Entrepreneurs selling common or preferred stock or issuing options or warrants for stock are issuing securities. That’s why all entrepreneurs and investors should care about securities laws. Even if you are raising a friends and family round, you must comply with state and federal securities laws.
What are securities and who decides?
Securities are proof of ownership or debt that has been assigned a value and may be sold [source]. After the stock market crash of 1929, Congress adopted The Securities Act of 1933, with the most recent amendment The Securities Act of 1940, which creates a structure for promulgating and regulating securities laws. Congress sought to provide securities purchasers with adequate information relating to the issuer and the offering at-hand. To accomplish this goal, the Act requires applicable entities to register securities with the Securities and Exchange Commission (SEC). Startups should be fluent on state securities regulations, too, which vary from jurisdiction to jurisdiction.
The SEC is the governing independent federal agency which oversees the market, including securities registration. The SEC’s mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. Unless exempt, the Act requires registration of all securities with the SEC. The information needed to complete registration forms, includes:
- a description of the company’s properties and business;
- a description of the security offered for sale;
- information about the management of the company; and
- financial statements certified by independent accountants.
You can save money on legal fees by ensuring you have this information (as much as possible) handy for your lawyer.
Exemptions to the general registration requirements include transactions of:
- private offerings to a limited number of persons or institutions;
- offerings of limited size;
- intrastate offerings; and
- securities of municipal, state, and federal governments.
Private investor security purchases are almost always exempt from the federal registration requirements. Because these exemptions are technical, failure to comply can have disastrous consequences. For example, your startup may be required to give each purchaser the right to rescind the purchase and get their money back or recover damages from the entity.
What’s a startup to do?
First, hire a securities lawyer. Even with no intent to commit fraud, companies can be found liable for securities fraud. Truly, you do not want to subject yourself to the consequences. Failure to comply with securities laws can wipe out your startup’s cash (and some). At the most extreme, offenders can face criminal charges on both the state and federal level. On the other side of the spectrum, the securities commissioner might bring claims for civil charges, which can result in injunctions (like, prohibiting further capital fundraising) or monetary damages. Also, if investors lose out on their investment, they can sue the company and because of the failure to comply with securities laws, the company might owe the investors their full investment back. Limited liability will not protect your personal assets because many debts in violation of securities laws will not hold up in bankruptcy.
All of this to say, you should hire a good securities lawyer to ensure compliance with both state and federal regulations. Securities laws are complex and require subject matter expertise to ensure full compliance.
Interested in other failures we see startups face often? Read our blog post on ten legal dos and dont’s. Hint, one of the failures is not complying with securities laws.