys and sales, compliance with Sarbanes- Oxley, etc.) is limited to 2,000 investors, not counting investors acquired during a crowdfunding effort under Section 4(a)(6)—“Regulation Crowdfunding,” whether your Company is publicly traded or not. Therefore, you may have up to 2,000 investors (plus the number acquired under Section 4(a)(6) Regulation Crowdfunding) in any type of organizational structure without the need to become an SEC-reporting company. SEC- reporting companies have an additional blanket of compliance and regulatory responsibility, which includes the need to produce and report through the quarterly, audited financial statements. This is not a bad thing rather another expensive, ongoing process. Thus, if you have more than 2,000 investors, just understand what it entails and be prepared to deal with it.

Fiduciary Duty

There are various districts of authority when it comes to definitions of fiduciary duty of officers and directors of corporations. Suffice it to say that if one exercises stringent corporate governance and protocols with the review and approval of legal counsel, one can avoid breaches of fiduciary duty. Why is maintenance of fiduciary duty a concern? Breaching corporate fiduciary duty to shareholders by officers and directors can pierce the limited liability protection afforded by the corporation or the LLC, as an entity of personal protection, thereby making the assets of each officer and or director subject to attachment, joint and several, in the event of a lawsuit, bankruptcy or court ordered liquidation to satisfy damages. That’s right… your personal assets can be taken from you to satisfy a lawsuit or bankruptcy.

“In discussing corporate fiduciary duties, it is very helpful to refer to the corporate law of Delaware. More than half of publicly traded companies are incorporated in Delaware. Nonetheless, corporations incorporated in other states may be bound by different rules and obligations. Consult Table of Statutes for statutes in specific jurisdictions.

Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but to refrain from doing - 86 - Copyright © Commonwealth Capital, LLC 2003-2019

anything that would [cause] work injury to the corporation, or to deprive it of profit or advantage which [said corporate officer or director’s] skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its power.”

Directors of corporations, in fulfilling their managerial responsibilities, are charged with certain fiduciary duties. The primary duties are the duty of care and the duty of loyalty.

• Duty of Care: This duty requires that directors inform themselves “prior to making a business decision, of all material information reasonably available to them.” Whether the directors were informed of all material information depends on the quality of the information, the advice available, and whether the directors had “sufficient opportunity to acquire knowledge concerning the problem before action.” Moreover, a director may not simply accept the information presented. Rather, the director must assess the information with a “critical eye,” so as to protect the interests of the corporations and its stockholders.

• Duty of Loyalty: As the Delaware Supreme Court explained in Guth v. Loft, 5 A.2d 503, 510 (Del. 1939): “Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. . . . A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but to refrain from doing anything that would [cause] work injury to the corporation, or to deprive it of profit or advantage which [said corporate officer or director’s] skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its power.”

Additionally, courts have imposed the following duties:

• Duty of Good Faith: Requiring the director to advance interests of the corporation, not violate the law, and fulfill his or her duties. For a thorough discussion of this duty, see In re The Walt Disney Co. Derivative Litig., 906 A.2d 27 (Del. 2006).

• Duty of Confidentiality: Required directors to keep corporate information confidential and not disclose it for their own benefit. Consult Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939) for more information.

• Duty of Prudence: Requires a trustee to administer a trust with a degree of care, skill, and caution that a prudent trustee would exercise. Consult Amgen Inc. v. Harris, 136 S. Ct. 758 (2016) for more information.

• Duty of Disclosure: This duty requires directors to act with “complete candor.” In certain circumstances, this requires the directors to disclose to the stockholders “all of the facts and circumstances” relevant to the directors’ decision.

These duties do not mean, however, that the court will always impose its own review over directors’ decisions. Under the “business judgment rule” the court presumes “that in making a business decision the directors of a corporation acted in an informed basis, in good faith and in the honest belief that the actions taken was in the bests interests of the company.” Under this rule, courts will generally refrain from questioning the directors’ judgment so long as their judgment can be attributed to some rational corporate purpose.

For a very thorough discussion of corporate officers’ fiduciary duties, consult William M. Lafferty, Lisa A. Schmidt, & Donald J. Wolfe, Jr., A Brief Introduction to the Fiduciary Duties of Directors Under Delaware Law, 116 Penn. St. L. Rev. 837 (2012).”45

Do Not Serve Two or More Masters.

The single biggest mistake an entrepreneur can make in this area is creating and managing more than one (1) corporation, joint venture or LLC. Many times we see entrepreneurs attempting to set up and run different entities for perceived liability protection. These strategies actually damage, if not completely negate, their ability to protect against personal liabilities arising out of running a business. If you serve two or more entities, it’s almost impossible not to breach your fiduciary duty to shareholders of either entity. We suggest, you build only one entity (corp. or LLC) and set up either operating divisions or wholly owned and controlled or partially owned but fully controlled subsidiaries—if necessary to avoid a breach of fiduciary duty.

We know this may seem confusing, but laws where written by attorneys for attorneys to maintain a monopoly on the knowledge and process—but that is changing in a very big way with “smart contracts.”

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

Setting the tone of corporate culture is one of management’s important functions. Management’s values are judged by evidence of its actions. What culture is communicated to employees and the outside world? The answer to this question may determine whether a company is situated to deflect investor complaints, regulatory investigations, and also criminal investigations. If it is the corporate culture to pay attention to its internal operations and how those operations may affect investors, the company is likely to have in-place structural systems (i.e., internal controls). These would operate to safeguard assets and proprietary information. Additionally, these controls

would document and retain evidence of transactions and ensure the company’s financial information is accurately and timely provided to management and disseminated to investors. What are management’s ethics? Do they produce a culture of white lies or honoring hand-shake agreements? If the company is internally sound because it has implemented appropriate systems of internal control, the company may be in a better position to deflect typical, investor allegations of breach of fiduciary duties and fraudulent activities by the company. If a company does not take steps to protect itself in the ordinary course of conducting business or whose management lacks integrity, it may not survive lawsuits asserting merely negligence-based state-law theories of misrepresentation in the offer and sale of securities. Walking the talk is a first line of defense. Small companies may well have a clean slate on which to write. Forethought given to building internal structure as companies plan to grow may distinguish them in intangible ways. For one aspect, they may exude an aura of professionalism in their communications with investors and the outside world. Building confidence in the investor ranks will tend to keep them pacified and less inclined to have their legal counsels inquire whether management carries officer and director insurance. This management culture and the corporation’s communications with investors are calculated and scrutinized to produce positive thoughts in the minds of investors if the company is large enough—in the minds of securities analysts. There is no intention of deception in this culture only the delivery of material—truthful information. A company that demonstrates a culture of legal compliance should avoid major liabilities resulting from its investor base. “Where is this fictional company?” you wonder. Comedian Rodney Dangerfield would say, “How about Fantasyland?”46 Fictional or not, what matters is the intention to build and the commencement of building a defense of integrity. The fantasy should be limited to the concept that systems can and will be implemented perfectly, while the reality is you have systems in place, you tested them in reasonable real-world scenarios, and you determined the systems are robust—but of course, not perfect. Here is a statement from the SEC explaining why it did not sue a company that violated the federal-securities laws:

The SEC has determined not to bring an enforcement action against First Solar due to the company’s extraordinary cooperation with the investigation among several other factors. Prior to Polizzotto’s selective disclosure on September 21, First Solar cultivated an environment of compliance through the use of a disclosure committee that focused on compliance with Regulation FD. The company immediately discovered Polizzotto’s selective disclosure and promptly issued a press release the next morning before the market opened. First Solar then quickly self-reported the misconduct to the SEC. Concurrent with the SEC’s investigation; First Solar undertook remedial measures to address the improper conduct. For example, the company conducted additional Regulation FD training for employees responsible for public disclosure.47

46 “Back to School” scene available at http://www.youtube.com/watch?v=YlVDGmjz7eM. 47 SECURITIES AND EXCHANGE COMMISSION, http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539799034#.UjEfj53D_IV (last visited Sep. 11, 2013). - 89 - Copyright © Commonwealth Capital, LLC 2003-2019

Statements like this from the federal government are almost as rare as a sighting of Halley’s Comet. This situation dealt not with a capital-raising transaction but with a public company’s reporting of bad news to the marketplace. My point here is the culture established by management can make or break the enterprise in times when the government is at the door. Most companies that suffer through a securities investigation spend thousands or hundreds of thousands of dollars on legal fees and still get sued or indicted. Most companies do not recover from this type of wringing. The goal here is to do something that is proactive before problems are encountered. Every effort helps, but the effort must be continuous and genuine. Looking at the worst case scenario, you as the defendant in a criminal securities trial, imagine facing an allegation that if you didn’t know what was going on at the company, you were willfully blind (to the obvious fact there was a pink elephant standing in the room) and should be convicted…of securities fraud or some related type of financial crime (e.g., intentional, records destruction or conspiracy to commit securities fraud). You need to offer credible testimony in your defense (probably from other witnesses) that there was a structure in place that was reasonable, that was tested, and worked; and there was no intention to mismanage, deceive investors, or destroy records with criminal intent. Therefore, you can argue the government’s viewpoint is based upon incomplete data, should be rejected, and you should be acquitted. While simplistic, in my experience, innocent people do get tried for crimes they did not commit, and their ability to walk out the courthouse’s front door or be wrongly convicted may boil down to circumstantial evidence of their lack of intent to do wrong. The takeaway points are management’s mindset and the culture of legal compliance it fosters (or not) determines the extent to which companies will take the high road with their investors. I see this as a first line of defense for lawsuit prevention. Some companies view their investors as being greedy vipers deserving of being stepped on. Such companies, I believe, will waste much time, money, and energy in needless litigation. Other companies view investors the way the securities laws view them—as needing protection. An investor-protecting company protects itself to an extent by preempting or pacifying their potential to drag the company to the courthouse. Legal compliance is not free, but companies can take simple but meaningful steps to protect themselves in transactions with investors and in ongoing corporate communications. The “ounce of prevention” strategy should help the company promote its business as a safer investment for such reason and thereby reduce the overall risk of litigation.

Chapter 9: Deal Structuring

With respect to the return of principal and profit to investors, the philosophy behind creating a “marketable deal structure,” also known as a “transaction” structure, is primarily based on the priority-afforded to investors’ financial interests. In other words, when it comes to raising substantial amounts of seed or development capital, it’s far more effective to offer investors securities that provide for the maximum amount of security of investment principal combined with the maximum amount of return on investment. By doing so with hybrid securities you also accomplish the goal of raising substantial amounts of capital without giving up too much of your Company too early for too little.

To effectively attract investment or human capital, you must first produce a marketable deal structure that investors see and that you can live with. You might be staring at this page, saying to yourself, “What the heck is a marketable deal structure?”

Maybe the best example of a marketable deal structure would be better explained by telling you a story about my personal experience raising capital as a young (yet experienced in securities compliance and deal structuring) entrepreneur. I left my position as Director of Compliance of a regional broker-dealer (SEC-registered investment bank) on the last day of trading (12/29/1992) to build a championship eighteen-hole golf- course-and-real-estate development in a beautiful resort community in Northern Michigan. My soon-to-be wife and I rolled into town on a snow-filled January day. Shortly thereafter, I started to build a PPM; and of course, I first had to craft the marketable deal structure.

Because my partners and I wanted to ensure we actually raised the capital we sought, we had to structure the securities offering in a way that would: 1. Be as safe as possible—so we decided on a 100% common-stock equity structure (no secured debt) within an LLC; 2. Protect investors first, with no dilution of founders’ shares—so we simply contracted rights as founders that would act like equity (synthetic stock)…but only if we were successful; 3. Further protect investors with special “equitable” distributions.

The $2 million in equity was sold through the issuance of 20,000 common equity- member units at $100 per unit, which represented 100% of the common equity. The offering qualified for an exemption from registration under Regulation D, Rule 506, and we elected to sell the units to accredited investors only.

Because we needed to entice and sell these units to investors quickly, due to the limited construction season in Northern Michigan, I had to come up with a deal structure that would promote larger investments as opposed to the minimum offering amount.

If you were a prospective investor—basically a wealthy golfer—I would offer you three choices of an investment in the project:

1) A $25,000 investment would buy you 1.25% (no dilution: $25,000.00/$2,000,000.00 = 1.25%), and that came with a “right” to purchase one “Charter Membership” in the golf course, which would allow you, your spouse, and children (through high school) to play golf for free…and I mean free—no cart fees and no range fees either. I wanted you and your family to feel like real owners of the course. Due to the fact the surrounding golf courses had regular memberships for sale with annual dues, which did not cover cart fees or range fees, my pitch line was “this investment will pay for itself if you regularly play golf—four times a week—in about seven years.” Now, due to the fact the Charter Membership would have inherent value, it had to be purchased by you (the investor) at $1.00 to establish a cost basis, so the IRS couldn’t claim it as a taxable distribution at a valuation that the IRS would determine. 12 years of average green, range and cart fees, plus a normal membership would equate to $25,000. That was an attractive benefit. 2) However, if you invested $100,000, you would receive 5% of the Company (no dilution); the right to purchase one Charter Membership at $1.00; and the right to purchase one (1) residential building site on the golf course—your choice of lot (on a first-come first-served basis) for $1.00. That was an even more attractive benefit. 3) Yet, if you invested $200,000, you would receive 10% of the Company (no dilution); the right to purchase one Charter Membership at $1.00; and the right to purchase three (3) residential building sites on the golf course—your choice of lot (on a first-come first-served basis) for $3.00. That was an extremely attractive benefit.

The residential building site plan called for 104 residential building sites, all at least one (1) acre in size. These residential building sites were selling for prices between $50,000 and $75,000 each, thereby greatly mitigating the risk. At the $200,000 investment level, 3 residential building sites (yet not fully developed) with an average value of $65,000 each would essentially return $195,000, plus the Charter Membership valued at $25,000, would equate to $220,00 in an un-realized (tax deferred) capital gain.

After the above sales pitch, the basic comment from a prospective investor was, “I’d be crazy not to invest $200,000 under those terms.” My response was, “Yes, you would.”

Remember, we didn’t have anything yet rather an option to buy the land. It was easy for me to give up 23 building sites out of the 104 we hadn’t yet developed because without the money being raised, we would never have the remaining eighty-one building sites or the golf course to begin with. The investors did take on some risk with this investment, but through this deal structure, the investors realized an immediate return.

I was in a small-resort community, where I didn’t know very many people and couldn’t advertise the offering. But the deal structure alone became the “gossip” of the community—went “viral” in 1993 (before that term was even coined). The capital was - 92 - Copyright © Commonwealth Capital, LLC 2003-2019

raised in about 2½ months. The reason for the lengthy time cycle was the wealthy golfers (target investors) were still at their southern homes when the offering started.

We built the golf course on time and under budget by $386,000. We also were able to secure a $525,000 line of credit—the bank’s federal, legal, lending limit—on this project with no operating history and with no personal guarantees from anyone. The tactic I used to secure that loan is reserved for our portfolio companies.

Suffice it to say, I gained much attention from a lot of people, especially the attorney, CPA, and banker involved in the project. They all had clients who needed my expertise. So I started playing “serial CFO” and capitalized a handful of other firms prior to formalizing the process in 1998, when I founded Commonwealth Capital Advisors, LLC the parent of Commonwealth Capital, LLC.

That is just one example of what I and other investors would consider a “marketable deal structure.”

There are an unlimited number of ways to structure a deal. Use your imagination to set your offering above the crowd.

To create a marketable deal structure you need to understand not only the competition for investor capital in the publicly traded securities markets, but also what motivates investors.

One could state that investors are only motivated by fear and greed. That statement is naive at best. Many investors are motivated by creating a better society or world for themselves as well as others, including future generations. There are many large publicly traded mutual funds that adhere to strict policies of “socially responsible” investing, because there is a demand for this type of financial product. Impact investing is another term for investing with a purpose where passion for a particular outcome outweighs the concern, albeit slightly, for a return of investment.

However, all investors have fear. Even when the investing is for other altruistic means, whereby an investor may have the mindset that it’s a donation, investors have fear that the outcomes may not be as they had hoped.

For simplicity sake, there are only two primary fears investors have: 1.) The fear of investment capital (or hope) loss (principal risk) and 2.) The fear of missing out on a great investment opportunity (opportunity risk). An investor might fear losing $100,000 of investment capital, but that same investor may fear losing a $500,000 return on investment capital even more.

Through proper corporate engineering and deal structuring of a securities-offering you can easily shift the fear of loss of money (or hope) to the fear of opportunity lost. It’s really not that hard once you know how.

After you’ve created the marketable deal structure, you have to put it somewhere. To ensure compliance with securities regulations, the marketable deal structure must be housed in a securities-offering document compliant with federal and state(s) securities laws—e.g., a PPM, an Offering Circular, or a Registration Statement. Business plans (alone) are highly insufficient for maintaining compliance. To repeat, you cannot include a “marketable deal structure” in a business plan. By doing so, you will inherently make it an offering of securities, no matter what. Without the proper securities documentation and process, you would be in violation of federal and state(s) securities laws. Business plans are not designed to raise money from individual investors, rather securities-offering documents are created for this purpose; however, when done correctly by outside professionals, securities-offering documents can be extremely expensive to produce…until now.

Please keep in mind that the following examples represent a philosophy of deal structuring rather than the mechanics of said process. The mechanics of deal structuring is included in the Financial Architect™ End User Instructions Manual included within each Financial Architect™ program.

Deal Structures for Operating Companies

Remember, the most successful capital-raising efforts done in a series of progressive securities-offerings and are illustrated as follows:

Operating companies are ultimately defined as any entity that is not a Fund Mgmt. Co.—a company set up to manage one or more Funds.

To produce a marketable deal structure for an operating company, you should understand how different deal structures interact within your Company’s capitalization planning for your securities offering. You need to know how much leverage (debt)—if any—can be or should be used as part of the overall capitalization plan, as well as the different rights and obligations inherent with different types of securities. The deal structure(s) your Company should use will be dependent on a few variables, such as how long your Company has been in operation; the value of its assets; the size and makeup of your Company’s management team, etc. These are just a few of the many possible variables that will determine your Company’s relative position of strength. The variables will ultimately determine the amount of equity that must be relinquished—if any— relative to the capital obtained, to arrive at a marketable deal structure.

To arrive at a marketable deal structure, the very first question we generally ask a portfolio company candidate is akin to asking a child, “What do you want to be when you grow up?” This is because the wrong course of action now will result in the wrong outcome later. Backing up and making changes to your organizational structure, deal structure(s), mode of operation, and five-year capitalization plan is not only expensive, but most often it is cost prohibitive to change later on. Another pertinent question would be, “What do you want your life to be like in seven-to-ten years from now? Do you want to own 100% of a $5 million company, 5% of a $100 million company, or something in between?” It has been my experience that money also relates to headaches, so I think of those ownership percentages relative to headaches, as well. Structuring your securities offering deal, without addressing these critical mindsets during a complete corporate engineering process, may result in you creating your own private prison.

Taking your Company public with an initial public offering (IPO) seems to be the way to get rich quick. Ask yourself one question: is wealth or freedom more important to me? They are not necessarily the same thing nor do they go hand in hand. You will lose freedom by taking your Company public, but you may gain more wealth, much more. However, there’s always a trade-off. You give something up when you gain. Going public means your competitors can easily review your audited financial statements. If so, they’ll learn the path of your last year’s capital expenditure, what your Company’s marketing budgets as a percentage of gross revenues are, and they may be able to decipher executive compensation to compete for your executive talent. You give privacy, but under the right circumstances, that can be managed and it may be well worth it, due to its temporary nature—assuming you exit there company personally and financially. Maybe remaining privately held will give you more freedom with a respectable amount of wealth. Those are personal decisions made by only you and your management team. You will have options as your Company grows, so take the best course of action based on your knowledge, experience, and your “gut feeling”—you can change it later with the assistance of other professionals, if necessary.

Based on the portfolio company candidate’s vision and direction for their company, we arrive at an indication of the optimal “mode of operation,” and only then can we start formulating potential deal structures. Therefore, you only need to determine the mode of operation to build your Company then run the capital-attracting numbers necessary to see what you can offer to prospective investors. Remember, this is meant to be philosophical, the mechanics some later.

In most cases, we tend to eliminate—or at least limit—common-stock (class A voting equity) offerings at the start-up and early stages of the capital-raising process. We do so because common-stock equity is the most precious element of any company’s financial structure, and we don’t want you to “sell out” the most precious element of the company too early for too little. Instead, we’ll typically suggest our portfolio companies wait a few years before they offer any common stock. However, as part of the capitalization plan, the entrepreneur’s private-capital market contacts may demand a portion of equity. Therefore, as part of Financial Architect’s® myriad of trademarked, capital-producing programs—Seed Capital Producer™, Development Capital Producer™, and Expansion Capital Producer™—within the securities-offering-document templates, we’ve included two types of deal structures that convert into a small amount of common equity. One represents a 100% debt (note or bond) with an equity conversion i.e. Convertible Notes; the other represents participating preferred equity convertible into common equity i.e. Convertible Preferred Stock.

The next step in the capital-raising process starts with designing the capitalization plan with the related deal structures for a series of securities offerings.

Producing the GAAP compliant pro forma financial projections—aka “running the numbers”—to arrive at a future valuation and to determine the company’s current, relative position of strength, is the first part of the deal-structuring process. The company’s history and or current financial position are of secondary importance to determine the company’s current, relative position of strength. We’re going to make this easy, as most start-up and early stage companies have a low position of relative strength—we make that assumption upfront. If you feel your Company has a high relative position of strength, you may be able to skip the first step of this two-step process, because preferred equity can be used as a form of seed capital.

Step One involves raising sufficient seed capital from friends and family to enable you to compete with financial institutions, such as banks, insurance companies, mutual funds, etc.—based on a current rate of return or “yield.” Raising sufficient seed capital is generally done by selling seed capital-convertible bridge notes as the primary deal structure to friends and family.

Think of it this way: a few dozen or so investors loan your Company money for a short time period, get a decent “current yield” (interest payments) on the loan, have a first lien position on assets in case of forced liquidation (bankruptcy) and obtain an opportunity to “get more action” (conversion) by converting the loan (Note(s)) into a small amount of common equity in your company to increase their overall return on - 96 - Copyright © Commonwealth Capital, LLC 2003-2019

investment in the event of success. Their liquidation and conversion rights are for taking on the elevated risk by investing in a new company early on. By offering this type of deal structure, you place them in the first or second (determined by you and your bank if your Company is bankable) lien position on assets (you’re putting everything you have invested in your Company on the table). More importantly, you return their principal within a few years, as determined by the length of time you need the loan—i.e., generally only two or three years (Note maturity date).

The conversion feature is at the noteholders’ or preferred shareholders’ pleasure, not yours. You can’t force conversion unless you mandate it in the deal structure. If so, those Notes will be much harder to sell.

Step Two involves raising sufficient development or expansion capital by creating a convertible preferred-equity securities offering with which you can legally solicit the sale of the securities through the general media and therefore, compete with financial institutions on the basis of current yield.

Although the convertible, participating preferred equity will have many attractive components, the convertible preferred equity should have a relatively “high-stated” dividend to provide “current yield.” The current yield percentage figure (7.5% for instance) is the only indication of a return on investment you can legally publish in the general media—once qualified to do so. The high-stated dividend for current yield (7.5% for instance) is the primary attraction you’ll be promoting to potential investors through the general media to motivate them to call you. This “lead- generating” technique is critical, as you’ll be competing directly with financial institutions based on this return figure. The other preferred equity features, such as; participation of profits, conversion rights and “Call” protection are attributes given to the preferred equity to balance out the additional risks investors take on by investing at the early stages.

Step Three (optional) involves raising substantial amounts of development and/or expansion capital by the continued selling of preferred equity, convertible, callable and participating or not, through broker-dealers if necessary. To gain greater interest from broker-dealers, consider listing the preferred securities on a publicly traded stock exchange. This is normally accomplished by creating and selling a Private Placement that will use the proceeds from the offering sold through a broker-dealer. (This is done to afford the necessary legal, audit, and marketing costs involved in creating and executing a listing on a publicly traded securities exchange.) This can be done as long as the expenditures are disclosed in the Sources and Uses Statement within the PPM. By doing so, your capital-raising probability—and/or using these securities as “currency” to acquire assets, such as other companies—will be dramatically increased. This is not a Do-it-Yourself process—it’s beyond the scope of the Financial Architect System™—but, if desired, you must plan for this process during the production of your pro forma financial projections and initial deal structure(s).

Now that you have these three basic securities-offering processes in mind, you will need to run the numbers—producing pro forma financial projections—to figure out - 97 - Copyright © Commonwealth Capital, LLC 2003-2019

how much equity or participation you need to give up for each structure. The goal here is to limit the issuance of common equity as much as possible.

No matter what stage your company is in or the type of capital you need, more often than not, it is wise to plan to over capitalize your Operating or Management Company and the Fund(s). There’s an old accounting adage… “Everything costs twice as much and takes three times longer than originally planned” that has some truth to it.

From a regulatory perspective it’s important to stay within the parameters of the exemption from registration restriction. So if you believe you only need $500,000 in seed capital to launch your company and plan to conduct a Title III – regulation crowdfunding capital raise supplemented with a Regulation D 504 (self-limited to a $1,000,000 offering) or SCOR offering, consider moving the capitalization to the limited amount of $1,000,000 under those exemptions. If you find that things are going exceedingly well with revenues once you’ve hit $500,000 in capital raised, you can certainly close the offering early, as you’re not obligated to raise the full $1,000,000 amount. Conversely, if you were allowed the full amount of $1,000,000 but only disclosed raising $500,000, you’re kind of stuck. You technically can raise the amount to $1,000,000 but it’ll require unanimous shareholder (of the $500,000 worth of securities) approval, possibly regulatory approval at the state level depending on the exemption claimed and opens the door to potential future shareholder litigation. In other words, it’s an administrative nightmare to increase an offering amount – after the fact – than decrease it at your leisure and convenience.

Deal Structures for Funds

Most of our portfolio companies have enjoyed previous successes as: real estate developers, agents, property managers, and managers of projects; film producers; oil & gas producers; and hedge fund managers. Many have capitalized their companies and previous operations with their own money and or limited outside-investor funds. Most have seen a need to re-organize their financial and operational structures as the administrative burdens of managing multiple projects with differing sets of investors are becoming too complicated. Some have now come to the juncture where their track records are very good, and they have earned the right to manage large pools of assets— cash and property with full discretionary authority.

Whether or not they can publish a track record, many management teams are ready to set-up an operation where they can access pools of equity capital quickly to take advantage of opportunities as they arise. Having immediate access to large pools of equity capital relieves the problem of feeling the pressure of missing out on great opportunities, because of the need to arrange the financing for each deal separately, as they arise. This can be accomplished more effectively with a standardized Fund or REIT structure, than any other type of organizational structure.

Most start-up or early stage Funds organize and capitalize a management company first. Some may elect to keep their current management company intact and use - 98 - Copyright © Commonwealth Capital, LLC 2003-2019

current cash flow and or capital to start this process. Others elect to start fresh and form a new management company to specifically and exclusively become the fund-management company. The decision rests on a handful of factors. However, the primary factor being the ability either to seed fund the management company internally from current cash flow of existing operations or the need to fund externally. If seed funding internally, then one could keep the existing company and evolve it. If one needs to fund it with outside investors, then starting fresh with a new management company makes more sense because it’s far easier to engineer a new entity for a securities offering than an older one. Like an operating company, one could offer convertible notes for seed capital, or more appropriately convertible participating preferred shares (or units for an LLC) for development capital, that is callable and/or convertible into a small amount of the management company’s common shares (or units for an LLC) at a later date. Preferred equity may be more appropriate due to the larger amount of capital needed to fund a large Fund or REIT.

Depending on the current size of the operation, the management company then sets up a private Fund to either remain private or eventually convert it into a publicly traded Fund. For most start-up or early stage management companies, it makes sense to initialize a private Fund as an LLC and grow its investor base to 100 or more before registering as a corporation prior to conversion into a publicly traded fund (Exchange Traded Fund or “ETF” or Real Estate Investment Trust “REIT”). ETFs and REITs technically need to be formed as a corporation (it is easy to convert an LLC into a corp.), have at least 100 investors—with no single investor owning more than 9.9% (the 5–50 test)—then file Form 1120 with the IRS to avoid the double taxation of a corporation.

The following structures are designed for all types of Funds. Here, we’ll use the example of a private real estate Fund that plans on issuing its Fund’s shares as a REIT, through a broker-dealer, for eventual listing on a securities (stock) exchange—a Real Estate Investment Trust or REIT. For simplicity’s sake, whether your Fund remains privately held Fund or you choose to go public as an ETF or REIT, we'll continue to use the term “Fund” to include both types of Funds, private, as well as public.

Once the Fund has been formed, the management company manages the assets of it. For instance, the Fund’s assets would include: Real estate for REITs or Real Estate Funds; film titles or other rights for Film Funds; oil & gas leases, properties, or other rights for Oil & Gas Funds; and securities, bullion, art, derivatives, commodities or other related assets for Venture/Hedge Funds.

The management company may contract with each Fund it creates or in the case of LLCs, it can use the LLC’s Operating Agreement as the contract—for a far more powerful position. Generally, raising $1–$5 million in seed capital for the management company is sufficient to market and sell the shares of a Fund or two. The seed capital amount is normally dependent on the size of the Fund(s) and should represent no less than 2% of the Fund’s proposed total amount to be raised or $1,000,000 whichever is more. Need $200 million for your Fund? Consider raising $4 million in seed capital for the management company, which will “Lend” the Fund a portion of the seed capital. This - 99 - Copyright © Commonwealth Capital, LLC 2003-2019

will enable the Fund to establish itself as a qualified capital-raising entity, through the issuance of securities. Once the Fund is capitalized, the management company is paid back the loan plus any accrued interest.

To understand how to properly structure one or more Funds, imagine one relatively small management company capitalized with $1 million to enable it to:

1. Hire the proper management-team members to carry out the task of initially raising capital for the Fund then tend to the funds’ day-to-day operations. 2. Afford the professionals—i.e., attorneys, accountants, broker dealers, financial advisors, R&D consultants, etc.

Imagine one Fund being created and capitalized simultaneously along with the capitalization of the Management Company. The management company’s fee structure for handling the Fund can be a combination of any number of various factors, but the industry norm is as follows:

Depending on difficulty of management and within industry norms, the Management Company typically receives a management fee of 1-3% on the total assets of the Fund. The Management Company shares in a percentage (normally 20%) of the net income and net capital gains from portfolio properties, as well. If the Management Company is a licensed real estate-brokerage firm, it may share in all or part of the real estate-brokerage commissions from the purchase and sales of portfolio properties. In addition, if the Management Company is a licensed property management firm then it may also share in all or part of the property management fees. However, the real estate commission and property management fee structure often creates a conflict of interest, so we strongly suggest against it, especially if your Fund will eventually go public.

Our position is based on a fundamental philosophy of the initial capitalization of a management company, first or simultaneously with the Fund. This strategy will enable the management company to afford the process of going after larger sums of capital for one or more Funds. In turn, the entrepreneur is moved to a higher level and enabled to raise substantial amounts of capital so they have access to these funds with full discretionary authority.

Also, to satisfy a broker-dealer’s concerns about the risk of any investment, especially private investments, it’s normally wise to offer to list the Fund’s securities subject for sale on a publicly traded stock exchange. Otherwise, the likelihood of getting any broker-dealer to participate in the offering is very low. The same goes for the individual accredited investor. Without a “Liquidity Event,” such as an exchange listing or an outright-sale option, the probability of getting any investor interest is highly unlikely.

To relieve the burden of cost from the entrepreneur to the new-investor pool, you can budget for an exchange listing, which is found within the offering’s “Use of

Proceeds” statement and the pro forma Sources and Uses Statement. Simply put, investors and broker-dealers are more than willing to shoulder the expense of creating the liquidity event—in this case, the exchange listing.

Suffice it to say, there are unlimited ways to seek capital. However, there are only a few methods to capitalize a private Fund with substantial amounts of capital while maintaining the vast majority of common equity ownership and voting control of the Fund’s management company, as well as management control over one or multiple Funds. Clearly, we cannot design or illustrate an optimum capitalization plan for your Fund(s) in a book’s dissertation, however, whether you have been through the capital- raising process or not, we are sure you will appreciate and learn from our process.

To increase the likelihood of obtaining enough assets and/or cash to make the effort a success, an issuer of securities would be wise to consider listing the Fund shares on a publicly traded stock exchange within a year to enable investors to realize liquidity and to attract broker-dealer interest. Without this liquidity event, investors have no incentive for swapping their titles for shares; and there is a low probability of getting broker-dealers to participate in selling the offering for a commission. Ultimately, if you can raise money and/or assets for the fund with your personal-investor contacts privately, an exchange listing is not necessary…otherwise it is.

Taxation Issues

As federal and state tax regulations limit ways to structure a Fund and its Management Company, the most common scenario employed includes the following:

 Set up and capitalize a Management Company as a LLC (with seed or development capital) to further capitalize the Funds and manage a series of separate Funds.  Set up and capitalize a series of Funds as LLCs or Limited Partnerships that will own the assets or properties, by issuing common or preferred equity.  Once you have sufficient assets or properties, you have the option to roll up all the Funds into a privately held or publicly traded fund, if this encompasses your exit strategy.

Specific to REITs

The true value of a “Tenants In Common” (TIC) deal structure is the availability of the 1031 Tax Deferred Exchange, for REITs. This exchange holds up if: one property is registered as Tenants In Common; and that property is held by one entity, regardless of ownership by one investor or an investor pool. Although the interests and distributions are prorated to each investor’s capital-contribution amounts, for tax purposes, the TIC property is treated as if it’s held by one entity, including the 1031 Tax Deferred Exchange. In addition, TICs are professionally managed—generally by a Property or Real Estate Management Company.

On the other hand, a pool of properties, such as a REIT or Real Estate Fund, will not qualify for the 1031 Tax Deferred Exchange; but as long as one uses the REIT Template to purchase a single property and registers each share or interest holder as “Tenants In Common,” using the Financial Architect’s REIT Producer™ will work for producing TIC Investment Deals. The Management Company Templates will work like a charm too, as most entrepreneurs will invariably need to form and/or capitalize a Management Company to handle the volume of administrative work that will be involved in managing “One Property Portfolios” or TICs.

If you have a serious interest in building one—or a portfolio of TICs—to manage, we suggest you purchase and slightly modify the REIT Producer™ to assemble the required securities-offering documents needed to pool investor capital.

Common or Preferred Equity?

Either type of equity can be used to capitalize the Fund. The advantages and disadvantages are as follows:

Issuing Common Equity to capitalize the Fund:

1. Common equity is the industry norm and therefore may be easier for investors to understand and accept as a deal structure. 2. Common equity shifts the vast majority of risk to the Fund’s common or preferred equity holders and away from the Management Company. 3. Common equity shifts the vast majority of return to the Fund’s common or preferred equity holders and away from the Management Company. 4. Common equity is harder to sell through general solicitation and advertising; because unless one has three years of an audited track-record of asset performance, one cannot advertise any type of expected return.

Issuing Preferred Equity to capitalize the Fund:

1. Preferred equity is not the industry norm and therefore may be more difficult for investors to understand and accept as a deal structure. However, once understood it is very popular with retirees seeking income from their investments.

2. Preferred equity shifts the vast majority of risk to the Mgmt. Co. and away from the Fund’s common or preferred equity holders.

3. Preferred equity shifts the vast majority of return to the Mgmt. Co. and away from the Fund’s common or preferred equity holders.

4. Preferred equity is easier to sell through general solicitation and advertising; because one can advertise the stated dividend (Corp.) or distribution (LLC) as the expected return, without the need for three years of an audited, track record of asset

performance. The stated dividend will enable you to effectively compete with financial institutions for investors.

There are pros and cons to the two, primary types of equity offerings for Funds— common and preferred. The offerings for capitalizing the Management Company automatically follow suit to the type of Fund equity offering chosen. The goal is to enhance or maximize the return to the Management Company (founders’ wealth) while lowering the risk to both the Fund (and inherently its investors) and the Management Company. These pros and cons are based on the premise that the vast majority of start-up Funds will need to be able to effectively and legally advertise, solicit, and sell the securities offered to the public at large, using the general media, in the US. Most start-up Funds will not have assets, which can or will be auditable. Audited, financial statements are often necessary when conducting mass solicitations to the general public—not only from a legal aspect but more importantly to attract investors with the ability to advertise an actual return on the investment. Therefore, with that set of premises in mind, please consider the following: Common-Equity Offerings

1. Pros. a. Low Fund-Investor Risk. Common Equity is “Pure Vanilla.” That’s a term often used in our industry for a security that has no other obligation other than to share profits—only if and when they’re realized. When it comes to producing returns to Fund investors, there’s less risk to the Fund’s common shareholders and to the Management Company in general. Selling common equity in the Fund has no dilutive ramifications. Think of the Fund as a balloon filled with oxygen and hydrogen. The balloon expands as assets go in (oxygen=cash, hydrogen=assets). In the case of any size Fund, the first investor who buys $10,000,000 worth of shares owns 100% of a $10,000,000 Fund at that point. The second investor who buys $5,000,000 worth of shares owns 33.34% of a $15,000,000 Fund (a $5,000,000 value) at that point. Ergo, the Fund investor has no dilution risk, which is good. If a portion the Fund were owned by anyone (Mgmt. Co. for instance), with little or no meaningful contribution to it, the investors would suffer a dilution of their investment.

b. Low Management-Company-Investor Risk. The Management Company receives a certain percentage of the assets under management (1%-2% is normal), which typically covers the Management Company’s overhead expenses.

c. Easy to Leverage. Because there is no “stated dividend” as with preferred equity, banks/bond holders are in a better position because the cash-flow drain on the company is minimized. In addition, adding any leverage through the use of any type of debt will increase the risk to a certain degree and increase the potential return to a lesser degree than the risk co-efficient. i. Traditional, bank debt may require personal guarantees from the officers of the Management Company due to its early stage.

ii. Selling bonds will not require personal guarantees from the officers of the Management Company, due to the nature of bonds.

2. Cons. a. Low Fund-Investor Return. Because the common equity is Pure Vanilla, there’s no stated dividend, call date or liquidation preference, or conversion rights as there is with preferred equity. Those attributes of preferred equity can result in a better return than the common equity.

b. Low Management-Company Return. Through its contractual statements within the Fund’s Operating Agreement, the Management Co. has a pseudo partnership with the Fund’s owners—so it need not be too concerned with the Fund’s performance. If things go great, terrific. If things don’t go as planned, oh, well, no big deal, as the Fund can muddle along. In the case of an asset-depreciation cycle, due to economic factors, this type of Fund and its accompanying Management Company will most likely survive (as long as there’s no debt on the Fund). For the Management Company, this type of Fund is low in market risk and market- return potential. Typically, the Management Company shares in a percentage of the net profits and net realized capital gains of the Fund. Twenty percent is normal, which is designed to provide the Management Company’s return on investment for its investors and/or founders. But that’s where the upside for the Management Company ends.

c. Difficult to Sell. Typically, a start-up Fund will not be able to publish a track record of performance, because such track records are required to be audited by an SEC-approved audit firm (CPA). Even if the assets themselves can be or have been audited, the compliance burden becomes cost prohibitive, and publishing the collective return still has to be approved by the SEC which is a very difficult and time-consuming process. Without a published, track record or rate of return, these securities are difficult to sell. If this is the case, the cons outweigh the pros— because if there’s no capital raised, the pros become a moot point.

Below are two (2) illustrations to compare offering Common or Preferred Equity to capitalize the Fund. Both infographics illustrate capitalizing a management company by selling convertible participating callable preferred equity to obtain the necessary seed capital of $1-3 million US Dollars to launch a private real estate Fund or REIT.

Issuing Common Equity for the Fund

The Fund issues Common Class -A- voting equity for cash and/or assets. No matter what the decided percentage of leveraging debt to be used, the Fund(s) only issue Common Class -A- voting equity.

Issuing Preferred Equity for the Fund

The Fund issues Class -B- non-voting convertible participating callable preferred equity for cash and/or assets. No matter what the decided percentage of leveraging debt to be used, the Fund(s) only issue common, class -A- voting equity.

Reasoning of Seed Capitalization Choices.

With Financial Architect™, you have two fundamental choices of issuing securities for capitalizing the Fund—common or preferred equity. If issuing preferred equity for the Fund, you also have two choices for seed capital for the Management Company—issuing convertible notes and convertible-participating preferred equity. However, if issuing common equity for the Fund, you only have one choice of issuing convertible-participating preferred equity for seed capital for the Management Company. The reasoning is that with the shifting of the vast majority of risk and return to the Mgmt. Co. with preferred equity for the Fund, (the Mgmt. Co. as the majority owner of the Fund’s common equity) the convertible notes for seed capital mitigates risk for investors in the early stages of this deal structure.

IMPORTANT: The preferred equity for the Fund structure is designed to enable your Mgmt. Co. to gain more wealth sooner rather than later, because it takes on more risk. U under this structure, your Mgmt. Co. shall own 100% of the common class -A- voting stock of the FUND or REIT, prior to preferred equity conversion, thereby maintaining control and maximum wealth creation for your management company and its shareholders.

For instance, no matter what the structure the FUND or REIT must distribute 90% of the net income from its operations to its equity holders to maintain its tax free corporate status. Hence, in the above scenario 50% is distributed to the preferred equity holders and 40% is distributed to the sole common equity holder – the Mgmt. Co. Assuming adjusted-gross-revenue on assets of 9.00%, less 1% on assets for Mgmt. fees, equates to 8%. Deduct 6% in stated dividends to arrive at a net 2%. Then 50% of that 2% (or 1%) is distributed as participation dividends to the preferred shareholders of the Fund. The Fund preferred shareholders would realize a 9.50% net cash return. Using the Rule of 7248, if the Fund assets realize an average annual growth of 7.20%, the original capital from preferred equity holders of $100,000,000 doubles to $200,000,000 in 10 years. The Preferred equity holders would reach “conversion parity” at that level because 50% [the conversion rate] of the Fund equates to the $100,000,000 of original capital from the preferred equity holders.

The Mgmt. Co. retains 100% of the balance of the Fund’s common equity upon full, partial or lack of conversion from the preferred equity holders. In the scenario above, no matter what how many preferred equity holders convert their preferred equity into the Fund’s common equity the Mgmt. Co. would be worth the balance. At 100% preferred equity conversion, the Mgmt. Co. would be worth at least $100,000,000. 49

48 Meaning at an ave. annual compounded return of 10% money doubles in 7.2 years or at an ave. annual compounded return of 7.2% it doubles in 10 years. 49 Simplified hypothetical illustration. - 106 - Copyright © Commonwealth Capital, LLC 2003-2019

Investor Perspectives

In general, most wealthy folk’s investment portfolios are allocated toward two primary classes of investment. The first portion of their investment portfolios is known as “safe” money investments, such as; Certificates of Deposits, US Treasury, Municipal and Corporate Bonds & Notes, low-leveraged Real Estate, and Oil & Gas Interests and Preferred Equity. The second portion of the investment portfolio is known as “risk capital,” which is generally invested in common stocks, high-leveraged real estate, speculative oil & gas interests, and other “alternative assets” such as precious metals, private placements, commodities, etc. On average, safe money normally makes up 70%– 90% of most portfolios. Risk capital makes up the balance.

Imagine simultaneously conducting two securities offerings not only to attract the risk capital portion of their investment portfolio, but more importantly to attract their larger “safe” money portion of their investment portfolio. The management company’s securities-offering is used to attract “risk capital,” and the Funds’ equity offering is to attract “safe money.” To further mitigate the risk in “risk capital, the management company’s preferred equity securities-offering is designed to be as safe as possible thereby making it the safest part of the “risk capital” portion of an investment portfolio.

Unleveraged common class -A- voting equity in the Fund also mitigates financial risk of investing in the Fund.

Now for the piece ‘de resistance.

The Fund’s Securities as Currency

You can trade your Fund’s securities to purchase assets. That’s right; you can use equity shares or units of the Fund as currency to attract and purchase the actual assets that will go into the Fund. You don’t need cash if you will be listing those securities on a publicly traded stock exchange, because those shares will become liquid and can easily and quickly be converted to cash. There are sale restriction rules, such as Rule 144, which require investors to hold pre-IPO-issued shares for a period of time—currently six months—after the IPO. This waiting period is normally not an issue for the sellers of asset because it’s a sale where a sale may not have occurred otherwise. Consider offering the first set of investors the ability to transfer their assets into the fund at their original cost basis. This will enable them to defer their capital gains until they sell the shares of the Fund. Liquidity and tax deferral secured with the assets they trade for the equity. Brilliant strategy, but rarely used because most don’t cater to the seller’s needs only their own.

The Dollar Amount(s).

The dollar amounts raised depend on a handful of factors, but suffice it to say that you’ll make your decision based on two primary factors: 1.) the cost involved with the various, registration processes or the dollar-limitation amounts provided by the various - 107 - Copyright © Commonwealth Capital, LLC 2003-2019

exemptions from registration and 2.) the IRRs produced for the Mgmt. Co. and the Fund by CapPro for Funds™ as you move through the process of pricing the securities.

More often than not, it is wise to plan to over capitalize your Operating or Management Company and the Fund(s). There’s an old accounting adage… “Everything costs twice as much and takes three times longer than originally planned” that has some truth to it.

****

LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

One rule of thumb is you should seek more than you need to provide a cushion to keep the corporation operating for at least one year, although no law requires this. Seeking less capital than you need obviously undercapitalizes the corporation and may set the business up for quick failure. Seeking what you need at the moment may not be the same dollar amount you realize you need two or three months from now. Usually, most companies need more capital in the short term until they generate sufficient revenues to be self- sustaining. Meanwhile, the corporation is generating expenses and using founding capital which may not last very long. Corporations that seek less than one-million dollars are signaling to the professional-investment community they do not want outside, equity participation. Ultimately, obtaining excess capital might present a temptation for executives to pay themselves unwarranted bonuses or expending funds on items that would ordinarily be unthinkable (e.g., holding the company annual meeting at a resort destination or buying expensive “company” cars). These are the kinds of things that incite investors into launching lawsuits and complaining to regulators.

Chapter 10: Company Valuation and Securities Pricing

Preamble

This section is conceptual in nature and is dedicated to helping you further develop a clear understanding of the nature of company capitalization, as well as how the issuance of different types of securities relate to that effort. We created CapPro™, available to you in the Corporate Engineering Conservatory™ at no charge, to help you get the job done quickly and accurately, so no need to be too concerned about the details and the possibilities of what follows. You need to understand a few basic concepts to frame your thoughts around this task.

Due to the changing nature of the securities markets, financial reporting, and disclosure requirements, we have provided a set of pro forma financial projections in the CapPro™ program and securities-offering-document templates in the Financial Architect System™ that are designed to be timeless in nature. These are the fundamental elements of deal structuring and securities-offering-document production, which probably will not change much. However, from time to time, we do update the entire Financial Architect™ family of programs; changes occur, concerning federal and state tax and securities laws, rules, and regulations and GAAP standard changes. To be safe, we suggest that every time you prepare a securities-offering document, you re-work a new set of pro forma financial projections from the CapPro™ programs and securities-offering-documents in the Financial Architect™ program modules, which are continually updated to be the latest edition. (Complete instructions are included with each program.)

Some projects may require 7–10 years to realize their maximum net operating margins; this is especially true for real estate or oil and gas projects. However, we have designed CapPro™ and CapPro for Funds™ to project only over a 5-year time horizon because it is very difficult to project revenues and expenses beyond a 5-year time period. As long your pro forma financial projections show a breakeven by year 3, you should be able to illustrate a decent IRR on the securities being issued using CapPro™ 5-year time horizon.

The CapPro™ programs and securities-offering-documents in the Financial Architect™ program modules have a fictitious company XYZ, Inc. or LLC, for you to work from, with default figures and assumptions (with notes to pro formas) so you can see how the fictitious company was properly engineered. You simply replace each defaulted figure in each item to coincide with your company and desired deal structure. In those default examples, we have used 100,000 Common Class A voting shares as the common denominator for the total (100%) authorized Common Class A voting shares in a corporation. One share, therefore, represents 0.001 (or 1/1000th) of 1%. One would need to own 1,000 shares of Common Class A voting stock to own 1% of the company. If your Company is an LLC, we suggest amending your Company’s Operating Agreement (or use the Operating Agreement templates within the Financial Architect™ program modules) to reflect that percentage as well (i.e., one membership interest share represents 0.001 (or 1/1000th) of 1%. We do not reference any Common Class B non-voting stock in

the illustration or in the templates. You could use Common Class B non-voting stock, but just realize it is treated, for dilution purposes, the same as the Common Class A voting stock. For ease of illustration in regard to this instructional course—not because we are lazy—the terms “common stock” and “shares” equate to “Common Class A voting stock” for corporation and “membership units” for LLCs or “partnership interests” for limited partnerships.

For early or later-stage companies that already have investors and established total authorized shares, we realize these changes may not be possible without obtaining a majority of ownership vote, which could be difficult as it may produce dilution. Simply keep in mind that we have used an easy way to calculate the percentage of ownership one would have by purchasing a certain amount of shares for illustrative purposed. If you feel that making changes to the total authorized shares or interests would cause you political problems throughout your Company’s current investor base, use your current total authorized shares or interests as the base point of your calculations in CapPro™. You will enter that number into various areas within the pro forma financial projections worksheets and the notes, to arrive at the proper calculations. If you are using a partnership as your organizational form, use the LLC templates and make terminology adjustments that coincide with your partnership agreement.

The Process

It seems to us, when it comes to start-ups, the number-one question most folks have is “With little or no assets and in the pre-revenue stage, how does one value a start- up company?” The answer is easy…it’s only worth what someone else will pay for it, so it’s probably worth zero. That’s probably not the answer you’re looking for, but it’s the truth. A better question may be…“how does one assign a value to a start-up company, with little or no assets and in the pre-revenue stage, so it can raise capital?” It depends on how one wants to raise capital. If you want to produce a business plan and submit it to financial institutions for funding, good luck.

I’ve outlined below, the most commonly used fundamental pricing models used in the securities industry to valuate private companies and their securities. The first two models listed are used in an ad hoc manner, for seeking initial “indications of interest” (investment interest) only.

1. The Book Value model. This model simply states that the company is worth X times “book.” Book means that the value of a private company is multiplied by the Net Equity (Equity, less debt including preferred equity) on the balance sheet. XYZ, Inc. has $140,000 in equity and $50,000 in debt for Net Equity of $90,000. Let’s assume that the companies in that industry, geographic location, etc. sell at 6 times book. That would place this company’s value at $540,000 ($90,000 multiplied by 6).

2. The Annual Sales model. This model simply states that the company is worth X (normally 1) times “Annual Sales,” less debt including preferred equity. This means - 110 - Copyright © Commonwealth Capital, LLC 2003-2019

that the value of a private company is multiplied by the gross revenue or sales over the last 12 months. XYZ, Inc. has gross sales of $650,000 for the last 12 months. Let’s assume that the companies in that industry, geographic location, etc., sell at 1.2 times Annual Sales. That would place this company’s value at $780,000, less debt including preferred equity. There are renditions of this model based on the trajectory of year-to-year sales and other esoteric measurements, but this is a simple model for seeking initial “indications of interest.”

3. Net Present Value model. This model simply states that the company is worth X amount of future cash flows discounted to net present value. Normally, used to value commercial real estate against future rents. Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.51

4. The Price / Earnings Ratio model. This model simply states that the company is worth X times “Net Earnings,” less debt including preferred equity. This is the most frequently used method of determining a company’s current value based on a PE Ratio (Price-Earnings Ratio) for both privately held, as well as publicly traded companies and their securities. To arrive at a full company value, simply multiply the earnings per share by the PE Ratio to determine the value of a single share, first. If your Company has 1,000,000 shares outstanding and the total net earnings are $200,000, the earnings per share equates to $2.00. If you establish a PE Ratio of five (5), based on industry and market standards, the earnings per share ($2.00) is multiplied by five (5) to arrive at the price for the common stock. In this case, you would price the common stock at $10.00 per share. With 1,000,000 shares currently outstanding (not the total authorized amount) multiplied by $10.00 per share, the company valuation would be $10,000,000 less any debt, secured or unsecured, including preferred equity. Well since the start-up (defined as pre-revenue) or even the early stage (defined as pre-earnings) company has no earnings yet, defined by its stage, how can one use this model? One cannot, unless one uses a Net Present Value model discounted to future earnings per share in combination with the Price / Earnings Ratio model.

Some “experts” state that you cannot truly valuate a start-up at the pre-revenue stage with any reasonable model. We disagree, as long as one produces conservative GAAP-compliant pro forma financial projections to combine the Price / Earnings Ratio model (future earnings) with the Net Present Value model, (discounted to a net present value) our experience has shown that one can properly valuate a start-up or an early stage company accurately through a process of pricing the securities first, which leads to company valuation second, through reverse engineering.

Not to belabor the point, but one creates securities borne from those GAAP- compliant pro forma financial projections, calculates the potential future value of the

company and the IRRs on the securities issued to raise capital—post money (capital attainment).

This procedure involves some fairly sophisticated calculations, mind framing, and thought protocols for determining reasonableness of future assumptions. One would be wise to be eminently practical in this approach and seek either qualified advisors or more importantly learn these skill sets to provide a framework for the proper valuation of a start-up company’s securities. By doing so, you’ll learn to create what is known as a “marketable deal structure” that leads to the types of securities most passive investors would like to buy. If this interests you, we’ll start with the fundamentals and lead to the practical application of the process.

The Fundamentals of Pricing Securities – the Wall Street way.

The PE Ratio is very important when conducting a securities offering because it is the way Wall Street prices securities based on company valuation. Although there are many ways to valuate a company, we believe most would agree the value of anything is what someone would actually pay for it. That is why the auction markets of publicly traded securities, which represent the liquid securities markets, are the purest and most correct form of company valuation and securities-pricing available. This type of valuation is known as the “Efficient Market Model”—it assumes all buyers and sellers know the same facts about the company (its outstanding securities, its liabilities, its underlying assets, the industry risks, geopolitical forces, etc.) and are inherently establishing the price of a security based on supply and demand of that security. The buy and sell decisions are based on the best available information, making this pricing model as good as any may ever be. There are a handful of valuation models, and some do have solid meaning in niche industries, such as; real estate, but those models cannot be applied universally. Some valuation experts may disagree with the PE Ratio valuation model, but until they can convince the publicly traded securities markets (Wall Street) of a better way, it’s all academic. That is why we only use the Wall Street company-valuation-and- securities pricing model—because it is based on the reality of what investors buy.

Comparing Private versus Public PE Ratios.

The liquidity of the U.S. Public securities markets enables companies to command the highest valuation possible. This is due to the fact that any current shareholder can liquidate any amount of their shareholdings on any given day that those markets are open for trading. Conversely, the illiquid nature of a private company’s securities decreases the private valuation from public valuations by 75 to 80%. For instance, if the S&P 500 stock index (an indication of aggregate public company valuation) is trading at a PE Ratio of 20 (normal) it’s customary to price a private company at a PE Ratio of 4 to 5 (discounted by 80% to 75%) The U.S. Public securities markets are also made up of “Industry Sectors” that affords further valuation insights. If the Industry Sector of any particular company is trading at a P/E of 15 it’s customary to price a private company within that sector at a PE Ratio of 3 to 3.75.

In addition, one must take into context the trajectory of earnings based on the company’s recent earnings history before one can properly valuate the company with any creditability. For instance, a private company, in an industry with a publicly traded PE Ratio of 15, with earnings that are declining may only command a PE Ratio of 2 to 2.5, flat 2.5 to 3, or rising 3.75 to 4.

Also, the above valuation model assumes full private company liquidation based on a PE Ratio, less debt including preferred equity. The valuation of individual shares of a private company has another issue to contend with. Minority shareholders, (typically less than 51% of outstanding voting shares) who do not have the legal right to sell the company have less valuation for their shares than a shareholder (or a syndicated group of shareholders) that control 51% or more of the voting shares, and hence can liquidate the company through a sale. What’s the differential between the minority and majority share valuations? It’s difficult to say, but one would be wise to go back to the concept that the value of anything is what someone would actually pay for it. The Minority could attempt to legally sell those shares in compliance with federal and state securities laws. Unfortunately, for a minority shareholder to actually sell their share position in a privately held company, they must meet stringent standards of securities laws to even try. For most minority shareholders the process is often cost prohibitive.

Using the Wall Street pricing model, the valuation of your Company utilizes the PE Ratio as its core-pricing component. That component is determined primarily by the estimated annual-earnings growth rate. Once again, although illustrating a healthy annual-earnings growth rate is important, it is more important that the growth rate be as realistic and conservative as possible. You should not be concerned when calculating the revenue growth rate—which would ultimately lead to the net-earnings growth rate— about how a slow, conservative, growth rate may relate to the estimated IRR of a particular security. Remember, the IRRs and ROI of hybrid securities rely primarily on the attributes they carry, as opposed to the actual underlying growth of the company, which is secondary.

Although the dynamics of the various, publicly traded securities markets are far more complicated than the examples given in this lesson, we are pricing privately held securities, which is relatively easy. These pricing models are acceptable, from the private and public markets’ standpoint, which is important when comparing IRRs on exit strategies, as you will soon note.

The previous example is for a company with current earnings per share. But what about the start-up or an early stage company that has yet to provide earnings per share to calculate from?

As previously mentioned, we use the combination of the NPV and PE Ratio models to arrive at a reasonable valuation of the securities first, then reverse engineer into the company valuation, as you will realize as you work through CapPro™.

Let’s now review some different types of securities that can be used for capitalizing start-up, early stage, or seasoned companies. Let’s assume a company- valuation exercise and the pricing of common stock included selling 40% of the company (40,000 shares from the 100,000 total authorized shares). Actually, conducting an offering of that nature may not be wise unless your capitalization effort is project specific. In other words, you may be developing a real estate or oil & gas project, which may only need a one-time capitalization effort. In addition, if you are building an operating company, you should consider giving up as little common-stock equity in the first couple of rounds, as you would need that equity for further rounds and possibly for an IPO in the future. We like to keep the amount of relinquishing common equity through conversion only, down to a total of 30% before an IPO. Simply keep that in mind as you develop your capitalization plan.

Using CapPro™, available to you in the Corporate Engineering Conservatory™ you’ll get the job done quickly and accurately. What used to take weeks, now only takes hours and what used to take hours, now only takes seconds.

The Common Stock

When pricing Common Stock, one analyzes 3 components: • The price of its original or discounted issuance. • The cumulative cash (dividend) distributions over a specified period, say at the end of the five years. • The principal of the Note or Bond to be received by the investor at maturity.

Barring any significant dividend distributions, common stock is the only security that is priced primarily on its future potential value through the PE Ratio model. For instance, let’s say you are using a PE Ratio (a “multiple”) in a private market of five (5). You estimate your Company earning $20.00 per share at the end of the 5th year. With a multiple of five, you would price the common stock at $100.00 per share at the end of the fifth year. Incidentally, a PE Ratio of five (5) is a reasonable earnings multiple for a privately held company.

You would then price the common stock, currently, to reflect a reasonable return for the risk involved in owning that security over that period. If you priced the common stock at $10.00 per share now and it is conservatively estimated to be worth $100 per share at the end of the 5th year, you could illustrate a 58.49% Internal Rate of Return (IRR) for an investment in the common stock. (The IRR calculation formula is automatically calculating with CapPro™.)

If you established the current price of the stock at $20.00 per share, as opposed to the $10.00, the IRR would be 37.97% with the common share estimated to be worth $100 per share at the end of the 5th year. If the given price and rate of return were acceptable to your private capital market, based on the risk profile of your company, and the securities offered (dilution factor), that would constitute the current value of the stock.

If you established the current price of the stock at $30.00 per share, as opposed to the $10.00, the IRR would be 27.23% with the common share estimated to be worth $100 per share at the end of the 5th year. If the given price and rate of return were acceptable to your private capital market, based on the risk profile of your company and the securities offered (dilution factor), that would constitute the current value of the stock.

See how we backed into the current company valuation based on the IRR of the common equity at the end of a 5 year time frame? To use the final example, you use reasonable GAAP compliant pro forma financial projections to price the company’s common equity end valuation to be $100 (X) at the end of year 5 and reverse engineer the current price $30.00 (Y) based on the IRR of 27.23% (Z). We used both the NPV and PE Ratio Model to valuate the company by pricing its common equity, through reverse engineering.

Are you beginning to understand the fundamentals of pricing the common stock? One bases its current value on its potential future value. After having conservatively estimated the future value of the common-stock shares at the end of a period, one simply adjusts the current price to reflect an acceptable rate of return to one’s private-capital contacts. This is the basis of a pre-revenue company valuation and on the pricing of, but not engaging in, a common-stock securities offering.

Remember, you base the value of anything on what someone else is willing to pay for it. You determine the preceding by testing the waters for an indication of interest. You could test the price of the common stock at any one of the estimated IRR scenarios as described above. Certainly, in this example, an investor would rather pay $10 per share than $30 per share. Therefore, you should consider a common-stock offering of maybe $20 per share—as well as two other deal structures that would provide a similar or greater-estimated IRR—along with more protections for the investor.

Note or Bonds.

When pricing Notes or Bonds, one analyzes 3 components: • The price of its original or discounted issuance. • The cumulative coupon or annual interest rate over a specified period, say at the end of the five years. • The principal of the Note or Bond to be received by the investor at maturity.

Commercial (as opposed to government) Notes and Bonds are typically priced at $1,000 each. However, one could price at any denomination for instance one bond for $10,000, $50,000 or a $100,000. Normally, one would issue 10 Notes or Bonds at a price of $1,000 for a $10,000 investment.

The difference between the term “Bonds” versus “Notes” is the length of its maturity date from their issuance date. One would generally issue Corporate Notes with maturity dates ranging from ninety days to five years—corporate bonds 5–30 years (5, 10, & 30 year Bonds are most common). - 115 - Copyright © Commonwealth Capital, LLC 2003-2019

Notes and Bonds are normally priced by the “current yield” or the annual interest or “coupon” rate. For instance, one would normally sell and issue $1,000 Notes with a coupon rate of 7%, 8% or 9% in today’s market to raise seed capital. Due to the aspect of inflationary and interest rate risk, the short-term nature of a Note, compared to a longer term maturity of a Bond allows the Note to carry a lower coupon rate. In this event, only the current yield can be stated in a tombstone ad for advertising.

Just as a notation, and not germane to raising capital for start-up or early stage companies, Notes and Bonds can be discounted from “face value” of the original issue price. For instance, a $10,000, 5-year Note can be discounted to any percentage, but let’s say 10% for this example. Let’s say its coupon is 7%. At a 10% discount the current yield would increase to 7.78% ($10,000-$1,000 (10% discount) = $9,000 / $700(the interest coupon) = 7.78%. The “yield to maturity” over five years would be 7% (the interest coupon) + 2% (10% / 5 years) = 9%. If one were to issue a Note or a Bond at a discount the term used is an “Original Issue Discount” Note or Bond. In this event, both the current yield and the yield to maturity can be stated in a tombstone ad for advertising when soliciting Notes or Bonds.

Convertible Notes or Bonds:

When pricing the Convertible Notes or Bonds, one analyzes 4 components: • The price of its original or discounted issuance. • The cumulative coupon or annual interest rate over a specified period, say at the end of the five years. • The principal of the Note or Bond to be received by the investor at maturity. • The value of the equity upon conversion into common equity —at the end of the conversion period, to arrive at a total, cumulative, aggregate end-value for conversion under 2 scenarios, staying private or going public.

To calculate the IRR, one would compare with the beginning price at “face value” or a discount from face, of the Note or Bond, plus the total, cumulative, aggregate cash received from all interest payments, plus end-value of the Note or Bond, to determine the estimated IRR. For instance, if you priced and issued the notes at $10,000 face value and the aggregate value per Note was estimated to be worth $20,000 (equity-conversion value plus cumulative interest) at the end of the 5th year, the estimated IRR would be 13.99%. If the 13.99% return is acceptable to your private-capital contacts based on the risk profile of your company and for the risk involved in holding that type of security over the specified time period, the $10,0,00 face value would constitute the price.

To “fine tune” this IRR scenario, one would change the conversion rate as opposed to the price of the note, maturity date or the interest rate, as small adjustments to the conversion rate will have a greater impact on the IRR than small adjustments to the price of the note, maturity date or the interest rate. You will learn much more on fine tuning and market positioning when working within CapPro.™

Only the current yield (or if discounted the yield to maturity) can be stated in a tombstone ad for advertising when soliciting Convertible Notes or Bonds, not the IRR.

The Preferred Stock:

When pricing the Participating Preferred Stock or Units, one analyzes 3 components: • The price of its original or discounted issuance. • The cumulative stated dividend rate over a specified period, say at the end of the five years. • The return of principal by the investor if “Called.”

You price the preferred stock somewhat like a Note or Bond. It has a par or face value upon its issuance, which matters very little when you analyze the Internal Rate of Return (IRR). There is not much difference between a par value (original issue price) of $10, $100, or $1,000 when it comes down to pricing this type of security. What matters most is the stated dividend. Let’s just focus on a regular preferred stock scenario for now. You simply price the stated dividend as an annual yield or rate-of-return component not the share price of the preferred share.

If you decide 11% is the annual yield or rate of return that is acceptable to your private capital market, it would establish the stated dividend of the preferred stock. A stated annual dividend of $11.00 on a preferred stock with a $100 par value and issuance price represents a 11% annual yield or rate of return. Most preferred stock is priced at $100 per share—also known as “par” value. In this case, you would need to establish a stated dividend of $11.00 per share to arrive at the 11% annual yield. Par value has very little meaning because you price the stated dividend not necessarily the par or face value of the preferred stock shares. However, like a Note or Bond, a preferred share can be issued at a discount to par value.

It is very much the same way when pricing a Note or Bond. The difference between the preferred stock and the bond (or note) is generally the safety’s function. With a bond or note, you own a debt instrument with a Security Agreement and pre- defined maturity date (see the template) as opposed to owning a security that represents a permanent or temporary form of equity capital—as with a preferred stock. The Note or Bond is a security with less risk than a preferred stock, which has less risk than a common stock. Therefore, when pricing securities, you can provide a lower rate of return on the safer security being considered for issuance, relative to all other securities under consideration. By the way, the shorter the maturity date, the less risk for the Note or Bond. In any event, with both types of securities, you price the annual return not the price of the security itself. In the case of a preferred stock, stated dividend and debt instrument—such as a Note or Bond —the annual interest rate is known as the “coupon.”

Preferred equity can be discounted from “par value” of the original issue price. For instance, preferred stock with a par value of $100, can be discounted to any percentage, but let’s say 20% for this example. Let’s say its stated dividend is 8% which would equate to an 8% current yield at par value. At a 20% discount the current yield - 117 - Copyright © Commonwealth Capital, LLC 2003-2019

would increase to 10% ($100-$20 (20% discount) = $80 / $8(the stated dividend) = 10.00%. The “Yield to Call” over five years would be 8% (the stated dividend) + 4% (20% / 5 years) = 12%, assuming there’s no Call Premium. If one were to issue a Preferred stock at a discount the term used is an “Original Issue Discount” Preferred stock. In this event, both the “current yield” and the “yield to call” can be stated in a tombstone ad for advertising when soliciting Preferred stock.

The Participating Preferred Stock:

When pricing the Participating Preferred Stock or Units, one analyzes 4 components: • The price of its original or discounted issuance. • The cumulative stated dividend rate over a specified period, say at the end of the five years. • The cumulative participative dividend rate over a specified period, say at the end of the five years. • The return of principal by the investor if “Called.”

When pricing the participating preferred stock, one analyzes the stated dividend and participation cash flow over a specified period—say at the end of the fifth year—to arrive at total, cumulative cash flow. That total, cumulative cash flow plus the par value of the participating preferred stock would produce an “aggregate end-value.” That aggregate end value—compared with the beginning value or original issue price—will determine the IRR if you priced and issued the preferred stock at a $100 par value per share and the aggregate end-value per share was $1,000, which included the principal paid back to the investors. By the exercise of a call-feature provision at the end of five years, the estimated IRR would be 58.49%. If the given rate of return was acceptable to the management team’s private-capital contacts for the risk involved in holding that illiquid security over that period, that would constitute the price. Since there is less risk with the ownership of a preferred stock than a common stock, maybe a participation and/or lower-stated percentage that illustrate an estimated IRR of 37.97% would be acceptable.

You can only estimate the IRR using the above formula if the participating preferred stock has a call date at the end of the period and your pro forma financial projections illustrate buying back those shares by exercising the call feature. You need to disclose that the exercise of the call provision is “planned” by the company, as the call provision of the preferred stock is the option of the issuer not the shareholder. (The preferred shareholder cannot assume that the principal will be returned.)

If you do not exercise the call feature, you would only use the total cumulative cash flow—leaving out the return-of-principal amount—to arrive at the aggregate end value, which would greatly reduce the estimated “realized” IRR figure. If you do not illustrate a call date in the pro forma financial projections, part of the IRR technically becomes “unrealized,” which gets confusing to investors. Remember, you can “Call” the preferred shares any time after the call date, as the call provision is at the pleasure of the issuing company. Technically speaking, the call date is known as the “call-protection - 118 - Copyright © Commonwealth Capital, LLC 2003-2019

date,” as it protects the investor from being forced to sell his/her preferred shares back to the company in the case of falling interest rates. If the call date is five years out, the investor knows they have locked in a certain rate-of-return expectation for five years. This is because the issuing company cannot force the investor to sell their preferred shares back to the company for five years.

The Convertible Participating Preferred Stock

When pricing Convertible Participating Preferred Stock or Units, one analyzes 5 components: • The price of its original or discounted issuance. • The cumulative stated dividend rate over a specified period, say at the end of the five years. • The cumulative participative dividend rate over a specified period, say at the end of the five years. • The return of principal by the investor if “Called.” • The value of the equity upon conversion into common equity—at the end of the conversion period, to arrive at a total, cumulative, aggregate end-value for conversion under 2 scenarios, staying private or going public.

To calculate the IRR, one would compare with the beginning price or “par value” or a discount from par, of the preferred equity, plus the total, cumulative, aggregate cash received from all dividend payments, plus end-value of the preferred equity, to determine the estimated IRR. For instance, if you priced and issued the preferred equity at $100 par value per share and the aggregate value per preferred share was estimated to be worth $200 (equity-conversion value plus cumulative dividends) at the end of the 5th year, the estimated IRR would be 13.99%. If that is acceptable to your private-capital contacts based on the risk profile of your company and for the risk involved in holding that type of security over that period, that would constitute the price.

Only the current yield (or if discounted the yield to call) can be stated in a tombstone ad for advertising when soliciting Convertible Preferred Equity, not the IRR.

Relax. Using CapPro™, available to you in the Corporate Engineering Conservatory™ you’ll get the job done quickly and accurately. What used to take weeks, now only takes hours and what used to take hours, now only takes seconds.

Chapter 11: Attracting Capital: Warping the Risk - Return Continuum

As you may recall, there may be many motivating factors that investors have when making investment decisions. However, there are only two primary fears investors have: 1.) The fear of investment capital (or hope) loss (principal risk) and 2.) The fear of missing out on a great investment opportunity (opportunity risk).

View your securities offering from the perspective of the investor. To do so, you must know about investment risk vs. return. Risk and return go hand-in-hand. The higher the risk the higher the return potential should be. Every savvy investor knows this. Your job is to shift the risk of investment capital (or hope) loss to the fear of missing out on a great investment opportunity, which is most effectively done through proper corporate engineering.

Inflationary Risk. The risk of purchasing power erosion in the currency you hold (or securities are exchanged into) or will receive. Every investment has some form of risk. Federally insured certificates of deposits and interest-bearing bank savings accounts have risk—not necessarily principal or interest-payment (aka credit) risk but inflationary risk. If you are receiving 3% on your money in a two-year CD at the bank and if your combined state and federal marginal tax bracket is 33%, you net out about 2%, after tax. If inflation were to rise to 5%, you would actually be losing 3% (2% Real Return -5% Inflation =-3% Net Purchasing Power Return) on your money in the form of purchasing power. Normally, most companies will not be affected by inflationary risk, unless you’re mining precious metals or other inflation sensitive assets as an Operating Company or acquiring those assets in a Fund.

Principal Risk. The risk of losing all or a portion of the total original amount of an investment. Swinging the pendulum back, one may view investing in penny stocks, options on futures contracts, foreign currencies, or other derivatives as high-risk concerning investment principal, but with potentially very high-returns. These types of investments generally have a higher return potential to make up for the higher principal risk. In general, risk and return potential go hand-in-hand. The higher the principal risk one takes on in an investment, the higher the potential return should be. Although the company itself may not be the direct subject of principal risk, its securities, used to raise capital, will most definitely be.

Opportunity Risk. The risk of not investing in an investment opportunity when presented. The securities of your start-up or early stage company most probably will not be subject to inflationary risk, but may be viewed as very high in principal risk by most savvy investors. Therefore, a very high return potential must accompany the purchase of your company’s securities to justify the risk of investment principal. But the high return potential should not be too high, otherwise it becomes inherently unbelievable or a “too good to be true” scenario. The trick to attracting capital for start-up and early stage companies is to reduce or mitigate principal risk through proper corporate engineering. By doing so, you inherently increase opportunity risk for the investor.

Your goal is to keep the return potential high, while reducing the risk, by strategically breaking down and mitigating specific risk categories. That is what’s meant by warping the risk return continuum.

The basic premise is to keep it simple and use a systematic approach to develop a comprehensive capitalization plan, which illustrates a series of securities offerings that provide for realistic exit strategies. Properly done, this strategy should recycle previous investment into subsequent rounds.

RISK MITIGATION

If you want to attract serious capital, you must mitigate risk of an investment in your Company and its securities. There are three, critical types of risk you cannot control, but you can mitigate or limit—operational risk, financial risk, and litigation risk.

Operational Risk

You mitigate operational risk in your Company with well-thought-out future operating budgets. Revenue expectations and Cost of Goods (or services) Sold should be very conservative, as well as the General and Administrative Overhead and Capital Budgets. Underestimate Revenue and Overestimate Expenses is the rule when producing pro forma financial projections. You want an investor to look at the financial assumptions and think, “Wow, this looks real!”—not some proverbial hockey- stick graph to the stars. In addition, you mitigate operational risk by providing budgets to cover intellectual property (“IP”) development and protection. You further mitigate operational risk through budgeting and paying for insurance premiums, such as General Liability Insurance, Key Person Insurance, Directors & Officers’ Liability Insurance, Errors & Omissions Insurance, as well as Lawsuit Insurance.

As the corporate engineering process unfolds, you learn to adjust (or completely change) the mode of operation to mitigate operational risk. When addressing the mode of operation, for instance ask yourself the following: ‘should I actually be building a company, or should you be licensing or selling the Company’s technologies; can I build 100% of my sales force through affiliation networks; and can I build my management team, with real equity partners, by attending the right conferences?’ The process of examining, rethinking, and then changing the mode of operation with regards to how your Company will conduct business and grow is designed to enable you to reduce operational risk to the lowest degree possible. “Lean and Mean” is not just a business cliché, it’s first the way of survival then becomes a position to thrive. You will learn this as you move through the actual Financial Architect System™ within the Corporate Engineering Conservatory.™

Financial Risk

Financial-risk mitigation involves lowering the risk of owning the securities that are being sold to capitalize your Company. You mitigate financial risk with proper capital - 121 - Copyright © Commonwealth Capital, LLC 2003-2019

budgeting and through the issuance of hybrid securities (convertible notes and preferred equity) that protect investors’ interests first. Hybrid securities normally are temporary or short-term investments by nature; therefore, they achieve the goal of financial-risk mitigation because of a liquidity event for the security itself, as opposed to a need to sell the company issuing the security as an exit strategy.

One also achieves the goal of financial-risk mitigation by creating and issuing securities that put the investor first in liquidation preference if the company fails and goes through bankruptcy. One further achieves the goal of financial-risk mitigation by enabling short-term immediate return, or cash flow, to the holders of the hybrid securities by issuing interest (in the case of selling short-term bridge loans—Notes) or dividends (in the case of selling preferred equity). You set the interest or dividend rate to the degree you want to attract investors—and to the degree you can live with. In addition, by planning and executing a listing of the hybrid security on a publicly traded securities exchange, you have essentially reduced financial risk to the investor(s) to the lowest degree possible.

Creating a 5-year capitalization plan, using hybrid securities with different deal structures, with a rolling forward strategy, reduces the financial risks of the securities being sold while maintaining the high-return potential for the investor. A rolling forward strategy means using the proceeds of one securities-offering to replace a previous securities-offering. For instance, raising $5,000,000 in preferred equity and using $1,000,000 out of those proceeds to pay off previously issued short-term Notes, is a form of this strategy and is perfectly legal as long as it is properly disclosed with the securities offering documents that are used to raise the $5,000,000 in preferred equity.

For instance, imagine investing in a new company or project in the following manner. You invest $1,000,000 for 20% of the company’s common equity, but you lose 80% of your investment immediately due to dilution of founders’ shares. (Only a fool invests where dilution is present.) Or you invest $1,000,000 by buying 100, $10,000 1- year convertible bridge notes. Once the notes mature, you roll over the $1,000,000 into a participating preferred stock being offered by the company that returns 10% in stated dividends and your portion of the offering participates in 5% of net profits of said company. By selecting this combination as your Company’s deal structure, you would have reduced financial risk while maintaining a high, potential return.

However, those tactics listed above are micro-tactics of financial-risk mitigation from an investor’s perspective. Financial-risk mitigation from an entrepreneur’s perspective is on a macro-scale. Tactical financial-risk mitigation stems from the position inherently available only through a securities offering, which enables many investors to invest relatively small amounts of their discretionary investable funds in your company. By doing so, if your company does fail, and millions of dollars are lost collectively, that business failure is not a hardship on any one individual investor. This macro-tactic is also a way to mitigate civil-litigation risk, as well. Who sues for $1,000, $5,000, or even a $10,000 loss?

Litigation/Regulatory Risk

There are actually many different types of litigation and regulatory risks, which are not mutually exclusive, in that one civil suit can lead to regulatory fines and other forms of punishment and vice versa. Regulatory risks stems from one or more non- compliant acts. Simply comply with regulations with documented legal counsel oversight (make sure you can prove it) to mitigate most regulatory risk. Reliance on opinion of legal counsel is an affirmative defense in regulatory proceedings.

Civil and criminal litigations are two categories all other types of litigation risk fall under. In Capital for Keeps, Russell C. Weigel, III, Esq., gets into the gritty detail of this subject matter; but he summarizes here for your benefit, so we’ll leave this area to Russ—as appropriate.

LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

Keeping investors happy may seem to be an improbable proposition, but attempting to do so is a primary means of avoiding litigation. Certainly, investors sue great companies and highly profitable companies all the time. Some of these suits can be characterized as being opportunistic, but others probably are the results of investor expectations not being met. How can you meet investor expectations?

I think there are four general ways to meet expectations: (1) know what the expectations are and exceed them, (2) deliver on promises, (3) communicate frequently and truthfully, and (4) continually strive to provide increased-investment value. Any company that is managed with a focus on these four items may not avoid all lawsuits but at least will reduce their probability.

Know and Exceed Expectations. Management should always know what the expectations are in the minds of those who have entrusted them with their investment funds. Obviously, as a general rule, investors expect management will take reasonable steps designed to increase investors’ returns on investment. However, I’ve seen many times, and to my surprise, management takes a contemptuous view of their investors. Such managers must think investors are hostile and greedy. There is certainly a basis in truth for that perspective, and I do not suggest that perspective to be irrational. We have a litigation culture in this country. Private enterprise is the frequent target of governments, lawyers, and class-action suits, social groups, environmental groups, labor groups, politicians, news media—the list goes on. How management treats its employees and vendors may serve as a telltale of how it will treat investors. A management culture that is growing a healthy corporation and well-run enterprise from within will almost inevitably have a beneficial outlook on the treatment of investors. A great place to work should mean the enterprise is a great place to invest. In my view, investors have low expectations; so every point of contact with them that is a positive experience is likely to exceed their expectations and promote a feeling of well-being. The corporation that executes investor relations well should implicitly be inoculating itself from the prospect of avoidable negative publicity and lawsuits.

Deliver on Promises. Each person who communicates with prospective investors is personally liable under state and federal securities laws. If you promised investors something and failed to deliver on it, the broken promise is likely to be the basis for a lawsuit premised on investors’ claims of reliance on your promises and their inducements to tender their funds to you. Even if you state in writing to prospective investors that you and your company are making no representations whatsoever to induce the investors to invest, you and your company continue to have an inescapable duty of good faith and fair dealing or a fiduciary duty to investors. You can execute this duty easily and effectively and within the protections of your business judgment if you keep track of what you said and do what you said you would do or exceed it.

Frequent Truthful Communications. For example, public companies are required by the federal securities laws to make and disseminate current, quarterly, and annual reports of financial and other material information. All of this information is required to be truthful and accurate. By the same token, a private company should consider the merits of frequent, truthful communications if it does not have legal obligations to report to the public and to the shareholder base. Having a system in place that ensures investors are receiving regular and balanced updates on the company’s performance will go a long way to building up the investors’ confidence in the company. Even if the news is all bad, it would be better for you and the company to be the ones who are the first to tell the story before others tell it and put their own spin on it. The truth will come out eventually anyway, whatever it is. Take the high road and disclose information investors want to know—don’t sugarcoat the news. You are striving to be credible, and you want the investor base to be conditioned to know it can rely on the company’s version of events in good and bad times.

Deliver Increasing Value. Most public-company executives understand one of their primary duties is to ensure shareholder value is maximized. Private-company executives need to have a similar mindset. While business cycles may make it impossible to always deliver increased earnings per share, this should always be one of private-company management’s goals. Again, this goes back to the understanding when you have the control of investment funds provided by others, you need to act in their best interests ahead of your own interests or the interests of the corporation. If you have this mindset and can demonstrate the steps you take consistently to maximize shareholder value (even if you do not avoid lawsuits), you’ll be in a better position to defend them.

Without belaboring the point: Do this right the first time and you’ll mitigate all three litigation risks as much as can practically be expected, which inherently increases your probability of capital attainment to the highest degree possible.

RETURN MAXIMIZATION.

Conservative Pro Forma Financial Projections

It is critically important to remain conservative in your pro forma financial projections. We suggest you understate your annual revenue projections and overstate your cost of goods sold or services delivered; general and administrative expenses; as well as capital budgets. The performance, determined primarily by gross and net operating margins (and annual increases thereof) of the company is one thing and the Internal Rates of Return (IRRs) of the various types of securities to be issued in another.

Internal Rates of Return of Securities.

Although somewhat dependent, the IRRs of hybrid securities, such as; convertible notes and or convertible preferred equity, are separate and distinct from overall company valuation and therefore common equity performance. The point is, project overall company performance conservatively as possible, and then adjust the attributes (interest or stated dividend rates, conversion rates and participation rates) of the securities (convertible notes and or preferred equity) to enhance the IRRs for the security to be sold to raise capital. Let the hybrid securities do the job of enhancing returns, as well as mitigating financial risk.

Illustrate Various Scenarios.

The IRRs of convertible notes and or preferred equity should illustrate 3 separate end game scenarios, as follows: 1.) Based on full maturity of the notes or “Call” of the preferred equity; 2.) Based on full conversion of the notes or preferred equity into the common stock– privately held; and 3.) Based on full conversion of the notes or preferred equity into the common stock – publicly traded. Not to worry, we got you covered as CapPro™ within Financial Architect™ automatically accounts for all three scenarios.

Enhancing Returns.

Can you offer higher returns to investors for larger investment amounts? The answer is yes, as long as it’s fully disclosed within the securities offering documents. This includes the securities offering documents to be used for offers outside a Regulation Crowdfunding portal, as well as on Form C for crowdfunding offering, inside a Regulation Crowdfunding portal, if crowdfunding is necessary. The IRRs (as illustrated for all three scenarios previously mentioned) for the securities offered are normally standardized at the Original Offering Price. One doesn’t adjust the IRRs for larger investment amounts. One either offers “volume discounts” or additional benefits for larger investments.

For instance, you can offer share or note price discounts on securities based on larger investments, thereby enhancing the IRRs. However, by doing so, you may alienate smaller investors, but that is easy to deflect in that the smaller investor doesn’t want to be the only one to invest, so attracting larger investors can be seen as a plus. You can also bonus for larger investments. If you recall, when our CEO built the 18-hole championship golf course in 1993, they gave away “goodies” for various amounts. As you may recall, for a $200,000 investment, investors received $200,000 worth of fully - 125 - Copyright © Commonwealth Capital, LLC 2003-2019

diluted common stock, a charter membership worth $25,000 and 3 building sites worth $65,000 each. That’s an immediate $220,000 or 110% return, with no out-of-pocket cost for the firm, as the building sites were developed by another entity and he made that entity give us 23 building sites as part of the right to build.

In addition, it’s not unusual to offer directorship positions for larger investments. Due to the fact that directorship positions come with executive compensation packages, including cash and equity, awarding the position inherently and immediately enhances ones return on investment.

Ignite The Offering.

You can offer discounts to share, unit or note prices based on entry level timing, as well. For instance, a $1,000,000 offering of seed capital, whether notes or preferred equity is a lot of money for most start-ups. Most investors are leery about becoming the “only one in the pond.” There’s more risk for the first $100,000 invested than the last $100,000 invested. You can offer price discounts on those securities based on the timing of entry. For instance, one may offer a 20% discount for the first $250,000, a 15% discount for the next $250,000, a 10% discount for the next $250,000 and 0% discount for the final $250,000. You do run the risk of not being able to sell the final $250,000, but you most likely will have raised $750,000, so you may want to plan on not receiving the final “tranche.” However, if you make enough progress with the $750,000 investors may clamor for the last $250,000, as there would be a lot less risk.

Remember, any such arrangements as mentioned previously must be fully disclosed in your company’s securities offering document to avoid claims of securities fraud.

The two most popular deal structures for start-up and early stage companies (convertible notes and or preferred equity), derived by proper corporate engineering, slightly change the risk-return continuum for the benefit of the investor. These deal structures allow for maximum upside while minimizing the downside. You can get creative with these structures by themselves or in combinations with each other.

Chapter 12: The Two Most Popular Deal Structures for Start-Ups

1. The Seed Capital Convertible Bridge Note™. This security was created specifically to meet an unusual demand by our portfolio company candidates. On occasion, some of these folks would call and say, “I have these investors standing around my office trying to invest in my company, but I don’t know what to do; how much of the company to give them; and how to legally take their checks. Can you help?” One Wall St. rule of thumb: “Take the Money.” (But do it legally so you don’t have to give it back.)

In General:

From both the entrepreneur’s and investor’s viewpoint, a Seed Capital Convertible Bridge Note comes as close to a perfect security as one can create. This structure works well for seed, as well as first-stage development-capital, especially if your new company or project is not bankable. The structure is effective, especially for a Start-Up, because the Notes are convertible into common equity, which benefits investors if and when the company becomes successful, but commands a first lien position against the assets of the company if liquidation were to occur—forced through bankruptcy or otherwise—that senior-secured bank debt would normally command, while they wait. If your Company or project is bankable (i.e., the plan includes the purchase of real estate and/or real property, machinery and equipment, or your Company has current receivables and marketable inventory), you could still use the Seed Capital Convertible Bridge Note structure for a seed capital offering, but it would need to be subordinated to the bank debt. If so, it would have, not a first lien on assets, but a forward lien.

No bank, we know of, will allow any sharing of the first lien position against assets with any previous or joint creditors (Noteholders). So, if you felt you needed to keep the Seed Capital Convertible Bridge Note in a first lien position, just keep in mind that you would eventually need to use the newly acquired bank debt to pay off the seed capital investors (Noteholders). This would work well if the investors do not mind taking a second position on liquidation rights. It may be wise to illustrate the Note pay-off with the use of bank debt or equity trough a subsequent securities-offering, within the Seed Capital Convertible Bridge Note documents to further strengthen your exit strategy for the Noteholders. Offering convertible preferred equity, with a stated and participative dividend, to the Noteholders through a subsequent securities-offering, may enable you to keep them in the deal by recycling the Notes proceeds into the preferred equity. The Noteholders could simply redeem their Note principal, with or without accrued interest, to the purchase of convertible preferred equity. They can re-invest their Note proceeds (at any time prior to or on the Note maturity date), which essentially pays off the Notes with preferred equity securities, as opposed to cash. Typically, to obtain a substantial amount of bank financing, you would need to provide a substantial amount of equity as a pre-requisite to bank financing. You could raise equity capital through the issuance of common or preferred stock first, but remember you need to disclose the bank debt as the 1st lien position on assets. Then you would have the minimum amount of equity required to secure the debt component through bank loans.

In general, Seed Capital through the issuance of debt, should be kept at a minimum. Too much debt could be detrimental to a new company. (The inability to make the interest and/or principle payments in a timely fashion could force a young Company into liquidation.)

Seed capital should only be used to cover your Company’s overhead expenses associated with initiating the overall organizational design and capitalization structure— as well as any other important action items to further protect your investor’s capital contribution, such as securing patents on previously developed intellectual property. Most importantly, seed capital should be employed to cover the costs associated with raising “Development Capital.”

Seed Capital Convertible Bridge Notes™ may not be the appropriate deal structure for a development-capital round of financing if you have already secured bank debt or any other debt with the first-lien position against the company’s assets and/or you have already raised capital from friends and family. If so, it may be appropriate for a development-capital round of financing with the use of preferred equity.

The interest rate and maturity are the only attributes of any type of debt that you can legally advertise. The interest rate is the only attribute that can be advertise to illustrate the expected return though.

No Dilution.

Issuing Seed Capital Convertible Bridge Notes does not create immediate dilution of the price of the security owned by the investor or dilution of votes (control) for the entrepreneur until and unless the Notes are converted into common equity.

2. Convertible, Participating, Cumulative, Callable Preferred Equity. A preferred stock for C corporations or preferred membership unit for an LLC, with the additional features listed below, becomes as close to a perfect security as one can create—from both the entrepreneur’s and investor’s viewpoint. It’s truly a win-win deal structure, as you will shortly realize. Actually, the default deal structure within Financial Architect™ is engineered for—and termed as—a “Convertible, Participating, Cumulative, and Callable Preferred Stock.” For simplicity’s sake—and for this explanation—we’ll keep it termed as Preferred Stock.

In General:

The preferred stock, as a deal structure, works well for seed, first, second and third-stage development—or expansion capital securities offerings—especially if your new Company or project is bankable. From an accounting perspective, preferred stock is considered equity and is reflected that way on your Company’s balance sheet, which further enables you to acquire bank debt, if necessary. However, preferred equity is considered a hybrid security resting between common equity and debt.

It is always wise to replace one first lien holder with other first lien holders, in a rolling forward fashion. For instance, Seed Capital Convertible Bridge Notes™ (original first lien holders) upon Note maturity date, are replaced by Convertible, Participating, Cumulative, and Callable Preferred shareholders (next first lien holders) upon the Call Date, are then replaced by traditional Bank Debt (final first lien holders).

In regards to liquidation preference—in the case of selling, unwinding, or bankruptcy of a company—a preferred stock is a hybrid security, which is placed between common-stock equity and debt in the form of bank loans, notes, or bonds. Upon liquidation, before common-stock shares receive any payment, preferred-stock shares are paid off only up to their par value or original issue price—same thing—plus any accrued dividends/cash distributions held in arrears. But preferred shares are subordinate to any debtors. This means they hold a liquidation position behind general creditors—i.e., noteholders, bond-holders, vendors, and banks are paid first. For simple valuation purposes, preferred-stock shares are valued at “par value” or at “conversion value” (the value they would be if fully converted into common stock)—whichever is higher. Most start-up and early stage companies should seriously consider issuing enough preferred stock to eliminate all current debt and remain debt free, thereby making this security a first-lien position on the company’s assets. By doing so, you increase the probability of funding.

More importantly, one can attach different attributes or “provisions” to create different “types” of preferred stock to form a “series” if needed. One can easily engineer a preferred stock to meet all the individual-investor-market demands while maintaining the maximum common equity ownership and voting control.

No Value Dilution.

Issuing preferred stock does not create immediate dilution of the price of the security owned for the investor or dilution of votes (control) for the entrepreneur until conversion into common equity.

By its very nature, preferred stock holds a forward position on liquidation rights (first lien in the absence of secured debt) over any common stock. Hence, there is no dilution of assets for the preferred shareholders. For instance, if one were to sell 30% of the company’s common-equity ownership to investors for $1 million, with little or no tangible assets prior to its issuance—including cash—the investors’ net assets per share would be diluted by 70% or the balance between 100% ownership and the 30% they do own. In other words, they invest $1 million and end up with only 30% of the company with current assets of essentially only $1 million, which would mean they now own only 30% ($300,000) of the $1 million in cash they just invested. They immediately lose $700,000 or 70% of their assets—not so if those investors purchase preferred stock. Because the preferred shareholders’ assets are forward to common stock on liquidation, in the absence of secured debt, the preferred shareholders inherently still retain $1 million in net-asset value on their preferred shares.

No Voting Dilution.

Another benefit for companies issuing a preferred stock is preferred stockholders generally have no “operational” voting rights, so control of the company can further remain in the founding principals’ hands.

Within a Corp.’s By-laws and Articles of Incorporation and an LLC’s Articles of Organization or Operating Agreement, you may create a Class B non-voting stock or membership interest—termed “Preferred Unit”—to serve the same functions for an LLC as a preferred stock does for corporations. You must originally style the preferred equity, with various attributes, within the Corp.’s By-laws or Operating Agreement. Editable Operating Agreement & By-law templates are available in the Corporate Engineering Conservatory™ to help you style preferred equity for your LLC or corporation.

Cumulative Stated Dividends.

Preferred stock not only has limited voting rights and a forward-lien position ahead of your Company’s common stock on assets, it generally has a stated dividend. What that means is the preferred stock may “state” a dividend, as opposed to common stock, which must be “declared” by the company’s Board of Directors. For example, a preferred stock could “state” in its indenture—the language on the actual preferred-stock certificate—that the preferred stock carries a seven-dollar-per-year dividend ($7.00) on a par value preferred stock of $100 per share. That stated dividend represents a 7% annual yield or return—normally paid quarterly—and is due and payable whether the company has net earnings or not. If there are no earnings or cash flow sufficient to be declared by management, if cumulative, the stated dividend amounts will accumulate until paid.

We suggest the stated dividend for any participating-preferred shares be cumulative. That means that preferred dividends that are not paid in cash or re-invested into preferred equity cumulate until paid. In such a case, no dividends can be paid to the common stockholders until all stated dividends, held in arrears (past dividends that are due but not yet paid) are paid to the preferred stockholders, first. The dividends accumulate—accrue as a liability on the balance sheet—if not paid on schedule. Actually, your capitalization plan can illustrate accumulating the dividend for one or two years before payments begin. This would help your Company’s cash flow stay as positive as possible during the early years of its existence. However, most preferred stockholders want their dividend payments, so if your Company’s operational plan will not be able to provide enough cash flow to pay the stated dividends in the early year(s), it may be wise to over capitalize your Company to pay those dividends out of principal on a timely basis. As long as it’s properly disclosed within the securities offering documents, it’s legal.

The stated dividend, participation & conversion rates and call date are the only attribute of any type of equity that you can legally advertise. The stated dividend is the only attribute that can be advertise to illustrate the expected return though.

In addition, unlike general creditors—e.g., banks, noteholders, or bondholders— preferred stockholders cannot force your Company into bankruptcy or liquidation for defaulting on dividend payments, especially if those payments are cumulative.

Cumulative Participating Dividends

A participating preferred stock has more return potential because it “participates” in a small percentage of net earnings. For instance, a $5 million preferred equity offering, as an aggregate amount, may participate in 10%, 15%, 20%, 25%—or possibly as high as 50% of net earnings of a company.

In the early stages, the participation rate can become expensive if you’re not careful. For instance, if your Company’s capitalization plan requires that you raise a large amount of equity—e.g., $10 million you may need to provide a 50% participation rate to make the offer attractive. But if the $10 million can be spread over a few years, we would suggest running the numbers on two consecutive $5 million preferred equity offerings with different participation rates. One would issue a Series A $5 million preferred equity offering then a subsequent Series B $5 million preferred equity offering to accomplish the following strategy.

For instance, in the 1st tranche, we would engineer a higher stated dividend of 9% with a higher participation of 20% of the company’s net earnings, than for the 2nd tranche. For the second scenario, we would engineer a lower stated dividend of 7% with a participation rate on the company’s net earnings of 10% because that later round of $5 million in capital will have less risk, a lot less risk, than the original $5 million. The total participation rate for the $10 million spread out over time with 2 tranches would only be 30% as opposed to 50%.

In addition, the IRRs on the 2nd $5 million may be slightly larger than the 1st $5 million even with a lower stated and participative dividend, because the cash flow that determines the IRRs on the 1st $5 million will be spread over 5 years—one or two additional years more than the 2nd $5 million. Proper engineering would bring the IRRs for both tranches closer together. You want the 1st set of IRRs to be slightly larger than the 2nd set of IRRs for the 2nd tranche because the 1st tranche investors are taking on more risk.

We suggest the participating dividend for your participating preferred shares be cumulative as well.

The “Call-protection” feature.

The preferred stock can, and normally does, include what is termed a “Call” feature. This feature allows you to “Call” or buy back the preferred shares from those preferred-stock shareholders after a certain period of time (The Call-protection Date) and at a pre-determined price (The Call Price). It’s generally at a slight premium (The Call Premium – 10% in this case) above its par value or issued price and expressed as a - 131 - Copyright © Commonwealth Capital, LLC 2003-2019

percentage of par value ($100)—e.g., 110% (The pre-set Call Price). The Preferred Equity’s Par Value plus the Call Premium equals the Call Price.

You can “Call” the preferred shares any time after the Call Date, as the Call provision is at the pleasure of the issuing company. The “Call provision” with preferred equity, allows you to replace expensive financing with less-expensive financing, such as bank debt or another series of preferred stock with a lower-stated dividend and/or participation rate.

Technically speaking, the Call Date is known as the “call-protection date.” The call-protection date protects the investor from being forced to sell his/her preferred shares back to the company. This would be the case of falling-interest rates in the general economy—whereby the issuer could re-finance with low interest rate bank debt to lower the cost of capital and eliminate any participation or conversion rights. If the Call Date is five years out, the investors know they have locked in a certain rate-of-return expectation for five years, because the issuing company cannot force the investor to sell back their preferred shares to the company for five years. Therefore, the issuing company can Call the stock any time after the call-protection date. By stating a Call Date, as the issuer, your Company has the option to make the preferred stock temporary or permanent equity as opposed to only permanent equity. The preferred stock becomes temporary if Called, any time after the Call Date, it stays permanent equity if never Called or if converted into common equity.

Let’s say in year four, your net-ending cash balances are projected to be $1.4 million. You would then be able to formulate a Call of your preferred-stock shares to coincide with a Call Date at the end of year four to be called at 110% of par or face value. Let’s say you sold $5 million worth of the Series A preferred stock. To Call the Series A preferred stock at the end of year 5, you would need to pay $5.5 million (110% of par) to the preferred shareholders. You would need to either borrow the $5.5 million from a bank and/or raise additional equity (common stock or a Series B preferred stock) to pay off the Series A preferred stock plus enough capital for a sufficient net-ending cash balance for the end of the 5th year.

You will also need to predict net-ending cash balances (consolidated statement of cash flows) conservatively before you set the Call Date and the Call Price for the issuance of those preferred shares, so that your Company can illustrate its ability to afford the exercise of the Call feature. However, you can illustrate in your pro formas obtaining bank debt to call the preferred shares as well.

The Conversion Option.

The preferred stock may include a conversion right, giving the preferred shareholders the right to convert anytime up to the Conversion Expiration Date. Normally the Conversion Expiration Date coincides with and is the same date as the Call Date. Although one can set the Conversion Expiration Date to be any date, when it coincides with and is the same date as the Call Date. It tends to force conversion into the Common - 132 - Copyright © Commonwealth Capital, LLC 2003-2019

Class A voting or Common Class B non-voting stock —priced right a very good thing. Remember, the investor has the option (but not the obligation) to convert into a pre- determined number or amount of Common Class A voting or Common Class B non- voting stock, which ever you choose prior to issuance.

The participating preferred stock may be convertible but does not necessarily need to be. The participating preferred stock, without the conversion feature, is generally attractive enough for investors when dealing with start-up, early stage, and seasoned companies; however, with conversion feature it’s especially attractive to investors if there is a real possibility of an aggressive buyout of the issuing company through merger or acquisition. If the company were to receive an unusually high buyout offer, without the conversion feature, the preferred stockholders would simply receive the par value or original purchase price and any accumulated dividends for their preferred stock. If, on the other hand, there is a conversion option as part of that preferred stock issuance, the preferred stockholders could elect to convert their preferred stock principal and any accruing preferred dividends, into the company’s common-stock. Obviously, in this scenario, the buyout price would need to be high enough to warrant conversion into the pre-determined common-shares amount.

Tax Advantages.

Currently, 50%–65% (depending on the amount of investment and percentage of ownership stake purchased) of any dividend payments from any form of stock, including the preferred stock’s stated and participating dividends, made to C corporations (as corporate or strategic investors) from other C corporations (your C Corp. if you have one) are excluded from the preferred shareholder’s taxable income. This is known as the “Dividend Exclusion Allowance.” This tax advantage encourages larger companies to invest in smaller companies. Both the stated and participating dividends should qualify for the tax exemption. Tax laws can change, so be sure to double check with your accountant before making that claim—if at all. (It may be wise to verbalize it in a sales presentation, rather than writing it on a securities-offering document.) Keep the Dividend Exclusion Allowance in mind when seeking a strategic alliance (other corporations) to invest in your start-up or early stage “C” corporation. Always be sure to check with your tax advisor before making any such claims in your securities-offering documents.

Legal Preparation.

Before issuing any preferred shares, you must amend your corporation’s Articles of Incorporation or LLC’s Articles of Organization, to reflect the total amount of preferred stock that you want authorized and the provisions to be included in the preferred shares. Be sure to conduct a shareholders’ or directors’ meeting to approve the issuance of any security before its issuance. Even if you own a controlling interest—51% or more of the voting equity—you need to have a meeting in accordance with your corporation’s By-laws or LLC’s Operating Agreement with yourself and enter it in the minutes. It may be wise to have a shareholders’ meeting and discuss the deal structure(s) you’re considering, for two reasons: (1) to get feedback, which may be helpful as a - 133 - Copyright © Commonwealth Capital, LLC 2003-2019

preliminary testing of the waters and (2) to get political support—i.e., referrals from your current investors, if any.

Remember, preferred stockholders generally have no “operational” voting rights, so voting control can further remain in the hands of the founding principals. However, according to many states’ laws, preferred stockholders generally have a “provisional” voting right. This means any preferred shareholder could possibly change the original provisions of the preferred shares—i.e., its “attributes.” Such radical changes generally require a unanimous vote of existing preferred shareholders. Individual state statutes mandate this rule for entities organized in their given state. You will need to check with your legal counsel before even considering a change to any preferred-stock attributes after its issuance. To easily block any attempt to change the above attributes or provisions issued by unanimous vote, it may be wise to personally purchase at least one share of the preferred stock if the unanimous-vote rule exists in the state where your organization filed its Articles of Incorporation or Organization.

Why issue preferred shares? Most start-up and early stage companies would do well by choosing to issue Preferred Stock/Units, with all the aforementioned attributes for their equity capitalization needs prior to an initial public offering. When properly engineered, preferred stock will sell better than any other type of security.

The trick to deal structuring with preferred equity is to arrive at the “sweet spot” by using all the attributes of the preferred equity to arrive at a 3 tier scenario or ascending IRRs, as illustrated below. As the last comment to be made, the participating preferred stock is probably the most valuable tool for your start-up, early stage, or even for seasoned companies—because it fulfills the demands and expectations of both the entrepreneur and the investor.

Privately Held - IF CALLED - No Conversion into Common SERIES -A- PARTICIPATING PREFERRED UNITS Year 1 - 2019 Year 2 - 2020 Year 3 - 2021 Year 4 - 2022 Year 5 - 2023 Stated Distributions per Preferred Unit $ - 3.54 7.08 7.08 7.08 Estimated Participation Distribution per Preferred Unit - 0.19 4.56 19.06 50.43 Estimated Principal Value per Preferred Units $ 110.00 Estimated Total Cash Distribution per Preferred Unit by Year $ - $ 3.73 $ 11.64 $ 26.14 $ 167.51 IRR Estimated Total Cash plus Unit Value Return $ 209.02 19.81% $100,000 Investment Example - Estimated Total Return $100,000 $ 209,020 Privately Held or Sold - Conversion into Common SERIES -A- PARTICIPATING PREFERRED UNITS Year 1 - 2019 Year 2 - 2020 Year 3 - 2021 Year 4 - 2022 Year 5 - 2023 Stated Distributions per Preferred Unit $ - 3.54 7.08 7.08 7.08 Estimated Participation Distribution per Preferred Unit $ - 0.19 4.56 19.06 50.43 Estimated Principal Value per Preferred Units $ 440.00 Estimated Total Cash Distribution per Preferred Unit by Year $ - $ 3.73 $ 11.64 $ 26.14 $ 497.51 IRR Estimated Total Cash plus Preferred Unit Value Return $ 539.02 43.85% $100,000 Investment Example - Estimated Total Return $100,000 $ 539,020 Publicly Traded - Conversion into Common

SERIES -A- PARTICIPATING PREFERRED UNITS Year 1 - 2019 Year 2 - 2020 Year 3 - 2021 Year 4 - 2022 Year 5 - 2023 Stated Distributions per Preferred Unit $ - 3.54 7.08 7.08 7.08 Estimated Participation Distribution per Preferred Unit $ - 0.19 4.56 19.06 50.43 Estimated Principal Value per Preferred Units $ 605.18 Estimated Total Cash Distribution per Preferred Unit by Year $ - $ 3.73 $ 11.64 $ 26.14 $ 662.69 IRR Estimated Total Cash plus Preferred Unit Value Return $ 704.20 50.68% $100,000 Investment Example - Estimated Total Return $100,000 $ 662,694

Chapter 13: Testing the Waters

Prior to conducting a full-blown securities-offering effort, one could “test the waters.” This is done by researching the local geographical area for angel-investor interest, as well as your management team’s personal private-investor contacts, fortified with one or two prototype offering structures. This process is known as the “red herring test.” Most states do, but some states do not, allow for a testing of the waters through general solicitation—i.e., public media—so check with your legal counsel before engaging in this discovery activity in any particular state.

A Red Herring document is used to test the waters for indications of interest of a proposed securities offering. It can consist of a simple letter stating your intentions and the proposed capitalization plan and potential securities offered. It generally includes an executive summary and a summary of the proposed securities to be offered. If securities are involved, be sure you include the following disclaimer on the front page of your Red Herring document:

“This correspondence does not include an offer or a solicitation of an offering to sell securities. An offering of securities is made by Private Placement Memorandum only.” The statement has a minimum size requirement. Font size: 10 pt. minimum.

To produce a “red herring” document to seek indications of interest, simply build your securities-offering document then make it a draft by including a watermark within the document that states the following: “Draft: Not an Official Offering” so it is on each and every page. Said tactic should protect you from inadvertently making an offering of securities, where none can or should be made.

Still, there may be peril associated with simply “testing the waters.” We cover it here, because although it won’t be germane to most entrepreneurs, it may be helpful to others. Although you may think you are saving money by holding off on creating a final draft copy securities-offering document—if indications of interest are positive—you should be prepared to sell the securities quickly. If your documents are not yet finalized, it might take too long to complete them— and investor interest often fades. We prefer to strike while the iron is hot. If you agree, have your securities-offering document almost completed and ready to make any final adjustments based on your testing the waters research then make those adjustments to finalize the securities-offering document for legal counsel review, then once reviewed and finalized by legal counsel send it those who show an interest. Otherwise, it may appear you do not really have your act together—a very bad thing when asking investors for money.

These “Testing the Waters” tactics to determine indications of interest are used by Wall Street firms, on a much larger scale through their in-house sales force, but you can avoid most of the formal research by shopping for high-yield investments. Act like an investor who just received $1 million in a 30-year, 12% tax-free municipal bond that just matured. On that $1 million Bond you were getting $10,000 a month in tax-free income, and now your job is to replace that income. You are smart enough to know you should

never buy a ten-, twenty-, or certainly thirty-year bond in a low-interest-rate environment—as in the current environment. What is out there? Check on what the bank is offering for one-, two-, or five-year CDs. Call a stockbroker, or search the Internet and find out the rates that one- to five-year corporate notes or preferred stocks are trading— based on yield. Once you complete a cursory investigation, you will know how to price your Company’s securities. Just beat the yield and offer upside potential against the risk associated with your deal by designing securities that meet investor demand, and you will raise capital.

THE R&D OF DEBT CAPITAL

Traditional Debt

If debt will be part of the company’s capitalization plan, consider getting in touch with a few banks and/or leasing companies before you contact any potential equity or debt investors. Contact those institutions with a loan or lease proposal outlining your Company’s basic business plan, which should include the pro forma financial projections you will use for your securities offering. You will need to present a deal structure that uses equity and debt as the main components of your Company’s capitalization plan within the Company’s securities-offering document for raising equity. This important step is for gaining “indications of interest” from the debt side of the capital equation.

Obtaining a conditional Letter of Commitment from a bank and adding that letter to your Company’s securities-offering document for raising equity capital —or “Red Herring” document—will carry significant weight in your prototype proposal. Incidentally, a “Red Herring” document is generally used by larger publicly traded companies to detect the market’s “indications of interests” of a potential type of securities offering. “Testing the Waters” is rarely used by younger companies, due to the impracticality of the time it takes, but a simple rendition may be helpful.

Let’s say the bank requires that you raise more equity as a percentage of total capital on the table—that’s fine. You simply rework the numbers to accommodate the bank’s request and resubmit that proposal. Let’s say you are looking for $1 million in total capital. If you go to the bank and ask, “If I raise $500,000 in equity capital, will you loan me the balance?” The banker may say, “Your Company or project would be considered generally un-bankable, but if you raise $700,000.00 in equity, we will loan you the $300,000 in debt.” Simply get the signed conditional Letter of Commitment in writing then rework your pro forma financial projections to reflect that 30/70 debt-to- equity (ratio) deal structure.

We cannot emphasize enough the importance of obtaining that written and signed Conditional Letter of Commitment. If bank debt will be a large part of your capitalization plan, do not proceed without one. In an equity investor’s mind, a Conditional Letter of Commitment from a bank generally gives the equity proposal increased validity and further assurance of a successful project. This will greatly increase the response rate from - 136 - Copyright © Commonwealth Capital, LLC 2003-2019

your equity investor pool and ultimately increase the probability of obtaining the full capitalization amount.

Note: We did not say you could not move forward without a Conditional Letter of Commitment. If you cannot get one, you may want to raise the equity capital first then deposit it into an escrow account held at the bank. When you have cash on deposit at the bank, ask for the loan. Remember, banks want to lend money to those who do not need it. By having a rather large deposit in the bank, they may perceive you as not needing any large amounts of additional debt capital. That is when you can start to negotiate from a relative position of strength. Remember, you must disclose the use of debt in any securities-offering document used to raise equity capital.

The key is most banks want to help you in your quest for debt capital, especially if you are successful in raising equity capital. Ask a commercial-loan officer to forward an SBA-loan application to you. Once your Company’s securities-offering (Red Herring) document is complete, you could use the existing financial-projections data to accommodate the information needed for the loan application. Be sure to fill out the application and supplement it with your securities-offering document. Why send along your securities-offering document? It may carry some major weight in the bank’s decision-making process. If, for some reason, you are unable to get any interest from any bank on your capitalization proposal, you may want to test the waters by adding a Note or Bond offering when marketing the “Red Herring” to gauge individual-investor interest.

Notes & Bonds

Maybe creating a securities-offering document with a four-year senior-secured convertible note at 12% interest would be attractive. If you file a qualification for an exemption from registration under: Regulation D, 506 (c) (IF you limit the 506 to accredited investors only); Regulation A with the SEC and the state(s); a SCOR offering in the states where solicitation will occur; or a CA (1001) for California companies, you can advertise the interest rate and maturity in the local newspaper, normally through a tombstone advertisement. Unless you’re a convicted felon involving securities or bank fraud, as a US Citizen, you have the legal right to go around financial institutions and directly solicit US investors for a direct investment, as opposed to using a financial intermediary.

If the bank sees you are advertising and competing for lenders—the bank’s depositors—they may lend you the money, especially if you are viewed as a threat to bankers’ deposit-raising efforts for the bank. We would use this tactic as a last resort, as you will want your banker to support all your efforts. Commercial bankers can become your friends, especially when you can raise equity capital or garner affluent co-signers.

Previously, we mentioned the maxim, “Banks will only lend money to you if you don’t need it.” In a perfect world, a banker would lend money only to the very wealthy or those who don’t need a loan. By doing so, the bank would eliminate repayment risk. However, in the real world, banks must lend money to those who need it because people - 137 - Copyright © Commonwealth Capital, LLC 2003-2019

don’t have enough capital to build their company. What if you could convince your banker to introduce or refer you to a few of the bank’s wealthy customers, to obtain a co- signer on a loan and receive some carried interest and/or an equity kicker/component for their co-signature? The banker gets what he/she wants, they get to loan money to those who don’t need it, and you get what you want—a loan—but more importantly, a relationship with one or more “angel” investors. We have done a few deals, in this manner, that involved the bank—the bank inadvertently became the primary investor- referral source. It is one of the most successful capital-raising strategies available for start-up, early stage, and seasoned companies. Remember, in this phase of the process, your job is to research the different local and national avenues of debt capital.

THE R&D OF EQUITY CAPITAL

This exercise should be considered the production and distribution of a “Red Herring” document to gain “indications of interest” from the equity side of the capital equation. A Red Herring document is an executive summary to test the waters for indications of interest for a securities offering. In other words, you are able to test investor interest in a particular company and its offering, prior to spending a fortune on producing the required securities-offering documents. Please realize this takes time and may not be appropriate for your Company’s situation, due to the nature of capital needs and the essence of time for most small companies—take all this with a “grain of salt.” It may take too much time, to “Test the Waters” considering that the construction time of a complete securities offering document (that’s ready to collect funds) takes only a little extra time than a Red Herring document, does.

The executive summary of a Red Herring would include:

1) The industry in which your Company will engage and compete. 2) The problems or changes within that industry that provide the opportunity to profit from selling your Company’s product and/or service line(s). 3) The solutions your Company’s product and/or service line(s) shall provide to solve those problems or address those changes. 4) The opportunity to profit from selling your Company’s product and/or service line(s) and for investors in terms of rate-of-return projections by investing in the securities to be offered by your Company. 5) The exit strategy for the investors.

After securing a conditional-commitment letter from the bank—if appropriate— we would advise you send the Red Herring document to your management team’s personal-and-professional prospective, investor contacts that may have an interest in your Company. We would suggest you limit the number of securities-offering scenarios to one, maybe two—to limit any confusion. Be sure the scenarios are germane to the stage your Company is in (i.e., convertible note for seed capital).

Include any officers’ and/or directors’ professional biographies, with no more than 30–40 words for each team member. If you can, add an advisory board to strengthen the experience factor of your project or company. Certainly do what you can to develop real corp. Board-of-Directors or an LLC Executive Board, but you may find that most professionals will not want to sit on your company’s board-of-directors in the beginning because that position carries fiduciary responsibilities to your shareholder base, which could create a direct liability against their personal assets if the management’s actions breach that fiduciary duty. That is why an advisory board has no actual power to vote on any action of the company, as it relieves the advisory board members from a legal, fiduciary duty to the shareholders of the company. Therefore, being included on an advisory board is considered more attractive to most professionals at the early stages of a company’s existence. Your relative position of strength will elevate when surrounding yourself with those who have in-depth experience in your industry or in general management. Be sure to get written permission from each advisory board member before you add his/her biography to your Red Herring document.

Remember, only bona fide employees—primarily the officers and directors (managers for an LLC) of your Company—can legally solicit and sell securities in the company in a private offering if you cannot engage an investment bank to sell your Company’s securities. If you can engage an investment bank to sell your Company’s securities, the stockbrokers of their selling group and both your officers and directors (managers for an LLC) can sell. However, be careful to not directly or indirectly compensate any employee, officer, or director for the sales of privately placed securities. (In a private or public offering, it is against the law to do so.)

Request in the Red Herring “testing” letter that the prospective investor, if interested in a particular securities-offering scenario, simply ask the investor to contact you to set up a time when it would be convenient to discuss the investment opportunity. Try a lunch meeting. Remember, there’s nothing like a face-to-face meeting to start building the trust relationship.

When approaching investors, always exude confidence and a subtle, professional attitude that you are going to move forward and succeed—with or without them.

Under Regulation D, 506(c) (with a self-limitation of accredited investors only) or Regulation A (a limited federal and state(s) qualification for an exemption from registration), or a SCOR offering or a CA (1001) for California companies, one can submit a tombstone advertisement publication in a local newspaper to gain indications of interest, only after the advertisement has been submitted to the SEC for review and comment for (Regulation A); to the states where registration will be made for (SCOR) or to the California Commissioner of Securities for CA (1001) for California companies, review and comment. The North American State Administrators’ Association (NASAA, the state regulators) has adopted a uniform offering exemption allowing companies that are soliciting and selling securities to accredited investors only, to advertise in the general media to seek indications of interest of a securities offering.

WARNING: SOME STATES DO NOT ALLOW A PUBLIC TESTING OF THE WATERS through the general media, even though Registrations A & A+ are “qualifications” of an exemption from federal registration.

For all practical purposes, testing of the waters should be done for the private placement of seed capital to pre-existing investor contacts (friends and family). Attempting to conduct a public testing of the waters can take a prohibitive amount of time. By contacting accredited investors in this manner, you are still starting from scratch. Just because you’re ready to sell them doesn’t mean they’re ready to buy. Your response rate is going to be 1%–2% if you’re lucky.

Throughout all your Company’s present and future capital-raising efforts, you must always deal from a relative position of strength if you are going to dictate the terms of the deal. Strength positioning begins with contacting your own personal and professional capital contacts in the early stages of the capital-raising effort. You should already have a relative position of strength when dealing with those who already know and trust your character and in your ability to build and run the business.

If you research any “Fortune 1,000” company, you will find the vast majority— over 95% of them—started raising capital from friends and family before they were able to raise capital from an institutional source or directly from a mass individual-investors scale. You may be thinking it is too politically sensitive to ask friends and family for capital. As investors, we would ask ourselves the question, “If you don’t have enough confidence in your Company’s ability to succeed, to raise capital from friends and family, why should we invest our money in your Company?”

By completing the production of your Company’s securities-offering document, you should increase your relative position of strength from your personal contacts’ perspective as well. Once they see your securities-offering document—realize you wrote it (within the Corporate Engineering Conservatory™) and that you’re serious about building a quality company, they should trust in your abilities even more. More importantly, they will further trust in your character in handling the tasks of building a profitable enterprise, because you’ll actually be the architectural engineer of it.

When your company has reached $5 million or more in annual sales, whether or not has sustained a profit, (considered early stage) you can approach strategic alliances (existing companies within your industry) to sell them securities in your Company. With that relative position of strength, you should receive a warm reception. This tactic does not necessarily work in the start-up phases though. More often than not, strategic alliances tend to take too long to make a decision. Some strategic alliances may want to dictate the terms of the deal if they do choose to move forward and invest. However, when you have $5 million or more in annual sales, to maintain a relative position of strength, you should be dealing with strategic alliances that are double or triple the size of your Company, not much larger. Be mindful when dealing with any larger strategic alliances—you will start to lose your relative position of strength the larger they are compared to your company. (It’s relative!) In addition, by letting these potential strategic - 140 - Copyright © Commonwealth Capital, LLC 2003-2019

alliances know you are shopping their competitors, it may increase your relative position of strength; they may move a lot quicker in their decision-making process than they otherwise would.

When searching for capital through strategic alliances, it’s best to approach businesses or professions that understand what your Company does to make money, especially if they would inherently benefit from your Company’s existence or expansion. So look for an “inherent benefit” opportunity for the capital contact of a strategic alliance. You should ask yourself, “Who or what company would inherently benefit from my project or company’s existence over and above the benefit of investing in the project or company?”

The Corporate Engineering Conservatory™ is geared specifically to enable the entrepreneur to raise capital and maintain control of their company. Many times, a strategic alliance will make a counter offer and fund their entire operation. However, they will most likely take control of the operation and give you some equity—maybe 10% and some cash—then build the company on their own terms and conditions. Depending of course on who the strategic alliance(s) is/are, you may want to accept the deal. If an acquiring company with worldwide-distribution channels, production facilities, and the marketing budget to turn your Company into a two-billion-dollar company within five years, and wants control of your Company, it may be wiser to take that deal than to compete as a potential competitor in the marketplace with them. In this case, it may be worth more by accepting less.

This inherent-benefit position goes further toward the “dealing with like minds” concept of solicitation and sales of securities. If you have a product or a service, like a real estate-agent-referral network driven by a special software program, real estate agents may be interested in investing in your Company. (The product would directly influence their day-to-day sales volume.) The agents can better relate to its value than other potential investors would, especially if they use and love the software.

In other words, by positioning your Company (its product, service lines, and your securities offering) to those who would inherently benefit from your Company’s existence—suppliers and customers—you build a network of investors and prospective customers with the securities-offering sales effort. For instance, you could design a multimedia presentation on a DVD or “housed” in a secured securities-offering portal on your Company’s website. Either method would include the company’s story, product or service segments, and an investment-opportunity presentation. This network may feed you leads for other investors. Trying to sell software-company securities to a farmer is the opposite of the “dealing-with-like-minds” concept unless the software increases milk production and you’re attempting to sell the securities to dairy farmers as investors. If they like your software—because it helps their profitability—they may want to invest in your Company. Ultimately, when prospecting for capital, approach and deal with those who at least understand and/or will directly benefit from your Company’s new project or product line.

This stage is about conducting a private testing of the waters to find indications of interest for a private offering of equity or debt securities. Why a private offering? It is easier, quicker, and less expensive than conducting a registered public offering. In the start-up or early stage phase of your Company, you will certainly have a difficult time raising it publicly if you can’t raise it privately—this is the general rule.

This is the very first step in the R&D-of-equity section of capitalization planning. Developing a securities offering is very much like creating a product offering. Research your private capital market before finalizing your securities-offering structure and document. Although the concept of R&D for a securities offering is homogeneous to R&D for a product or service launch, the approach and process of a securities offering is highly regulated on the federal level and in all 50 states. Financial Architect™, within the Corporate Engineering Conservatory™, has already streamlined the process.

Since much of the equity’s R&D involves actual indication-of-interest soliciting on a “Marketable” deal structure, and because you can produce an actual securities- offering document—quickly, easily, and inexpensively with Financial Architect™—you may choose to forget the Red Herring exercise. If so, simply put together a great deal structure with a generous IRR on the security and sell it the best you can. Sometimes a Red Herring can backfire; because if you do get positive indications of interest, you may take too long to produce the actual securities-offering document.

Be sure to follow up with these potential investors within 1–2 weeks of delivery to get indications of interest. If the deal structure prototype receives responses that are equally negative across the board, you may need to refine your deal structure prototype and either re-issue another Red Herring document (with another deal structure prototype) or just move directly to creating a securities offering document to solicit and sell securities with a new completed deal structure. To capitalize your Company, figure out what securities scenario to sell. You may also want to ask, “In a perfect world, what kind of investment would you be interested in?” In fact, from the very beginning of your capitalization plan’s research-and-development-of-the-equity process, you may want to tell a dozen or so wealthy individuals, whom you know personally, how you plan to proceed in your research and ask them for wise counsel. Why? If you allow them to help map out the deal structure in the beginning stages, they most often will feel they are the ones who will make your success happen. (They will be more inclined to invest and provide referrals from their friends.) Be sure to ask them, “What terms would you be interested in seeing in an investment? What stimulates your interest and why? Do you know anyone else who may be interested investing in the company?”

Consider an alternative scenario, where you get no response from your Red Herring test—even after you’ve reworked the deal structure. If you have done a comprehensive job of listing all personal and professional contacts of your management team—as well as sent them your Company’s Red Herring document, but your response was weak or nonexistent—you will need to consider registering your securities offering to conduct what is known as a “direct public offering” or simply do it under Regulation D, Rule 506(c). Under Regulation D, Rule 506(c) you can use the general media to solicit - 142 - Copyright © Commonwealth Capital, LLC 2003-2019

accredited investors only. Simply use Regulation D, Rule 506(c) as cover for your Red Herring to garner indications of interest from the general public.

Although there are other exemptions from registration that allow you to advertise, you actually must produce the final securities offering document and submit it to regulatory authorities prior to solicitation. If you use other exemptions, to conduct a Red Herring Test using the media to benefit from general solicitation you run the risk of needing to re-file more than a few times, to test new prototype deal structures, which can get very expensive. For instance, a SCOR offering can cost $25–$50,000; CA (1001) for California exemption from state qualification under paragraph (n) of Section 25102, $45– $65,000; and a Regulation A offering can cost as high as $50,000 to $100,000— depending on the professionals you hire to produce the documentation and do the filings. That’s why it’s important to do all testing Under Regulation D, 506(c), as no pre-filings are required and you can advertise the securities in the local newspaper or any other form of general media.

Chapter 14: Making Structural Changes

Making structural changes means altering the deal structure of a securities offering by changing the elements of the pro forma financial projections. The various techniques and the mechanics of this process are disclosed in detail with the instructions to CapPro™.

If you receive a positive indication of interest on one or more of the “Red Herring” scenarios, your direction is clear. Produce your securities-offering documents to those indications of interest, and send it to those potential investors. Don’t over think this. Remember, there are two sides to this equation, what they desire and what you can live with.

Reworking the deal structure prototype, which are defined by your company’s securities’ features and benefits, will be relatively easy once you have entered the financial assumptions into the CapPro™. You can easily run different “what if” scenario.

Maybe a participating preferred stock offering that has a dividend of 8.5% with 20% participation for a total annual-return potential of 30%, with a ten-year Call Price of 120% ($120) of par value, as opposed to the 110% ($110) in the previous example, would be more appealing for the investors. That is the beauty of running the numbers in the first place—you will know what you can afford to give up and how to structure the deal so it sells to your private market or into the public markets. Notice that with the two most popular deal structures for private or public placements, very little of the voting common-stock equity was relinquished with the limited conversion rights. The company’s voting control remained in the entrepreneur’s hands. Sometimes that is unrealistic especially if the entrepreneur has little or no money in the company.

A prudent investor’s biggest fear is losing their investment. One way to circumvent this fear for a potential investor base is to indicate in your Red Herring research letter or the securities offering document that you will escrow the money. In other words, you provide an escrow clause within the securities offering document, which states unless 100% of the funds are secured, including the bank loan, if appropriate, their entire investment will be returned to them as well as bank interest. Indicate that the money will be safe and only become an investment “if and when” all of the funds have been secured. That approach should calm or mitigate some fears, especially in regards to investing in a start-up. Once again, it really goes back to the entrepreneur’s personal and professional contacts. Maybe a minimum-investment amount you indicated in your research letter was $25,000, and no one in your influence circle can obtain that amount of cash. Maybe a $5,000 or $10,000 minimum-investment amount would have a greater acceptance rate. You are trying to attract investors’ risk capital with securities normally used to attract their larger “safe money” investments, so you need to constantly mitigate risk for them.

Remember, in regards to raising capital, it may be wiser to have multiple investors investing relatively small amounts, as opposed to a few investors investing - 144 - Copyright © Commonwealth Capital, LLC 2003-2019

large amounts in your Company. This concept not only lessens the probability of an 800 lb. gorilla trying to run the show and aggressive lawsuits if things don’t work out, but on a positive note, it enables you to create a growing pool of private-capital contacts to whom you might return in connection with future securities offerings. The more investors you have, the higher the probability of actually raising the capital sought—round after round, which you will need whether or not you think so. By cultivating a large investor pool, you also increase the probability of getting additional investor referrals.

Maybe the IRRs seem too high because the revenue assumptions are perceived too aggressive; or there is too much debt (leverage) in the capitalization plan. You may need to simply increase the equity portion of the capitalization plan or produce an “all- equity” plan. Investors don’t like the idea of being second in line on asset liquidation, so an all equity capitalization plan using preferred equity as the securities to be sold, inherently puts the investors first in line.

If bank debt is really needed for the capitalization plan, consider having a trusted associate or close friend sign a personal guarantee with the bank, so you can obtain a line of credit. (Even SBA-backed credit facilities frequently require personal guarantees, and their likelihood of approval by SBA is enhanced with same.). To induce the co- signor/guarantor, you might have to give them some carried interest plus equity. Incidentally, “carried” interest is the type you pay the co-signer, over and above the bank’s interest rate of 9% (example), for taking on the risk. You may pay them 4% (example) for a loan’s total interest rate of 13%. If so, that may constitute a securities offering, and an accompanying document may need to be produced and regulations followed. Any arrangement to compensate co-signors for bank loans will need to be disclosed with in the securities offering document used to raise the equity portion.

There can be many capital-plan combinations. Remember, there are an unlimited number of ways to structure a deal and formulate a securities offering—so try to keep it simple. Once you get some sales-generated cash flowing into the company, it may become bankable on its own merits for other product and/or service development.

Once again, you need sufficient seed capital to go after larger amounts of development or expansion capital. If you need over $1 million in development capital, raise $200,000 from friends and family. (Use some of that money to register the offering so you can advertise a “qualified” offering.) The [sad] fact is if you want to raise substantial amounts of capital—more often than not—you have to invest time and money in the process. If after you have tested the waters in a public forum—but you are still unsuccessful in garnering sufficient indications of interest for your proposed securities offering—you may need to either rework your offering structure (i.e., your securities’ features and benefits that were offered) and/or rethink your operation mode.

Changing the Mode of Operation

Changing the Mode of Operation means re-thinking how you’ll operate the company and is reflected primarily in the pro forma financial projections. Maybe your company’s operation mode is the real problem. It could be time to rethink your company’s mode of operation, which inherently determines its capitalization needs. Let’s say the current operation mode requires a capitalization total of $10 million to get off the ground. From a potential-investor standpoint, that amount may be too much. Far too many times, our clients have grandiose, unrealistic plans that require millions and millions of dollars. After testing their private market—prospective investors: family, friends, and professional contacts—they soon discovered that rethinking their operation mode for a reduced initial-capital requirement greatly increased their funding probability. Most often, they actually do receive the funding after this conclusion has been reached because they have reduced and adapted their capitalization plan to meet their private capital market’s demand(s).

Additionally, let’s say the original sought-after $10 million was to buy land, building, and equipment to produce your product or service. Could you lease the plant or equipment? Would that bring your capital needs to a total of $1,000,000 due to off balance sheet leverage, such as leasing? If so, maybe you need to raise only $300,000 in equity and obtain an SBA-backed loan from the bank for another $700,000. You can buy the plant and equipment later, after your Company has a few more years of operating history.

Can you rely on independent-manufacturer representatives to sell your product or service line(s), as opposed to hiring an in-house sales force—at least for the first few years? Can you adjust your marketing and sales strategy to be primarily commission oriented? Read up on your industry’s trends, and figure out where you can gain strategic marketing alliances. Think about economies of scale. How can you get more for less? This is known as “bootstrapping.”

Should you actually be trying to build a company, or would licensing your Company’s technology to a strategic alliance require less capital and have a better chance of creating profitability? If so, maybe you need to raise only $100,000, in equity and $100,000 in bank debt, to be spent on legal fees to put together your licensing agreement, travel, lodging, printing, and your salary. Yes, you can have a reasonable salary as long as it’s disclosed in your Company’s securities-offering document.

If you can raise equity capital, raising debt capital is much easier. The point is you can easily increase the equity-raising probability by minimizing your overall, capital needs in the beginning then raise more capital over time. More often than not, most start- up companies require very little capital to get up and running. Once your Company has reached this point, and you can prove there is in fact a market for your product and/or service lines(s), you will further assure a successful placement of equity and/or debt- related securities for further development and expansion. More often than not, investors want to see a “proven economic model” before they commit to invest substantial amounts - 146 - Copyright © Commonwealth Capital, LLC 2003-2019

of their cash. Sadly many entrepreneurs wait too long before the start the capital raising process, and have burnt through critical seed capital without using it to go after development capital.

Before doing anything else, you should reevaluate your operation mode as best you can. For the next week, ask yourself, “How can I make this happen with the least amount of money, the fewest employees, and the lowest overhead?” Afterward, design your capitalization plan around that new set of methods and assumptions. Unfortunately, there is not an unlimited number of ways to change your company’s mode of operation, so you’ll need to concentrate on adjusting what you can while you can.

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Chapter 15: Securities-Offering-Document Production

We assume your Company has already produced a written business plan in MS Word® format or at least convertible into the MS Word® format. If not, the following information should serve as a guideline of what you will need to produce a complete business plan to be copied and pasted into the templates, which is the first step in the production of your Company’s securities-offering document.

If you have a business plan, please review the following to ensure you will have the information necessary to convert it into a securities-offering document. We have embedded text needed for compliance into Financial Architect™ templates. If you Do Not have a business plan, please review the following to ensure you will have the information necessary to create your business plan directly into the securities-offering document templates within Financial Architect™. That’s right, no need to develop a business plan outside of Financial Architect™, as its more effective to build it with Financial Architect™, anyway.

For some entrepreneurs, the “Red Herring” document will be the first document to be produced to seek indications of interest. A Red Herring document is a summary of a securities offering document, as explained in a previous chapter with an executive summary laid out in the Private Placement Memorandum (PPM) together with the pro forma financial projections and notes thereto as exhibits. You will need to add and insert some disclaimers into the Red Herring, specifying that it is not an offer, nor a solicitation of an offer, to sell securities. Simply add this [red-colored] disclaimer to the bottom of each page of a Red Herring: “This correspondence does not constitute an offer or a solicitation of an offer to solicit or sell securities.”

If you have not already done so, you will need to convert the existing text-writing style in your Company’s business plan to third-party prose. If you have not, wait, we will instruct you on how to do that in the Securities Offering Document Templates within Financial Architect™ itself.

When producing your securities offering documentation, keep in mind most investors want answers to—among other things—seven basic questions about your Company, its capitalization plan, and the securities-offering deal structure. If you cannot answer these questions in a credible and professionally written manner within the proper securities-offering documentation, there is a low probability of you and your Management Team raising capital for your Company. (Some of this information is being repeated while accompanied with new material.)

1. What does your Company do, and why is it different from the competition?

You can easily answer this question by inserting the correct components of your Company’s business plan into the Financial Architect™ Private Placement Memorandum (PPM) templates or by developing the correct response from your Company’s product and/or service line(s’) marketing materials.

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2. Who are you?

This question identifies the members of the management team. You can answer this question by including your Management Team’s background in the securities- offering document. Obviously, the more experienced management teams have a greater probability of raising the needed capital, due to the nature of their personal and professional capital contacts—potential investors that they have a pre-existing relationship with. Do what you can to form an experienced board of directors, executive- officer staff, and an advisory board. Choose a “well-networked” team not only to assist you in building the company but to raise capital as well. Make sure you have signed & dated, written engagement letters or executive compensation agreements before you add any management team member to the PPM and or before any Red Herring or PPM is distributed to any potential investor. Doing otherwise could open you up to civil litigation or criminal investigations of securities fraud.

Also, be careful not to compensate them for directly or indirectly selling securities though—it is illegal to do so. That means no payments should be made as a commission or bonus related to their individual efforts involving a securities offering. A non-monetary reward, e.g. a cruise to the US Virgin Islands, for the entire management team upon completion of an offering, may be acceptable, but be sure to check with legal counsel before engaging in this level of reward.

The CFO or VP of Finance can be compensated for other duties and responsibilities, but the function of soliciting and selling securities must be incidental to their other duties, unless their primary job is raising capital. If that is the case, the VP of Finance cannot be compensated with a percentage of capital raised; otherwise the compensation is considered a commission, which is illegal unless the sales effort is run through the books of an SEC-registered broker-dealer/securities firm. Even then, the VP of Finance would need to be licensed with that firm and working for your Company as a VP of Finance, which, for all practical purposes, would not be allowed because the broker-dealer/securities firm must ensure the VP of Finance’s compensation does not violate FINRA rules of fair practice. In other words, a FINRA Member broker- dealer/securities firm is not going to allow it. (From a FINRA compliance standpoint, it is too cumbersome.)

3. What will you do with my investment?

To answer this question, a detailed “Sources and Uses” statement and an “Estimated Use of Proceeds” statement must be in a securities-offering document. The Sources and Uses statement serves as your detailed Estimated Use of Proceeds statement for the first year of operations, which is a required disclosure in a securities-offering document. A statement that the money will be used for “general working capital” is not sufficient. You must give details— and the more detail, the better. The pro forma financial projections you will have produced using CapPro™ contain that Sources and Uses statement that is automatically populated and calculated for this purpose. You will also need said statement for you or preferably your legal counsel to complete the “Notice of Sales” federal-and-state-filings requirement after each sale of your Company’s securities.

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4. How safe is my investment?

This question is generally difficult to answer. More often than not, entrepreneurs will attempt to sell a non-controlling interest in their firm for a substantial amount of equity capital. For instance, management may attempt to sell 20% of the equity interest in a start-up or early stage company for a certain amount of capital. For illustrative purposes, let’s say $1 million. Generally, including the entrepreneur’s cash there are no other tangible assets in the company. A sophisticated investor would realize that, by investing, he/she would immediately lose 80% of their $1 million investment due to the outstanding stock’s total-dilution factor. So an immediate loss of a major percentage of an investment, through dilution, although unattractive, must be disclosed. How safe is it? Under that scenario, not at all safe.

Illustrated herein and included in Financial Architect™ templates, the two most popular deal structures provide for additional elements of safety due to the non-dilutive aspect of those types of securities. Remember, the sooner you can return your investors’ capital contribution(s), the safer the illiquid investment becomes. In addition, the faster the company’s product and/or service line(s) are accepted into the marketplace, the quicker a “proven economic model” can be established, which inherently leads to higher degrees of safety of an investment.

5. How do I get my investment back?

Exit strategies generally need to be rather quick. Although IPOs or outright sales of the entire company may seem attractive for exit strategies, those strategies cannot be guaranteed or further assured. Therefore, those exit strategies are not taken too seriously by a knowledgeable investor.

The two most popular deal structures (Convertible Seed Capital Notes and Convertible Participating Preferred Stock) provide for realistic exit strategies for potential investors from the securities, not the company, they invested in. Notes have maturity dates that are finite. And although Call provisions on preferred are not based on investor rights or issuers obligations, assuming success, there’s a high probably of the preferred equity being called—bought back at a pre-determined price.

You may be able to attract the interest of strategic alliances—i.e., other businesses in your industry that would inherently benefit from your Company’s existence and so may provide the required equity and/or debt capital. A favorable exit strategy with a non- diluted equity position would be attractive to most strategic-alliance candidates as well as individual investors.

6. If the firm fails, what are my liquidation rights and lien position on assets?

The deal structure of your Company’s securities offering should provide a forward or first lien position on assets for investors, which subordinate common equity in case of liquidation. In the mind of an investor, this type of deal structure further justifies taking on the risk of an investment in an illiquid security. All start-up and early stage

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companies are risky in the mind of the informed investor. On average, they know 50% of all start-up and early stage companies fail or stagnate within the first five years of their existence—35% of the remaining firms merely survive—providing little or no return. Therefore, you need to mitigate an investor’s risk through the issuance of non- subordinated securities and proper capitalization structuring.

7. If things go as planned, what will be the rate of return on my investment?

Most business plans and securities offering documents do not include rate-of- return projections for the purchase of securities and/or a current, company valuation based on reasonable future financial projections, which is a major mistake. You will need to determine your Company’s current value based on realistic, future financial projections then calculate the IRR potential for an investment in your Company’s securities under 3 different scenarios; outright exit of the security; full conversion into common equity privately held; and full conversion into common equity publicly traded. Once you have produced the pro forma financial projections, you may find the percentage of equity you were willing to relinquish may be too much, for too little, in regards to the capital sought.

Most securities attorneys would prefer that you not project a rate of return on the securities offered by your Company. This is primarily because they fear it would increase the probability of your Company being sued if financial projections aren’t met—that is a legitimate concern. However, Financial Architect™ is based on and distinguished by the IRR projections. In most investors’ minds, that is the bottom line. The securities-offering- document templates have disclaimers that should warrant sufficient protection against litigation for not meeting those financial projections. In reality, if you do not provide IRR estimations, there is a virtually non-existent likelihood of attracting any meaningful amount of capital, which makes any increased probability of being sued “moot.”

Document Production

The PPM’s Executive Summary is macro in nature, where the PPM’s body is detailed and micro in nature. The Executive Summary would include summarizations of the main body of the PPM’s text on:

By perusing the Internet, you can find securities-offering documents—aka Private Placement Memorandums (PPMs)—to use as models for your securities-offering documents. However, they may not be updated to current regulatory requirements—be sure to check with a securities attorney when you’re done.

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From here forward, using Financial Architect™, we’ll give you just a brief summary of our process for producing a securities-offering document. Full instructions are included with Financial Architect™ End-User Instructions, within the Corporate Engineering Conservatory™.

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Chapter 16: US Securities Laws

The following is a summarization of basic US securities laws, rules, and regulations. However, though we have made Regulation A+ available through Financial Architect™ Expansion Capital Producer™ to go further than a private placement under Regulation D, you really should hire a team of professionals who understand what they are doing.

To conduct a securities offering in the United States, legally, you must:

A. Produce and pre-file a registration statement with the Securities and Exchange Commission (SEC)—and up to fifty states (Blue-sky law). This is considered a “Registered Offering,” such as an S-1 for an Initial Public Offering (IPO)—it’s expensive. However, you may raise an unlimited amount of capital, advertise the securities—with certain content constraints—and the securities will be freely traded on a securities exchange. Cannot be sold by your management team only through FINRA Member (stockbrokerage) firms. (Very Expensive).

B. Produce and pre-file form 1-A under Regulation A+ (Tier 1 or Tier 2) (and or CA (1001) with the state of California) with the Securities and Exchange Commission (SEC) and the state securities bureau, which allows Regulation A securities to be sold in their state. This is considered a “qualification” for an exemption from registration under Regulation A, CA (1001) and the California Corporations Code 25102. This is more cost-effective than pre-filing a registration statement with the SEC and up to fifty states. The CA (1001) and the California Corporations Code 25102 have a $5 million maximum limitation within a twelve-month period. You may advertise the securities—with certain content constraints. The securities may be freely traded on a securities exchange—subject to additional constraints—and the investor qualifications are less stringent that Reg. A+. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Expensive).

C. Produce and pre-file form U-7 under the Small Corporate Offering Registration (SCOR) with the state(s), which allow SCOR (not all states do) and where the securities will be solicited and sold. This is considered a “qualification” for an exemption from registration under the SCOR. This is more cost-effective than pre-filing form 1-A Regulation A and CA (1001) statement with the SEC and any of the fifty states. It has a $1 million maximum limitation within a twelve-month period. You may advertise the securities—with certain content constraints—and the securities may be freely traded on a securities exchange and are subject to additional constraints. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Moderately Expensive).

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D. Produce a Private Placement Memorandum (PPM aka an Offering Circular), which “claims” an exemption from registration under Regulation D 506(b) (private placement), where no general solicitation or advertising is allowed or under Regulation D, Rule 506(c) (restricted public placement), as long as you restrict the offering to accredited investors only. Third party verification of accreditation for each investor is required. The private placement of securities—under Regulation D, Rules 504, 506, and/or 4(a)(5) of the Securities Act of 1933—cannot be advertised to the general public through general solicitation. However, it will generally be exempt from registration if the document provides for sufficient disclosures and disclaimers—and where compliance requirements for “Notice of Sales” filings requirements are met. Both offerings must be accompanied by a securities-offering document, which complies with the various federal and state laws, rules, and regulations. Both offerings can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Relatively Inexpensive).

E. Claim the Accredited Investor Exemption 4(5) where compliance requirements for “Notice of Sales” filings requirements for private placements are met. One must restrict the offering to $5,000,000 in any given 12-month period and to Accredited Investors only that have a pre-existing relationship to bona fide members of the company’s management team. No pre-filing required. No securities offering documentation is required, however there are no Safe Harbor provisions against claims of fraud without the proper disclosures. Can be sold by your management team or through FINRA Member (stockbrokerage) firms. (Inexpensive, but potentially dangerous).

NOTE: These lessons are based on soliciting and selling securities effectively to US Investors under US Securities law. Regulation S is available for US Companies to solicit and sell securities to foreign investors. All the securities offering document templates, that you can use in Financial Architect™ are written and designed to comply with both; Regulation D-Rules 504, 505 and 506, as well as Regulation S, enabling you to solicit and sell securities to foreign investors.

Claiming and Exemption from Registration.

Each Financial Architect™ program defaults to the commensurate exemption to claim; so you have only to understand the rules of solicitation, which are further defined throughout the programs in the End-User Instructions. However, you should know:

1. Regulation D, Rule 504 allows up to $5 million to be raised in a twelve-month period and does not need to have an audited balance sheet. Up to thirty-five non- accredited investors are allowed in the deal. Only direct solicitation to current management team members of only pre-existing relationships is allowed, unless its run through a broker dealer. What constitutes pre-existing relationships? Check with your legal counsel, as this dynamic is a continually changing due to social media’s reach. - 154 -

2. Regulation D, Rule 506(b) allows unlimited dollar amounts to be raised privately in a twelve-month period and does need to have an audited balance sheet, if your Company has any operating history and if you will be allowing ANY non-accredited investors in the deal. Up to thirty-five (35) non-accredited investors allowed in the deal with the audited balance sheet. The audited balance sheets must not be older than 120 days, so keep that in mind when you establish the expiration date of the PPM. Once the balance sheet is older than 120 days, the document will not qualify for exemption from registration. You will need to make the above changes in different areas throughout the PPM that reference these regulations. Only direct solicitation to current management team members of only pre-existing relationships is allowed, unless its run through a broker dealer. What constitutes pre-existing relationships? Check with your legal counsel, as this dynamic is a continually changing due to social media’s reach.

3. Regulation D, Rule 506(c) allows unlimited dollar amounts to be raised publicly in a twelve-month period and does not need to have an audited balance sheet. No non-accredited investors allowed in the deal, period. Third party verification of accreditation for each investor is required. The non-audited balance sheets must not be older than 120 days, so keep that in mind when you establish the expiration date of the PPM. Once the non-audited balance sheet is older than 120 days, the document will not qualify for exemption from registration. You will need to make the above changes in different areas throughout the PPM that reference these regulations. Regulation D, Rule 506(c) allows public solicitation of a private placement. It is not deemed a public offering.

4. Public Solicitation—Unlimited Amount—Within California only. Under California’s (1001) & 25102(n), you can issue securities through a public placement to an unlimited number* of investors who reside in the state of California, using the general solicitation through the general media within the state. However, as a practical matter, we suggest limiting the offering to accredited investors only. It’s better to have those who can sustain a loss—just in case your Company fails. In order to qualify, one can either form their Corp. or LLC in the state of California if they have yet to form the entity in another state or register their Corp. or LLC in the state of California as a foreign Corp. or LLC if the entity is already formed in another state. Neither you nor your Company needs to move to California, to use these exemptions.52

NOTE: Although your Company has the ability for inclusion of an unlimited number of accredited investors, once you’ve passed the 2,000-investors mark, your Company becomes an SEC-Reporting Company—whether your Company’s securities are publicly traded or not.

At this point, your Company’s choice of securities offering should be relatively easy—whether the offering is registered or claiming or qualifying for an exemption (not the deal structure). When thinking of pre-existing prospective-investor relationships, do not forget friends, family, customers, suppliers, professional advisors, or any other pre-

52 See CA Code differences within the Exemption Decision Matrix. - 155 -

existing personal relationships of the company’s management-team. Under Regulation D, soliciting and selling only to pre-existing relationships further your claim from registration.

We know securities laws, rules and regulations can be confusing—not only from a regulatory-legality perspective but more importantly from the perspective of practicality. If this process is just too costly and/or burdensome, most simply won’t go through with it. That has been the case for quite some time. With the creation of Financial Architect™, we’ve attempted to simplify the process and greatly reduce the cost of engagement.

Therefore, along with us having been in the financial world since 1985, the following chart hopefully clarifies the difficulty of engagement with the capital-raising probability.

Exemption Decision Matrix

The Most Cost Effective way to The 2nd Most Cost Effective Degree of Difficulty > Raise Capital due way to Raise Capital due to Document Production vs. Raising Capital to the JOBS Act of the JOBS Act of 2012 Darker = Difficulty 2012 Accredited Reg. D 506(b): Title II Regulation ~~CA 25102(n) ~CA 1001 for Regulation A Title III Investor *Reg. D 35 Non- Reg. D 506(c): A (Tier 1) ~ Exemption from Registration~ *SCOR for California California (Tier 2) $50 Crowdfunding Exemption 504 Accredited For Accredited $20 million Co.s Only Co.s Only million Max 4(5) Investors Investors Only Max Minimum Amount? No No No No No No No No No No Maximum Amount $1,000,000 Yes No No Yes No No No No No No Maximum Amount $5,000,000 N/A Yes Yes N/A No No No Yes No No Maximum Amount Unlimited No No No No Yes Yes No No No No Limited to one State? No No No Yes No No Yes Yes No No Post filing - Notice of Sales required? Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Pre-filing with the SEC required? Yes No No No No No No No Yes Yes Pre-filing with the State(s) required? No No No Yes No No Yes Yes Yes No Audited Financial Statements required? No No No No ^Yes No No No No Yes Continued reporting to the SEC required? Yes No No No No No No No No Yes Do all state(s) recognize this exemption? Yes Yes Yes No Yes Yes No No Yes Yes Integration Issues? No Yes Yes Yes Yes Yes Yes Yes Yes Yes General Public Solicitation Allowed? Yes No No Yes No #Yes Yes Yes Yes Yes

We’ve denoted the areas in green for go and yellow for caution. The red text denotes activities that can be extremely time intensive and costly and therefore should be avoided, if possible, until you are capitalized enough to hire the necessary professionals, if possible.

The ban on General Solicitation for Regulation D Rule 506 ended on September 23, 2013 and it is now known as Regulation D 506(c) under Title II of the JOBS Act of 2012. In conjunction with the effects of other laws, you can sell up to 2,000 equity investors and an unlimited number of debt investors so long as all of the investors can prove their accredited status, without the need to register with the SEC as a fully reporting company. The final requirements and procedures are included within the Corporate Engineering Conservatory™ and are to be reviewed by your legal counsel once you’ve produced the Regulation D, Rule 506(c) document—included within all of the Financial Architect™ Programs.

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* As of January 20th 201753, Regulation D: Rule 504 enables you to sell up to $5,000,000 in securities over a 12-month period. However, if you self-limit the amount to $1,000,000 offering in a 12-month period, you can use the disclosure for FORM C a Title III “Crowdfunding” through a Registered FINRA Member portal. Also this could be used for a SCOR offering, which is registered at the state level as an Intrastate Offering. In conjunction with the effects of other laws, you can sell up to 2,000 equity investors and an unlimited number of debt investors with non-accredited status, without the need to register with the SEC as a fully reporting company. If the offering is registered at the state level, and depending on the particular state, you may be able to advertise through general solicitation. SCOR can be registered in more than one state, but the $1,000,000 total amount holds fast. All 50 states accept SCOR except: Alabama (under consideration), Delaware, District of Columbia (has no securities laws), Florida, Hawaii, and Nebraska.

^ If you solicit and sell the securities only to accredited investors under Regulation D Rule 506(c), you will not need audited balance sheets. Under all Regulation D Exemptions, you may solicit and sell up to 35 non-accredited investors; however, if you do not limit the total amount to $5,000,000 and claim Regulation D, Rule 506(b) (as the exemption) you may need to provide at least an audited balance sheet that is no older than 120 days—unless you can prove it would be cost prohibitive to produce and provide the audited balance sheets.

# If you solicit and sell the securities only to accredited investors under Regulation D, Rule 506, you will be able to advertise nationally.

~ This applies to California Corporations only, or Corporations that are registered as for Foreign Corporations in the state of California. For more information, see California Secretary of State’s website.

~~ This applies to California Corporations only, which must be registered in the state— not necessarily headquartered or operating there. See CA 25102(n).

The information below provides further clarification to clearly understand the available options, especially if the Exemption Decision Matrix above creates any further confusion.

PRIVATE OFFERINGS

Regulation D Rule 504: for $5,000,000 or less in capital over a twelve-month period. – No Audited Financial Statements Required.

53 https://www.sec.gov/divisions/corpfin/guidance/rule504-issuer-small-entity-compliance.html - 157 -

• Your company’s securities offering will be for less than or equal to $5,000,000 then Regulation D §504 would be the exemption you would claim. 54

Regulation D Rule 506(b): for an Unlimited Amount in capital over a twelve-month period. – Audited Balance Sheet May Be Required.

If your company is at the point where: • you need to allow non-accredited investors in the deal; • you do not need to advertise your company’s securities, because you may have ample personal and professional investor contacts; • you qualify (normally start-ups) to be exempt from producing an audited balance sheet and are not willing to spend the money on creating audited financial statements at this juncture, and; • Your company’s securities offering will be for any amount greater than $5,000,000 then Regulation D §506(b) would be the exemption you would claim.

The Accredited Investor Exemption 4(5): for $5,000,000 or less in capital over a twelve-month period: – No Audited Financials Required. If your company is at the point where:

• you allow only accredited investors in the deal; • you do not need to advertise your company’s securities, because you may have ample personal and professional investor contacts; • you are not willing to spend the money on creating audited financial statements at this juncture, and; • Your company’s securities offering will be for more than $1,000,000 but less than $5,000,000 then 4(5) the Accredit Investor Exemption would be the exemption you would claim. • No securities offering documentation is required, however there are no Safe Harbor provisions against claims of fraud without the proper disclosures, as provided for in most securities offering documents.

54 NOTE: On October 26, 2016 the SEC adopted the final rules to Rule 504. Rule 504 retains the existing framework, while increasing the aggregate amount of securities that may be offered and sold under Rule 504 in any 12-month period from $1 million to $5 million and disqualifying certain bad actors from participation in Rule 504 offerings. The $1 million aggregate offering limit in Rule 504 has been in place since 1988. The final rules repeal Rule 505, as well. https://www.sec.gov/divisions/corpfin/guidance/rule504-issuer-small-entity-compliance.html - 158 -

PUBLIC OFFERINGS OF PRIVATE SECURITIES

Small Company Offering Registration (SCOR): for $1,000,000 or less in capital over a twelve-month period. – No Audited Financials Required.

If your company is at the point where: • you need to allow non-accredited investors in the deal; • you need to advertise your company’s securities, because you do not have ample personal and professional investor contacts; • you are not willing to spend the money on creating audited financial statements at this juncture, and; • your company’s securities offering will be for less than or equal to $1,000,000 then a Small Company Offering Registration (SCOR) would be the exemption you would pre-file with the state(s), where the securities are to be solicited and sold, to “qualify” for the exemption from registration.

Regulation D, Rule 506(c)55 Public solicitation of a Privately Placed Security – No Audited Financial Statements Required.

If your company is at the point where: • you allow only accredited investors in the deal; • you do need to advertise your company’s securities, because you do not have ample personal and professional investor contacts; • you’re willing to obtain 3rd party verification of accreditation on each and every investor. • you are not willing to spend the money on creating audited financial statements at this juncture, and; • your company’s securities offering will be for any amount then Regulation D Rule 506(c) would be the exemption you would claim, because under Title II of the JOBS Act of 2013 you can now solicit and sell securities across state line with the use of the general media. See page 112 of SEC Final Rules.

Regulation A (Tier 1 & Tier 2). Audited Balance Sheet May Be Required for Tier 1. Audited Financial Statements Required for Tier 2.

If your company is at the point where: o You need to allow non-accredited investors in the deal; o You need to advertise your Company’s securities, because you do not have sufficient personal and professional investor contacts;

55 On July 10, 2013, the SEC adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act to implement the requirements of Section 201(a) of the JOBS Act. The amendments are effective on September 23, 2013 https://www.sec.gov/info/smallbus/secg/general-solicitation-small-entity-compliance-guide.htm - 159 -

o You are willing to spend the money to create, or you already have available, current audited financial statements; and o Your Company’s securities offering will be for more than $5,000,000 but less than $50,000,000.

Referencing Regulation A. U.S. and Canadian companies, that are not required to file reports under the Exchange Act, can raise up to $50 million. The final rules create two tiers: Tier 1 for smaller offerings, raising up to $20 million in any 12-month period, and Tier 2 for offerings raising up to $50 million in any 12 month period, as well. The new rules also make the exemption available, subject to limitations on the amount, for the sale of securities by existing stockholders. The new rules modernize the existing framework under Regulation A by, among other things, requiring that disclosure documents be filed on EDGAR, allowing an issuer to make a confidential submission with the SEC, permitting certain test-the-waters communications, and disqualifying bad actors. The final rules impose different disclosure requirements for Tier 1 and Tier 2 offerings, with more disclosure required for Tier 2 offerings, including audited financial statements. Tier 1 offerings will be subject to both SEC and state blue sky pre-sale review. Tier 2 offerings will be subject to SEC, but not state blue sky, pre-sale review; however, investors in a Tier 2 offering will be subject to investment limits (except when securities are sold to accredited investors or are listed on a national securities exchange) and Tier 2 issuers will be required to comply with periodic filing requirements, which include a requirement to file current reports upon the occurrence of certain events, semi- annual reports and annual reports.

Regulation A Tier 1 or Tier 2 is highly inappropriate for start-up and early stage companies, because of: 1.) The amount of legal and accounting work required for preparation is often cost prohibitive and 2.) The large amounts allowed to be raised, inherently position the start-up and early stage company to sell too much of the company too early for too little capital. Think of it this way. What do you think you need to give up, in ownership percentage (through conversion rights or otherwise and voting control, to attract $50 million dollars for a young company? When you think about it, its absurd.

Public Exchange Listing SEC Form S-1 (S-11 for Funds/REITS). Form S-1 (or S-11) would be the registration statement you would file with the SEC and the state(s) where solicitation and sales would occur if the following apply: —Audited Financial Statements Required.56

If your company is at the point where: o You need to allow an unlimited number of non-accredited investors in the deal; o You need to advertise your Company’s securities, because you do not have sufficient personal and professional investor contacts; o You are willing to spend the money to create, or you already have available, current audited financial statements; and o Your Company’s securities offering will be for more than $5,000,000.

56 Be sure to check with your attorney before conducting the actual offering of securities, as securities, organizational structures, tax, procedural laws, and rules & regulations can change at any time.

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Like Regulations A & A+, registration of an S-1 (or S-11) is highly inappropriate for start-up and early stage companies, because of: 1.) The amount of legal and accounting work required for preparation is often cost prohibitive and 2.) The large amounts allowed to be raised, inherently position the start-up and early stage company to sell too much of the company too early for too little capital.

The First Two Rounds:

Let’s make this part of the decision-making process as simple as can be. Consider the following deal structure and claim of exemption from registration.

Round One:

The vast majority of Start-Up or Early Stage Companies will do well to conduct a seed capital securities offering by: 1. Selling Seed Capital Convertible Bridge Notes. 2. Limiting the maximum dollar amount to $1 million for the first [seed capital] round. 3. Allowing thirty-five (35) Non-accredited investors and an unlimited amount of accredited investors in the offering. 4. Not needing the company’s financial statements to be audited. 5. Not needing to advertise the offering to the general public. 6. Claiming Regulation D, Rule 504 as the exemption from registration to solicit privately to pre-existing contacts, then converting the Regulation D, Rule 504 (constructed to only $1,000,000) into a SCOR offering, if allowed in the state where your Company resides, to advertise the securities to the general public. Or using the disclosures afforded under Regulation D, Rule 504(constructed to only $1,000,000) to fill out Form C on a Regulated Crowdfunding Portal for general solicitation to the crowd—general public, under Title III of the Jobs Act of 2012. Round 2:

The vast majority of Start-Up, Early Stage, and Middle-Stage Companies will do well to conduct a development or expansion-capital securities offering by: 1. Claiming Regulation D, Rule 506(c) as the exemption from registration. 2. Selling convertible, participating preferred equity. 3. Not limiting the total dollar amount. 4. Not allowing any non-accredited investors and an unlimited number of accredited investors in the offering. 5. Not needing the company’s financial statements to be audited. 6. Needing to advertise the offering to the general public. 7. Willing to obtain 3rd party verification for each investor’s accreditation

After those rounds, one should hire a team of professionals to handle future securities offerings, because, structured correctly, your financing options increase; but if they’re written incorrectly, your financing options decrease.

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

Certain Officers and Directors

Only officers and directors authorized by their corporation may communicate with prospective investors. Lower-level employees, equity holders who are not officers, directors, attorneys, or other corporation agents may not do so unless they are registered as securities broker-dealers. Indeed, no officer or director may be specially compensated directly or indirectly for communicating with prospective investors. They cannot receive commissions. They cannot receive success fees. No officer or director may have as his/her full-time job the position of communicating with prospective investors to obtain capital, unless that person is registered as a broker-dealer.

Officers and Directors May Be Required to Register as “Brokers”

Generally, the federal and state definitions of a “securities broker” are purposefully broad to include persons who are not compensated for introducing an investor to an investment opportunity. Anyone who engages in the activity of finding potential investors is a broker. Thus, corporate officers and directors who communicate with prospective investors are also brokers. Federal law, however, provides an issuer-employee exemption for participation in one offering per year. Also, most states exempt these persons from being required to register as securities brokers, provided they are not compensated for their services as securities brokers—and so long as it is not their full- time duty to raise funds for the corporation.

Persons with Disqualifying Histories

Some people with histories of relevant, criminal convictions, injunctions, cease-and- desist orders, bars from the securities industry, or from being a public-corporation officer or director, or a penny-stock bar are automatically barred under federal law and the laws of most states from participating in some but not all categories of unregistered-securities offers. However, these same persons (unless they are barred from the industry or have been barred from offerings of penny stock) may participate in registered securities offers. This is because registration statements require material-facts disclosure, and disclosure of criminal convictions, injunctions, and findings of violations in investment-related litigation are matters requiring disclosure—not preclusion.

Friends and Family

Contacting anyone (including friends and family) for interest in funding your venture is illegal unless a statute or administrative-agency rule provides an investment-offer registration exemption (and the ability to solicit funds). How large is your family? How - 162 -

many friends do you have on Facebook? As stated above, many states have a limited- offering exemption of approximately twenty-five (25) purchasers. Federal law, under Regulation D, Rules 504 and 506(b), permits up to thirty-five (35) non-accredited purchasers in a single offering. Communications using interstate commerce with friends and family under these thresholds are permissible; but in both the state and federal exemption schemes, you must have a pre-existing relationship with the offerees. If you do not actually know the “friends” or “family” before contacting them, and you communicate with them with the ultimate goal of seeking their investment interest, that is an unregistered non-exempt public offering. It only takes a single stranger in the mix to void the ability to claim the exemption. There is more to this restriction. You are permitted to contact friends, family, and others with whom you have a relationship, provided you are knowledgeable of whether they are accredited or unaccredited investors. This point is very important. If you contact too many unaccredited investors, and/or you (or the other officers or directors or broker agents of the issuer) do not actually know them, you can void the ability to conduct a private offering and subject yourself and everyone involved in the offering to liability. Prior to enactment of the JOBS Act of 2012, under the federal-securities laws, Regulation D prohibited general solicitation and advertising in connection with private-investment offerings. The basic idea is registered; public offerings are examined by the SEC for compliance with disclosure requirements. These registered-securities transactions can then be offered and sold to the general public. On the other hand, private offerings are not reviewed by the SEC; therefore, there is greater risk disclosures will be inadequate for certain types of investors—especially if the amount of persons solicited to invest is numerous or the cash sought to be raised exceeds $1,000,000. As defined by Regulation D, Rule 502(c), among other things, general solicitation or general advertising includes “(1) [a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media,” and “(2) [a]ny seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” Title II of the JOBS Act directed the SEC to amend Rule 506 of Regulation D to release the ban on general solicitation and advertising provided that only accredited investors were permitted to invest in the advertised offering. Title III of the JOBS Act (crowdfunding) contains a similar concept. Title III permits a maximum, capital raise of $1,000,000, but any number of investors with any degree of business knowledge can invest. In this respect, crowdfunding is similar to Rule 504, however it has no limit to the number of non-accredited investors who may participate in the offering. Although the total dollar amount is limited to $1,000,000, crowdfunding investments are based upon an income and net-worth scale, hence Title III imposes restrictions on how much money each investor can invest.

However, the big news is general solicitation and capital-raise advertising is legal for Rule 506(c) offerings—it will be legal for crowdfunding and Regulation A+ offerings.

Since advertising and general solicitation connotes a lack of pre-existing relationship and a generalized form of communication, the issuer may be able to hold a meeting with a small number of prospective investors provided the issuer can demonstrate that it did not create the invitation list from a generic source—a list of attorneys licensed in a particular

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jurisdiction. The SEC advises “[t]he types of relationships with offerees that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists or that otherwise are of some substance and duration.” A permissible example of this is where a securities broker-dealer sends out fifty monthly questionnaires to local businessmen and professionals using lists created by the sender where the proposed solicitation is generic in nature, does not reference a specific securities investment offered or contemplated to be offered, and a procedure is in place to ensure that no one who receives a mailing is able to invest in a security that was being offered while at the time of the mailing. The business relationship is substantiated with responding persons for a period of at least forty-five days before any of them are provided materials concerning a particular investment.

Thus, a substantive relationship may be established with a person who has provided a satisfactory response to a questionnaire that enables the sender to have sufficient information to evaluate the prospective offeree’s sophistication and financial circumstances. Engaging in general solicitation and advertising violates the “private” nature of private- securities offerings. Unless such securities offerings are registered or are offered in compliance with new rules promulgated by the SEC pursuant to the requirements of the JOBS Act, such offerings will violate the federal and possibly state-securities laws.

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Chapter 17: Crowdfunding

This is one of the more difficult and lengthy sections to get through, but take heart, each subsequent section is broken into digestible sub-sections, but this subject needs to be presented and understood in a cohesive manner.

The term, “crowd funding,” has been thrown around a bit too loosely. The original term was properly used for Donation-based Crowd Funding, and it still is. Then the term was used to define the exemption from registration under Title II (2) of the JOBS Act of 2012, more specifically Regulation D - Rule 506(c) and then Title IV (4) of the JOBS Act of 2012 more specifically Regulation A+. Regulation D, Rule 506(c), enables one (an issuer) to advertise a securities offering, using the general media, but to accredited investors only—their accreditation verification is mandated. But that’s not a “crowd” as defined under Title III (3) of the JOBS Act of 2012. Under Title III (3) of the JOBS Act of 2012, crowd funding is officially termed “Regulation Crowdfunding.” This means the originally intended term, “crowd funding,” in reference to raising capital, is meant to enable one to raise up to $1,000,000 per year from many investors (accredited or not)—aka “the crowd,” but only through a mandate to use a registered Crowdfunding Portal exclusively for the offering. Title IV (4) of the JOBS Act of 2012 more specifically Regulation A+ is meant to enable one to raise up to $20,000,000 (Tier 1) or $50,000,000 (Tier 2) per year from many investors (accredited or not)—aka “the crowd” but it’s still not considered a “crowdfunding effort” because there is a mandate to use a registered Crowdfunding Portal exclusively for the offering.

I. Donation-Based Crowdfunding

Donation-fueled crowd funding really isn’t considered raising capital—certainly not substantial amounts—because that model is weak and fading. In addition, do you realize crowd-funded proceeds are considered revenue and therefore subject to federal and state income tax?57 58 That’s right…if you were even remotely lucky enough to raise $500,000 through a crowd-funding donation-based model for your “C” corporation, under the tax code for 2016 and assuming a flat 7.5% state-tax corporate rate with little or no cost of goods sold (the cost of the little thank-you gifts), you can expect to pay 40%59 or $200,000 to the federal, state and local governments. You’d be left with only $300,000 in working capital—ouch! Even LLCs are subject to this extreme tax treatment. Due to the pass through of average, individual, tax brackets and factoring in FICA & Medicare withholdings (aka self-employment tax matched by the LLC) make the effective tax-rate percentage essentially the same.60 It is our understanding that some of the crowdfunding portals do send out 1099-MISC tax-reporting forms to recipients of funds from a donation-fueled crowdfunding campaign. They do so to shift that tax liability off their backs and onto yours.

If you’ve been in a professional or business capacity in the US for any length of time, you know by now that the federal and state taxing authorities rarely miss an

57 http://www.forbes.com/sites/suwcharmananderson/2012/05/23/kickstarters-sting-in-the-tail-tax/ 58 http://www.irs.gov/irm/part4/irm_04-076-051.html 59 https://home.kpmg.com/xx/en/home/services/tax/tax-tools-and-resources/tax-rates-online/corporate-tax-rates- table.html 60 http://www.bankrate.com/finance/taxes/tax-brackets.aspx - 165 -

opportunity to tax, if they can. It’s pure speculation when internet-based-publication authors claim that conducting a corporately structured crowd-funding campaign may dodge taxation issues. Officially, the IRS has not ruled on this issue. The current position is they examine on a case-by-case basis. Therefore, if the internet-based-publication authors are wrong, you may be in violation of federal and state tax laws. If they’re right, it’s because you’ve booked it as a capital contribution on your accounting records, which means you’re most likely in violation of federal and state securities laws, unless of course, you have produced and distributed the required securities-offering documents in compliance with federal and state securities laws, rules, and regulations. Remember, there is no tax on the capital raised for your company, through a securities or cryptocurrency offering, bank loan or direct venture capital investment.

II. Capital-Based, Regulation Crowdfunding

Issuers of Securities

Title III of the JOBS Act (“Title III”) added new Securities Act Section 4(a)(6),61 which provides an exemption from the registration requirements of Securities Act Section 5 for certain crowdfunding transactions known as Regulation Crowdfunding.

The following includes excerpts from the 685 page document known as the SEC Final Rules regarding Regulation Crowdfunding “Crowdfunding” with comments from us to clarify, warn, praise, or most importantly make one aware of the practicality of various strategies behind the process to ensure success.

Not to get too complicated, there are handful of items you and your company, as the issuer of securities, will need to be aware of when it comes to Regulation Crowdfunding.

Qualification

Regulation Crowdfunding is the new term used to identify the exemption for registering securities under the Title III regulations. Very much like the Regulation D exemptions, certain companies are not eligible to use the Regulation Crowdfunding exemption. Ineligible companies include non-U.S. companies, companies that already are Exchange Act reporting companies (aka SEC Reporting Companies), certain investment companies (Mutual Funds–open and closed- end), companies that are disqualified under Regulation Crowdfunding’s disqualification rules, companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

61 15 U.S.C. 77d(a)(6). - 166 -

Limitation on Investment Amounts

To qualify for the exemption under Section 4(a)(6), crowdfunding transactions by an issuer (including all entities controlled by or under common control with the issuer) must meet specified requirements, including the following: • An issuer is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period; • Individual investors, over the course of a 12-month period, are permitted to invest in the aggregate across all crowdfunding offerings up to: (1) The greater of: $2,000 or 5 percent of the lesser of the investor’s annual income or net worth if either annual income or net worth is less than $100,000; or (2) 10 percent of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more and • During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.

Under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500.

For further clarification see Chart below:

Investor Annual Income Investor Net Worth Calculation Investment Limit $30,000 $105,000 Greater of $2,000 or $2,000 5% of $30,000 ($1,500) $150,000 $80,000 Greater of $2,000 or $4,000 5% of $80,000 ($4,000) $150,000 $100,000 10% of $100,000 $10,000 ($10,000) $200,000 $900,000 10% of $200,000 $20,000 ($20,000) $1,200,000 $2,000,000 10% of $1,200,000 $100,000 ($120,000), subject to $100,000 cap

The rules allow an investor’s annual income and net worth to be calculated as those values are calculated for purposes of determining accredited investor status under Regulation D. 6263 The rules allow spouses to calculate their net worth or annual income jointly, and when such a joint calculation is used, the aggregate investment of the spouses

62 See Instruction 1 to paragraph (a)(2) of Rule 100 of Regulation Crowdfunding. 63 17 CFR 230.501. Thus, for example, a natural person’s primary residence shall not be included as an asset in the calculation of net worth. 17 CFR 230.501(a)(5)(i)(A). - 167 -

may not exceed the limit that would apply to an individual investor at that income and net worth level.64

The rules allow an issuer to rely on efforts that an intermediary is required to undertake in order to determine that the aggregate amount of securities purchased by an investor does not cause the investor to exceed the investment limits, provided that the issuer does not have knowledge that the investor had exceeded, or would exceed, the investment limits as a result of purchasing securities in the issuer’s offering.65 This is good news as the portal would need to provide some mechanism for investors to calculate and determine the maximum allowable investment, thereby relieving you, the issuer, from such determination and burden of proof.

Disclosure Requirements

Securities Act Section 4A(b)(1) sets forth specific disclosures that an issuer offering or selling securities in reliance on Section 4(a)(6) must “file with the SEC and provide to investors and the relevant broker or funding portal, and make available to potential investors.” These disclosures include: 1. the name, legal status, physical address and website address of the issuer; 2. the names of the directors and officers (and any persons occupying a similar status or performing a similar function), and each person holding more than 20 percent of the shares of the issuer; 3. a description of the business of the issuer and the anticipated business plan of the issuer; 4. a description of the financial condition of the issuer (for offers of more than $100,000, up to 2-years of past financial statements {balance sheets, statements of comprehensive income, statements of cash flows and statement of changes in stockholders’ equity} produced under U.S. GAAP rules); 5. a description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount; 6. the target offering amount, the deadline to reach the target offering amount and regular updates about the progress of the issuer in meeting the target offering amount [over-subscription amounts and limitations]; 7. the price to the public of the securities or the method for determining the price; and 8. A description of the ownership and capital structure of the issuer.

By filing Form C with the SEC and providing it to the relevant intermediary, issuers will satisfy the requirement of Securities Act Section 4A(b) that issuers relying on Section 4(a)(6) must “file with the SEC and provide to investors and the relevant broker of funding portal, and make available to potential investors” certain information. In a clarifying change from the proposal, we have moved the definition of “investor” from proposed Rule 300(c)(4) to Rule 100(d) to clarify that for purposes of all of Regulation

64 For example, if each spouse’s annual income is $30,000, the spouses jointly may invest up to an aggregate of 5% of their joint income of $60,000. If one spouse’s annual income is $120,000 and the other’s is $30,000, the spouses jointly may invest up to an aggregate of 10% of their joint income of $150,000, the same investment limit that would apply for an individual investor with income of $150,000. See Instruction 2 to paragraph (a)(2) of Rule 100 of Regulation Crowdfunding. 65 See Instruction 3 to paragraph (a)(2) of Rule 100 of Regulation Crowdfunding. - 168 -

Crowdfunding, “investor” includes any investor or any potential investor, as the context requires.

Surprisingly, the SEC did not adopt an exclusive but held to a non-exclusive list of items that must be contained within the business plan. Although a business plan must be part of the disclosure, the SEC states: We anticipate that issuers engaging in crowdfunding transactions may have businesses at various stages of development in different industries, and therefore, we believe that the rules should provide flexibility for these issuers regarding what information they disclose about their businesses. This flexible approach is consistent with the suggestion of one commenter that the business plan requirements be scaled to match the size of the offering. We [SEC] also are concerned that a non-exclusive list of the types of information an issuer should consider providing would be viewed as a de facto disclosure requirement that all issuers would feel compelled to meet and would, therefore, undermine the intended flexibility of the final rules.

The final rules will amend Regulation S-T to permit an issuer to submit exhibits to Form C in Portable Document Format (“PDF”) as official filings. Form C allows for pdf exhibits to accommodate for charts, graphs, pro forma financial projections, transcripts of video presentations, etc. The beauty in all of this is that you can add attachments to Form C. This is important for actually getting investors to invest. Every investor knows what the downside risk is to his or her investment… 100% loss. However, rarely is an investor supplied with the potential upside return on investment and timing of that return. That’s where U.S. GAAP compliant pro forma financial projections come in.

We commend the SEC for providing this degree or flexibility, as it’s our experience that to effectively sell securities to investors your disclosures should be embedded within a story that excites and motivates investors to invest, but also includes the necessary disclosures for compliance. Form C also provides for an “answer and question” format for filling out Form C. As professional investors, we can tell you that the Q&A format is elementary and smacks of naiveté.

The flexibility of business plan submission may seem like a great way for issuers to keep confidential matters…confidential. However, we caution issuers to not take this course too lightly. It is our opinion that lack of certain disclosures, such as; material breach of contracts (by either party), regulatory proceedings, pending litigation, current litigation or any outstanding court order or judgment affecting the issuer or its property, in the business plan could be a basis for claiming securities fraud, a criminal offense. It’s simply wise, on many levels, to tell the truth and disclose to investors everything you would want to know if you were making the investment in a company you didn’t control.

To avoid serious problems that could arise with the lack of disclosure on Form C for Crowdfunding, we suggest creating a securities-offering document constructed under Regulation D – Rule 506, because it has a comprehensive list of disclosure items (Regulation D – Rule 502) and it is an old body of law. The degree of disclosure required under Regulation D – Rule 502 will help the issuer avoid claims of securities fraud. Once completed, you simply “copy and paste” areas within your securities-offering document

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under Regulation D – Rule 506 to properly fill out Form C with the SEC for Crowdfunding. It’s important that you have the exact same disclosures in your Form C as you do in your Regulation D – Rule 506 document to strengthen your defense against any claims against you for securities fraud.

More importantly, creating a securities-offering document Regulation D – Rule 506 will easily allow you to run two concurrent offerings simultaneously thereby increasing the probability of success exponentially. When you create securities-offering documents under Regulation D – Rule 506(b) or (c), or 504, disclosures for Rule 502 are covered.

All of the Financial Architect™ programs, contained within this Corporate Engineering Conservatory™ produce securities-offering documents under Regulation D – Rule 506 (which covers Rule 504) for legal counsel review. In addition, the “Use of Proceeds” Statement as required by item 5 above; prices the securities with the method of determination as required by item 7 above. More importantly, Financial Architect™ produces a marketable deal-structure based on GAAP-compliant pro forma financial projections with an illustration of Internal Rate of Return (IRR) and a projected timing of that return. When using the Convertible Note deal structure contained in Seed Capital Producer™ or the Convertible Preferred Equity deal structure within Development Capital Producer™ you do not need to worry about properly valuing the company or its common equity, because your securities will be arbitrarily priced at $1,000 per Note or $100 per Preferred Share. By adding these critical elements as attachments to your Form C, you will be able to show prospective investors potential IRRs under various scenarios with a 5-year time period. This accomplishes two critical elements to a successful capital raising effort through a securities offering. This process: 1.) assures that you will not be selling too much of your company too early, for too little; and 2.) sets your securities offering head and shoulders above the crowd (rest of the issuers looking for capital) thereby increasing the probability of getting funded.

Intermediaries – Crowdfunding Portals

It’s not for us to educate you on all the crowdfunding portal regulations in detail, but you and your company as an issuer of securities, should be aware what their responsibilities are so you can be sure you’re engaging a crowdfunding portal that is in compliance. The burden of securities offering compliance ultimately falls on the issuer of securities, i.e. your company.

Due to these new changes in securities laws, there are many new opportunities in servicing young companies, in the process of raising capital. Many businesses have taken the route of establishing crowdfunding portals and selling those services to entrepreneurs to capitalize on these changes. The business models that are engaged in establishing crowdfunding portals as a means of attracting investors for their various customers (young companies) may not understand the complexity and compliance issues involving the securities industry...nor the impending litigation risk that comes with the turf. Although there are some fairly simple rules for registered portals to follow, many may act, inadvertently, as un-registered broker dealers, which is a violation of federal and state(s) securities laws. We doubt many broker-dealers will engage and compete in this

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arena for some time, due to the lack of being able to accurately ascertain risks of the function of “broker.” When companies fail, and start-ups fail a lot, brokers are the only entity left to sue. If a broker dealer chooses to engage in this area they most likely will set up a separate corporation, as a wholly-owned subsidiary, to act as a registered portal. Therefore, the following discussion will focus on registered crowdfunding portals only.

One of the key investor protections of Title III of the JOBS Act is the requirement that Regulation Crowdfunding transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.

Under Regulation Crowdfunding, offerings must be conducted exclusively through a platform operated by a registered broker-dealer or a funding portal, which is a new type of SEC registrant.

The rules require these intermediaries to: • Provide investors with educational materials; • Take measures to reduce the risk of fraud; • Make available information about the issuer and the offering; • Provide communication channels to permit discussions about offerings on the platform; and • Facilitate the offer and sale of crowdfunded securities.

The rules prohibit funding portals from: • Offering investment advice or making recommendations; • Soliciting purchases, sales or offers to buy securities offered or displayed on its platform; • Compensating promoters and others for solicitations based on the sale of securities; and • Holding, possessing, or handling investor funds or securities.

Transaction Conducted Through an Intermediary (Broker Dealer or Registered Crowdfunding Portal)

Section 4(a)(6)(C) requires that a transaction in reliance on Section 4(a)(6) be conducted through a broker or funding portal that complies with the requirements of Securities Act Section 4A(a).

The SEC believes that requiring an issuer to use only one intermediary to conduct an offering or concurrent offerings in reliance on Section 4(a)(6) would help foster the creation of a “crowd” and better accomplish the purpose of the statute. In order for a crowd to effectively share information, the SEC believes it would be most beneficial to have one meeting place for the crowd to obtain and share information, thus avoiding dilution or disbursement of the “crowd.” The SEC also believes that limiting a crowdfunding transaction to a single intermediary’s online platform helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding.

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In essence, an issuer can only use one Crowdfunding portal to solicit and attract investors. This is probably best for both issuers and investors but limits competition among portals and requires an issuer to choose a portal based on claims by the portal. We suggest you use other methods to conduct portal due diligence, such as; researching through third parties, to determine if any or all claims a portal makes are valid. Just because a portal may be owned or operated by a broker-dealer, doesn’t mean the claims are valid.

Securities Act Section 4A(a)(1) requires that a person acting as an intermediary in a crowdfunding transaction register with the Commission as a broker or as a funding portal.66 Proposed Rule 300(a)(1) of Regulation Crowdfunding would implement this requirement by providing that a person acting as an intermediary in a transaction involving the offer or sale of securities made in reliance on Section 4(a)(6) must be registered with the Commission as a broker under Exchange Act Section 15(b), or as a funding portal pursuant to Section 4A(a)(1) and proposed Rule 400 of Regulation Crowdfunding. Securities Act Section 4A(a)(2) requires an intermediary to register with any applicable self-regulatory organization (“SRO”), as defined in Exchange Act Section 3(a)(26).67 Act Section 3(h)(1)(B) separately requires, as a condition of the exemption from broker registration, that a funding portal be a member of a national securities association that is registered with the Commission under Exchange Act Section 15A. Proposed Rule 300(a)(2) would implement these provisions by requiring an intermediary in a transaction involving the offer or sale of securities made in reliance on Section 4(a)(6) to be a member of FINRA or any other national securities association registered under Exchange Act Section 15A. Currently, FINRA is the only registered national securities association. Hence, be sure the portal you choose is both registered with the SEC and FINRA.

Being former securities regulatory compliance professionals, we are intimately familiar with SEC / FINRA regulations. For the most part, FINRA establishes and maintains a code of ethical conduct for its members, which isn’t too difficult to understand or follow. If a portal is duly registered and is a member-in-good-standing with FINRA,68 it can be assumed, but not guaranteed, that the portal is in compliance thereby relieving you and your firm of some of that burden.

Intermediaries are generally prohibited under the rule as adopted from having such a financial interest, as discussed below, in response to comments, the SEC has amended the rule to permit an intermediary to have a financial interest in an issuer that is offering or selling securities in reliance on Section 4(a)(6) through the intermediary’s platform, provided that: (1) the intermediary receives the financial interest from the issuer as compensation for the services provided to, or for the benefit of, the issuer in connection with the offer or sale of such securities being offered or sold in reliance on Section 4(a)(6) through the intermediary’s platform; and (2) the financial interest consists

66 As the SEC noted in the Proposing Release, facilitating crowdfunded transactions (which involve the offer or sale of securities by an issuer and not secondary market activity) alone would not require an intermediary to register as an exchange or as an alternative trading system (i.e., registration as a broker-dealer subject to Regulation ATS). See Proposing Release at 78 FR 66459 (discussing secondary market activity and exchange or ATS registration). 67 15 U.S.C. 78c(a)(26). Exchange Act Section 3(a)(26) defines an “SRO” to include, among other things, a “registered securities association.” Id. 68 See FINRA rules for Portals http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=12221 - 172 -

of securities of the same class and having the same terms, conditions and rights as the securities being offered or sold in reliance on Section 4(a)(6) through the intermediary’s platform. Among other things, Rule 302(d) requires an intermediary to clearly disclose the manner in which it will be compensated in connection with offerings and sales of securities made in reliance on Section 4(a)(6) at account opening and Rule 303(f) requires disclosure of remuneration received by an intermediary (including securities received as remuneration) on confirmations.69 In addition, the intermediary must comply with all other applicable requirements of Regulation Crowdfunding, including the statutory limitations on a funding portal’s activities.70

In other words, the Crowdfunding portal cannot invest directly or indirectly in an issuer using its portal, but can be compensated, for its services as a portal directly related to selling the securities, with the same type and price of securities being offered. We doubt many portals will be able to afford the lack of cash flow in their business model by accepting illiquid securities as compensation for services rendered. Think about it if your company was a portal, you’d soon be in a severe cash crunch, because every issuer would just as soon pay for your services with “paper” (their securities) as opposed to cash, because small companies are often starved for cash… hence the reason for raising capital in the first place.

The reason you need to know this, is because the burden of securities compliance ultimately falls upon you and your company as the issuer of securities, in the absence of a broker-dealer. Broker-dealers may share in that burden but never totally relieve that burden from the issuer. Therefore, if and when using the Regulation-Crowdfunding exemption, you will need to engage only one Crowdfunding Portal and it must be SEC registered and a FINRA Member. Remember, it’s up to you and or your legal counsel to ensure you’re using a portal that is in compliance and more importantly that your disclosures limit the possibility of claims against you for securities fraud—a criminal offense.

69 See Sections II.C.4.d and II.C.5.f. See also Rule 302(c) of Regulation Crowdfunding (requiring intermediaries to inform investors, at the time of account opening, that promoters must clearly disclose in all communications on the platform the receipt of compensation and the fact that he or she is engaging in promotional activities on behalf of the issuer). 70 See Exchange Act Section 3(a)(80) (defining “funding portal” and establishing certain limitations on their activities consistent with the statute, such as prohibiting a funding portal from offering investment advice or recommendation; soliciting purchases, sales or offers to buy securities offered or displayed on its website or portal; or holding, managing, possessing, or otherwise handling investor funds or securities). In this regard, compliance with disclosures required by Regulation Crowdfunding generally would not cause a funding portal to provide investment advice or recommendations. Nonetheless, a funding portal should seek to ensure that disclosure of its financial interest(s) in an issuer is not inconsistent with the statutory prohibition on providing investment advice or recommendations. For example, a funding portal must not present its financial interest in an issuer as a recommendation or endorsement of that issuer. See Section II.D.3. We also note that if a funding portal holds, owns or proposes to acquire securities issued by an issuer, or multiple issuers, that individually or in aggregate exceed more than 40% of the value of the funding portal’s total assets (excluding government securities and cash items) on an unconsolidated basis, the funding portal may fall within the definition of investment company under Section 3(a)(1)(C) of the Investment Company Act. We generally would expect, however, that such funding portal would seek to rely on the exclusion from the definition of investment company in Section 3(c)(2) of the Investment Company. - 173 -

Non-Integration with Concurrent Offerings

Offerings made in reliance on Section 4(a)(6) will not be integrated71 with other exempt offerings made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering. This is excellent news in that one can immediately move to another offering exempt from registration within the 12-month period, such as; Regulation D - Rules 504, 506(b) or 506(c) or Securities Act Section 4(a)(5) - the Accredited Investor Exemption - and continue the capital raise under the same deal structure. Technically, one could conduct concurrent offerings with the same deal structure under various exemptions and stay in compliance. From a practical standpoint, this would make a lot of sense in that one would not be reliant on only one method of solicitation (Regulation Crowdfunding) with only one portal. An issuer could “double down” by soliciting inside as well as outside the portal under various other exemptions from registration, such as; Regulation D, SCOR or Regulation A. This would require legal review and over-sight but should prove cost-effective given the increased probability of a successful capital raising effort.

Under Section 4(a)(6), the amount of securities sold in reliance on Section 4(a)(6) by entities controlled by or under common control with the issuer must be aggregated with the amount to be sold by the issuer in the current offering to determine the aggregate amount sold in reliance on Section 4(a)(6) during the preceding 12-month period. Under the proposed rules, for purposes of determining whether an entity is “controlled by or under common control with” the issuer, an issuer would be required to consider whether it has “control” based on the definition in Securities Act Rule 405.19 As proposed, the amount of securities sold in reliance on Section 4(a)(6) also would include securities sold by any predecessor of the issuer in reliance on Section 4(a)(6) during the preceding 12- month period.

We [the SEC] provide guidance that an offering made in reliance on Section 4(a)(6) is not required to be integrated with another exempt offering made by the issuer to the extent that each offering complies with the requirements of the applicable exemption that is being relied upon for that particular offering. As mentioned earlier, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Alternatively, an issuer conducting a concurrent exempt offering for which general solicitation is permitted, for example, under Rule 506(c), cannot include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with Section 4(a)(6) and the final rules.

In our opinion, the non-integration with other exemptions provision is the most important position the SEC has taken on crowdfunding. The reasoning is the SEC takes notice that crowdfunding, due to its limitation on the size any particular investor can make, will dissuade professional and true angel investors from participating in a crowdfunding campaign. The ability to continue (simultaneously) the capital raising

71 The integration doctrine seeks to prevent an issuer from improperly avoiding registration by artificially dividing a single offering into multiple offerings such that Securities Act exemptions would apply to multiple offerings that would not be available for the combined offering. See, e.g., Final Rule: Nonpublic Offering Exemption, Release No. 33-4552 (Nov. 6, 1962). - 174 -

effort through another exemption outside Regulation Crowdfunding may prove invaluable to young companies seeking seed or development capital.

Advertising the Offering

The statute and the final rules prohibit an issuer from advertising the terms of the offering, except for notices that direct investors to an intermediary’s platform. The terms of the offering include the amount offered, the nature of the securities, price of the securities and length of the offering period.72 The final rules allow an issuer to publish a notice about the terms of the offering made in reliance on Section 4(a)(6), subject to certain limitations on the content of the notice.73 The notices are similar to the “tombstone ads” permitted under Securities Act Rule 134,74 except that the final rules require the notices to direct investors to the intermediary’s platform, through which the offering made in reliance on Section 4(a)(6) is being conducted.

Under the final rules, an advertising notice that includes the terms of the offering can include no more than: (1) a statement that the issuer is conducting an offering, the name of the intermediary through which the offering is being conducted and a link directing the investor to the intermediary’s platform; (2) the terms of the offering; and (3) factual information about the legal identity and business location of the issuer, limited to the name of the issuer of the security, the address, phone number and website of the issuer, the e-mail address of a representative of the issuer and a brief description of the business of the issuer. Consistent with the proposal, the final rules define “terms of the offering” to include: (1) the amount of securities offered; (2) the nature of the securities; (3) the price of the securities; and (4) the closing date of the offering period. 75The permitted notices will be similar to “tombstone ads” under Securities Act Rule 134,76 except that the notices will be required to direct an investor to the intermediary’s platform through which the offering is being conducted, such as through a link directing the investor to the platform. The final rules do not impose limitations on how the issuer distributes the notices. For example, an issuer could place notices in newspapers or post notices on social media sites or the issuer’s own website. We believe the final rules will allow issuers to leverage social media to attract investors, while at the same time protecting investors by limiting the ability of issuers to advertise the terms of the offering without directing them to the required disclosure.

In our opinion, this provision has sufficient latitude and is an efficient use of costs. As in other exemptions, a tombstone advertisement, done correctly, will motivate a prospective investor to investigate further by going to your company’s offering page on the portal.

72 See Instruction to Rule 204 of Regulation Crowdfunding. 73 See Rule 204(b) of Regulation Crowdfunding. See also Section II.B.4. 74 17 CFR 230.134. 75 See Instruction to Rule 204 of Regulation Crowdfunding. 76 17 CFR 230.134. - 175 -

Oversubscription and Offering Price

The final rules permit an issuer to accept investments in excess of the target offering amount, subject to the $1 million limitation, but require the issuer to disclose the maximum amount the issuer will accept and how shares in oversubscribed offerings will be allocated. We [the SEC] continue to believe that permitting oversubscriptions will provide flexibility to issuers so that they can raise the amount of capital they deem necessary to finance their businesses. Given the uncertainty on the part of the issuer about potential market demand for the issuer’s securities, we believe it is valuable for issuers to have the option to permit oversubscriptions. For example, permitting oversubscriptions will allow an issuer to raise more funds, while lowering compliance costs as a proportion of the amount raised, if the issuer discovers during the offering process that there is greater investor interest in the offering than initially anticipated or if the cost of capital is lower than initially anticipated.

This is another pleasantly surprising form of leniency on the part of the SEC. We encourage all our customers to go for the maximum $1,000,000 allowable amount under Regulation Crowdfunding, but design a greater amount in your deal structure, then simply provide for disclosure on Form C that you can go for more. It was called a “green- shoe” option back in the day on Wall Street. We have yet to meet an entrepreneur that could use less capital than originally planned for.

Restrictions on Resales

The statute and the final rules include restrictions on the transfer of securities for one year, subject to limited exceptions (e.g., for transfers to the issuer of the securities, in a registered offering, to an accredited investor or to certain family members).77 Under the statute and the final rules, the securities will be freely tradable after one year. This too is more lenient than most other exemptions from registration, opening the door to an exit strategy for investors. This may also enable an issuer to liquidate previous investor holdings during subsequent private offerings, with full disclosure, thereby enabling one to “clean-up” the investor base. Sometimes an issuer can have “problem” investors and this is a good way to get them out of your hair without costly registration of securities.

Relationship with State Law

Section 305 of the JOBS Act amended Securities Act Section 18(b)(4)78 to preempt the ability of states to regulate certain aspects of crowdfunding conducted pursuant to Section 4(a)(6). The requirement in the final rules that issuers file information on EDGAR also helps to ensure that information about issuers is available to individual state regulators, which retain the authority to bring enforcement actions for fraud.

This is another lenient provision provided by the title of the JOBS Act of 2012 itself. It was always intended that the Act be national and hence only federal regulators, barring fraud, have jurisdiction on regulation and enforcement.

77 See Section 4A(e). See also Rule 501(a) of Regulation Crowdfunding. 78 15 U.S.C. 77r(b)(4). - 176 -

Exemption from Section 12(g) - Becoming an SEC Reporting Co.

Rule 12g-6 provides that securities issued pursuant to an offering made under Section 4(a)(6) are exempted from the record holder count under Section 12(g) provided the issuer is current in its ongoing annual reports required pursuant to Rule 202 of Regulation Crowdfunding, has total assets as of the end of its last fiscal year not in excess of $25 million, and has engaged the services of a transfer agent registered with the Commission pursuant to Section 17A of the Exchange Act. An issuer that exceeds the $25 million total asset threshold in addition to exceeding the thresholds in Section 12(g) will be granted a two-year transition period before it is required to register its class of securities pursuant to Section 12(g), provided it timely files all its ongoing reports due pursuant to Rule 202 of Regulation Crowdfunding during such period. Section 12(g) registration will be required only if, on the last day of the fiscal year in which the company exceeded the $25 million total asset threshold, the company has total assets of more than $10 million and the class of equity securities is held by more than 2,000 persons or 500 persons who are not accredited investors.79 In such circumstances, an issuer that exceeds the thresholds in Section 12(g) and has total assets of $25 million or more is required to begin reporting under the Exchange Act the fiscal year immediately following the end of the two-year transition period. An issuer entering Exchange Act reporting will be considered an “emerging growth company” to the extent the issuer otherwise qualifies for such status.

The conditional 12(g) exemption will defer the more extensive Exchange Act reporting requirements until the issuer either sells securities in a registered transaction or registers a class of securities under the Exchange Act. Consequently, smaller issuers will not be required to become an Exchange Act reporting company as a result of a Section 4(a)(6) offering.

Therefore, before Title III, if your small company had over 2,000 investors you became an SEC Reporting company whether your company’s securities were publicly traded or not. This is still the case, but the amount investors you obtain during a crowdfunding campaign will not be counted toward that 2,000 number. We applaud this thoughtful and lenient policy of the SEC.

In conclusion, done correctly, Regulation Crowdfunding conducted under Title III of the JOBS Act of 2012, in conjunction and offered concurrently with other exemptions from registration, such as; Regulation D 506(c), with a marketable deal structure will enable serious entrepreneurs to raise substantial amounts of capital like never before. Unlike the previous eight decades prior to May 16th 2016, it’s now relatively easy to raise capital the right way—in compliance with federal and state securities and tax laws, rules, and regulations.

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79 15 U.S.C. 78l(g). - 177 -

Chapter 18: Soliciting & Selling Securities to Raise Capital

If you have completed the following four items, you are ready to raise capital through the selling and issuance of securities.

1. Decided on a deal structure. 2. Produced the appropriate securities-offering document. 3. Checked the “Compliance” section in the Corporate Engineering Conservatory™, to ensure any additional requirements have been met to complete the document. 4. Had your Company’s final securities-offering documentation reviewed by your attorney.

If you have completed the above steps, you may be one of a very few individuals who will succeed in raising capital for your start-up or early stage Company! You have come a long way. However, you still need to sell the securities, in a highly regulated environment, to raise capital.

This lesson is not a course on selling. Although we have outlined the techniques of selling securities in a highly regulated environment, one must understand the fundamentals of basic selling first. If you don’t know how to sell what are you doing in business? If you do know how to sell your company’s products and services, you can learn to sell its securities. You can also employ help by hiring a CFO with a securities industry background.

Everyone sells all the time. Some are simply better than others. You have been selling yourself and your abilities all your life. Most investors like to be sold. Most knowledgeable investors know a CEO and his/her management team had better be able to sell everything in sight. You and your Management Team need to be able to sell your Company’s products and/or services into distribution channels. You also need to be able to sell your Company’s corporate culture to the potential, talented employees you want working for your Company—not your competitors. In addition, you and your management team need to be able to sell the banker on providing the loan after the equity is raised. Sell the FDA, FCC, OSHA, or any other regulatory authority the company must interact with, that your Company’s operations does in fact comply with the various regulations. More important, you and your management team need to be able to sell securities to raise capital for your Company—even if you engage an SEC-registered broker-dealer to act as an underwriter.

Some folks are more successful at selling because of their inherent personalities. If you have a real problem with the concept of selling intangible assets—such as securities to capitalize your Company—you may want to rethink your mode of operation one more time and attempt to raise enough capital to license and place your inventions, products, or services with a potential strategic alliance as opposed to building a business.

Better yet, hire someone from the securities industry (your new CFO or VP of Finance), who is ready, willing, and able to sell your companies securities as part of your senior-management team.

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There are quite a few selling courses available—Zig Ziglar and Dale Carnegie come to mind. Og Mandino’s book, The Greatest Salesman in the World, is a must for those who want to perfect their selling skills. Neil Rackham’s SPIN Selling and Tom Hopkins’s How to Master the Art of Selling are two more. There are many excellent programs and books available—learn from them if you’re not used to selling. For the “selling type,” to get refreshed and energized, you may want to review those selling courses—this is “show time.” (Arm yourself with basic selling abilities and skills.) Once you feel confident with basic selling skills, employ the following techniques outlined here and in the Corporate Engineering Conservatory™ to sell your Company’s securities. In addition, to keep “pumped up” through this process, we suggest a classic book, The Power of Positive Thinking, by Dr. Norman Vincent Peale.

The Key Points to Selling a Private Placement of Securities:

1. In a previous lesson, we suggested you “test the waters” of your private-capital market for indications of interest. This means finding out what others want in an investment and tailoring your securities offering to meet that demand. Your success in your capital-raising efforts will be in direct relation to how well you have attempted to serve the needs of others. Recall that we suggested you ask a few wealthy folks to help you in your quest to formulate your deal structure for a securities offering. If you had put together your prototypes and asked these folks for their honest opinion on the deal structure, you would have gathered a feeling about where your private market is—as far as their desire for a particular deal structure. Humbly, with “hat in hand,” you approached them and asked for their wisdom, sagely advice, and help. By finding out their level of interest, you were able to customize a securities-offering that fits the demand. Many times, when an investor says he/she will like this/that, they are giving you their honest opinion. They are many investors in the US and around the world and they invest money all the time. There are many affluent folks looking to invest. We’ve read estimates that stated over $60 billion was invested in start-up and early stage companies in the year 2000—even after the dot- com collapse. It is simply up to you to draw upon these investors. Do you realize 1/10 of that figure is $6 billion; 1/100 is $600 million; 1/1,000 is $60 million; 1/10,000 is $6 million; and 1/100,000 is $600,000? All you have to do is attract…for $600,000 in start-up capital! Use that amount of equity capital to convince the bank to loan your Company $400,000. Now you have $1 million in capital.

2. You are selling an intangible asset. Attempt to make the investor’s buying experience as tangible as possible. If you have developed a prototype product, ensure the prospective investor(s) get a hands-on experience. If you provide a service, ensure the hands-on experience as well as showing the value.

3. You are selling a high-risk/potentially high-return security—sell it for what it is. Tell the prospective investor you’ve attempted to remove from the security as much risk as possible through the formulated deal structure. Sell the deal structure after you have sold the opportunity the company is meant to capitalize on. You have put them first in all manners of safety and return.

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4. Soliciting and selling securities is a highly regulated numbers game. You can solicit and sell securities to a limit of thirty-five (35) non-accredited investors— under most circumstances—and an unlimited number of accredited investors under the three subsections of Regulation D. If you can, we suggest you solicit and sell to accredited investors only. By doing so, you will further remove yourself and your Company from inadvertently violating any rules of the Regulation D, exemptions from registration.

5. Trusted relationships with potential investors are crucial to successfully raising capital. For a prospective investor to actually invest in your Company, you must meet four key elements: • A [strong] belief in you and your business opportunity. • They must understand what your Company does. • They must trust you and your ability to make them a profit. • More than anything else, they must like you.

How Stockbrokers Sell Securities

Stockbrokers—also known as “financial advisors” or “financial consultants”—are the only professionals who can legally raise capital for other issuers of securities (companies) in the United States. Technically, they are “registered representatives” of SEC-registered broker-dealers/FINRA Member firms.

All stockbrokers have restrictions on the way they prospect for new clients. They are highly regulated by a number of regulatory authorities. Actually, over sixty regulatory US authorities regulate how stockbrokers operate. However, they can sell investments to just about anyone, as long as the investment is suitable. If the investment is not suitable, the stockbrokers can get heavily fined, possibly lose their licenses, and/or, in extreme cases, serve jail time. They may advertise anywhere and everywhere, under certain content restrictions, as long as it does not involve a private placement of securities.

You, too, have restrictions on new-investor-prospect methods when engaged in a private placement. You may not use a general form of advertising unless your Company’s securities have been registered at the state and/or federal levels or have qualified for an exemption, thereof. For a private placement, you must keep the solicitation and sales effort private or directed to accredited investors only, with no use of general solicitation—not even direct mail, email, or even a password-protected area on your Company’s website—unless certain regulatory protocols are complied with. This may seem like a disadvantage, but it is a blessing in disguise.

General advertising doesn’t work for most start-up and early stage companies unless you can advertise a relatively safe security, like a Note, Bond or a Preferred stock with a high yield in the newspaper to generate investor leads. A private deal has the element of secrecy. You have absolute exclusivity to your securities offering unless, of course, you are engaged with a FINRA Member, syndicated, selling group. Even then, you still have relative exclusivity. You are different and should command an investor’s attention if you approach them correctly.

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Accredited investors are bombarded by stockbrokers, financial advisors and consultants every day. For the most part, these professionals are selling the same old stuff. Any broker can sell a bond, a publicly traded stock, a mutual fund, or a professionally managed fee-based account to an investor. They’re all fishing from the same public pond, essentially. Even new municipal bonds are market priced, so the exclusivity one broker has over the other, for all intent and purpose, is meaningless because all bonds are priced the same according to coupon rate, maturity, and safety—it becomes a bit boring. Historically, the S&P Index has outperformed 98% of all money managers (including mutual funds) every year. Most accredited investors know that and buy index Funds. Most accredited investors like to review special and exclusive deals with exit strategies and real upside potential.

Most stockbrokers sell securities that are publicly traded and, therefore, liquid. Investors can buy and sell them all day long. This seems to be an advantage if you look at it that way. First, the liquid stock has already gone through its initial IPO. It is already priced to the publicly traded market, or where it should be priced. The entire bang for the investment buck is gone! The greatest amount of upside potential in most stocks is getting in BEFORE the IPO. Hot IPOs can go up ten times their original offering price after going public. Moreover, some have done it in less than a year. What about the returns to the original investors who got in at maybe 1/10 or 1/20 of the original IPO price? Those returns are massive. Now that is upside potential and is what you are offering investors if your Company’s plan is to go public someday. Don’t forget, you can list your hybrid securities on a limited public exchange, like the OTCBB, as well.

In bull markets (markets increasing in value), investors can make this argument: “Why should we take on the risk of an early stage or start-up venture when my mutual fund has been returning an annual 22% for the past few years?” Your comeback could be: “Do you think that’ll last over the next year or two?” and/or “Why don’t you start paring back by selling some of those shares to raise some cash to take advantage of the next market downturn?” or “Why don’t you take 10% or 20% of that cash and invest it in our company?” Everybody loves the public securities markets at the top and they hate those same markets at the bottom. All good traders know, they should love them (buy) at the bottom and hate them (sell) at the top.

In bear markets (markets decreasing in value), investors want to hold on to the ever-fleeting hope that their stocks will rebound, and they will regain their lost profit or at least break even on their principal amount. More often than not, it is highly unlikely that it will happen anytime soon. In bear markets, even after suffering paper losses, investors will eventually become inpatient and will look for high-yielding cash-flow-producing investments. This is where your Company’s hybrid securities can compete.

Overall, we believe you and or your new CFO or VP of Finance will have a distinct advantage over the average stockbroker. You do not need administrative support, research, or the regulatory compliance costs associated with running a typical broker- dealer. You can prospect actively in person, which is the most effective way. You have an exclusive offer that is pre-IPO with huge upside potential. Indeed, you now have a real fighting chance!

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The point being you have what everybody wished they invested in years before the IPO or outright strategic sale to Corporate America. Sell the dream!

Productive Prospecting

Okay, now you know about your competition. It is time to make contact with investors. You have your current private, personal, and professional contacts. They are your most valuable contacts, who should not be approached until later. You cannot afford to fail with these folks. Practice the snap and elevator pitches on colleagues and advisors before you present to friends, family, and personal-investor contacts. This way, you’re refining your presentation on prospects you don’t expect will invest—before you go to expectant investors. Who knows, you may get lucky and be surprised when these folks do invest.

Getting the Message Through

You need to get the securities-offering message through to all of your prospects in the most productive manner possible. Productivity here means spending your time efficiently and not wasting theirs. We have found that when talking to investors about a particular securities offering, the average attention span is limited to a maximum of about 7–10 seconds. It’s called a “snap80” presentation. You have 7 to 10 seconds to get a potential investor to say “Wow.” After that, they will give you their un-divided attention. Without that “Wow” response at the end of the 7 seconds, you’re just bothering them.

Try this. Say this sentence out-loud. “We are becoming the primary source of quality deal flow for Wall Street and Corporate America. Imagine making one investment and participating in hundreds, if not thousands, of IPOs over the next decade.” That’s about 10 seconds. If the investor doesn’t understand the “snap” either the snap is too long, not clear or the potential investor has no idea what you’re talking about, because he or she is simply not familiar with the opportunity.

Unless they express real interest after the “snap”, simply move on.

IF you get a WOW, consider an extension of the snap to the “elevator pitch.” Develop the quick 30-second to 1-minute sales presentation known as the “elevator pitch” as an extension to the snap. After that pull back and listen. Investors like to talk. They also like a little exclusivity and want to invest before others. The next step is to tell them you’ll send along a private invitation to view and video presentation and the securities being offered. A sense of urgency can be put forth here, but don’t be pushy. The sense of urgency can wait for the follow-up call.

Proactive Prospecting

For most forms of solicitation, the least expensive contact method usually results in the least effective process of producing qualified-investor prospects, which in turn leads to a lower sales-closing ratio. Email spam is the least expensive way to reach a mass audience and is basically a waste of time—along with being a nuisance—and in

80 Developed by CEO Space International - 182 -

most circumstances illegal when offering securities. Next is newspaper advertising; this is another avenue to reach a mass audience and generally results in a respectable response rate. Direct mail is probably the next, least expensive—the response rate starts to improve.

If any of the foregoing are employed in a securities-offering context and the securities are not registered or qualified under Regulation D, 506(c)—with Accredited Investor Limitation—Regulation A or A+, SCOR, or CA (1001), the above techniques will violate securities laws. However, once qualified under Regulation A or A+, SCOR, or CA (1001), you can clearly target your mailing to accredited investors who invest primarily in fixed-income securities.

Face-to-face is the most expensive form of solicitation, and the response rate starts to improve greatly. The face-to-face cold call can be used for the solicitation and sales of registered securities or securities that have been qualified for an exemption from registration (i.e., Regulation D, 506(c) (with Accredited Investor Limitation), Regulation A or A+, SCOR, or CA (1001)). The very first face-to-face cold call is obviously the most difficult because you are dealing with the unknown. Dealing with the unknown creates fear as a normal human reaction. You need to ask, “What’s the worst that could happen?” Although very rare, probably the worst outcome is some angry business owner would say, “Get out of my office, and don’t come back.” When you think about it, would you really want this person as one of your investors? (Not likely.) If you get a nasty rejection, be grateful your time is not being wasted and just move on.

Here are a few techniques to clear through the clutter: first, if the prospective investor has a securities-brokerage account, ask them what they like or dislike about some of their investments. Listen carefully to how they respond. You should be able to pick up an indication as to whether or not they are trustworthy, just from this part of the conversation. Make the general assumption that they may be exaggerating. On the follow-up process, its three strikes and you are out. If they cannot commit to your Company’s securities offering by the third contact, move on and never look back. By doing so, you will avoid passing up investor prospects who will commit their funds to your Company. Remember, it’s a numbers game.

After establishing that the prospective investor is “real” and has interest in your Company’s securities offering, simply give them your sales presentation and hand them a PPM. Remember, the distribution of a PPM is a legal requirement and not necessarily the ultimate sales tool. Although Financial Architect™ securities-offering-document templates are written in the sales-tool fashion; ultimately you and your management team must sell the deal.

Prospecting in Every Day Life

In everyday life, you will want your “snap” and “elevator pitch” to create curiosity as quickly as possible. The 7-10 second snap, and 20-30 second elevator pitch, can be followed up with a 5 to 7 minute personal or video sales presentation—something you can send a link to, use on the phone or on the golf course. Pitch the sizzle of the company’s story not the securities offering. Once someone says, “Wow!” about the story,

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say something like, “You know, we are accepting investors on this opportunity now, before we go public.” (Of course…only if an IPO is in the plan). Pitch it and drop it. Create some mystery here. Remember, you are offering an exclusive opportunity. Keep the mindset that you will choose whom you will let in the deal and not the other way around.

There are billions of dollars out there, looking for good opportunities. Sometimes people want what they cannot have; keep that concept in mind as well. Productive prospecting and good selling techniques are based on asking questions and listening. You have one mouth and two ears, so let the ears do twice the work. Your inquiries should relate to your indication-of-interest efforts in your Company’s securities offering.

The Seminar Approach

The seminar approach is a leveraged way to amplify your message.

For Private Offerings: Consider mailing a seminar-presentation invitation to all of the management team’s personal and professional contacts and selected, company clients or customers—if appropriate. If you use the procedures under Regulation D 506(c), A or A+, SCOR, or CA (1001) or (25102(n), through general solicitation—like mass mailing a letter to accredited investors in and around your geographical area—you may be able to find investors for the seminar. In addition, for some limited private offerings, you should check with your state’s securities regulatory office, as some states allow you to test the waters intrastate (within the state only). If so, you may rent a local accredited-investor mailing list and invite them to a very exclusive and private seminar.

Most marketing or mailing-list companies have access to mailing lists for accredited investors. If you would like to know what an accredited investor is, you can easily find out by visiting the SEC’s website: http://www.sec.gov/.

You will need to give the marketing company or the mailing-list company your criteria for accredited-investor selections. The accredited investors must have a certain annual-income level and/or have a total, minimum, net worth. Simply look up a few marketing companies in the yellow pages or on the Internet. You will have costs associated for renting the mailing list, mailing to accredited-investor prospects, and for the hotel conference room to hold the seminar. Remember, with a private placement, you cannot advertise the seminar, using the general media.

To get more “bang for buck”—i.e., your invitation dollar—offer a series of dates and times (e.g., 10:00–11:00 a.m. and 1:00–2:00 p.m.). Do this on Friday and Saturday, for the next two weeks. (You do not want to open the window of opportunity too wide with additional weeks.)

If you decide on an evening-seminar format, these programs should be scheduled as follows: 5:30–6:15 for cocktails and 6:15–7:00 p.m. for the presentation. The presentation should last only ten minutes, and time limits should be highlighted in the invitation. Allow an additional ten minutes for Q&As. Cut it off at that point; make them

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want to know more—on a private basis. Arrange to meet with these prospects in the near future. Be brief and to the point, on each section of your seminar.

Present the Story: in two, short, five-minute steps.

1. Explain the “world” as it exists within your industry. 2. Explain the existing “problems” in that world. 3. Explain the “solution(s)” to those “problem(s)” and how the solution(s) relate to your Company making money. 4. Explain the “investment opportunity” that now exists by purchasing securities in your Company.

These four sections make up the (1) introduction, (2 & 3) the body, and (4) the conclusion of your seminar and sales presentation to be used over the phone, on the golf course, or in the elevator.

When attempting to conduct seminars, the first problem you’ll probably meet is everyone has an excuse for being absent—e.g., holidays, tax time, kids are out of school, etc. It is now time to start spending some of that seed capital. we would invite only the elite of your management team’s contacts or selected accredited investors to the following events:

Weather permitting, consider a golf outing for attracting your best personal contacts and accredited investors. Make it on a weekday, preferably in the midmorning on a Tuesday or Wednesday—a lot of doctors and dentists take Wednesdays off. Ask the golf-course professional if you can have a 10–10:30 a.m. “shotgun start” with an hour lunch scheduled for 12:00 or 12:30 p.m. (In a “shotgun start,” everyone’s positioned at different course tees and simultaneously starts at the sound of a shotgun fired from the clubhouse; hence, everyone finishes at the same time.)

Ensure your invitations are golf-oriented—e.g., “You are invited to the XYZ Widget Co. 1st Annual Golf Classic.” Make sure your guests know there is no charge for them—e.g., their green and cart fees have been taken care of, compliments of XYZ Widget Co. In addition, be sure to inform your guests of the special-investment presentation to be held at lunch. Be upfront about your intentions to conduct an investment-opportunity presentation during lunch. If you are not upfront about your motives, you will be wasting your money. Investors do not like to be tricked into a sales presentation—most will resent you for it. In all aspects of business, especially when raising capital, honesty is not only the “Best” policy; it is the ONLY policy.

Nine holes should take about two hours to play. After the first nine holes, you will want everyone to gather in the clubhouse for lunch, so you and your management team can give the sales presentation. You want a secondary post-lunch “shotgun start,” so people won’t start leaving right after they’ve eaten and will take the time to hear your Company’s story.

In different parts of the country, golf courses have seasonal and non-seasonal rates. We’ve seen entrepreneurs drop $5,000 to close the course to the public for the day.

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(I think that is one of the most professional ways to attract seminar prospects.) Make sure there are complimentary cocktails and hors d’oeuvres, as well as door prizes after the outing—all compliments of your Company. You will want a little post-outing personal- conversation time with your guests. Be sure you and your management-team members “work the room”—i.e., they should be talking to investor prospects, not each other.

You should have eighteen foursomes, which equates to seventy-two potential investors, participating in the golf outing. However, husbands and wives sometimes play golf together—although rarely in an outing—so they would be considered one investor. The actual amount of investors should be between thirty-six and seventy-two. If it ends up that your turnout represents an average of fifty-four investors—actual investors as an average not couples—that is a rather productive way to spend your day. If your cost is $5,000 for the outing and you conduct five outings, you should attract 270 investors on average. This makes for a total investment of $25,000 for the course and $5,000 in mailing, door prizes, etc. If you have your sales skills mastered, you should be able to get half (135) of them to invest at least $10,000 each—that’s $1.35 million. If you are conducting an equity offering, you may be able to secure an additional $1.65 million in debt from your bank for a total capitalization amount of $3 million. (Not bad for a week’s work and a $30,000 investment!)

You also may want to consider a day or weekend cruise. It is the same, basic invitation as the golf outing; however, it is a cruise with gambling or some other type of activity. One of our clients spent almost $12,000 on an afternoon cruise for about fifty doctors and their wives. Just over $600,000 in capital was raised over the next six weeks, primarily from the connections they made on that cruise.

If you can afford ($5,000–$10,000) to give your presentation with professional multimedia, we STRONGLY suggest you do so. With a pre-edited electronic presentation burnt to a DVD, or “housed” in a Secured Securities-Offering Portal on your Company’s website, you can perfect your securities sales presentation. You will want your presentation to be as close to perfect as possible. You cannot afford to make any mistakes because you are spending your seed capital for this sales effort. (You won’t get a second chance to make a first impression.) Besides, you could have your presentation running again in a more private room, off the main clubroom, after the outing and during the cocktail time. On DVD format, give out the multimedia presentation to everyone who attends.

Allow those prospective investors to get a securities-offering document during the event. Most of our client-multimedia pieces contain the private- or public-placement memorandum (PPM) embedded in the DVD or “housed” in a secured securities-offering portal on your Company’s website. Not only is it a very simple and productive way to deliver the “sizzle” with the steak, but it will cut down on hard-copy document-printing costs as well. Also, remember to send a securities-offering document (multimedia or otherwise) to prospective investors if they cannot attend your function. To ensure securities compliance, the content of any multi-media video presentation must be extracted directly from the attorney-reviewed, securities offering document and must have a disclaimer as to securities are sold be private placement only.

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This is the first step in re-establishing a trust relationship with your personal and professional contacts, as well as establishing new trust relationships with freshly acquainted, accredited investors in your community. These are simply examples of how you can “capture” your seminar audience. You should tailor your [creative] seminar ideas to your particular region and/or situation.

The Follow Up

Everybody hates the follow up. This is where rejection happens. Fear not…for your Company’s securities-offering documents’ deal structure should sell itself. If your sales presentation is indicative of your own risk—e.g., “If this project fails, we lose not only my money but my house as well.”—investors will feel much better about cutting a check or signing a personal guarantee on a bank loan.

Ask for the money. We know that is obvious to some, but most never have the guts to ask. There are many closing techniques for this. However, remember you’re not selling used cars. Your approach should be soft and slow—e.g., “What level of financial commitment do you feel most comfortable with—$25,000 or $50,000? No… Would $10,000 be more comfortable?” If your prospect’s response is a flat “no,” don’t ask, “Why not?” In an inquiring tone, just ask, “Oh?” You want to ask open-ended questions. You want to find out what the real objection is. (You will not know unless you persist.)

Don’t ask, “When can we come by to pick up the check?” This makes you seem too eager and is likely to make the prospect reluctant to invest. Don’t ask, “Why don’t we have lunch next Tuesday, and we’ll complete the transaction then.” Start it off with, “Would you like . . .” Rephrase it in a softer, sophisticated tone—e.g., “Would you like me to stop by this afternoon to pick up your investment?” “Would you like to have lunch next Tuesday, and we’ll complete the transaction then?” By taking this stance, you’re at his/her service in a very professional manner—e.g., “Would you like to put this investment in your self-directed IRA, to avoid a potentially large capital-gains tax?”

Incidentally, some people do not think of their IRA as money; they think of it as an asset—a long-term investment. This is because, more often than not, they were sold the investments within the IRA as such. Sometimes they don’t know those investments can be sold to produce the cash available for an investment in your Company’s securities. (See the Corporate Engineering Conservatory™ on techniques and procedures to attract qualified plan funds, such as IRAs, SEPs, and Keoghs, to capitalize your Company.)

In the follow-up call, you need a reason… Don’t say, “I’m calling to just follow up and see if you have any questions about our securities offering.” That is an incredibly unprofessional remark. Don’t call until there’s a reason! Reasons would constitute reaching certain milestones in your project or in the capital-raising effort itself. Let’s say you were raising $300,000 in equity and there’s only $150,000 left. That would constitute a reason to call. Let’s say your prototype product has a newly developed technology or application added to the product. That would also constitute a reason to call. You want to keep your very best prospective investor(s) informed. You should call or contact them by mail or email every thirty or sixty days—just on a friendly “Thought we would let you know how the company is progressing…” kind of call. Investors appreciate this. You are

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letting them know you are still around, truly committed to the process and moving in a positive direction. Only create a sense of urgency and a “call to action” or commitment if it feels right during the conversation.

Electronic Posting on Various Websites

This issue is dynamic and changes often. Please refer to the Corporate Engineering Conservatory™, which has instructions and links to various websites where you can post your completed securities-offering document. Those postings won’t get you very far though. That’s why we allow a select group of investors into our Corporate Engineering Conservatory™—the private password-protected area on the website, to view securities offerings of our portfolio companies in Commonwealth Capital Income Fund-I. We provide a nest of angel investors who appreciate how we engineer companies and conduct due diligence. We provide this as a valuable tool that enables you to access many accredited investors inexpensively.

Hiring a CFO or VP of Finance.

The third part of the “perfect storm” lies with recognizing that one can hire— relative to the past—securities professionals who have investor contacts and skills sets to assist you in raising substantial amounts of capital for your Company. As aforementioned, this is not a pre-requisite for raising substantial amounts of capital for your Company. This part of the process is generally reserved for companies doing third- or fourth-round financing. One should have ample seed or development capital on hand and/or sufficient cash flow from sustained operations, before considering this part of the process. Remember, this is an additional option, primarily for early or later stage companies—not a requirement of the process. As a rule, this option is rarely used for start-ups, but of course there are exceptions to every rule.

The securities industry has become—and continues to be—commoditized. This means the cost of the process, product, or service is being brought down to its lowest level possible—because said items are standardized and automated—to the greatest degrees possible…at the time. Because of the advent of online trading, investment- portfolio management, and information available on the Internet, those time-flexible investors can easily learn how to manage their investment funds without the need for professional advice. As a result, firms in the securities industry have been cutting costs to compete for the still-available hands-on advisory business. Services are being increased and prices decreased. That’s good news for the average investor but bad news for the industry—especially for the financial-advisor profession. Most investment portfolios are managed in “fee-based accounts” that started out with annual fees of 2%–3% in the 1990s and are now down to as low as 0.25%–1%. (They could continue to move lower.)

Let’s analyze this further. Let’s say the fee for the average account size under management is 1%. At most investment firms, the average commission payout to the financial advisor is 35%. Therefore, a new financial advisor will need to attract and raise a lot of capital, just to eat. To be fair, most firms will pay a salary for one or two years for the “Financial Advisor Trainee,” but if the commission payout doesn’t warrant the salary paid to the financial advisor, he/she is let go.

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Let’s say a financial advisor can raise $20 million in the first two years of employment. Assuming the 1% fee with the 35% commission pays out, the financial advisor will start off the third year at $70,000 in income. The financial advisor had to raise only $192,307/week, on average (52 weeks per year x 2 years with no time off) for an annual income of $70,000 in the third year. What’s the big deal, right? Imagine having to sell securities at a rate of $200,000/week with nothing special or different about them! The financial advisor is selling the same commoditized services as everyone else in the industry. They’re all fishing in the same publicly traded pond. No one has an edge over anyone else. As an informed investor, why would we want to move my funds from one firm to another? In addition, what happens to our friendly financial advisor when markets crash? Investors move into other things, like real estate and private placements of new companies. What happens when markets rise? Investors don’t move from one brokerage house to another for no reason. However, they do feel wealthier when markets rise. In riskier ventures, it is easier to get them to invest a small amount of their total portfolio. Money doesn’t disappear—it moves. Get ahead of the movement with a securities offering that will attract capital.

In the securities industry, its common knowledge that 82% of all new trainees leave the industry after their twenty-fourth month. As a licensed twenty-two-year professional in the securities industry, we saw these trends coming some time ago; that is why we decided to get out—ahead of that wind of change. The point is financial advisors now have to kill themselves to eke out a living within the framework of the securities industry. The average cold-call quota for the major Wall Street firms is two hundred a day—a thousand a week—and it’s closely monitored. Can you imagine what kind of degrading work that must be? Fail to make the calls? You’re fired—period. Make sure your desk is cleaned out by close of business. And, oh, by the way, thanks for opening accounts for all your friends and family members.

What does this mean for you, concerning raising capital for your Company? We think you can answer that yourself. Do you think these financial advisors would like to be part of your Company’s senior management team, starting out with a respectable base salary—not to mention some semblance of self-respect for their intellect and investor contacts—or continue to slug it out over the phone like dogs fighting over a bone? Do you think they may know individual investors who would be interested in investing in your Company? Do you think they have the selling skills and compliance knowledge to handle the task? Could you afford one or two if they each raised $200,000 a week, a month, or a quarter for your Company?

The fact is most of these young professionals are caught in proverbial high-end sweatshops; they are looking for a way to use their knowledge—most would jump at the chance to become part of the senior-management team of a promising start-up or early stage company. Most have the selling skills to pitch securities and handle the administrative compliance to get the job done. Better yet, there are many “seasoned,” former professionals from the securities industry who have huge contacts (for capital and otherwise) who are just itching to get back in the game—part time of course. Imagine your board of directors or board of advisors having one or more of these heavy hitters fulfilling the need of high-level introductions to your firm. Get creative here!

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How do you hire one or two of these highly trained professionals who have investor contacts? Put an advertisement in your local newspaper, or use any other familiar method when seeking talented employees. This is not rocket science; it’s what Wall Street firms do every day. If you believe hiring a real CFO or VP of Finance is appropriate for your Company at this stage, and once you have started the securities offering document production process, you should immediately start the hiring process by placing advertisements in the employment section of your local newspaper. Alternatively, if you’re in a small city, consider placing one in the newspaper of the closest large city. Collect resumes for the first two weeks; set up and conduct interviews in weeks three and four. By the time the interviewing process begins, your securities-offering-document draft should be complete. You can then show a prospective CFO or VP of Finance what he/she will be expected to sell. If hired, they will need to add their biography to the Management team in the securities-offering document.

What happens to your new CFO or VP of Finance once the capital is raised? First of all, many entrepreneurs feel they need to raise only a certain dollar amount of capital, and the business will then fund its own growth. Rarely is that the case. Typically, to grow a company to its full potential, there is a consistent need for additional capital. You will need your CFO or VP of Finance to plan, prepare, and oversee your Company’s ongoing, financial needs and capital-raising efforts—as well as handle administrative-compliance duties of any securities offerings. The CFO or VP of Finance does not replace a Controller. A Controller is generally someone versed in accounting practices such as a CPA, who “accounts” for all the financial transactions of the company. On the other hand, the CFO or VP of Finance plans for future capital needs, researching what capital and financial structures are best suited for the company to meet its goals. The CFO or VP of Finance will generally oversee all securities offerings, refinancing efforts, leasing arrangements, and franchise sales if applicable. The point is the CFO or VP of Finance’s work is rarely done. If your Company grows, affording the CFO or VP of Finance is never a problem. Your Finance Department may just be the cornerstone of your Company’s success, not a beast of burden.

This third part of the “perfect storm” simply recognizes your freedom to hire former (early retirees from the securities industry) or current Financial Advisors away from Wall Street firms in any town, city, or village that has a branch office of investment firms, for a reasonable base salary and benefits.

Where’s the Money?

A prominent securities attorney once asked me why US east and west coast entrepreneurs are so much more likely to attract and raise risk capital. The answer is “It’s simply cultural. Do you think it is easier to raise money in New York or New Guinea— San Diego or Sudan? If investors are not in your backyard, you need a new backyard.” Remember, there’s nothing like a face-to-face meeting with those who have the money to risk.

Most entrepreneurs are under the illusion that, due to the advent of the Internet, they can reach a mass audience of potential investors with relative ease, which they

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may—in time. However, there are more reasons why they may not. As previously mentioned, we allow a select group of investors into Corporate Engineering Conservatory™—the private password-protected area on the website, to view securities offerings of our portfolio companies in Commonwealth Capital Income Fund-I. The reason we have done this is that it is a very inexpensive way to reach an audience of potential investors—broken down by areas of interest. However, start-up and early stage companies need to solicit and sell securities—first to the management team’s personal and professional contacts then reaching outward in a geographical sense. By advertising the securities locally, you will be able to meet personally with potential investors. More importantly, they will be able to meet with you—a critical element in developing the trust relationship. Without establishing a trust relationship, you simply will not receive funds.

The best place to start is within your areas of influence “professionally”…then geographically. As aforementioned, conduct a private seed capital round through friends, family, personal, and professional contacts, then expand the deal structure to a preferred offering with a high-stated dividend, to locally advertise in the general media.

Now you are competing head-to-head with financial institutions for individual investors—based on the ability to provide a higher “current yield” and consistent cash flow to investors. SCOR offerings qualifying for soliciting your Company’s securities through the general media enables you to advertise in your regional Wall Street Journal, Investors’ Business Daily, local newspaper, as well as direct mail and/or radio advertising. Imagine investors calling you to inquire about funding your Company. This is an extremely important strategy. Except for the Oil & Gas Producer™—SCOR is not available for mineral extraction projects; it’s a regulatory thing (not our fault)—all Financial Architect™ programs enable you to accomplish this registration process with relative ease and at a fraction of the traditional cost.

Raising sufficient development or expansion capital is generally done by selling participating-preferred shares to new investors in your local community, advertising the securities in the local newspaper, or through a direct-mail campaign. Before the Internet, advertising the securities in the local newspaper—“Tombstone” ads—was the way Wall Street investment banks notified potential individuals as well as institutional investors.

TOMBSTONE EXAMPLE ONLY—NOT AN OFFER OF SECURITIES

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Think of it this way: they invest in your Company because you are offering a higher current yield on the investment by creating a stated dividend on the preferred shares. You are also offering a participation of the profits to increase their overall return, in the event of success. Investors get all this for taking on the elevated risk, by investing in a new company in its early stage. By offering this type of deal structure, you place them in the first- (once you pay off the notes) or second- (if you don’t pay off the notes) lien position on assets (you’re putting everything you have invested in your Company on the table again). More importantly, you are not giving up any permanent equity, as the preferred shares may be “called.” You may decide to pay off or “Call” the preferred shares with a combination of retained earnings and/or bank debt, if your Company becomes bankable.

Current securities laws state there are only two ways to legally raise capital for your Company: produce a business plan and send it to financial institutions (for a 0.77% probability of funding); or, after creating the required securities-offering document, sell securities directly to individual investors, in compliance with federal and state securities laws—for a much higher probability of funding—or engage an SEC-registered investment bank/NASD-member broker-dealer to sell the securities on your Company’s behalf. Only SEC-registered investment banks/securities broker-dealers (investment firms) or bona fide issuing-company employees can legally solicit and sell your Company’s securities. Reputable broker-dealers will not engage a start-up or very early stage (generally defined as companies with revenue less than $5 million annually) company. Therefore, if you do not have a qualified person to handle these tasks already, you may need to hire (away from a broker-dealer) a qualified, bona fide Officer or Director to become your Company’s VP of Finance. Better yet, hire one who has recently left the industry to search for new opportunities or is getting a little bored with early retirement. If a financial advisor applying for the position of VP of Finance can’t raise money, you shouldn’t hire him/her. Hire those who are willing, ready, and able to handle the task of raising capital for your Company. (It’s that simple.)

We know exactly what most entrepreneurs want and expect: someone or some entity to raise the capital for their company on a straight-commission basis with no upfront fees. They also need the money within 30–60 days. Most think capital-raising securities sales are like listing property with a real estate brokerage firm. Nothing is farther from the truth for a start-up or early stage company. The problem: only SEC- registered broker-dealers can legally solicit and sell your Company’s securities for a commission. SEC-registered broker-dealers charge prospective companies between $25,000 and $100,000 up front in due-diligence fees—depending on the complexity of the deal—before they commit to an engagement. Additionally, most will not engage start- up and early stage companies under any circumstance. Even if the company qualifies for an engagement with a SEC-registered broker-dealer, the due-diligence process can be 60– 90 days. Also, one should not expect the money within the aforementioned time constraints. The 60–90 days is needed just to make a decision whether or not to engage your firm in a securities-underwriting agreement. Once that has been accomplished, the securities-offering documents must be prepared, which can take another sixty days and cost anywhere from $30–$50,000 for a private placement memorandum—up to $250,000 or more for an exchange listing. The point being, this is not a real estate listing arrangement; it’s serious business. The real players know it—now you do too.

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If you produce securities and the requisite documents with competitive-yield and income-participation components that meet investor demand relative to the risk—we’ll get there soon enough—you can attract some of the massive amounts of capital available from maturing bonds. You’ll be amazed at how easy it is, once you have learned the process and have built an effective finance department.

Now and over the next twenty years, the baby boomer generation will inherit a massive amount of wealth. In fact, the largest assets transfer ever in the US. Those known as the “world’s greatest generation”—coined by Tom Brokaw of NBC—the current owners of that wealth, have a risk-averse savings mentality (“tight” money) because most of this population grew up during the Great Depression. Now there is and will continue to be a massive shift from “tight” money to “loose” money. The individuals who comprise the baby boomer generation through Generation X have much more of a risk-taking mentality. They are your prospective investors, as opposed to institutions such as banks and venture-capital firms. The reason for their elevated tolerance for risk is most start planning for retirement as soon as they enter the job market and feel that any excess is available to take on higher risk for higher returns.

In addition—and more important—today’s working society has and continues to invest billions of dollars into individual-retirement accounts (IRAs). This is due to the tax benefits associated with these types of accounts. With the right institution as custodian of your Company’s securities for qualified retirement plans—such as IRAs—a portion of these dollars can now be invested in your Company’s privately or publicly placed securities, which furthers the success of your capital-raising efforts. There are billions of dollars sitting in these IRAs, waiting to be invested in companies like yours. To learn how this is done, log on to the Corporate Engineering Conservatory™—a members-only area requiring a user ID and password—reserved for purchasers of Financial Architect™ programs or for our Corporate Finance Advisory Services clientele. Different deal structures sell in different economic environments; to keep you informed on what’s selling and what’s not, we developed the Corporate Engineering Conservatory™, which contains up-to-date selling techniques and strategies to further your probability of success.

The information contained in the Corporate Engineering Conservatory™ is secretive, dynamic, and changes often. The information in this book is fundamental and rarely changes.

NOTE: INTERESTING STATISTICS:

According to Baird & Co., at the end of 2012, there was just over $10 trillion US Dollars in US Banks earning less than 1% per annum. By January of 2016, 15.5 trillion US Dollars in US Banks earning less than 1% per annum, so the trend is growing.

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According to the annual World Wealth Report from Merrill Lynch and Capgemini, the US had 4.68 million High-Net-Worth-Investors (HNWI)81 at the end of 2015—up from 2.86 million HNWI in 2009.

The wealth held by these HNWI also hit a record by the end of 2015. North American millionaires had a combined wealth of $16.23 trillion—up from $10.7 trillion in 2009.

By the end of 2015, North America’s HNWI population grew by 8.3% to 4.68 million and their wealth by 9.1% to US $16.23 trillion, driven largely by strong equity market performance.82

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81 Merrill and Capgemini define HNWI as individuals with $1 million or more in investible assets, not including primary home, collectibles, consumables and consumer durables.

82 https://www.worldwealthreport.com/reports/population/north_america - 194 -

Chapter 19: Compliance with Federal and State Securities Laws

The critical-compliance component is included and summarized only in the Corporate Engineering Conservatory™. You become a member of the Corporate Engineering Conservatory™ when you purchase a Financial Architect System™ program. Additional compliance information may obtain at www.sec.gov, FORM D, and www.nasaa.org. You should not attempt to issue securities without reviewing that critical information and obtaining a legal-opinion review of your Company’s securities-offering document—as well as the sales-and-solicitation plan from a qualified securities attorney prior to execution.

Peruse the various regulatory-authorities links to keep updated on any changes in federal and state securities laws, which may change from time to time. We have decided to keep the Compliance section of Financial Architect™ separate from this book and house such information within our Corporate Engineering Conservatory™. This was done so we may send you notifications of recently updated compliance directions and instructions located in the Corporate Engineering Conservatory™ when necessary.

Once again, to further mitigate risk, it may be wise to check with your attorney before conducting the actual offering of securities, as securities, organizational structures, tax, procedural laws, rules, and regulations can change at any time.

Seeking Proper Legal / Securities Counsel

When providing the Financial Architect™ programs to our customers, the primary question we’re asked about, for legal counsel review is “How much will that legal review cost?” The answer is “It depends.” Quality legal counsel is not cheap nor should it be. The real question is… can you strike a deal?

For instance, you certainly can seek legal counsel review with a business plan written on the back of a bar napkin and inquire what it will cost to turn it into a legitimate, securities-offering document…the answer—the maximum an attorney can charge.

However, if you deliver an inherently complete, securities-offering document with an excellent, marketable-deal-structure based on GAAP compliant pro forma financial projections that you created with Financial Architect™, the answer—the minimum an attorney would charge. This would be the case due to the prospect that your firm could become a well-capitalized client in need of legal services for some time to come. If you are savvy you may want to “shop it” and tell each attorney that you’re looking to fund legal fees with the use of proceeds from the securities offering, i. e. with investor capital, thereby realizing little to no out-of-pocket upfront costs. You may even be able to negotiate stock or a combination of stock and cash for legal fees.

Of course, this is a highly subjective area that only you can make the proper decision based on your available cash, equity and ability to negotiate. In our experience, the maximum without Financial Architect™ has been $50,000 cash and the minimum with Financial Architect™ has been $0.00 cash and 1-2% equity. Financial Architect™

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is designed to give you negotiating strength to save 90% of the typical cash cost involved with the entire process.

The bottom line in successfully raising capital for start-up, early stage, and seasoned companies—while maintaining control of the company and retaining the maximum equity for yourself and/or your management team—is to use the Wall Street process of raising capital, as disclosed throughout this book. This often takes time, money, and a concerted sales effort. Plan on it, and be patient. I know I keep reminding you about this, but I strongly encourage you to hire someone from the securities industry to help you develop and conduct a development- or expansion-capital securities offering. This strategy will afford you the patience it will take to complete your Company’s capital-raising effort through the issuance of securities in compliance with federal and state(s) securities laws, rules, and regulations. Remember, throughout the entire process, you must analyze the deal and remove as much risk from the investor’s side of the equation as possible. If you do this, you should be successful in funding your start-up, early stage, or seasoned company.

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LEGAL PERSPECTIVE - by Russell C. Weigel, III, Esq.

Albeit substantially more expensive than a Regulation D offering, another alternative is to submit a Regulation A offering circular and notice to the SEC and to each state where you wish to seek funds from prospective investors. Getting state approval may be difficult or impossible in some states because many conduct a merit review—a requirement that the offeror demonstrate a certain number of years of revenue before approval will be given. But if the offering receives appropriate approval, you will be able to advertise the offering in the states where approval was given. You can offer in more than one state but will need approval from each state of the offering circular. There is a limit of five-million dollars combined in all states. Under the Jumpstart Our Business Startups Act of 2012, two new, registration exemptions were created. One is new Regulation D, Rule 506(c). New Rule 506(c) permits an advertised, exempt offering anywhere in the United States—provided the only purchasers are verified as having met the definition of “accredited investor.” There are no dollar limits on a Rule 506 offering. The other exemption is the creation of investment “crowdfunding,” patterned after a program in use in the United Kingdom and Australia. Under investment crowdfunding, a company that does not already have a securities class registered with the SEC may use any means available to contact prospective investors—provided no more than one-million dollars is raised in a twelve-month period. There are caps on the dollar amount an investor can invest, and the issuer must direct all prospects to its funding “portal” or its licensed broker-dealer to obtain more information about the offering. Crowdfund issuers cannot accept investment funds directly from the public. Presumably, all investments must be made through the issuer’s broker-dealer or its funding portal, but the statute does not state to whom the investor must tender his/her investment money.

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Both the new Rule 506(c) and crowdfunding have unique, potential risks to the companies that utilize them, so as always, caution is necessary before journeying into these realms without counsel. Who You Should Not Speak To Investor Residence

It is critically important to know the state in which a prospective investor resides before contacting him/her. This is because in some states, the officers and directors who are soliciting investor interest may first have to be registered as brokers with that state. Additionally, in most other states, in an exempt offering, payment of a fee and a notice filing may be required. (Sample state-notice filings and a New York agent-registration form are included in the Appendix.) In a federal-registered offering for a smaller corporation, you need to know where you might conduct the offer because a state registration or qualification may also be necessary. Thus, if you are not going to register or seek exemption in a particular state, you should not communicate with any prospective investor in that state.

Age or Incapacity of Offeree

No one under eighteen years of age may independently purchase a security. As a general legal principal, this is because minors do not have the legal capacity to enter into a contract, and the transaction in which a security is purchased in exchange for money is a contract. If a minor succeeds in purchasing a security, he/she can later seek rescission. You should not try to sell your securities to an adult who is mentally infirm or who has been adjudicated as being mentally incompetent. Such contracts may be voidable by their guardians, personal representatives, or heirs.

Investor Status

In a registered offering, any competent member of the public over the age of eighteen is eligible to purchase your security. In an exempt offering, you need to know whether the prospective investor is eligible, accredited, or unaccredited. Further, in certain cases, you also need to know whether he/she (or his/her investor representative) is knowledgeable and sophisticated in business matters. The knowledgeable-and-sophisticated qualification is required for unaccredited investors under SEC Regulation D, Rule 506(b), but it is not required under SEC Rules 504. Some states have investor-suitability requirements that must be followed when conducting a private offering. Look before you leap.

Unsolicited Inquiries from Prospective Investors

Law-enforcement sting operations occur frequently and typically target public-company executives—among other securities-industry targets. Company executives may be solicited to receive funding from a person posing as the representative of a private-equity firm or hedge fund. Executives are baited to receive funding provided they agree to “kick back” to the person a finder’s fee or some other type of fee or commission—the operative word being “kick back.” The executives are being set up to violate the federal anti- kickback statute. People who fall victim to this government, baiting program can look - 197 -

forward to up to five years in federal prison, suffering reputational damage on the internet, being sued by the SEC, and barred for life from operating a public company. As a collateral consequence of a finance-related criminal conviction, convicted persons may find it difficult to open or maintain a bank account, brokerage account, or from obtaining a personal mortgage because financial institutions have perceived operational and regulatory risk when doing business with felons. State-securities-commission-staff sometimes pose as non-accredited investors. They may troll the internet, communicating through chat rooms or internet-based angel-investor networks or funding platforms trying to engage corporate executives into offering to sell securities into their state where no registration statement or exemption notice has been filed or where company officers and directors have not registered as broker-dealers. After a few telephone calls and probably email communications where company information has been delivered to the undercover agent, the trap is sprung and the company and its representatives may be charged as unlicensed, securities brokers. Executives can easily be confused by this tactic, as most states allow a sale of a security in their state if the offering is made under Regulation D, and a Regulation D offering notice has been filed with the SEC within fourteen days after the first in-state sale and payment of a fee. But brokers and dealers cannot make offers where they are not licensed but are required to be. Company executives typically do not see themselves as brokers because they are funding their own companies. Getting trapped and zapped by a state-securities commission for a lack of securities registration or lack of broker registration has the collateral effect of: (1) forever putting one’s name into the national-securities-enforcement database, (2) causing reputational damage that will be posted on the internet forever, and (3) perhaps statutorily disqualifying the company and the participating executives from conducting private raising of capital. If the state-securities commission believes the failure to register the offer was in some way deliberate, or there was some misrepresentation made in connection with the offer, criminal prosecution is a real possibility. A sample New York selling-agent registration used by company officers is included in the Appendix.

Methods of Communicating Financial Offers

Generally speaking, for non-NASDAQ or larger companies, unless a federal and/or state- registration statement is in effect in the state in which investor interest is being sought, it is illegal to communicate an investment offer to the public through any media. Thus, one answer to the question of what can you say to a prospective investor is nothing (if the offer is not registered). How then are offers made without the time and expense of registering a securities offering? Do friends and family offers need to be registered? Do you need a registration statement to seek capital from one potential investor for a real estate purchase? The answers to these common questions depend on how you go about it. There are several alternatives with each variety dependent on compliance with the particular, registration exemption you have chosen. These alternatives are summarized in Chapter 20. There is one extreme way of avoiding federal-registration requirements altogether for a solicitation for funds: communicate the offer orally in a face-to-face conversation in which the offeror and the offeree are situated in the same state. If you tell someone in a face-to-face conversation where no means of interstate commerce are involved (perhaps in a closed room) that communication is exempt from registration. However, if you - 198 -

invited them to the room, using any means of interstate commerce (e.g., the mail, telephone, or internet) that type of communication invokes federal jurisdiction under the US Constitution’s commerce clause. Thus, to utilize the oral-offer exclusion from federal registration, you would in all probability have to be in the same state with a person with whom you are having the conversation. If one person was standing in Missouri at the state line and the other person was a few feet away standing in Kansas, an oral- investment solicitation from one to the other would be an interstate communication for which registration may be required. If the offeror and all offerees are in the same state (even if the mails, phones, or internet are used in the solicitation process) there is a federal exemption for intrastate-only transactions. Do the states require registration of oral offers? The question is usually academic because most states have a “limited-offering exemption” (usually ranging between twenty-five to thirty-five purchasers) before a registration requirement would apply. Check your state’s law. The flip side of this chapter is if the offering qualifies for a particular, registration exemption, you can use all communication methods permissible in the exemption. Also, keep in mind we are talking only about the registration requirements and registration exemptions in this chapter. Federal and state anti-fraud statutes apply to every investment offer—whether oral or written (whether registered or unregistered). Anytime during pre-incorporation or post-incorporation, a corporation can raise capital from investors. Here is an example. XYZ Widget Corp. desires to raise one-million dollars from friends, friends of friends, and some family members. How does it go about it? Using any one of the registrations or registration exemptions discussed above, a million- dollar capital raise theoretically can be conducted in a registered offering at both the state and federal level, at the state level only, and the federal level only (if the transaction would result in the company’s securities being traded on NASDAQ or similar, large, securities exchange). Registration is typically expensive and slow. For example, if XYZ Widget Corp.’s board of directors engaged in a Regulation A offering, it would have to undertake similar steps to conducting a SEC-reviewed full-blown federal-securities registration. This requires the corporation prepare financial statements according to generally accepted accounting principles, have its balance sheet audited, and prepare a Regulation A Form 1-A offering circular, file it with the SEC and the states in which investors will be sought, respond to comments from both the SEC and the states, and publish notice about the offering in states where the offering circular has been approved. XYZ would be smart to not waste time trying to get a securities-registration approved in states that require merit review because start-up companies usually will not qualify. Another option is to conduct the offering under the registration exemption provided by SEC Regulation D. All three Rule exemptions under Regulation D are available, but all require substantial, financial disclosure to unaccredited investors: Rule 504 for a limited number of unaccredited investors but with maximum capital raise of $5,000,000; Rule 506(b), where all of the non-accredited investors must be knowledgeable and sophisticated about business matters but which has no ceiling on the amount raised. Successive offerings are permissible so long as no more than the annual limit for each exemption is reached and there is at least a six-month cooling-off period between - 199 -

offerings. Rule 506 is always preferred because state laws that pertain to offerings are preempted in a Rule 506 offering by federal law. Complying with Rule 506 removes the delay and expense caused by the state-review process. However, none of these offerings can be advertised. In September, 2013, Rule 506(c) went into effect, and issuers are now able to advertise their Rule 506 offerings (but can sell only to verified, accredited investors). Another option is to seek capital offshore. The corporation could conduct an offshore offering under Regulation S for which there is no dollar limit on the US side but requires the offshore purchasers do not resell to a US citizen for at least one year. This is because securities offered under Regulation S cannot be repatriated until one year has lapsed from the start of the offering. Thought must be given to compliance with applicable foreign- jurisdiction securities-offering laws and regulations. Offers can be conducted under Regulations A, D, and S simultaneously so long as the ceilings imposed by Regulation A or Rules 504 are complied with. In a more typical scenario where multiple exemptions are used, an offering could be conducted under Rule 506(b) (not advertised) and Regulation S (not advertised offshore) or using Rule 506(c) (advertised) and Regulation S (advertised if legal in the foreign jurisdiction). The company is now able to conduct a crowdfunded offering. Likewise, Regulation A+ is available, as well. Regulation A+ may be attractive if the issuer expects to obtain investment from institutional investors and/or accredited investors. Regulation A+ offers a short six-month holding period and preempts state registration. Offers made using Regulation A+ will be public offerings and because state securities registration is preempted, these offers will avoid the small-company dual state- and federal-registration requirement inherent in small-company (non-NASDAQ) initial public offerings. When business is conducted on a shoestring, typically the additional expenses of accounting and legal assistance are beyond consideration. But raising capital on a shoestring without qualified professional assistance is foolish. Those who take money from investors, violate legal requirements, and lack the ability to return the money, face the highest probability of any group (other than those who misappropriate funds or intentionally commit fraud), of being criminally prosecuted. Jail is often the only remedy when investor money cannot be returned. As with everything else in life, there is risk and there are costs and benefits to be weighed. Not everyone goes to a doctor for an annual checkup. Not everyone takes his car for an oil change every 3,000 miles. Not everyone uses an accountant to prepare tax returns, but when raising capital, those who play fast and loose with the rules (or are completely oblivious to them), stand a good chance of facing legal action from regulators and prosecutors. All transactions have the risk they will not work out. Eighty percent of all businesses fail in the first year. With giant odds operating against the success of an investment, it is wise to spend the time and effort to button down the offer with professional assistance to limit your legal exposure. Why risk getting sued and losing perhaps everything you have worked for? Remember, the securities laws are designed to protect the investor—not you. You can do this. We know you can because others have done this without the knowledge contained within this book. You have an incredible advantage over all those other entrepreneurs. Once you have this process down, there will be no stopping you.

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About the Authors:

Timothy Daniel Hogan Mr. Hogan has been in the Investment Banking and Securities Industry, since May 5th 1985. His securities industry training started with a few large securities brokerage and investment banking firms, such as; Merrill Lynch, E. F. Hutton and Shearson Lehman Brothers, now known as, Salomon/Smith Barney a Member of Citigroup. He’s held Six (6) NASD/FINRA securities licenses and registrations primarily of “Principal” status. Mr. Hogan is a former Director of Compliance and Senior Trading Principal for North American Financial Group, Inc. a SEC Registered Investment Bank and Securities Broker. Chairman of the Investment Policy Committee for North American Capital Advisors, Inc. a SEC Registered Investment Advisory firm.

Mr. Hogan has been a Founding Principal of seven entrepreneurial endeavors, including an eighteen-hole championship golf course and real estate development, a software- development firm and other Internet related businesses, as well as, an investment-banking company. He has held board and executive committee seats on various firms. Mr. Hogan holds a double major (Marketing & Finance) Bachelors of Business Administration from Grand Valley State University’s Seidman College of Business.

Russell C. Weigel III, Esq. Mr. Weigel is a securities lawyer that started his legal career in 1989. Between 1989 and 1990, Mr. Weigel served the state of Florida as a criminal prosecutor. Between 1990 and 2001, Mr. Weigel worked for the Securities and Exchange Commission as an enforcement attorney. He supervised and conducted numerous investigations and litigated many civil injunctive and administrative proceedings nationwide. Most of his cases involved allegations of fraud, sales of unregistered non-exempt securities or regulatory compliance violations. Mr. Weigel also supervised investigations and litigated cases involving securities issuers’ Ponzi schemes and false financial reporting. The targets of Mr. Weigel’s cases typically were stock promoters, public companies, broker dealers, investment advisers, and stock transfer agents.

Mr. Weigel currently has a private practice, specializing in securities law. He handles both securities transactional and securities litigation matters. His focus includes advising public and private company clients on capital raising transactions and mergers, preparing their SEC reports and registration statement filings, regulatory compliance matters for securities-industry participants, and defending clients involved in arbitrations and FINRA, SEC, and state securities enforcement matters. Mr. Weigel is an AV-rated83 securities attorney. Mr. Weigel joined Commonwealth Capital Advisors et al as a Managing Director and Chief Legal Counsel in April of 2014. He joined Commonwealth Capital, LLC in the same capacity. His Law firm does business as www.InvestmentAttorneys.com

Welcome to our world! Good luck and Godspeed

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