Basics of securities regulations for private companies

For startup founders, obtaining proper financing is critical. No matter whom they approach with regards to funding, they are essentially pitching investment opportunities. All of the transactions entrepreneurs engage in to secure funding are regulated by U.S. federal and state securities laws. Even accidental transgressions have serious legal consequences. Therefore, it is essential that entrepreneurs engaged in fund-raising for their new businesses are aware of relevant laws and regulations.


The Securities Act of 1933 was adopted to protect public from unscrupulous market dealers. The Act requires that all offerings of securities be registered with and supervised by the Securities and Exchange Commission (SEC) unless the security or transaction is exempt from registration. Registering public offering is quite expensive. And not all companies are proper candidates for a public offering for the reasons beyond financial one. Thus the attorneys for startups/small businesses usually try to structure the transaction to fall under one of the limited number of exemptions to registration.


Exemptions to securities registrations with the SEC are limited in amount of raised investments, time period, geographical location.  They are also very detailed and specific to the type of the seller and the processes. Securities laws prescribe certain matters and impose restrains not only on the actual sale of securities, but to all actions associated with raising money. Solicitation is defined very broadly under the law and many activities that may seem common in the business world are prohibited when we talk about the offers of investment opportunities.


Exceptions to registration have its own requirements and do not relieve the issuers from responsibility for misrepresentations or omissions. Violations of securities laws can bring drastic consequences. The company may be forced to return all investments that were accepted in violation of the regulation, pay high penalties, and if it is proved the violation was intentional, even criminal charges may be brought. Therefore, it is vitally important to get assistance of an experienced attorney who works with private offerings.


Let’s briefly review what exemptions are available and the scope of each.


Non-public offering (private placement) exemptions


Section 4(a)(2) of the Securities Act exempts from registration certain transactions that do not involve public offering." To qualify for this exemption, the purchasers of the securities must:


     Either have enough knowledge and experience in finance and business matters to be able to evaluate the risks and merits of the investment, or be able to withstand the investment's economic peril;

     Have access to the type of information normally provided for a registered securities offering; and

     Not to resell the securities to the public.


General solicitation of investments is prohibited. The seller should have a strong reason to believe that persons he approaches with the offer are ones as described above. If a company is successful in raising funds and a number of purchases increases, it may become more difficult to prove that the offering qualifies for this exemption. If the company offers securities even to one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.


Regulation D — Rules 504, 505 and 506


Regulation D contains Rules 504, 505 and 506, which establish exemptions from Securities Act registration. Nevertheless, the sellers of securities are required to file a notice with SEC within 15 days after the first sale of securities in the offering. The purpose of the filing is to notify federal (and state) authorities of the transaction and applicable exemption.  


Certain rules under Regulation D specify particular disclosures that must be made to investors and are subject to the antifraud provisions of the securities laws. The issue should take care that sufficient information is available to investors and that any information provided is free from false or misleading statements or omissions.


Felons and other persons with bad history are disqualified from these exemptions. If it is found that an issuer is disqualified from these rules, the issue may still qualify to apply for a waiver of disqualification in limited circumstances.


Each rule of the Regulation D exemptions has its own requirements and limitations. The nature of the transaction and goals of the parties are considered when selecting which one will be used.


Rule 504. Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. The company may not use general solicitation or advertising to market the securities, and purchasers receive “restricted securities” (cannot be resold on the second market for at least a year without the issuer registering the transaction with the SEC).


Rule 505. Rule 505 provides an exemption for offers and sales of securities in the amount not exceeding $5 million during any 12-month period. Under this exemption, the company may sell to an unlimited number of “accredited investors” and up to 35 non-accredited investors. The issued securities are “restricted securities,” meaning purchasers may not resell them without registration or an applicable exemption. The company may not use general solicitation or advertising to sell the securities. Under this rule if an offering involves any purchasers that are not accredited investors, they must be provided with extensive disclosure documents.


Rule 506. Rule 506 provides two different exemptions and is divided into Rule 506(b) and Rule 506(c).


Rule 506(b).


Rule 506(b) is a "safe harbor" for the non-public offering. It does not limit the amount of money a company may raise. Similar to Rule 505, the company may sell to an unlimited number of “accredited investors” and up to 35 non-accredited investors. Rule 506(b) has additional regulatory constrain that are not present for Rule 504 and 505:


·        Non-accredited investors must be “sophisticated” (or have a sophisticated representative), meaning based on their education, work experience, or professional position they should be able to evaluate merits and risks of the prospective investment. On practice this requirement actually pushes issuers to offer only to accredited investors, because sophistication requirement under Rule 506 is vague and issuers face risk of liability in case of mistake. However, issuer need only reasonably believe purchaser meets accredited test

·        General solicitation or advertising of the securities is not allowed. The transactions are generally happen because of the preexisting relationship between the offeree and placement agent if any;

·        No special disclosure is required for accredited investors. For non-accredited investors, a long specific list of disclosure items exist based on type of the issuer and size of the offering (may require non-financial and financial information)

·        Securities sold 506 are “restricted” (can’t be resold absent an exemption or registration with the SEC)


Rule 506(c). To implement Section 201(a) of the JOBS Act, the SEC promulgated Rule 506(c) to eliminate the prohibition on using general solicitation where


·        All purchasers of the securities are accredited investors; and

·        The issuer takes reasonable steps to verify that the purchasers are accredited investors.


Purchasers receive “restricted securities” like in other exempted offerings (may not freely trade the securities after the offering).


Revised Regulation A: $20/$50 million offering limit in a 12-month period


Regulation A is an exemption from registration for public offerings. In March 2015, in order to implement Section 401 of the Jumpstart Our Business Startups (JOBS) Act, the Commission amended Regulation A by creating two offering tiers:


·        Tier 1, for offerings of up to $20 million in a 12-month period; and

·        Tier 2, for offerings of up to $50 million in a 12-month period. 


There are certain requirements applicable to both Tier 1 and Tier 2 offerings, including company eligibility requirements, bad actor disqualification provisions, disclosure, and other matters.  Additional requirements apply to Tier 2 offerings, including limitations on the amount of money a non-accredited investor may invest, requirements for audited financial statements and the filing of ongoing reports.


Securities in a Regulation A offering can be offered publicly, using general solicitation and advertising, and sold to purchasers irrespective of their status as accredited investors.  Securities sold in a Regulation A offering are not considered “restricted securities” for purposes of aftermarket resale.  “Restricted securities” are securities issued in private offerings that must be held by purchasers for a certain period of time before they may be resold.  


The SEC must issue a “notice of qualification” before an issuer can make any sales under Regulation A offering.

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