Raising Capital for Startups and Securities Laws

Yes, the shares and SAFEs you issued when raising capital are securities. But do you need to worry about Securities Laws?

Early-stage startups are often forced to resort to raising capital from friends, family or acquaintances, with no resources available to cover attorney’s fees. Our experience shows that – sooner or later – somebody chimes in and warns the founders about compliance with U.S. securities laws. While such individual usually means well, their friendly advice is often not productive and results in unnecessary anxiety.

In this article, we attempt to cast some light on the applicable regulations regarding security issuances and point out a few critical issues which founders should take into consideration when raising money in the early stages of their startups’ development.

If you already have a certain understanding of securities laws, this article is probably not for you – our goal is to present a reader-friendly explanation of the securities laws in the context of the early stages of raising capital in U.S. startups.

Please mind that this article is neither legal advice nor should be treated as an exhaustive description of all applicable laws. Having the formalities out of the way, let’s move to the meat of the matter.

Have You Issued a Security?

Simply put, a security is a financial instrument that holds value, for example, represents a claim to or ownership of a company. The definition of a security is quite broad and includes any note, stock, bond or other instrument issued by a company to an investor. In the early stages of business development, startups usually choose to raise financing by issuing common stock, or – often after doing some research online – convertible notes or Simple Agreements for Future Equity (SAFEs).

Without getting into too many legal details, all of those instruments fall within the definition of a security. Consequently, if you have incorporated a company and have raised capital via issuance of stocks, convertible notes, SAFEs, or similar financial instruments, you have in fact issued a security and all securities laws apply. That, however, does not automatically mean that you violated any legal obligation or are otherwise in trouble.

Registration and Exemptions

In general, all issuances of securities must be registered with the U.S. Securities and Exchange Commission (SEC) or must qualify for an exemption. Registering means filing extensive reports with the SEC, including a description of the security offered, information about the company, and financial statements. As an example, when Lyft filed for its IPO, it “registered with the SEC”.

Clearly, complying with this requirement would financially kill every early-stage startup. At the same time, the consequences of non-compliance are severe – the purchaser of security acquires the right to rescind the sale for a period of one year after the sale (i.e. basically a right to request for his or her money back – a financial disaster for the startup, often already in red) and the company may be theoretically fined by the SEC as well.

It looks daunting, however, there are multiple exemptions available. If at least one of them applies, you do not have to register your securities offering with the SEC. Of course, it does not relieve you of disclosure obligations to your investors, but you usually do not have to directly deal with the SEC when raising capital in such case.

Basic Federal Exemption

The lawmakers realized that there is no need to burden securities issuers with extensive obligations if an offering was made to a limited number of individuals who do not require protection, i.e. people with sufficient knowledge, or in a close relationship with the issuer, thus in a position to realistically estimate the security’s worth.

Thus, the lawmakers have enacted the most commonly cited exemption, and probably the one you will rely on when issuing securities to your friends and family – the exemption established by Section 4(a)(2) of Securities Act of 1933. This exemption is commonly known as the “private placement exemption” and provides that you do not have to register your issuance if it’s a transaction not involving any public offering.

Thankfully, courts have broadly explained the enigmatic one sentence rule and have clarified the particular criteria one must look at to determine whether an issuance falls within the exemption. You must take into consideration and make your decision based on the following factors.

Primarily, you must consider the number of offerees. The more people you offer the securities to, the more “public” your offering becomes. Equally important is the relationship of the offerees to each other and to you – offering securities to a significantly large group of random people without preexisting relationship suggests a public offering. In the meantime, offering a small percentage of your company to a few good friends or family members (while providing them with all information necessary at the same time), does not suggest a public offering. The size of the offering itself is also of significance – the smaller the offering, the higher the chances of it falling within the private placement exemption.

Furthermore, in order to be considered a private placement, the offering of securities cannot include any general advertising or general solicitation. This is the cardinal sin in early-stage startups and a sure way to remove the offering from the 4(a)(2) exemption scope. General advertising or solicitation constitutes a public offering and automatically triggers the consequences of noncompliance with those requirements – in such case securities lose the ability to enjoy one or more exemptions from the requirement to register with the SEC. If in doubt, general solicitation includes advertising via social media (such as LinkedIn or Facebook), general announcements during conferences, mass emails and other similar ways of advertising. There are certain narrow exceptions to this rule – e.g. 506(c) of Regulation D, but as a rule of thumb, you should avoid general solicitation. For example, numerous ICO companies have stepped on this mine in the past by publicly advertising tokens issued while not in compliance with the SEC requirements.

Finally, you must consider the sophistication and experience of the offerees and their ability to bear the risk. The more business-savvy and affluent in relation to the investment the offerees are, the better chances you have of falling within the exemption. Remember that irrespective of their sophistication, they still must be provided information regarding the company allowing informed decision-making.

Good News – Safe Harbors

In case you do not feel knowledgeable enough to conduct the 4(a)(2) analysis, or you are not sure whether your offering falls under the exemption because of the complexity of your situation, you may file what is known as “Form D” with the SEC to guarantee that you fall within the 4(a)(2). To be able to do that, you must first ensure compliance with one of the exemptions provided in Regulation D (Rule 504, Rule 506) or Section 4(a)(5) of the Securities Act of 1933 by meticulously analyzing each one of them, however these exemptions are much more clearly defined and provide a list of requirements that have to be met to enjoy the benefits and protection of filing the Form D. Depending on your situation, the requirements of these safe harbors might be significantly easier to examine and rely on. Filing form D does not constitute registering with the SEC, it rather is a brief notice that includes basic information about the company and its promoters, executive officers and directors as well as some information about the offering itself. This process may not be absolutely necessary in your case, and, if conducted, will result in some legal costs, however, it will definitely provide more security if in doubt.

Bad News – State & Federal Layers

The above-provided information is a simplified guide to federal securities regulations and exemptions that might apply to your company on the federal level. Unfortunately, each state has its own securities laws (often called “blue sky” laws) to protect its citizens from potential abuse or fraud. Therefore, each state also its own regulator and a corresponding rule – securities issuance must be registered on the state level unless a state exemption applies. In other words, if aiming to comply with the applicable regulations with no registration of securities issuance when raising capital, your issuance will generally have to fall within both a federal exemption and a state exemption from the registration requirement. Furthermore, the applicable state law in such case is the law of the state of investor’s residence, therefore if your investors are residing in several different states, multiple state laws might have to be analyzed. Filing the aforementioned Form D makes it easier to comply with the blue sky laws but it will be discussed in a separate article.

Summary

It is very common for startups in the early stages of business development to turn to friends and family for capital contributions. The investments made by founders and other acquaintances always have a legal form and most often are represented by stock of the company. Stock, as well as any other financial instruments that might be used to raise capital, are securities, therefore companies issuing them become securities issuers and automatically fall under U.S. Securities Laws. Even though most often such actions by startups do not qualify as public securities offerings, due to severe consequences of noncompliance, the Securities Laws must be taken into account. It might seem extremely complex (and that is true), however, there are several quite simple steps that can be taken to make sure you are not in violation of any regulation. First of all, exemption established by Section 4(a)(2) of Securities Act of 1933 should be looked at – you do not have to register your issuance if it’s a transaction not involving any public offering. If in doubt, Regulation D should then be analyzed to determine whether you could take advantage of one of the safe harbors provided therein. In case one of the exemptions apply to your offering, filing of Form D should be considered for additional security. Finally, the applicable state laws should be analyzed to make sure your offering also falls under an exemption from the registration requirement. Even though you should be able to do such analysis yourself, if possible, we definitely recommend seeking help of a lawyer. An experienced professional most likely will be able to judge the situation from experience while you will be able to cross this off your list and move on to more exciting projects.