Securities laws are not to be trifled with. Among other things, if you violate them, your investors can ask for their money back from your company and from those who control the company.
Yet founders are sometimes careless in complying with securities laws.
Here are some very high-level guidelines for complying:
- The broad rule is this: either you register the shares to be offered or you find an exemption for the type of offering your company will make. It has to be one or the other.
Registration at the federal level is a public offering. No early-stage startup does that.
At the state level, registration is still a formal and expensive process. Few early-stage startups do these either.
Therefore, the key securities law concern for any stock issuance by an early-stage startup is to make sure that the offering fits within an exemption to the registration requirements.
- You must not only find an exemption under which you can make the offering, but you must find an exemption that applies to each purchase and sale of the stock that is made under the offering.
You will need a federal exemption. The easy one is the intra-state offering exemption, where all purchasers in your company’s offering reside in your home state. Beyond that, the question is fundamentally whether your offering is a private placement or a public offering. A private placement may qualify for an exemption under either Section 4(2) or under Regulation D, the former of which is subject to murky legal standards and the latter of which defines “safe harbors” that enable to you know with a fair measure of certainty that your offering will be exempt.
You will also need a state exemption for each state in which one of your purchasers resides. The securities laws of each of the respective 50 states are known as “blue sky” laws. Whenever your company sells stock, you need to do “blue sky compliance” for each state in which one of your purchasers resides.
- Federal and state securities law exemptions are tricky and complex. Use a good business lawyer to guide you through the process. With skilled guidance, the process is neither too involved nor too expensive for most early-stage offerings.
So where do founders wrong in this area?
Founders will sometimes use counsel for an initial offering and will complete that offering with proper securities law compliance being done by counsel. So far so good.
Where founders get into trouble is where they thereafter assume they have learned the blueprint for the offering and thereby do a next offering by themselves, without attorney help and without bothering with the securities law compliance details. Focusing solely on the buy-sell aspect of the stock sales, they forget the accompanying details that make those sales legal in the first place. This will not happen if they inform counsel of their plans. It happens when they don’t bother with that step.
Another variation is this. Most states have some variation on what California calls the limited-offering exemption, which is basically an offering and sale of stock to a limited number of people who have a pre-existing relationship with the company or its founders. As long as the offering is limited to the number of purchasers authorized by the exemption, and counsel guides the process, there is normally no problem.
Problems arise when founders complete their offering and then later have second and third offerings of a similar type within comparatively short time periods. This is what I call the rolling-offering problem.
Under applicable securities laws, such offerings can be “integrated” with one another. If they are integrated, then a sale of stock to 25 non-accredited investors in one offering can be combined with another sale to 15 other non-accredited investors, with the result being that the company is deemed to have made an offering to 40 investors. If the applicable exemption says that, in order to be exempt, the offering must be limited to 35 persons, the integration will cause your company to blow the exemption.
The common problem in both these examples is that founders assume they don’t need to consult with their business attorney once they think they know the “blueprint” for a stock offering. They then run wild and unsupervised in making their stock sales. And they get themselves into trouble.
What are the penalties?
The main one is rescission. If stock is sold that is neither properly registered nor exempt, then each purchaser can rescind the sale and get his money back either from the issuer or from those who control the issuer. A very dangerous and potentially expensive remedy for founders who play too loosely with securities laws. This is not just corporate liability. It is personal liability.
The rescission remedy can also be problematic if stock issued initially to founders or other key people is issued in violation of securities laws. Of course, no one cares if such a purchaser rescinds and asks that his trivial cash purchase price be returned. But what if the purchase price included an assignment of IP into the company? Rescission enables such a purchaser to rescind and ask that all items of value transferred into the company be returned to him. Again, a very dangerous and potentially expensive problem for your startup if it results in a cloud hanging over the company’s key IP.
How to prevent these problems?
Two key things to keep in mind: (1) do use competent securities law counsel to assist with your stock offerings, whether to founders, bridge or seed investors, angel investors, or VC investors; and (2) whenever possible, limit your stock sales to “accredited” investors. Accredited investors can be individuals or entities and there are detailed rules defining who they are. In general, for individuals, it is either high-income individuals or those having a net worth of at least $1 million. See your business attorney for details.
Why is it important to deal with accredited investors only, if at all possible? Because they don’t count toward the number of purchasers to whom you may offer stock in qualifying for most exemptions. Thus, in our example above of the rolling offering, you would not have a problem with the offerings being integrated if your investors were all accredited. In such a case, you would not exceed the numerical limit because the accredited investors don’t count toward that number.
Don’t trifle with securities laws. Work closely with a good business lawyer to ensure compliance. If you don’t, it will likely cost you far more to untangle problems than any money you might have saved in trying to skimp on the lawyer costs.