Legal Bulletins

For start-up companies looking to raise capital, selling equity in the company is a straight-forward and lucrative way to raise money to jump start and grow the business. However, emerging businesses need to be aware of the federal and state securities laws when raising capital in this manner, or they may run into issues that could have destructive consequences for the company before it can reach its potential.

Consider this scenario: you (and maybe some of your friends) have an innovative idea for a business.  As is typical, you use your own funds to get it up and running. You gain traction with your start-up, but realize you need additional capital to serve your current customers or clients, connect with new ones, expand and brand your services and keep the momentum going.  Your business is successful and interested investors take notice. You need capital, so you agree to give away a piece of your business—equity in the company—in exchange for their investment. It’s a win-win situation – you get capital, the investor owns a part of a promising business venture, and you both get to make money in the long run. What you may not realize, however, is that you have just sold a “security,” and your deal with the investor is subject to a complex framework of federal and state securities laws. You need to be cognizant of when these laws apply, when they do not, and the penalties associated with noncompliance.

What is a Security?

The Securities Act of 1933, as amended (the “Securities Act”) was passed in the wake of the 1929 stock market crash to protect the investing public.  Section 2(a)(1) of the Securities Act defines “security” very broadly:

[A]ny note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . . transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, . . . any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities . . . , or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

The above definition does not address whether an interest in an LLC or a limited partnership is or isn't a security because such terms are not found in the definition of a "security" under the Securities Act. Such classification, instead, is based on case law.  Most case law in this area involves an examination of whether such an interest is an “investment contract.”  An investment contract exists if there is: (a) an investment of money, (b) in a common enterprise, (c) with the expectation of profits derived solely from the efforts of others.  Courts examine the facts and circumstances of each situation in making this determination, meaning that some interests in LLCs or limited partnerships are a security and some are not.

Due to the all-encompassing definition of a security, the founder of a start-up should assume that any channel used to raise capital for the company (other than a simple bank or personal loan) will involve issuing securities.  This includes issuing common stock, preferred stock,  Simple Agreement for Future Equity (SAFEs), convertible notes and options.

Debt can be a security if the debt is convertible into equity (e.g., a convertible promissory note), there is no fixed obligation of principal or interest like in a typical mortgage loan, or if payment to the lender is only due if the business makes money.  Promissory notes are presumed to be securities, but that presumption can be rebutted.  Typical bank notes or short-term notes secured by assets would not be deemed securities.

Common Misconceptions Regarding Securities and Registration

The Securities Act provides that in the event of any sale, purchase, offer to sell, or offer to purchase a security, the security must be registered with the Securities and Exchange Commission (the “SEC”) (i.e., through an initial public offering -- a very expensive endeavor) or the sale is pursuant to an available exemption.  Additionally, securities either must be registered or exempt from registration in each state where an investor resides.  A public offering of securities in a start-up company is not practical or ideal, and therefore the offeror must rely on an exemption.

Some commonly held misconceptions regarding securities and registration include the following:

• Sales to friends and family are exempt;
• Sales to fewer than 35 people do not require any compliance - there is no magic number;
• Sales to "accredited investors" do not require disclosures;
• If investors have voting rights then it's not a security;
• Loans from friends and family are not securities;
• Issuing equity to employees and consultants does not require any compliance with securities laws.

The Securities Law Schema (in a Nutshell)

Start-ups must pay attention to securities laws at both the federal and state level.  At the federal level, the SEC regulates securities and promulgates regulations while the Securities Act governs the issuance of securities.  Each state has its own set of securities laws and regulations, which are referred to as “Blue Sky Laws.”  Blue Sky Laws can present challenges for start-ups, because each state has its own unique set of requirements, and in some cases, states may have contradictory requirements.  The good news is, however, that the Securities Act has certain provisions which “preempt” state laws, meaning that issuers can ignore Blue Sky Laws when issuing securities, other than a requirement to file a simple notice called a “Form D” and pay a fee in each state where securities are issued (see the reference to Rule 506 below).

Many exemptions from registration are available to issuers of securities, but some are more expensive to comply with than others.  Some exemptions include:

• The instrastate exemption: Securities Act applies to offerings only to residents of a single state.
• Securities Act Regulation Crowdfunding: This exemption allows a public offering of securities if the transactions take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal, and requires disclosure of information in filings with the SEC.  Regulation Crowdfunding permits an issuer to raise a maximum aggregate amount of $5,000,000 through crowdfunding offerings in a 12-month period, and allows sales to non-accredited investors, but limits the amounts they can invest.
• Regulation A+ Offerings: The revised Regulation A under the Securities Act (now called Regulation A+) to create two tiers of exempt offerings.  Regulation A+ offerings are more like “mini-IPOs.”
• Securities Act Section 4(a)(2): Provides a general exemption for transactions “not involving any public offering or distribution” and also require compliance with state Blue Sky Laws.
• Regulation D: Promulgated under Section 4(a)(2), Regulation D provides a safe harbor from the registration requirements if an issue complies with the Rules under Regulation D, and includes offerings under Rule 504 and Rule 506 of Regulation D.
• Rule 506 of Regulation D: The most common offering exemption that private issuers rely on because it preempts the state Blue Sky Laws.  Offerings under Rule 506(b) may not be made using any form of general solicitation or advertising.  If the offering is only made to accredited investors, there are no specific disclosure requirements.  Offerings under Rule 506(c) may be made by using general solicitation (i.e. email blasts, advertising, social media), but investors may only be accredited investors and the issuer must take reasonable steps to verify that each investor is accredited.

Finally, no matter what exemption an issuer relies on, the anti-fraud provisions of Rule 10b-5 of the Securities Exchange Act of 1934 as amended always apply to offerings of securities.  Issuers must disclose any material facts necessary to make any disclosed or omitted information not misleading.  Accordingly, even though there are no specific disclosure requirements for Rule 506 offerings to accredited investors, anti-fraud concerns nevertheless warrant some form of disclosure document.

Consequences for Failing to Comply with Federal and State Securities Laws

When a start-up company raises capital without complying with federal and state securities laws, the consequences for the start-up company, and its leadership, can be disastrous.  Those consequences include: 1) civil or criminal liability; 2) rescission; and 3) future investment challenges.

Start-ups can face civil or criminal liability brought by a civil or criminal action by the federal or state government.  Start-ups can also face civil liability for lawsuits brought by investors.  Liability could include financial penalties or even incarceration, depending on the type and severity of the offense (as well as the laws of the state, dependent on which state seeks enforcement of its security laws).  Furthermore, depending on the type of action, the start-up company, as well as certain individuals associated with the company, may be subject to “bad actor” disqualification, essentially precluding a company from capital raising in reliance on Rule 506(b) and Rule 506(c) of Regulation D exemptions, the most popular exemptions from registration.

Additionally, if a start-up fails to comply with the registration requirements of the Securities Act and Blue Sky Laws, investors could have a right of rescission, which forces the start-up to return to investors their investment plus interest.  This is particularly challenging for the start-up that has already used the capital to fund the operations of the company.

Finally, the start-up will face future investment challenges in addition to the “bad actor” disqualification discussed above.  Future investors may choose to forego investments entirely in order to avoid a potential lawsuit or rescission offer.  Moreover, sophisticated investors may demand representations and warranties regarding past compliance with securities laws, an opinion letter from legal counsel, or other documentation of compliance as a condition of their investment, and will choose not to invest unless the start-up company and individuals associated with it have a good history.

In Maryland, any person who willfully violates any provision of rule or order under the Maryland Securities Act, is subject upon conviction to a fine not exceeding $50,000, imprisonment not exceeding three years, or both.  Furthermore, the Maryland Securities Commissioner may take administrative action in court to obtain similar remedies or a civil penalty up to a maximum amount of $5,000 for any single violation.

Conclusion

Selling equity in your start-up company can be an effective way of raising capital, but start-ups should be aware of the federal and state securities laws that impact that transaction.  Failure to comply with the federal and state securities laws could be fatal to the start-up business, financially catastrophic for the individuals associated with the start-up business, and indeed could prevent additional business ventures in the future.  Start-ups should be aware of what they are selling, how they are selling, and the laws that impact the transaction as a whole. 

If you have any questions, please contact Michele Bresnick Walsh, Andy D. Bulgin, Sara Y. Lucas, or Abba David Poliakoff.

Michele Bresnick Walsh
410-576-4216 • mwalsh@gfrlaw.com

Andy D. Bulgin
410-576-4280 • abulgin@gfrlaw.com

Sara Y. Lucas
410-576-4024 • slucas@gfrlaw.com

Abba David Poliakoff
410-576-4067 • apoliakoff@gfrlaw.com