Avoiding Key Legal Mistakes in Startup Companies: Part 5
Part five of our blog series on common legal mistakes made by startup companies focuses on the importance of ensuring the startup’s capital raises comply with securities laws. Effectively raising money plays a substantial role in determining whether your startup company will make it. Maybe you have used your personal money, investments from family or friends, or a combination of the two to launch your startup. No matter the way you have gone about funding your startup’s operations, there will most likely come a point where you need to raise money from investors.
When your startup comes to this juncture, it is important that your company be organized as the appropriate legal entity and your company successfully navigates and complies with the numerous requirements of the federal and state securities laws applicable to startup offerings. One of the most common mistakes I see with startup companies is the failure to comply with relevant securities regulations. This can create serious liability problems for the startup and its officers, directors, and key employees, as well as turn away potential investors.
5) Ensuring the Startup’s Capital Raises Comply with Securities Laws
Federal and state laws regulate the offer and sale of the types of securities that startups make available and issue to investors in connection with startup fundraising efforts. Generally, these securities include the more traditional forms of equity (common and preferred stock), as well as options. Let’s discuss the federal and state laws at play when a startup offers various types of securities for sale.
Federal Law:
There are two big sources of federal law that regulate securities transactions (yes, this includes startup capital raises). These are the Securities Act of 1933, as amended (Securities Act) and the Securities Exchange Act of 1934, as amended (Exchange Act). The Securities Act regulates all issuances of securities. The Exchange Act regulates the resale of securities and generally is not applicable until a company has made its initial offering of stock to the public (which typically takes place after a startup has conducted its early stages of capital raising). In addition, the Securities and Exchange Commission (SEC) is the principal federal agency tasked with overseeing compliance and enforcement of federal securities laws.
The Securities Act prohibits all offers and sales of securities within the United States unless:
A registration statement is filed with the SEC and subsequently declared effective; and
Either the security itself, or the proposed transaction in which it will be offered and sold, is exempt from registration.
SEC Registration Statement
A registration statement has two principal parts.
Part 1 is the prospectus, that is, the legal offering or “selling” document that must be delivered to everyone who is offered or buys the securities. In the prospectus, your company must clearly describe important information about its business operations, financial condition, results of operations, risk factors, and management. The prospectus must also include audited financial statements.
Part 2 contains additional information and exhibits that the company does not have to deliver to investors but must file with the SEC.
The basic form for registration statements is Form S-1.
SEC Registration Exemptions
There are a number of registration exemptions under current federal law. What is most important to keep in mind is that when a company sells shares or other ownership interests in a transaction that is not required to be registered with the SEC (such as an exempt private placement under Regulation D or Section 4(a)(2) of the Securities Act), the buyers of those ownership interests must meet certain investor suitability standards. This requirement applies to any purchaser who is not affiliated with the company, regardless of whether the purchaser is a close friend or family member of the company’s founders.
State Law:
In addition to federal securities laws, individual states have enacted their own securities regulations (commonly known as “blue sky” laws), which issuers and sellers of securities must be sure to comply with. Many states’ blue sky laws include transactional exemptions similar to the registration exemptions provided by federal law. In some states, there is also an exemption for isolated transactions. These isolated transactions generally involve very few sales within a prescribed period of time meeting the legal requirements of the particular state.
Putting Everything Together
Funding your startup is crucial to its success but navigating federal and state securities laws is a complex task. It is important to consult with an attorney who understands your business’s operations and ensures compliance with relevant regulations when it comes time to seek outside investment.
Contact us today with any questions you have regarding capital raises for your startup and compliance with SEC regulations.
Check out the whole series: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, and Part 8.
Photo by Precondo CA on Unsplash
*The material and information in this blog is for general informational purposes only. In no way is this information to be construed as legal advice for a particular situation.*