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Securities Laws for Startups Raising Capital

Federal and state securities laws cover startups raising money through sales of equity.

Federal and state securities laws cover startups raising money through sales of equity.

People often associate securities laws as relating only to large public companies.  Securities laws, however, cover even the most basic of equity transactions in small startups.  The following is an overview of securities laws for startups raising capital.

Purpose – As explained on the SEC website: “[t]he main purpose of [securities] laws can be reduced to two common-sense notions: (i) Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing. (ii) People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors’ interests first.”

What is a “Security”? – Section 2(a)(1) of the 1933 Act defines “security”  broadly and includes preferred stock, convertible debt, LLC membership interests, etc.

Complying with Securities Laws Generally speaking, when selling securities, one must (1) either register the securities prior to selling them; or (2) fall under an exemption to the securities laws.

Common Startup Exemptions –There are generally 4 federal exemptions to which startups look when issuing securities to investors:

1.         Section 4(2) – Nonpublic offerings under Section 4(2), which exempts “transactions by an issuer not involving any public offering.”  There is limited guidance on what constitutes a “public offering” and therefore startups typically rely on Section 4(2) as an exemption for only small offerings to a very limited number of investors.

2.         Regulation D –  Regulation D contains three primary exemptions that provide safe harbors:

Reg D Chart

No General Solicitation or Advertising – None of the above exemptions permit the general solicitation or advertising of securities.  While “general solicitation” is not defined in the securities laws, SEC no-action letters have broadly construed it to prohibit mail, email, or other forms of mass communication to anyone unless a substantive pre-existing relationship exists between the issuer and the prospective investor.

Form DIssuers relying on Regulation D must file a Form D with the SEC within 15 days of their first sale. The SEC provides a guide to filing the Form D.  In order to file a From D, the issuer must first successfully apply for EDGAR access.  Startup counsel should start this process well before the Form D filing deadline because the EDGAR application requires a notarized signature of an officer or director and the application approval is not immediate.

State Securities Laws (Blue Sky Laws)Issuers also need to register or find exemptions for their offerings under state securities laws.  The advantage of Rule 506 is that it preempts state securities laws (although issuers still must make certain filings in the states where investors reside, e.g., often a copy of the Form D, a payment, and in some states a consent to service of process).  For example, for a Rule 506 offering to an investor residing in Michigan, the issuer must:

 • File a copy of Form D, manually signed.

• Include a cover letter stating the date of the first sale in Michigan (or advising that sales have not yet occurred in Michigan) and the name of the salesperson.

• Pay a $100 filing fee payable to “State of Michigan.”

• Mail the above to:

Michigan Department of Licensing & Regulatory Affairs

Office of Financial and Insurance Regulation

Securities Division

Constitution Hall, 1st Floor North

525 West Allegan Street

Lansing, MI 48933-1502

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