04 May Early Stage 10: The nuances of federal laws
Editor’s note: This is the 10th in a series of articles on developing start-up companies in the technology or biotechnology sectors.
Madison, Wis. – In Step 9 we discussed general concepts on the securities laws. This time we focus specifically on the federal laws.
Any business that offers or sells securities is subject to both state and federal securities laws and regulations. Of equal importance are the securities laws of those states from and into which a business sells its securities, but since state securities laws vary so widely, this article will only touch briefly on issues concerning the coordination of state and federal securities regulation. Readers should keep in mind that all states have “blue sky laws” that require adequate disclosures be made to investors to enable them to understand their investment and the business in which they are investing.
A non-public company that is selling its securities needs to find one or more applicable exemptions from the general requirement that securities being offered for sale must be registered with the U.S. Securities and Exchange Commission (the “SEC”). Exemptions from registration themselves are governed by complex laws and regulations, most of which require some element of reporting to the SEC, but all of which are less complex, time consuming, and expensive than the process of securities registration.
One of the most common exemptions from securities registration is the “intrastate” exemption. For this exemption to apply, a business can only sell its securities to residents of the same state in which it is incorporated and doing business. Any business utilizing this exemption must ensure that the purchasing investors do not re-sell the securities to someone outside of the state until the original offering of the securities has come to rest. Typically, this means the offering must have ceased for at least nine months.
The SEC has also adopted Regulation D, which establishes three rules that provide exemptions from the registration of securities being sold across state lines. The first of these, Rule 504, exempts from registration sales of securities in offerings of less than $1 million. This exemption does not limit to whom the securities may be sold, nor are there any requirements as to the form of informational disclosures that the investors must be given.
The next exemption, Rule 505, exempts from registration the sales of securities in offerings of less than $5 million, provides that no more than 35 of the investors are not accredited. Generally, an accredited investor is an investor that has either a high net worth (minimum of $1 million for individuals), has a high income (generally a minimum of $200,000 per year for a single individual), or is an officer or director of the business.
The third of the Regulation D exemptions, Rule 506, does not have any dollar limitation on the size of the offering, and like Rule 505, provides that no more than 35 of the investors may be non-accredited. In addition, any non-accredited investors need to be financially “sophisticated.” Rules 505 and 506 also require that a very specific and detailed prospectus of informational disclosure about the investment and the business be given to non-accredited investors.
A business relying on any of the Regulation D exemptions must give the SEC notice of the offering within 15 days of the first sale of securities. In addition, Rules 505 and 506 restrict the resale by investors of the securities purchased in reliance on them. This restriction may require the investor to hold the securities for two years or even more before reselling them, although there are a number of exceptions that provide opportunities for an investor to re-sell sooner in certain circumstances.
Rule 504 is a convenient exemption to rely upon if a business can be certain that it will not need to raise additional capital shortly after the first offering. If an offering of securities made in reliance on any of the Regulation D rules occurs within six months of another offering, it will be considered integrated – or combined – with the other offering.
This means that if the total raised in two integrated offerings exceeds $1 million, then Rule 504 cannot be utilized as an exemption for either of them. If Rule 504 had been relied upon in the original offering, the exemption would be lost. Unless the integrated offering qualifies for another exemption, the business will be in violation of federal securities laws.
One thing that a business can do to make its compliance with the Regulation D exemptions easier is to always rely on Rule 506 and limit its securities offerings to only accredited investors. Although this limits the pool of possible investors, by doing so, the business avoids having to provide the detailed (and expensive to prepare) prospectus that is required to be provided if non-accredited investors are involved, and issues arising from the integration of one offering with the next are avoided.
In addition, federal law requires that all states recognize Rule 506 as an exemption from state securities registration requirements, although a business may be required to file a notice and pay a fee to the state to use this exemption.
There are other, less common ways in which a business can sell its securities in compliance with federal law. Regulation A provides for a form of securities registration that does not cause the business to become a public company. Because Regulation A requires the delivery of a very detailed prospectus to investors and because an offering relying on Regulation A may not exceed $5 million, most businesses prefer to rely on the less burdensome Rules 505 and 506.
The SEC also allows a form of registration called “SCOR” for offerings of less than $1 million, but requires the disclosure of prescribed information to investors. Unfortunately, most states require their own review and regulation of SCOR offerings, which usually means that compliance with both state and federal laws becomes costly and time consuming, especially if several states are involved.
Compliance with federal securities laws is a complex matter and this article just scratches the surface. Any business contemplating raising money from investors is well advised to consult a qualified lawyer well in advance of any attempts to sell its securities.
Previous Early-Stage articles by Joe Boucher
• Early Stage, Step 8: Misclassifying workers brings risk
• Joe Boucher and Bonnie Wendorff: Early Stage 7, Part I: Just what is an employee?
• Joe Boucher: Early Stage: Step 6 – Taxes, taxes, taxes!
• Joe Boucher: Early Stage: Step 5 – Forming the entity
• Joe Boucher: Early Stage, Step 4: Cautionary trademark tales
• Joe Boucher: Early Stage, Step 3: Naming the entity
• Joe Boucher: Early Stage Step 2: Choosing a domain name
• Joe Boucher: Starting a tech business? Step 1 is minding the intellectual property
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