“Ask the Attorney” – Securities Lawsby Scott Edward Walker on January 12th, 2010
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).
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?
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.