“Ask the Attorney” – Securities Laws

by Scott Edward Walker on January 12th, 2010

Introduction

This post is part of a new series entitled “Ask the Attorney,” which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

The goal here is two-fold: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain english (as opposed to legalese).

Question

My buddy and I launched a software company about a year ago, and we’re running out of money.  Luckily, we have a few friends who are interested in investing in our company.  My neighbor, a divorce attorney, said we need to comply with the securities laws.  Do the securities laws apply to the sale of stock to friends?  If so, how do we comply?

Answer

This issue comes-up all the time.  The short answer is yes, the securities laws apply, and the best way to comply with them is to sell stock only to friends who are “accredited investors” (as discussed below).

Indeed, whenever a company offers or sells its securities – whether it be to founders, friends and family, angel investors, whomever – federal and state securities laws must be addressed.  Unfortunately, these laws are complex and are a potential minefield for the unwary.  Moreover, in light of the Madoff affair and other external pressures, the Securities and Exchange Commission (SEC) and State securities law commissions are significantly stepping-up enforcement of the securities laws.

The basic rule is that a company may not offer or sell its securities unless (i) the securities have been registered with the SEC and registered/qualified with applicable State securities commissions; or (ii) there is an exemption from registration.  The most common exemption used by start-up companies is the so-called “private placement” exemption under Section 4(2) of the Securites Act of 1933.  As the term implies, a private placement is a private offering to a small number of investors – like a few friends; however, there are different rules depending upon whether the investors are accredited or non-accredited.

If a startup sells stock only to accredited investors, compliance is much simpler and cheaper because it can rely on SEC Rule 506, which has two important advantages over other SEC rules.  First, Rule 506 preempts or overrides State securities laws, which means that the startup doesn’t have to deal with State securities regulators for compliance purposes, other than filing a brief notice known as a Form D (which is also filed with the SEC).  Second, there is no written disclosure requirement under Rule 506 if the investors are accredited.

On the other hand, if one or more of the investors is not accredited, it opens a Pandora’s box of compliance and disclosure issues under both federal and state law.  Yes, there are ways for a startup to structure an offer and sale of securities to non-accredited investors in compliance with applicable securities laws; however, the cost, risks and onerous disclosure requirements generally outweigh the benefit.

So who is an “accredited investor”?  The current definition of accredited investor under SEC Rule 501 includes eight different categories of investors, the most significant of which is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase, not including the value of his primary residence; or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year.

Based on the foregoing, I strongly recommend that you only offer and sell stock to those friends who meet the above net worth/income test and represent and warrant that they are accredited investors in a written agreement.  Needless to say, I also strongly recommend that you retain an experienced securities lawyer to help you.  Non-compliance with applicable securities laws could result in severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution. 

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16 Responses to ““Ask the Attorney” – Securities Laws”

  1. Adnan says:

    What about dissolving the current partnership and creating a new one with the friends? Could a new entity be created with the friends which acquires the existing entity? As a bootstrapper myself, not all of potential sources of funding are “accredited”.

  2. Yes, I think a new entity could be created which acquires the existing entity; however, I don't think that will solve their money problems. As I noted in the post, unless you are raising funds from “accredited investors,” compliance with the securities laws is both tricky and expensive. Many thanks.

  3. Celestino says:

    What if an investor signs a document to self-certify that he's accredited? Does the SEC go back to check whether such individual is indeed accredited when it's time to exit?

  4. Thanks for your question, Celestino. The introductory language to the definition of “accredited investor” under SEC Rule 501 provides that any person who falls within one of the eight categories or who the issuer “reasonably believes” falls within one of the categories is an accredited investor. The term “reasonably believes” is a factual determination, and the steps that must be taken to establish reasonable belief varies with the circumstances of each offering. Some securities practitioners recommend that the issuer require investors not only to represent and warrant that they are accredited investors in a subscription agreement (or other document), but also to execute a questionnaire — so that the issuer can indeed satisfy the “reasonable belief” standard.

  5. Celestino says:

    Thank you so much for your help. I'll keep that in mind when raising funds from angel investors.

  6. Celestino says:

    Thank you so much for your help. I'll keep that in mind when raising funds from angel investors.

  7. David says:

    Scott,

    I realize this is a really old post.  Hopefully you are still reading these comments. 

    I found this post via a google search.  I’m not sure if our situation is applicable (it probably is), but I thought I would ask. 

    There is a CPO (commodity pool operator – that trades commodities/futures) that I am very interested in investing in.  The minimum investment is more than I can do alone.  However, I can pool together a group of people to meet the minimum.  The idea was to get a lawyer and form a partnership.  After the entity is formed and our money is in the account, the partnership itself invests in the CPOs fund.

    Now, I’m wondering if each of us in the partnership have to be accredited investors?  Ignoring for a moment whether the CPO requires accredited investors or not.  Do we, in order to form this partnership need to be accredited?   Does this even fall under the SEC rules?  I’m not really clear on where the divide is.   

    Maybe the only requirement is whether the CPO requires an accredited investor or not?

    I thought this was a brilliant idea (forming a partnership of equally interested parties), however, now I’m wondering if we are going to run into SEC laws that we weren’t aware of. 

    Thanks

  8. Yes, each of the partners must be accredited investors. Thanks.

  9. David says:

    Thank you Scott.  I appreciate the response. 

    So, even if the CPO does not require accredited investors- the partnership cannot form without each one being accredited?  Interesting.  I wouldn’t of thought that was the case.  Figured it more or less an issue with the CPO’s requirement.  I’m disappointed, but I guess I shouldn’t be surprised.

    Thank you

  10. I assume the CPO will require only accredited investors.

  11. Jilinqueensu says:

    Hi Scott,

    I really wonder that SEC has a record of all accredited investors or not. I am doing some research on angel investors and I want to know how many angels are accredited investors and how many angels are non-accredited angels. Where can I get these data?

    Thanks a lot and look forward for your replying

    Lin

  12. I will be out of the office on vacation until August 11th and will have limited access to email until such date. If you need immediate assistance, please contact my colleague Terry Thomas (at tthomas@walkercorporatelaw.com) or Howard Kern (at hkern@walkercorporatelaw.com). Thank you.

  13. Jilinqueensu says:

    Have a nice trip~

    Btw, you have really done a great job. The website is quite useful. Thanks so much!

  14. I will be out of the office on vacation until August 11th and will have limited access to email until such date. If you need immediate assistance, please contact my colleague Terry Thomas (at tthomas@walkercorporatelaw.com) or Howard Kern (at hkern@walkercorporatelaw.com). Thank you.