Often, companies are started with just an idea. A founder may decide to quickly form a limited liability company to help protect assets, or operate as a sole proprietor for a period of time. Prior to taking on funds from outside investors, that company may decide to form a corporation. For companies that follow that early stage cycle, the financial statements to be included in a Reg CF filing may not just be the financials of the corporation. If the previous entity or sole proprietorship was operating in the period required to be covered by GAAP financials, those activities must be represented in the financial statements as well.
In Reg CF, the SEC provides clear instructions that the financial statement requirements refer to the issuer and its predecessors, if any existed in the period to be covered by the financial statements. The definition of predecessor is found in Rule 405 under the Securities Act and applies across all mentions of that term in Securities Act rulemakings. Generally, a predecessor is person or entity from which an issuer has acquired or succeeded to a major portion of the business or assets of the predecessor. So when a company begins its business as an LLC and later creates a corporation to take over the operations, the LLC is a predecessor because the corporation succeeded to the business of the previously operating LLC. The same goes for businesses that were started without a business entity separate from the founders.
Under this standard, we have seen a number of companies raising funds under Reg CF not provide financial statements in accordance with Reg CF. In those situations, what we often see is a newly-formed Delaware corporation that has succeeded to the operations of a predecessor LLC, but the financial statements only cover the period of existence for the corporation. In such cases, it is possible that investors will have a right of rescission against the issuer (the right to make the issuer buy the investment back) for not meeting the requirements of Reg CF.
A similar analysis applies for probable acquisitions. When the to-be-acquired entity would form a substantial portion of the business and assets of the issuer, then that entity would still be considered a “predecessor”, and financial statements for that entity would be required as part of an offering under Reg CF. Issuers should be aware of this potential result if they intend to use proceeds of an offering to undertake a probable acquisition.
When in doubt, management of an issuer should ask themselves, if I was an investor, would this information be important? Issuers should not underestimate the breadth of the requirement under Rule 201(y) to provide any material information necessary to make other statements made not misleading. Discussions of results of a predecessor in the Form C likely mean that the predecessor should be covered in the financial statements. A statement that a planned acquisition will improve the financial performance of the company may mean that financial statements for the target entity are necessary to provide appropriate context for investors.
To date, many companies have raised funds under Reg CF without doing so in a fully compliant manner. This includes omitting material information required to be included in the financial statements that cover any predecessor entities, or the operations of the founder prior to forming a business entity. Issuers that want to use funds to undertake acquisitions may find themselves tripped up by the need for financial statements covering the target entity as well.