Securities laws should not be played with. Among other things, if you violate them, your investors can demand their money back from your company and those who control the company.
However, founders are sometimes careless in complying with securities laws.
Here are some very high-level guidelines to adhere to:
1. The general rule is this: either register the shares to be offered or 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 remains 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 ensure that the offering conforms to an exemption from registration requirements.
2. You must not only find an exemption under which you can make the offer, but you must find an exemption that applies to every purchase and sale of stock that takes place under the offer.
You will need a federal waiver (SEC). The easy one is the intrastate offer exemption, which applies when all purchasers of the offer reside in your company’s home state. Beyond that, the question is fundamentally whether your offering is a private placement under Section 4(2) or under Regulation D, the former of which is subject to murky legal standards and the latter defines “safe harbors” that essentially remove the murkiness Finally, Rule 701 exempts qualified issues under employee incentive plans.
You will also need a state exemption for each state in which any of your clients reside. The securities laws of each of the respective 50 states are known as “blue sky” laws. Every time your company sells stock, you must do a “blue sky compliance” for each state involved in the offering.
3. Exemptions from federal and state securities laws are tricky and complex. Use a good business attorney to guide you through the process. With expert guidance, the process isn’t too complicated or expensive for most early-stage deals.
So where do founders go wrong in this area?
Founders will sometimes use an attorney for an initial offering and complete that offering with proper compliance with securities law due to the attorney’s guidance. So far so good.
Where founders get into trouble is when they assume they’ve learned the blueprint for one offering and make the next one themselves, without the help of an attorney and without concern for securities law compliance. By focusing solely on the buying and selling aspect of stock sales, they forget the accompanying details that make those sales legal in the first place. This will not normally happen when the attorney is informed of their plans. It happens when they don’t bother with that step.
Another way founders get into trouble is to get caught up in the “integration” doctrine.
Most states have some variation of what California calls a limited offer exemption, which is basically an offer 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 offer is limited to the number of buyers authorized by the exemption, there is usually no problem.
Problems arise when founders complete their offer and then have a second and third offer of a similar type within comparatively short time frames. This is what I call the problem of continuous offerings.
Under securities law, such offerings may be “bundled” with each other, that is, treated as if they were not separate offerings but rather one continuing offering. If they are so integrated, then a sale of shares to 25 people in one offer can be combined with another sale to 15 other people, with the result that the company is considered to have sold shares to 40 people in a single offer. If the applicable exemption says that to be exempt, the offer must be limited to 35 people, then the integration will ruin the exemption.
The common problem in both 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 go wild and unsupervised when making their stock sales. And they get into trouble.
What are the penalties?
The main one is termination. If shares are sold that are not properly registered or exempt, each buyer can rescind the sale and get their money back from the issuer or those who control it. 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 responsibility.
The termination remedy can also be problematic if the shares initially issued to the founders or other key persons are issued in violation of securities laws. Of course, no one cares if such early-stage buyers back out and ask for their trivial cash purchase price back. But what if the purchase price includes assignments of intellectual property in the company? Termination allows such purchasers to terminate and require all items of value transferred to the company to be returned to them. Again, a very dangerous and potentially costly problem for your startup if it results in a cloud hovering over key business IP.
How to prevent these problems?
Three key things to keep in mind: (1) remember that no stock can be issued without compliance with securities law, ever; never trade stocks, stock options, warrants, etc. as if they were treats that you can simply hand out to any willing recipient; (2) use a knowledgeable securities attorney to help you with your stock offerings, whether for founders, bridge or early investors, angel investors, or venture capitalists; and (3) whenever possible, limit your stock sales to “accredited” investors. Accredited investors can be individuals or legal entities and there are detailed rules that define who they are. In general, for individuals, they are high income earners or those who have a net worth of at least $1 million. Consult your business attorney for more details.
Why is it important to deal only with accredited investors, if possible? Because they typically don’t count toward the number of buyers to whom you can sell shares to qualify for most exemptions. Therefore, in our example of the continuous offer above, you would not have any problems with the integration of the offers if all your investors were accredited. In such a case, you would not exceed the numerical limit because accredited investors would not count towards that number.
Also, with accredited investors, you will typically find it much easier to comply with the disclosure and other requirements that are part of the exemption process than with less sophisticated investors.
Don’t play with securities laws. Work closely with a good business attorney to ensure compliance. If you don’t, it will likely cost you much more to untangle the issues than the money you could have saved by skimping on attorney fees. Don’t be silly about pennies and pounds in this important area.
