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What are securities laws?

By May 6, 2024No Comments

Securities laws are a complex set of U.S. federal and state laws, regulations, and court cases that govern the offering and sale of financial instruments known as securities. Many other countries have their own securities laws which govern securities transactions within those countries. Examples of securities include common stock, preferred stock, SAFEs, convertible notes, bonds, options, warrants, certain digital assets, limited partnership interests, LLC units, and investment contracts.

A primary purpose of securities laws is to protect investors from being defrauded by issuers of securities. In the United States, the basic premise of federal securities laws is that issuers must register all offerings of securities with the Securities and Exchange Commission (SEC) unless there is an exemption from registration.

The registration process is the procedure companies undergo when they make an initial public offering (IPO) of their securities or “go public.” Registration requires a company to provide audited financial statements and detailed written disclosures about its business, its management, the securities being offered, and potential risks of investing in the company, to the SEC and potential investors. Once a company has gone public, it must regularly update this information, at least quarterly. The registration and reporting requirements are time-consuming and costly. As a result, only larger companies with sufficient resources and sophisticated internal controls and processes capable of managing the periodic reporting obligations choose this path.

All other companies, ranging from early-stage startups to pre-IPO firms, must find an exemption from registration when offering securities for sale to investors. These exemptions, detailed in the securities regulations, generally stipulate that certain types of securities offered to a limited number of qualified investors in specific ways do not require registration with the SEC.

When fundraising, startups typically use a “private placement exemption” to sell securities to “accredited investors.” These investors, as defined in the securities regulations, include individuals with a net worth exceeding $1 million (excluding the value of their primary residence) or an annual income over $200,000 individually, or $300,000 when combined with a spouse. Companies can offer and sell securities to non-accredited investors but must provide them with the same information as in a registered offering. Accordingly, startups are advised to sell securities only to accredited investors to avoid potential securities law violations and the expense of needing to prepare and maintain detailed disclosure documents.

Securities offered to a company’s employees, consultants, or advisors, such as restricted stock or stock options, must also be registered or qualify for an exemption from registration. For this purpose, startups often use the federal exemption known as Rule 701 for securities offered to service providers. This rule provides a registration exemption for compensatory benefit plans, like the equity incentive plans or stock plans companies use to grant stock options. As a company grows and begins to make significant grants under these benefit plans with a value exceeding certain dollar thresholds, Rule 701 requires the company to disclose information about itself, including risk factors and financial statements, to its service providers who hold securities under these plans.

In addition to federal securities law compliance, a company may also need to comply with state-level securities laws, known as “blue sky laws,” in each state where its investors reside, depending on the federal exemption the company uses and whether the federal exemption takes precedence over, or preempts, state securities laws.

If a company fails to comply with securities laws, affected investors gain a “right of rescission.” This right allows investors to sue the company, undo their securities purchase, and recover their money. Noncompliance can also lead to fines and, depending on the severity and type of violation, other civil and criminal penalties for the company and other responsible parties. Given the complexity of navigating securities laws, startups should work with knowledgeable securities counsel for even the earliest stages of financing and equity compensation.

Author Foley Ignite

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