FAQs about Securities for Start-ups

January 22, 2015

Author: Gil B. Selinger

  • Why should I care about “securities”?

Selling an interest in your company, or a debt instrument (a “Security”) implicates state and federal laws related to the sale of Securities. So does the identity of the person selling the Security. The sale of every Security, and every person selling the Security, must be either “registered” or “exempt” or it is illegal. No startup wants to be selling illegal Securities. Registration of both the Security and the person is a lengthy and expensive process that is not suitable for a startup. That leaves finding the proper exemption.

Additionally, any person selling Securities must not make a material omission of fact or a misstatement of fact in connection with the offer or sale. This part of the Securities laws, known as “10b-5,” is designed to protect the investor from the risks of buying Securities. Anything and everything you say in the context of selling Securities in your startup implicates 10b-5 and the consequences can be criminal.

  • What is the most commonly used exemption for selling Securities?

The federal Securities laws have created certain “safe harbors” for the private sale of securities. If the conditions of a safe harbor are met, the sale of Securities will be exempt from registration. In the world of startups, the most commonly used exemption is the safe harbor under Rule 506(b) of Regulation D, which allows the sale of an unrestricted dollar amount of securities, to up to 35 non-accredited investors, and an unlimited number of accredited investors. General solicitation and general advertising are not permitted in an offering under Rule 506(b).

  • I’m not sure if the people I have lined up to invest in my startup are “accredited investors.” What does that mean?

An accredited investor is an investor who has the financial resources and acumen to be able to make their own, reasonable investment decisions, when presented with all relevant information, and be able to withstand totally losing their entire investment. A questionnaire is generally used to inquire about an investor’s accreditation, and they will self certify how they are accredited. There are certain criteria that must be met in order to be an “accredited investor,” including:

For a natural person, the individual’s net worth or combined net worth, with their spouse, excluding the value of their primary residence, must be in excess of $1,000,000; or, alternatively, the individual’s income is greater than $200,000, or $300,000 jointly with their spouse, for each of the two most recent years. A natural person may also be deemed to be accredited if they are an insider of the issuing company.

For various types of entities, the entity must not have been organized solely for the purpose of making the investment, and it generally must have $5,000,000 in assets. Sometimes, the underlying investors of the entity must also be accredited.

Additionally, if you choose to sell your Securities to those 35 permitted non-accredited investors, you will be required to provide them with additional disclosures, including an audited balance sheet. These additional disclosures are to protect the naïve, non-accredited investor from securities fraud. Failing to make the proper disclosures to the non-accredited investors jeopardizes the safe harbor for the entire offering, so these disclosures are very important.

  • Wait, I can’t advertise or widely disseminate that I’m selling my Securities?

If you want to advertise to the masses that you are selling Securities, you can’t use Rule 506(b) as your safe harbor. However, there is a new safe harbor available to you, Rule 506(c). An issuer can now advertise to the masses when they need capital via any medium imaginable: internet, TV, text messages, Twitter, newspapers, magazines, Facebook, email, LinkedIn, etc., but they can only sell to accredited investors. If you use general solicitation to raise funds, you must comply with the new rules, and manage certain processes. The issuer, or a 3rd party, must actually verify that an investor is “accredited” which may include review of financial and tax records. If any one non-accredited investor slips through the verification process, the entire safe harbor is jeopardized. Other roadblocks to successfully using Rule 506(c) as your safe harbor include keeping track of prospective investors, managing a secure online system for investment memoranda, and increased 10b-5 exposure.

  • None of this sounds like crowdfunding. I thought I could sell my Securities, in small amounts, to everyone?

Crowdfunding, the idea that you can sell a low dollar amount of Securities to a massive number of people to fund your company remains illegal. The Securities and Exchange Commission is in the process of creating rules by which crowdfunding will be permissible. However, the SEC is still looking out for securities fraud and to protect the naïve investor. As a result, there will be dollar amount limits on how much any investor can invest in a crowdfunding offering, and the offering must be conducted either through a registered Broker-Dealer or a funding portal. A crowdfunding offering also has the potential of complicating a startup’s capitalization table, making an exit more difficult.

This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

Copyright © 2015 Fairfield and Woods, P.C., ALL RIGHTS RESERVED.