ENDEAVORLEGAL lawyers regularly advise clients regarding the complexities of Federal securities laws and their application in the offering and sale of any interest in a business enterprise. In cannot be emphasized enough that proper planning and precautions must be made to ensure that the offering and sale of interests in your business are conducted within the scope of the law. Failure to adhere to federal laws, rules and regulations open an enterprise to the possibility of investigation and costly litigation.
Please contact us should you have any questions regarding the offering or sale of an ownership interest in a business enterprise and the application of Federal securities laws relating thereto.
The following information is a brief overview of certain Federal securities laws that commonly affect new businesses. Securities laws are complex and must be taken seriously when incorporating or forming a limited liability company, especially when the founders wish to sell ownership interests in a business enterprise to investors and other persons or entities.
What are Securities?
Securities include shares of the capital stock of a corporation, partnership interests, and membership interests in a limited liability company (LLC). A company, whether it be a corporation, limited partnership or limited liability company does not have any owner until it issues securities. Anyone who operates a business under the umbrella of a corporation, partnership or LLC owns securities in the business enterprise.
Prior to commencing operations, a business entity must issue securities. In order to issue securities, a business must either register an offer and sale of securities with the Securities Exchange Commission (SEC) or establish an exemption from Federal and state securities registration.
The issuance of securities is governed at the Federal level by the Securities Act of 1933. Often referred to as the “truth in securities” law, the Securities Act of 1933 (Securities Act) has two basic objectives: require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities. The SEC oversees Federal securities law compliance. Even the smallest company must comply with these laws to properly and legally issue its securities. EL attorneys ensure that our clients properly offer their securities to prospective owners, investors, consultants and employees within the confines of the law.
The general rule of Federal securities law is that, absent an exemption from registration, all offers and sales of securities must be registered. To register an offer and sale and conduct a “public offering,” a registration statement must be filed with the SEC. The disclosures required in a registration statement are detailed and complex, the document’s length is massive, and the costs of preparing a registration statement (including accountant, attorney, investment banker and printer fees) can easily exceed the hundred thousand dollar mark. This is obviously not a practical path for a fledging business venture. Seeking to foster capital formation by lowering the cost of offering securities to the public, the Securities Act and the SEC have established exemptions from the registration process permitting many small offerings to forego the registration process. Some exemptions from the registration requirement include: private offerings to a limited number of persons or institutions; offerings of limited size; intrastate offerings; and securities of municipal, state and federal governments.
Exemptions from the Registration Requirements
The fact that Federal law provides a number of exemptions from registration does not mean that small companies do not need to follow the rules, but rather there exists a different set of rules that must be followed in order to issue securities within the confines of the law. We work with “start-up” ventures to determine the appropriate exemption from registration for each offering circumstance. Some common registration exemptions for small businesses and start-up ventures are described below.
Intrastate Offering Exemption
This exemption is often used to facilitate the financing of local business operations. To qualify for the intrastate offering exemption, a business venture must:
Be incorporated in the state where it is offering the securities;
Carry out a significant amount of its business in that state; and
Conduct offers and sales only to residents of that state.
There is no fixed limit on the size of the offering or the number of purchasers. The offering company is charged with determining the residence of each purchaser. If any of the securities are offered or sold to even one out-of-state person, this exemption may be lost. If a purchaser resells any of the securities to a person who resides outside the state within a short period of time after the company’s offering is complete (the usual test is nine months), the entire transaction, including the original sales, may be in violation of Federal securities law.
It is difficult for a company to rely on the intrastate exemption unless the principals know the purchasers and the terms of the offer are negotiated directly with them. If a venture holds assets outside the state of organization or derives a substantial portion of its revenues outside such state, it is likely that it will not qualify for this exemption. Companies must also provide certain company information to persons to whom it offers securities.
Section 4(2) Private Offering Exemption
Section 4(2) exempts from registration “transactions by an issuer not involving any public offering.” The guidelines of this exemption are as follows:
The offering organization must not engage in general solicitation or advertising of the proposed offering. An entrepreneur must be careful when e-mailing offers to purchase securities, as mass e-mailing and any resulting forwarding of the offering e-mail may be considered general solicitation.
Each person to whom securities are offered must have, or at least have access to, the type of company information that is required by a registration statement.
The offering venture must limit the number of persons to whom it offers its securities and take precautions against re-sales of the offered securities.
The persons to whom the venture offers securities must be financially sophisticated and understand and bear the consequences and economic risk of an investment in a privately held company.
Perfection of an exemption from registration under Section 4(2) is not a clear cut matter; the rules and guidelines of this exemption were developed under various court decisions and are considered vague. The precise limits of this exemption are uncertain. As the number of persons to whom securities are being offered increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for this exemption.
Safe Harbor for Section 4(2) Offering: Rule 505
The SEC provides a “safe harbor” rule with objective standards that a business venture can rely on to meet the requirements of the Section 4(2) exemption. Under Rule 505 of Regulation D, if a company satisfies the following standards, it can be assured that it is within the Section 4(2) exemption:
Can only offer and sell up to $5 million of its securities in any 12 month period;
May sell to an unlimited number of accredited investors (as identified below) and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions;
Must inform purchasers that they receive “restricted” securities, meaning that the securities cannot be sold for 6 months or longer without registering them; and
Cannot use general solicitation or advertising to sell the securities.
Rule 505 allows companies to decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of Federal securities laws. But companies must give non-accredited investors disclosure documents that generally are equivalent to those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company must also be available to answer questions by prospective purchasers.
Here are some specifics about the financial statement requirements applicable to this type of offering:
Financial statements need to be certified by an independent public accountant;
If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s balance sheet (to be dated within 120 days of the start of the offering) must be audited; and
Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.
While companies using the Rule 505 exemption are not required to register their securities and usually do not have to file reports with the SEC, they must file what is known as a Form D with the SEC after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company. In 2008, the SEC adopted amendments to Form D, requiring electronic filing of Form D.
Safe Harbor for Section 4(2) Offering: Rule 506
The SEC provides a “safe harbor” rule with objective standards that a business venture can rely on to meet the requirements of the Section 4(2) exemption. Under Rule 506 of Regulation D, if a company satisfies the following standards, it can be assured that it is within the Section 4(2) exemption:
The business can raise an unlimited amount of capital;
The organization cannot use general solicitation or advertising to market the securities;
The company can sell securities to an unlimited number of accredited investors (as identified below) and up to 35 other purchasers. All non-accredited investors, either alone or with a purchaser representative, must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
It is up to the offering company to decide what information to give to accredited investors, so long as it does not violate Federal or state antifraud prohibitions; however, non-accredited investors must be provided with disclosure documents that generally are the same as those used in registered offerings. Information provided to non-accredited investors must be made available to accredited investors as well;
The business venture must be available to answer questions by prospective purchasers;
The prospective purchasers must also be provided with financial statements in line with the requirements of Rule 505; and
Purchasers receive “restricted” securities. Consequently, purchasers may not freely sell, transfer, gift or otherwise dispose of the securities after the offering.
While companies using the Rule 506 exemption are not required to register their securities and usually do not have to file reports with the SEC, they also must file Form D just like those companies using the Rule 505 exemption from registration.
The Federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
a bank, insurance company, registered investment company, business development company, or small business investment company;
an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
a charitable organization, corporation, or partnership with assets exceeding $5 million;
a director, executive officer, or general partner of the company selling the securities;
a business in which all the equity owners are accredited investors;
a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase (excluding the value of primary residence);
a natural person with 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 the same income level in the current year; or
a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.