Securities Law for Startups Part I

Raising capital can create securities law obligations even for small, privately held startups. This article introduces the basic concept of securities, explains why federal and state securities laws regulate their offer and sale, and discusses why startups should determine the appropriate registration exemption and compliance requirements before seeking investments.

Key Takeaways

• Selling stock or other investment interests can trigger federal and state securities laws.
• Securities include more than traditional shares of corporate stock.
• Startups do not necessarily have to complete a full public securities registration to raise capital.
• Federal securities laws provide several exemptions that may be available for private startup fundraising.
• Each exemption has its own requirements involving investors, solicitation, disclosures, filings, offering amounts, or other conditions.
• Securities offerings remain subject to anti-fraud requirements even when an exemption from registration applies.
• State securities laws and filing requirements may also apply.
• Securities law violations can expose a startup and, in some circumstances, individuals involved in the offering to significant legal and financial consequences.

(Part I – The Basics)

Is your startup planning to raise money from outside investors? Then you might want to have a basic understanding of securities law.

Don’t worry. You don’t have to become an expert.

But you do need to know what securities are and how (and why) they are regulated.

In today’s post we are going to get you up to speed on the basic securities law issues that startups face. In a future post, we will show you how to raise capital using the major federal and state securities law exemptions.

What are securities?

When you start your business, you may decide to sell stock or other ownership interests to raise money to get your venture off the ground.

For example, a corporation may issue shares of stock to investors in exchange for capital. Other types of investments, including certain notes, investment contracts, convertible instruments, and other financial interests, may also be considered securities under federal or state law. 

So you form a business entity and break it up into shares, ownership interests that you can issue to investors. This process is called “securitization.” The shares of stock or other “ownership interests” are “securities.”

What are securities laws?

Every state in the Union has securities laws called “blue sky laws.” Of course, the federal government has its own securities laws. But what are securities laws and why do they exist?

Securities laws are set up to protect investors from fraud and unscrupulous scammers. Minimizing fraud creates greater confidence in investment markets and makes it easier for legitimate businesses to raise capital.

If there weren’t securities laws, investors would have fewer protections against fraudulent or misleading investment opportunities, making them less likely to invest in businesses. Wary investors might not feel as comfortable investing in your startup, and businesses would have trouble raising capital.

Because of securities law, investors are much more willing to invest in corporate stock and other ownership interests.

The danger of not complying with securities law

If you do not comply with securities laws, it can expose a startup to significant legal and financial consequences. Depending on the violation and applicable law, investors may have claims that allow them to seek rescission, damages, or other financial remedies. 

The bigger danger is that the investor can get her money back not only from the business she invested in, but also from anyone responsible for selling securities for the business. This is an area of law where the corporate or other entity shield does not protect an officer, director, or employee of a corporation or other entity.

It is important to take securities law seriously. Even just a technical violation can land you in a lot of trouble.

Even if you do not intend to violate securities law, but you make a technical mistake in complying with securities laws, you may be liable. Perhaps you forget to give an investor the proper information or documents, or you sell stock to an investor who does not meet specific guidelines. Then all of the investors in your company could potentially get their money back plus interest even though you were honest in every way about the business and its risks.

Even worse is if there has been securities fraud – that is if someone has been misrepresenting the business or the business opportunity – then the investors can sue the corporation and anyone involved for fraud.

So you always want to do everything you can to comply with securities law.

How do you comply with securities law?

At the federal level, offers and sales of securities generally must either be registered with the Securities and Exchange Commission or qualify for an exemption from registration. State securities laws may impose additional requirements. 

It can cost a lot of money to file all the applications with the proper state and federal agencies. Often a startup will not have the resources to do this.

When this is the case, the best path is often to raise capital under a securities law exemption.

We will discuss these exemptions in a future post.

How to get help with securities law issues

Now you know that securities laws exist and why you need to comply with them.

But be careful. Securities law is not simple. If you are thinking about selling stock to raise money for your business, then you need to work with a lawyer. A good lawyer will ensure that you don’t unintentionally violate any securities laws.

When you are ready to start raising capital, we can help guide you through the process. Send us an email, and we can meet to discuss your options.

Frequently Asked Questions

What is a security?

A security is a financial instrument or investment interest regulated under federal or state securities laws. Stocks are a common example, but certain notes, investment contracts, convertible instruments, and other investments may also qualify as securities.

Do securities laws apply to small startups?

Yes. A company’s size does not by itself determine whether securities laws apply. Even a small, privately held startup may be subject to federal and state securities requirements when raising money from investors.

Does a startup have to register its securities before raising money?

Not necessarily. Many startups rely on exemptions from federal securities registration. However, each exemption has its own requirements, and state securities laws and filing requirements may also apply.

Can a startup raise money from friends and family without worrying about securities laws?

Raising money from friends or family does not automatically remove the transaction from securities laws. If the transaction involves the offer or sale of a security, the startup still needs to determine which federal and state requirements apply.

What happens if a startup violates securities laws?

The consequences depend on the violation. Potential results may include investor claims, rescission rights, damages, regulatory enforcement, penalties, and difficulties with future financing.

Can startup founders be personally liable for securities law violations?

In some circumstances, individuals who participate in an unlawful securities offering or securities fraud may face personal liability. Whether personal liability applies depends on the law involved and the individual’s role in the transaction.

When should a startup talk to an attorney about securities law?

Ideally, a startup should obtain legal guidance before approaching investors or accepting investment funds. Addressing securities compliance at the beginning of the fundraising process can help avoid problems that may be difficult or expensive to correct later.

The content presented in this article is for general informational purposes only. It is not, nor is it intended to be, legal advice. It does not constitute the formation of an attorney-client relationship. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.