Startups should ensure compliance with the federal and state securities laws in stock and option issuances, friends and family financing transactions, and issuance of SAFEs and convertible notes.
While founders issue common stock when a new enterprise is formed, stock options to key employees and service providers, and Simple Agreements for Future Equity (SAFEs) and convertible notes to early investors, the implications of these equity issuances under the US federal and state securities laws are sometimes overlooked. Although compliance with the federal securities laws and state securities laws (sometimes referred to as “blue sky laws”) is mandatory, the practical effect of non-compliance is a clean-up exercise at the first priced round (Seed or Series A), which increases legal fees and time to close. A better policy is to ensure ongoing compliance with securities laws, and to keep all filings securely in the company’s records.
- Startups (like any other company) are required to register their shares with federal and state governments or file an exemption from registration. Registering shares (as in an IPO) is highly impractical and expensive, and therefore startups are required to meet an exemption from registration.
- At the federal level (regulated by the Securities and Exchange Commission (SEC)), the issuance of the initial common stock to founders (referred to as “founders stock” although this is not a legal term), can be exempt from registration under Section 4(a)(2) of the Securities Act of 1933 for transactions not involving a public offering.
- At the state level, in issuing the founders stock, the company should comply with the blue sky laws of any state involved in the offer or sale of the common stock (e.g. the state where the offer is made and the states where the offer is received). Many states have exemptions that do not require a filing (known as a “self-executing” exemption), while others may require a filing (e.g. California under Corporations Code Section 25102(f)).
- Section 4(a)(2) and state exemptions, as applicable, may also be relied on when SAFEs or convertible notes are issued (in each case, these instruments convert to equity and therefore would qualify as securities).
- It has become increasingly common for SAFEs and Convertible Notes to be issued in larger amounts, effectively replacing the Seed round. In these circumstances, or in a Series Seed raise, it may be appropriate to rely at the federal level on an exemption under Regulation D, in particular Rule 504 or Rule 506, or another exemption. Each of Section 4(a)(2), Rule 504 and Rule 506 has advantages and disadvantages, and as the fundraising proceeds, the company should consult with its counsel on the appropriate exemptions. Note that while Rule 506 preempts state law (other than notice requirements) – so compliance is required only at the federal level – one of its principal benefits, other exemptions may not preempt state law requirements.
- Issuances of equity under an equity incentive plan – typically options – have their own exemption at the federal level under Rule 701 of the Securities Act. Rule 701 applies when the shares are allocated to the plan, so a filing is not triggered by each option grant. There are certain numerical tests that apply to equity (option) issuances under Rule 701. Some of the online cap tables keep track of these calculations each time options are granted. Blue Sky Laws also apply to equity incentive plans. Many states have self-executing exemptions for option grants, but in some states, there is also a state securities exemption filing required, e.g. in California under Corporations Code Section 25102(o).
If you require any further information about the applicability of federal and state securities laws to startups, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.