Securities Law


(Part 1 of 2)
When people think of the securities laws, they think of big companies that are “going public” through an initial public offering. But even startups have to worry about securities law compliance.
Both the federal government and the states regulate the issue of  “securities.” Technically, a security is any sort of investment (debt or equity) with a number of exceptions and conditions that vary from state to state. A membership interest in an L.L.C., especially one in which the investor will not be involved in the day-to-day operations of the business, will almost certainly be considered a security. Generally, whenever you make an offering of securities, you have to file documents with the Securities and Exchange Commission at the federal level, and the state securities commissioner at the state level. Those documents would include a prospectus and registration statement (at the federal level, its SEC Form S-1). This is a time-consuming, expensive and extremely painful process, and most early stage companies don’t go through it until they are ready for their IPO.

There are numerous exemptions to the registration requirement at both the federal and the state level, and the goal for any startup is to shoehorn its offering into as many of these exemptions as possible so that if it loses one, it can fall back on another. The most commonly relied-upon exemptions for startups are:

Section 4(6) of the Securities Act of 1933 and SEC Rule 504

 Under this exemption, you can offer and sell up to $1 million in securities during a rolling 12-month period without having to register with the SEC at the federal level. The states, however, frequently impose additional restrictions on this exemption. For example, in some states, you may have to complete and file a document (called Form D) with the state securities commissioner’s office and pay a filing fee.

Section 4(2) of the Securities Act of 1933 and SEC Rule 506
 Under this exemption, you can offer and sell as many securities as you want without having to register, as long as the people purchasing them are “accredited investors” (highly sophisticated and/or rich individuals that meet certain statutory qualifications). Under SEC Rule 506, you are also allowed up to 35 “non-accredited investors” (anyone other than accredited investors), including company founders who don’t pay for their shares. A number of states have imposed further restrictions on this exemption (for example, not more than 10 of the 35 nonaccredited investors may be residents of the state).

De minimis offerings

 In every state, there is a “de minimis” exemption saying you don’t have to register at the state level, as long as the total number of purchasers or offerees during a rolling 12-month period is less than X. Sometimes the X is limited to residents of the state; sometimes the X is all purchasers in the offering.
Whenever you bring on board investors in other states, someone has to check the state securities laws of that state to make sure you qualify for the Rule 504, 506 or “de minimis” offering in that state (this is referred to as “blue skying” the offering). Since your investors live in three different states, your attorney will need to research the state securities laws in each state to make sure your offering will be exempt in all three states. Most attorneys who do this type of work charge $5,000 or more because it is tedious, time-consuming and highly risky (when an investor decides he’s made a bad deal, the first thing he does is sue the lawyers and accountants who gave the “green light” to the deal). Many otherwise competent business attorneys will not advise you at all on securities law questions because they cannot afford the exorbitant premiums for “securities coverage” under their malpractice insurance policies.     

Part 2 will address the right way to structure a startup so as to avoid securities law problems.