A Securities Law Primer for Startups: Part 1 of 2
"Some friends of mine and I are forming a limited liability company (LLC) to develop and market a mobile phone software application (app). There are 12 of us in total, and we live in three different states. Five of us will be developing the product in our spare time without putting in any money. Three of us just want to put in money without getting involved in running the company, while the remaining four will be putting in money as well as doing some consulting work to develop and market the product.
Our lawyer has told us we will have problems setting up this company because of the federal securities laws. Say what? We're only looking to raise about $25,000."
When people think of the securities laws, they think of big companies that are "going public" through an initial public offering. But even startups have to worry about securities law compliance, and this email is a classic example of how NOT to structure a startup without securities law issues.
Both the federal government and the states regulate the issue of "securities." Technically, a "security" is any sort of investment (debt or equity), with a number of exceptions and conditions that vary from state to state. A membership interest in an LLC, especially one in which the investor will not be involved in the day-to-day operations of the business, will almost certainly be considered a "security."
Generally, whenever you make an offering of securities, you have to file documents with the Securities and Exchange Commission at the federal level and the state securities commissioner at the state level. Those documents would include a prospectus and a registration statement (at the federal level, it's SEC Form S-1). This is a time-consuming, expensive and extremely painful process, and most early-stage companies don't go through it until they are ready for their IPO.
There are numerous exemptions to the registration requirement at both the federal and state level, and the goal for any startup is to shoehorn its offering into as many of these exemptions as possible so that if it loses one, it can fall back on another. The most commonly relied-upon exemptions for startups are:
Section 4(6) of the Securities Act of 1933 and SEC Rule 504: Under this exemption, you can offer and sell up to $1 million in securities during a rolling 12-month period without having to register with the SEC at the federal level. The states, however, frequently impose additional restrictions on this exemption. For example, in some states you may have to complete and file a document (called Form D) with the state securities commissioner's office and pay a filing fee.
Section 4(2) of the Securities Act of 1933 and SEC Rule 506: Under this exemption, you can offer and sell as many securities as you want without having to register, as long as the people purchasing them are "accredited investors" (highly sophisticated and/or rich individuals who meet certain statutory qualifications). Under SEC Rule 506, you are also allowed up to 35 "nonaccredited investors" (anyone other than "accredited investors"), including company founders who don't pay for their shares. A number of states have imposed further restrictions on this exemption (for example, not more than 10 of the 35 nonaccredited investors may be residents of the state).
"De Minimis" Offerings: In every state, there is a "de minimis" exemption saying you don't have to register at the state level as long as the total number of purchasers or offerees during a rolling 12-month period is less than X. Sometimes the X is limited to residents of the state; sometimes the X is all purchasers in the offering.
Whenever you bring on board investors in other states, someone has to check the state securities laws of that state to make sure you qualify for the Rule 504, 506 or "de minimis" offering in that state (this is referred to as "blue-skying" the offering). Since your investors live in three different states, your attorney will need to research the state securities laws in each state to make sure your offering will be exempt in all three states.
Is your head spinning yet? I wouldn't be surprised; this is complicated stuff with no easy answers. Most attorneys who do this type of work charge $5,000 or more because it is tedious, time-consuming and highly risky. (When an investor decides he's made a bad deal, the first thing he does is sue the lawyers and accountants who gave the green light to the deal.) Many otherwise competent business attorneys will not advise you at all on securities law questions because they cannot afford the exorbitant premiums for "securities coverage" under their malpractice insurance policies.
So, what's the right way to structure a startup so as to avoid securities law problems? The answer ... next week.
Cliff Ennico (email@example.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.