Absolutely yes! In our experience, many new entrepreneurs harbor the misconception that securities laws do not apply to them either because their business is small or because its new or because they are just raising small amounts from their family and friends. However, any issuance of “security” by any business (whether big or small, new or mature) must comply with federal and state securities laws. Therefore, it is vital that every new startup owner has some basic understanding of what constitutes a “security” and the fundamentals of securities laws.
Any transaction involving “securities” are regulated at both federal and state level. At the federal level, the offering of securities must comply with the Securities Act of 1933 (the “Act”) and related regulations. Under the Act, the term “security” is broadly defined and includes “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”. “Issuer” of securities is also broadly defined and includes “every person who issues or proposes to issue any security”. The term “person” includes, amongst others, an individual, a corporation, a partnership, an association, a joint-stock company, or any unincorporated organization. Because of the broad definitions under the Act, it is safe to say, any issuance of equity by a for-profit business, even one that is new or small, must comply with the Act.
Under the Act, before an issuer issues securities, the offering must either be registered, or it must fall within one of the exemptions from the registration requirements. Typically, new businesses rely on one of the exemptions as its costly and time consuming to register securities with the SEC. However, careful attention must be paid in selecting the exemption that will apply to the offering and to complying with its requirements to avoid running afoul of securities laws.
Besides federal securities laws, an issuer must also comply with the state securities laws in each state in which the offering of securities is made. These state laws are commonly called “Blue Sky” laws. However, certain provisions of the Act “preempt” state Blue Sky laws, and in certain instances filing a simple form (called “Form D”) and complying with some fees requirements in each state where securities are issued may suffice.
Most startups rely on Section 4(a)(2) of the Act for issuances to founders. This Section exempts from registration certain offering that qualify as “private placements”. The exact parameters of this exemption are not very clear, but typically exempts from registration issuances to persons who know the business well (aka founders), or whom the founders personally know (aka family and close friends). However, this Section does not preempt state laws and the offering must still comply with requirements under the laws of each state in which the offering is made. Typically, startups rely on the exemptions under Regulation D when raising funds form early-stage investors. However, each of the Regulation D exemptions (that is, under Rules 504, 506(b), and 506(c) has nuances that must be carefully navigated and complied with to properly avail these exemptions. For instance, Reg D Rule 506 (c) “safe harbor” exemption for private placements under Section 4(a)(2), can only be used to raise capital from “accredited” investors, but state laws are pre-empted, while Regulation D Rule 504 can be used to raise up to 10 million per year and without restriction on the type of investor BUT state “Blue Sky” laws are not preempted.
It is beyond the scope of this blog to discuss each exemption and its availability in different scenarios. For more information on exemption applicable to small businesses, you may review https://www.sec.gov/smallbusiness/exemptofferings The point is it is important to consider and comply with securities laws when issuing stock in your business to any person. Running afoul of securities laws may not only leave your business exposed to possible penalties, but also raise a “red flag” with future investors, thus acting as an impediment to your business’s growth.