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Financing Your Startup: How to Sell Stock without Going to Jail

Posted in For Entrepreneurs and Companies, Fundraising, Startups, VC & Private Equity

pic-trent.jpgCONTRIBUTED BY
Trent Dykes
trent.dykes@dlapiper.com

 (in collaboration with Megan Muir)

We recently guest posted the below article on TechFlash.  At the end of this post, we have added some supplemental information in an effort to respond to a few questions we received from TechFlash readers. 

* * * * *

As the founder of a startup, one of the first issues you need to address is how to finance your company’s operations.  If you are lucky enough to be able to fund your startup out-of-pocket, or through generous family members, congratulations.  You can probably skip the rest of this post and get back to building your business.  However, if you are like most founders, you won’t be able to self-fund your company entirely and your revenues won’t exist yet, or won’t be adequate to grow the company.  In some instances you may be able to obtain government grants or if you have some type of hard asset or significant accounts receivable to use as collateral, you may be able to borrow from a bank.

This post addresses a common method for financing the growth of a tech startup – by selling stock in your company.  What type of investor is right for your company – family and friends, angel investors, venture capitalists, or some combination of these – is something you will want to consider carefully.  We’ll save that discussion for another post as it’s an interesting topic on its own.

Securities Law Basics

A corporate/securities lawyer will guide you through the stock financing steps, prepare the appropriate documents and make the necessary state and federal securities filings, but it will be helpful for you to have some understanding of how it is done so the process makes more sense as you go through it, and so you understand the reasoning behind some of the restrictions you’ll hear about from your lawyer.

“Securities laws” refers to the state and federal laws and regulations that govern sales of stock.  There are “securities” other than stock, but we’ll limit this post to the sale of your private company’s common or preferred stock.  There are both state and federal securities laws; they are all intended to protect investors from the financial risks associated with investing in companies.  Below is a brief summary of the exemptions that are most relevant to startups looking to raise funds by selling stock.

All offers or sales of securities must either be registered with a state and/or federal entity, such as an IPO registered with the Securities and Exchange Commission (the “SEC”), or be exempt from the registration requirements.  If your offer or sale of stock is not registered or exempt, it is illegal.  Unlawful sales of securities expose you and your company to potential civil, and in some cases criminal, liability, ranging from rescission (i.e., having to return the investor’s money at a future date with interest, usually once the investment did not pan out), administrative fines and other penalties, on up to jail time.  You will likely meet other entrepreneurs who tell you they sold stock without following any of the pesky securities laws described below.  Not only is that approach risky from a legal perspective, but if you have hopes of raising venture capital investment or someday being acquired or going public, your company’s lingering securities law liability may kill a deal when discovered by a potential investor, acquiror or investment banker.

Rule 506

Since companies starting out are not ready to register their securities, such as through an IPO, every sale (and subsequent resale) of a company’s stock must qualify for at least one exemption to be legal.  The exemption most often used by startups to sell their stock is commonly referred to as a “Rule 506” offering.  This refers to Rule 506 of Regulation D of the Securities Act of 1933 (the “1933 Act”).  To utilize Rule 506 as your exemption, all of your investors must (generally) be “accredited” as defined under Rule 501(a).  This generally means a person or entity that is considered suitable to undertake an investment, based on a defined set of criteria established by the SEC, such as experience, net worth and income levels.  Note that the definition of “accredited” was amended by the Dodd-Frank Act and Rule 501(a) is in the process of being updated by the SEC.

Here is a link to a useful primer from the SEC that addresses how small businesses may sell securities and includes a summary of Regulation D and Rule 506.

If your investors do not all qualify as accredited, there are other exemptions you may be able to use to sell stock, although they have more restrictions than Rule 506.

Rules 504/505

There are some other exemptions that are not as commonly used with startups due to various limitations applicable to such exemptions, such as limits on the dollar amount that can be sold, geographic restrictions, or a limit to the number of investors who can purchase under a particular exemption.  You can find the SEC’s overview of some of these exemptions (pursuant to Regulation D and Rules 504 and 505) at http://www.sec.gov/info/smallbus/qasbsec.htm.

One of the primary differences between Rules 504/505 and Rule 506 is that Rules 504/505 more easily allow the inclusion of non-accredited investors in the offering.  However, including such non-accredited investors comes with various restrictions.  These include the following:

  • Rules 504/505 require an increased level of company disclosure and, in some states (such as Washington), a pre-offering filing with the securities regulators (the additional disclosure can often be time consuming and expensive to prepare);
  • allowing unsophisticated investors to invest can increase the company’s exposure to risk related to the offering because such investors may have unreasonable expectations due to their limited experience with such investments; and
  • venture capital investors may be concerned by the inclusion of non-accredited investors due to such risks; and having non-accredited shareholders can cause challenges for your company if it is sold to another company.

For these reasons, startups that plan to seek additional investment from venture capitalists or that want to go public someday seldom sell stock using the exemptions under Rules 504 or 505 of Regulation D.

Section 4(2) 

There is a more general exemption under Section 4(2) of the 1933 Act that provides for an exemption from registration for securities sold in “transactions by an issuer not involving any public offering.”  Under federal law, there is no filing, fee, or notice requirement for a 4(2) transaction – it is simply a facts and circumstances analysis.  That said, startups try to qualify for Rule 506 when they can because the determination of whether or not an issuance of stock is exempt under Section 4(2) is based on the particular facts, leaving the outcome dependent on the court interpreting the facts, while Rule 506 provides a “safe harbor” exemption with clear parameters.

Factors that are typically considered in evaluating whether there is a “public offering” include: (a) the dollar amount of the offering; (b) the number of offerees; (c) the qualification (financial sophistication and wealth) of those offered the stock; (d) the availability and access to information about the company; (e) the manner of the offering and (f) the absence of further transfers of the securities.  Additionally, investors should have a “pre-existing, substantive relationship” with the company issuing the securities.  Particularly critical factors in the analysis of whether an offering is exempt under Section 4(2) are the qualification of the offerees and the availability and access to adequate information about the company (particularly financial information).  The United States Supreme Court described these last two requirements as related to the following questions: “whether the particular class of persons affected need the protection of the 1933 Act;” whether investors need the “protections afforded by registration;” and whether investors can “fend for themselves.”

State Securities Laws

In addition to the above federal securities laws, every sale of securities must also qualify under a state exemption in the each state where such securities are sold.  In many ways, the state requirements mirror the federal requirements.  For example, an offering that is exempt under Rule 506 is exempt under Washington law.  However, there are circumstances where the state level requirements are more stringent, such as in an offering done pursuant to Rule 504. Here is a good resource provided by the Washington State Department of Financial Institutions regarding Washington State securities laws and related exemptions.

Please note that this post was not drafted as a complete analysis of all of the laws that your startup may face when selling securities or as a guide to securities law compliance.  Please contact your attorney before attempting to offer or sell any securities of your startup.

** UPDATED February 7, 2010 **

Rule 701

Companies that are not publicly-traded may sell securities in connection with employee benefit plans pursuant to Rule 701.  Rule 701 is the exemption under which startup companies grant stock options.

Founder Stock Issuances

The initial capital contribution by a founder has a good claim for exemption under Section 4(2). The SEC provided the following guidance in Release No. 33-4552 on the subject of Section 4(2) (which was formerly the second clause of Section 4(1)): “The sale of stock to promoters who take the initiative in founding or organizing the business would come within the exemption. On the other hand, the transaction tends to become public when the promoters begin to bring in a diverse group of uninformed friends, neighbors and associates.”

As a side note, another issue arises – albeit a tax issue, not securities issue – if the founder stock is subject to vesting, then IRS Section 83(b) comes into play.  See our post on Section 83(b) elections.

  • Edwin Robinson

    I have a couple of board games that I know would be used. One is called Major Chords, a boardgame that enhances musicans abilities to build musical chords. However, I have never started up a business and what to know from someone who has boardgame experience and can share with me the “5-W’s and How” in the process of getting started, especially in the world of boardgames. I’ve performed interviews, done some marketing amoung experts in the field of of music, and their interests found my product doable in their practice, making educational institiutes targeted markets; grade schools through second year college music majors. Major Chords, a boardgame for musicans only. “Master The Other Basic Four” (Major, minor, augmented, and dimished chords).

  • http://www.theventurealley.com/authors/asher-bearman.html Asher Bearman

    Edwin,
    Please feel free to email or call me or Trent anytime – happy to walk you through the basics of forming your business.
    Best,
    Asher