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:
1. The broad rule is this: either you register the shares to be offered or you find an exemption from registration 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 that 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.
2. 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 (SEC) exemption. The easy one is the intra-state offering exemption, which applies where all purchasers in the offering reside in your company’s home state. Beyond that, the question is fundamentally whether your offering is a private placement 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 essentially take away the murkiness. Finally, Rule 701 exempts qualified issuances under employee incentive plans.
You will also need a state exemption for each state in which any 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 involved in the offering.
3. 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 go wrong in this area?
Founders will sometimes use counsel for an initial offering and will complete that offering with proper securities law compliance owing to counsel’s guidance. So far so good.
Where founders get into trouble is where they thereafter assume they have learned the blueprint for an offering and do the next one themselves, without attorney help and without bothering with securities law compliance. 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 normally not happen when they inform counsel of their plans. It happens when they don’t bother with that step.
Another way that founders get into trouble is by getting ensnared by the doctrine of “integration.”
Most states have some variation on what California calls a 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, there normally is 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 securities laws, such offerings can be “integrated” with one another, i.e., treated as if they were not separate offerings but rather one continuous offering. If they are so integrated, then a sale of stock to 25 persons in one offering can be combined with another sale to 15 other persons, with the result being that the company is deemed to have sold stock to 40 persons in a single offering. If the applicable exemption says that, in order to be exempt, the offering must be limited to 35 persons, then integration will 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 early-stage purchasers rescind and ask that their trivial cash purchase price be returned. But what if the purchase price included assignments of IP into the company? Rescission enables such purchasers to rescind and to demand that all items of value transferred into the company be returned to them. 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?
Three key things to keep in mind: (1) remember that no equity can be issued without securities law compliance, ever — don’t ever treat stock, stock options, warrants, etc. as if they were items of candy that you can simply hand out to any willing recipient; (2) 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 (3) 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 normally don’t count toward the number of purchasers to whom you may sell 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 wouldn’t count toward that number.
In addition, with accredited investors, you will normally have a much easier time generally complying with disclosure and other requirements that are part of the exemption process than you will have in dealing with less sophisticated investors.
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. Don’t be penny-wise and pound-foolish in this important area.