Securities Law for Entrepreneurs
October 1, 2021 | Matthew Moisan, Jon O’Connell, Matthew Melville, Justin Lurie, and Justin Porter
Do you want your startup to expand and become a major player in your industry? If so, you will most likely need to seek capital from outside investors to help you build infrastructure and fulfill orders.
To raise this money, you will probably have to issue securities. Should you do so in an improper or illegal way, you could become personally liable for any damages. And you could even face criminal penalties.
If you want to avoid these consequences, it is vital for you to have a basic understanding of U.S. securities laws.
What Is a Security?
In the United States, securities laws apply to any and all instruments that meet the definition of a “security.”
The exact definition of a security may vary from one state to the next. However, in 15 U.S. Code § 77b, the federal government provides the following definition of a security:
“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 interest 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.”
This definition grants the federal government the authority to regulate a broad range of financial instruments, including:
- Common Stock
- Preferred Stock
- Convertible Notes
- Options, and
- Simple Agreements for Future Equity (SAFEs)
In other words, just about every method of raising capital for a startup involves securities laws.
What Are the Basic Rules Governing Securities in the U.S.?
In the U.S., every state and territory has the power to enact and enforce its own securities laws. These rules are known as blue sky laws.
These state-level regulations are often incredibly complex and intricate. In some instances, they are even contradictory. As such, they can be quite problematic for startups.
Fortunately, federal law frequently allows companies to disregard blue sky laws. The Securities Act of 1933 contains a range of provisions that preempt state regulations and offer exemptions to founders if they file Form D (Notice of Exempt Offering of Securities) and pay a small fee.
To take advantage of these preemptions, companies must ensure they issue their securities in a qualifying way.
Must Startups Register Securities with the SEC?
According to the Securities Act of 1933, all offerings of securities in the United States must be:
- Registered with the Securities and Exchange Commission (SEC), or
- Exempt from SEC registration requirements
Registering a security with the SEC is a complex, expensive, and time-consuming process. A classic example is securities registered on Form S-1 in connection with a company’s initial public offering (IPO). Most startups prefer to offer their securities in a way that qualifies for an exemption from registration until they get to the point where they are ready for an IPO.
The two most commonly used exemptions are:
1. Section 4(a)(2) of the Securities Act of 1933
Section 4(a)(2) of the Securities Act of 1933 exempts private placement security offerings from SEC registration. It allows startup founders to offer securities in “transactions by an issuer not involving any public offering.” What does it mean for a transaction to not involve a “public offering”?
Several fact-specific factors contribute to whether or not a transaction will ultimately be deemed a public offering. The factors that various judicial and regulatory interpretations have considered include the:
- Number of securities offered
- Size of the offering
- Manner of the offering
- Type and accessibility of information provided to offerees
- Number of offerees
- Relation of the offerees to each other and to the issuer
- Experience and sophistication of the offerees
- Actions taken by the issuer to prevent the resale of the securities
While these factors are helpful in predicting whether or not a transaction will be considered a public offering, they are no determinative, and thus do not provide certainty for a startup who wishes to conduct a private offering. Nonetheless, they are helpful in determining whether or not an offering will qualify for the private placement exception.
Founders usually use this exemption to issue securities to themselves when they first start their business. They also use it to raise capital from close friends and family members.
There is one noteworthy drawback to this exemption, however. It does not preempt any state blue sky laws.
As mentioned above, all states have their own exemptions for the initial issuance of company stock. However, anyone who wishes to use Section 4(a)(2) of the Securities Act of 1933 to issue securities to their family and friends must ensure they comply with all applicable state rules and regulations.
2. Rule 506 of Regulation D
Rule 506 of Regulation D provides a “safe harbor” for private placement security offerings issued under Section 4(a)(2) of the Securities Act of 1933.
Rule 506 of Regulation D preempts state blue sky laws and allows startups to raise unlimited capital from “accredited investors.”
The SEC defines an accredited investor as any individual who:
- Earned more than $200,000 (or $300,000 together with a spouse) in the prior two years and reasonably expects to maintain this level of income for the current year, or
- Has a net worth in excess of $1 million, alone or together with a spouse (excluding the value of their primary residence), or
- Holds in good standing a Series 7, 65, or 82 license.
Rule 506 of Regulation D also allows startups to raise funds from other entities that:
- Hold more than $5 million in total assets, or
- Are solely owned by accredited investors.
Organizations that wish to use Rule 506 of Regulation D to raise capital must generally disclose material information to prospective investors and file necessary paperwork with the government in a timely manner. One such required filing is Form D, which is filed with the SEC within 15 days of the initial closing of a capital raising transaction using the Electronic Data Gathering Analysis and Retrieval (EDGAR) submission tool. Form D is just a notice and will not receive comments from the SEC. However, the Form D filings on EDGAR are available publicly, and thus so are the material details of the financing plan. Founders will want to consider the effects of making such disclosures public before moving forward, including whether the filing of a Form D could preempt a pre-planned press strategy.
As an aside, it is worth mentioning that Rule 506 has two subsections, (b) and (c). Startups may rely on either Rule 506(b) or Rule 506(c) of Regulation D to meet the safe harbor standards. However, there are key differences between the two that should be contemplated prior to a private offering.
A 506(b) offering permits an unlimited number of accredited investors, and up to 35 nonaccredited investors. On the other hand, a 506(c) offering is limited to only accredited investors.
Additionally, for a 506(b) offering, the issuer may rely on a statement by the investor to confirm they are accredited. With a 506(c) offering, the issuer must go through a verification process to confirm the investors are accredited. This is often done by a third party and can end up being quite costly.
However, no means of general solicitation or advertising can be used to promote a 506(b) offering. Investments can only be made by investors with whom a prior relationship exists. The same is not true for 506(c) offerings, and thus certain advertising is permitted. Most startups typically rely on 506(b) for their exemption from registration.
What Are the Penalties for Violating U.S. Securities Laws?
Individuals and organizations that violate state or federal securities laws can face some severe penalties. The most common ramifications include:
- Fines: Regulatory agencies frequently issue hefty fines to people and companies who fail to comply with securities laws.
- Rescission: When startups violate securities laws, investors can often exercise their rescission rights and reclaim their capital.
- Imprisonment: Individuals who repeatedly violate U.S. securities laws frequently spend time in jail or prison.
Because of the severity of the penalties for violating securities laws, anyone who is accused of committing such an offense should consult with an experienced attorney as soon as possible.
U.S. securities law compliance is complex. Startups should consult with an experience securities lawyer in order to determine whether a potential transaction qualifies for an exemption from registration requirements. Please note that this overview is not exhaustive or exclusive. And this overview is not intended to constitute legal advice. We encourage you to either contact a member of our team or your legal counsel to analyze the specifics of your circumstance.
This summary is for informational purposes only and not for the purpose of providing legal advice. The opinions expressed in this summary are the opinions of the individual authors and may not reflect the opinions of Crowell & Moring LLP or any other attorneys at Crowell & Moring LLP.