If you are a founder of a startup, it is crucial that you have a basic understanding of U.S. securities laws. If you ever plan to raise money from investors you are likely going to be issuing securities, and if you issue securities without complying with both federal and state securities laws, the transaction may result in liability for your company, personal liability for yourself and the other founders, and even liability for the recipient of the securities.
While the securities laws are quite complicated, knowing and following a few simple rules can be enough to prevent the average entrepreneur from making any serious mistakes, at least until they are ready to reach out to a professional.
What Is a Security?
Federal and state securities laws only apply to instruments that meet the definition of a “security,” which can vary from state to state and between states and federal law. Federal securities law 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.
If that definition seems incredibly inclusive, that’s because it is. The Securities Act of 1933, as amended (Securities Act) intentionally sweeps many different financial instruments under the umbrella of “securities” in order to give the government the ability to regulate them.
As the founder of a startup, that means you should assume that any channel you use to raise capital for your company, other than a simple bank or personal loan, will involve issuing securities. This includes issuing common stock, preferred stock, SAFEs, FASTs, convertible notes, and options.
What Are the Basic Rules Governing Securities?
Securities are governed at both the federal and state level. The Securities Act, and the regulations promulgated by the Securities and Exchange Commission (SEC) pursuant to the Securities Act, are the main sources of federal law governing securities. States have their own set of securities laws and regulations, which are generally referred to as "Blue Sky" laws.
Blue Sky laws can be particularly problematic for startups, because each state has different requirements (and in some cases, contradictory ones), and an issuer of securities (in this case, your startup) will need to pay particular attention to make sure it complies with the requirements of each state in which it is issuing securities. Even determining the correct states to pay attention to can be difficult, as early stage angel investors may have homes in multiple states, or may want to invest through investment vehicles located in states other than their home states.
However, there is good news. The Securities Act contains certain provisions which “preempt” state laws, meaning that issuers can essentially ignore Blue Sky laws when issuing securities, other than a requirement to file a simple notice called a “Form D” and pay a small fee in each state where securities are issued. In order to take advantage of this preemption however, the issuer will need to pay careful attention to ensure that a particular issuance falls within the requirements of the Securities Act’s provisions.
Registration and Common Exemptions
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 opt to find an applicable exemption.
Section 4(a)(2) of the Securities Act – Most Common Exemption Used to Issue Stock to Founders
Startups at the earliest stages of growth typically rely on Section 4(a)(2) of the Securities Act, which exempts from registration what are referred to as “private placement” offerings. This exemption allows a startup and its founders to offer securities to people they personally know, so the securities offered are technically not deemed to be part of an offering to the “public” which is the kind of offering the Securities Act was intended to regulate.
This is the exemption primarily used by founders when they first form a startup to issue stock to themselves, and to take initial investments from close friends and family. However, the exact metes and bounds of this exemption are fuzzy, and a startup can get into trouble if it relies on this exemption to sell securities to anyone other than the founders.
Further, and most important, Section 4(a)(2) of the Securities Act does not preempt Blue Sky laws. While all states have an exemption for an initial issuance to founders, if you want to rely on this exemption for any “friend and family” fundraising, you will need to confirm that any such issuance is also exempt under all relevant Blue Sky laws.
Rule 506 – Most Common Exemption Used by Startups Raising Capital from Investors
The most common exemption used by startups to raise money is Rule 506 of Regulation D, which offers what is referred to as a “safe harbor” for private placements under Section 4(a)(2). Rule 506 will preempt Blue Sky laws, so long as an issuer complies with all of its requirements.
This exemption allows a startup to raise an unlimited amount of money from “accredited investors.” The definition of “accredited investor” is complicated, but it basically boils down to someone the SEC has determined is either wealthy enough or experienced enough to make investments without the SEC needing to protect them.
As a practical matter, this means startups should only be issuing securities to:
A. Individuals who either:
(i) Have individual net worth, or joint net worth with that person’s spouse, of at least $1 million (not including 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 last three years.
(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 proposed certain changes to the definition of accredited investor late last year, but the proposed changes don’t change the dollar thresholds.
We hope the above overview was helpful, but stress that the securities laws are complicated, and that each startup has a unique situation which may require analysis by a trained legal professional. If you would like to reach out to a professional with questions about your specific situation, DWT attorneys are standing by ready to help answer them.