Navigating a capital raise is one of the more challenging aspects of launching a startup. It doesn’t matter if you’re pitching to friends and family, angel investors, or venture capital funds; all securities offerings are governed by a complex web of federal and state securities laws designed to protect investors.
Compliance with these rules and regulations is not optional. Even a minor misstep can expose your company to serious legal and financial risks before it even has a chance to get off the ground. Whether you’re preparing to issue SAFEs, convertible notes, or launch a priced equity round, understanding the intricacies of federal and state securities filings for startups is critical to the success of your fundraising journey.
Federal Securities Laws: SEC Compliance for Startups
The Securities and Exchange Commission (SEC) is the federal agency responsible for protecting investors and maintaining fair and orderly markets. The primary federal law governing the sale of securities is the Securities Act of 1933, which mandates that all offerings must either be registered with the SEC or qualify for an exemption from registration.
Startups generally rely on exemptions from registration to raise needed funding. Some common exemptions used by early-stage companies include:
Section 4(a)(2): The Private Placement Exemption
To qualify for the Section 4(a)(2) statutory private placement exemption, your transaction must not involve a public offering. Transactions falling within this exemption may include the initial stock issuances to founders and small, early “friends and family” rounds. The logic is that these securities are offered only to people with a pre-existing personal relationship with the company or its founders, so the offering isn’t truly “public.” However, it’s important to note that this exemption doesn’t override state securities laws. You may still have to comply with the specific requirements mandated by the states where your investors are located.
Regulation D: The Fundraising “Safe Harbor”
Regulation D (Reg D), which establishes a “safe harbor” under Section 4(a)(2), is the most common exemption used by startups. It provides clear rules that can ensure your offering is exempt from federal registration. There are three exemptions in Reg D that are particularly relevant to startups:
- Rule 504: A company may sell up to $5 million in securities within a 12-month period to an unlimited number of accredited and unaccredited investors. However, because Rule 504 does not preempt state Blue Sky laws, it may be less practical if your offering involves investors in a state with onerous blue sky requirement or in multiple states.
- Rule 506(b): This rule allows a company to raise an unlimited amount of capital. If you go this route, you may sell to an unlimited number of accredited investors and up to 35 non-accredited investors. However, including non-accredited investors will trigger extensive disclosure requirements, which is why many startup attorneys advise raising funds only from accredited investors. Offerings made under Rule 506(b) may not be advertised and are also exempt from state securities laws, although there are often still notice filing requirements with the states.
- Rule 506(c): If you want to publicly advertise your fundraising round, Rule 506(c) is the exemption for you. Like Rule 506(b), it allows you to raise unlimited capital from accredited investors and preempts state laws. Unlike Rule 506(b), an offering under this exemption can only include accredited investors. More importantly an offering under this exemption requires the company to take reasonable steps to verify that an investor is accredited (unlike Rule 506(b), under which the company may rely on an investors representation that the investor is accredited).
For the purposes of Regulation D, there are numerous ways an investor can be deemed “accredited”, however, some of the most common ways are as follows: :
- Individuals with a net worth over $1 million (excluding their primary residence) or an annual income over $200,000 ($300,000 with a spouse).
- Individuals holding specific licenses, certifications, or designations, such as Series 7, 65, or 82 licenses, or “knowledgeable employees” of private funds.
- Business entities like banks, insurance companies, registered investment companies, and certain trusts may also qualify, depending on their structure or assets.
Rule 701: Equity Incentive Plans
Rule 701 provides an exemption from registration for private companies to issue securities as compensation to employees, directors, and consultants, as long as they stay within specific quantitative limits. To benefit from the exemption, the offering must be issued under written compensatory benefit plans or contracts, such as stock options or equity incentive plans. The rule also limits the value of securities that can be issued in any 12-month period to either $1 million in aggregate offering price, 15% of the total assets of the issuer, or 15% of the outstanding shares of that class of securities. Offerings under Rule 701 that cross specified thresholds also require certain disclosures to be provided.
State Securities Laws (“Blue Sky” Laws)
In addition to federal regulations, every startup must comply with the securities laws of each state where it offers or sells securities. Known as “Blue Sky” laws, they typically require either registering the offering in the state or meeting the criteria for a state-specific exemption.
State securities administrators are responsible for enforcing these laws. Because the rules can vary significantly from state to state, compliance can be challenging. For example, an offering made to investors in California, New York, and Texas could require compliance with three different sets of state securities laws.
Federal exemptions, such as Rule 506(b) or 506(c), generally allow companies to bypass most state registration requirements. However, certain states might still require a notice filing and payment of associated fees.
State and Federal Level Securities Filings for Startups: Compliance Procedures and Penalties
Failure to timely submit the required state and federal securities filings for your startup will likely have negative consequences—including possible investor lawsuits, government penalties, and “bad actor” disqualification—that you’ll need to address before future funding rounds.
To avoid such a scenario, it’s critical that you
- File Form D with the SEC: After you sell your first securities under Regulation D, you must file a Form D with the SEC. It’s due within 15 days of the first sale, and can be completed electronically through the SEC’s EDGAR system.
- File State Notice Filings: For offerings under Rule 506, you may be required to file a notice with the state(s) where your investors are located. This is typically done by submitting your SEC Form D and paying a filing fee through the North American Securities Administrators Association (NASAA)’s Electronic Filing Depository (EFD).
Securities Laws for Startups: FAQs
What penalties might a startup face for misusing securities exemptions?
Failure to perfect a federal or state exemption can lead to severe consequences, including rescission rights, where investors can demand their money back, substantial fines, or even criminal charges for willful violations of securities laws. You should engage qualified legal professionals to ensure your offerings adhere to all relevant rules and regulations.
How can startups ensure compliance with federal anti-fraud provisions while fundraising?
The antifraud provisions included in federal securities laws prohibit companies from making untrue statements of material facts or omitting material information necessary for informed investor decision-making. Before any offering, you should rigorously vet all investor materials, including pitch decks, offering memoranda, and verbal statements, ensuring they are accurate and do not exaggerate financial forecasts or downplay risks. Implementing clear internal controls for sharing information and engaging experienced legal counsel to review all documentation will help mitigate the potential for fraud claims. Companies may face claims from both investors and governmental authorities under these laws, as well as under similar provisions included in state law.
When should startups engage a lawyer to ensure compliance with securities laws?
You should engage legal counsel as early as possible in the fundraising process—ideally before soliciting investors or preparing offering materials. An experienced startup lawyer can help you determine which exemptions apply, draft compliant offering documents, review investor communications, and establish record-keeping systems that demonstrate good faith compliance.
Build Your Startup on a Solid Legal Foundation
Compliance with federal and state securities laws can be difficult to navigate, especially for an early-stage company with limited resources.
Drawing on our considerable experience as entrepreneurs, investors, and startup attorneys, the NEXT team has developed several fixed-fee legal packages that include assistance with both federal and state level securities filing for startups preparing to issue SAFEs, convertible notes, and priced-equity financing rounds. No matter where you are in your fundraising journey, NEXT is here to empower your success.
Ready to learn more? Schedule your free introductory call today.