The Importance of Understanding Basic U.S. Securities Laws Before Seeking Investors

May 2021

Small businesses need capital to startup, operate, and grow. When entrepreneurs lack the ability or desire to fund a venture entirely from personal assets, they will seek capital from outside investors. If you have or plan on founding a startup, it is imperative to have a general understanding of United States securities laws. Many entrepreneurs assume that they don’t need to worry about securities laws unless they’re “going public” but, if you intend to raise any outside money you must comply with both federal and state securities laws while doing so, otherwise your raise may result in liability for your business, personal liability for yourself and co-founders, and possibly even liability for the investors.

Although U.S. securities laws are rather complicated, understanding and complying with a few simple guidelines should suffice to prevent the average founder from making any serious mistakes – at least until they engage a good business attorney.

Federal and state securities laws apply to any instrument that meets the definition of a “security.” The definition of a security can vary from state to state as well as between state and federal laws, but the Securities Act of 1933, as amended (Securities Act) covers the umbrella of “securities” giving the federal government regulatory authority and is a good starting point. It defines a “security” as:

Any note, stock, treasury stock, security future, 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 intentionally includes a broad range of financial instruments, which means that, in raising money for a startup, a founder should assume that almost every way he/she/they do so (aside from a bank or personal loan) will involve securities and securities laws.

In the early stages of the startup life cycle, founders usually choose to raise financing by issuing common stock, convertible notes, or Simple Agreements for Future Equity (SAFEs).

Securities are governed at both the federal and state level. The Securities Act, and the regulations set forth by the Securities and Exchange Commission (SEC) pursuant to the Securities Act, are the primary sources of federal law governing securities. In addition, every U.S. state and territory has also adopted legislation regulating the securities industry, and these state-level regulations are commonly referred to as “blue sky laws.” Due to the sheer number of blue sky laws, their complexity, and the intricate interaction between blue sky laws and federal securities laws, compliance with applicable blue sky laws can be particularly problematic for startups — even determining which states’ laws must be complied with can be cumbersome and confusing if a startup’s investors live in different states, or use investment vehicles domiciled in states other than the investors’ home states.

There’s good news, though. The federal Securities Act includes some provisions that “preempt” state laws, meaning that founders can take advantage of exemptions from blue sky laws when issuing securities, as long as they qualify for filing a relatively simple notice called a “Form D” notice, accompanied by payment of a fee in each state where securities are issued. To take advantage of this preemption however, the founder will need to pay careful attention to ensure that a particular issuance of securities is done in a way that qualifies.

The Securities Act requires that all offerings of securities be either (i) registered with the SEC or (ii) exempt from such registration. Since it is expensive and time consuming to register securities with the SEC, most startups will choose to issue securities in a way that will qualify for an exemption.

Early-stage startups often rely on Section 4(a)(2), which exempts “private placements” offerings from registration. Section 4(a)(2) allows a startup to issue securities to investors they personally know, so the securities issued are theoretically not deemed to be part of a public offering, which is the kind of offering the Securities Act was constructed to regulate.

Section 4(a)(2) is primarily relied on by founders after forming the startup to issue shares in the company to themselves, and to take initial investments from close friends and family. However, the specific parameters of the 4(a)(2) exemption can be ambiguous, and founders can get themselves and their startup into trouble by relying on this exemption to issue securities to anyone beyond foundation-level persons.

The issue with Section 4(a)(2) is that it does not pre-empt state blue sky laws. All states have their own exemptions for stock issued to founders, but if a founder intends to rely on 4(a)(2) to issue securities to family and friends, they’ll also need to comply with state blue sky laws in all states in which securities are issued.

The most common exemption used by founders to raise capital is Rule 506 of Regulation D, which offers a “safe harbor” for private placements under Section 4(a)(2). Rule 506 preempts blue sky laws as long as an issuer complies with all of its requirements.

The 506 exemption allows a startup to raise an unlimited amount of capital from “accredited investors.” Defining an “accredited investor” is complex, but it is essentially someone the SEC would determine is either wealthy or experienced enough to make investments without the SEC holding their hand or watching over them.

A. Individuals who either:

(i) Have individual net worth, or joint net worth with that person’s spouse, of at least $1 million (excluding his/her/their primary residence); or

(ii) Individual income in excess of $200,000 or joint income with that person’s spouse in excess of $300,000 for the prior three years.

B. Entities:

(i) That have total assets in excess of $5 million; or

(ii) In which all of the entity’s owners are themselves accredited investors.

Note that the SEC modernized the definition of “accredited investor” late last year, but those changes did not affect the financial thresholds.

Rule 506 is split into two options (506(b) and 506(c)) based on whether the issuer will engage in general solicitation or advertising to market the securities. If the issuer will not use general solicitation or advertising to market the securities, then the sale of securities can be issued under Rule 506(b) to an unlimited number of accredited investors and up to 35 other purchasers.

While there are a number of other exemptions and safe harbors that companies may consider when planning for a raise, they are beyond the scope of this discussion and more appropriately addressed in consultation with counsel.

Because securities laws can be complex and cumbersome, and each startup’s fundraising needs and situation are unique, it is imperative for founders to be aware of the need to comply with securities laws when planning for a raise and to utilize experienced legal counsel as they pursue capital from outside investors.

Dallas N. Verhagen

DVerhagen@FLASllp.com

(805) 966-4225

www.FLASllp.com