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Securities Laws for Small Businesses

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Business owners have many options when it comes to funding their business. One option is to pour their personal funds into the business. If personal funds are limited, they might ask family or friends for a loan. Many business owners rely on loans from a bank or other institution. Depending on the circumstances, it might be a good idea for a small business owner to consider securities.

If you're thinking about offering securities to raise capital for your small business, then you might want to take some time to look over the federal securities laws. You will need to comply with state laws if you offer securities to the public. These laws were put in place to protect investors after the stock market crash of 1929. Failure to meet the requirements of the federal and state laws on securities could lead to penalties.

What Is a Security?

Securities law is complex, and the area of law is still growing. Is crowdfunding a security? Are interests in a limited liability company securities? These are tough questions, but it helps to understand what a security is.

A security is evidence of indebtedness, ownership, or the right to ownership. Common examples of securities are:

  • Notes
  • Stocks
  • Bonds
  • Investment contracts

There are two general types of securities: equity and debt. The equity type of security represents an ownership interest in a company. The debt type of security represents money that has been borrowed.

The sale of securities involves the entity that sells the security (the issuer) and the person who buys the security (the investor). In a typical situation, the investor isn't personally involved in the business. A prospective investor uses information about the company to assess risk. After the stock market crash of 1929, regulations were put in place to ensure that businesses provide the information that prospective investors need to make an informed decision.

How Are Securities Regulated?

The Securities Act of 1933 and the Securities Exchange Act of 1934 are two critical sources of rules on the sale of securities. Under the Securities Act of 1933, the company must either be registered or exempt from registration to offer securities for sale.

Registration can be a long and expensive process, and there are ongoing requirements after registration is effective. For this reason, many small business owners turn to the list of exemptions. It is up to the business owners to decide if they should "go public" or seek an exemption from registration. There are different requirements under federal and state law for registration and exemptions.

Registration Under the Securities Act

Before a company can make a registered offering of securities, it must go through the registration process. The registration process involves preparing a registration statement for the SEC (Securities and Exchange Commission). The prospectus is an integral part of the registration statement. If you decide to file a registration statement using Form S-1, you will need to disclose the following information:

  • Description of business operations
  • Description of risk factors in investing in your business
  • Description of financial condition
  • Identity of management
  • Description and copies of material contracts
  • Description of the securities

There are rules and information that the SEC has provided on how to set out the above information. Regulation S-K contains restrictions on non-financial disclosures. Regulation S-X contains rules on financial disclosures. The SEC must make the registration statement "effective" before a company may begin selling securities.

There are more straightforward procedures for two types of companies. These are the smaller reporting companies and emerging growth companies. Make sure that your company qualifies as a smaller reporting company or emerging growth company before you proceed under the scaled-down requirements for these two types of companies.

Reporting requirements kick in once a company's registration statement is effective or once it becomes an SEC reporting company under Section 12 of the Securities Exchange Act of 1934. These requirements involve making annual, quarterly, and current reports. The reports can be filed with the SEC through the EDGAR system.

Exemptions from Registration Under the Securities Act

There are several common exemptions that small business owners can use to sell securities. Exemption from registration can be an attractive option for business owners who can't invest the time and money it takes to "go public." A business owner may also want to avoid the additional legal obligations that come with registration.

It is important to note that you still need to check securities laws in your state, even if you qualify for an exemption under federal securities laws. There could be state requirements that you must satisfy even though you are eligible for an exemption under federal regulations.

  • Non-Public Offerings. To qualify for the "private placement" exemption, securities must be sold to "sophisticated investors" who have access to the type of information that is usually disclosed in the registration process. Additionally, the investors must agree not to resell the securities.
  • Rule 504. This Regulation D exemption allows "for the offer and sale of up to $1,000,000 of securities in 12 months." This exemption can't be used for a blank check company (a developing company with no business plan). Whether or not you can do general advertising and solicitation under this exemption depends on the circumstances.
  • Rule 505. This Regulation D exemption allows "for offers and sales of securities totaling up to $5 million in any 12-month period." Business owners can use this exemption to sell securities to accredited investors (individuals or entities with a high net worth and/or income) and up to 35 non-accredited investors. Non-accredited investors must receive disclosure documents with the type of information usually disclosed in the registration process. The investors' purpose must be to invest, not to resell the securities. Only under certain circumstances can securities purchased under this exemption be resold.
  • Rule 506 (b). Rule 506 (b) is a safe harbor provision. If the specific requirements under Rule 506 (b) are met, a prospective issuer can feel confident that their offering qualifies for the "private placement" exemption. Under Rule 506 (b), general solicitation and advertising aren't allowed. Additionally, you can sell your securities to no more than 35 non-accredited investors. Those non-accredited investors must receive disclosure documents.
  • Rule 506 (c). Rule 506 (c) allows issuers of securities to use general solicitation and advertising. However, all purchasers of securities must be accredited investors, and the issuer must take steps to verify that the purchaser is an accredited investor. The securities purchased under this exemption generally can't be resold.
  • Regulation A. Regulation A allows for transactions of up to $5 million in a 12-month period. An issuer's obligations under Regulation A are similar to the requirements that issuers of registered offerings have. A document that is like a prospectus must be provided to investors. However, the financial statements provided don't have to be as complex. Companies often use a Regulation A offering to test the waters before going through the registration process. General solicitation and advertising are allowed under Regulation A, and purchasers can distribute the securities. SEC reporting companies and blank check companies are prohibited from Regulation A offerings.
  • Accredited Investor Exemption. This exemption applies to transactions with accredited investors in which the price is lower than $5 million. There are no requirements for disclosure documents under the Accredited Investor Exemption.
  • Intrastate Offering Exemption. To qualify for the Intrastate Offering Exemption, your business must be organized in the state in which you're making the offering, you must conduct a significant portion of your business in that state, and you make offerings in that state only. There could be a violation if you sell securities to an investor who resells to someone outside of your state within a short period of time. A violation of this kind could put the entire offering at risk.
  • Rule 701. Rule 701 allows companies to sell at least $1,000,000 to employees. The employees can't freely distribute the securities that they receive under Rule 701, except under certain circumstances.

Form D Filings

Under the federal securities laws, a company must file a Form D notice of exempt offerings for securities sold under:

  • Rule 504
  • Rule 506
  • Section 4(a)(5) (also referred to as the Accredited Investor Exemption)

The Form D notice must be filed within fifteen days of the first sale of securities under the offering. Companies submit Form D to the SEC through the EDGAR system.

SCOR Registration

If you're thinking about offering securities under one of the registration exemptions, you might be able to combine a SCOR (Small Corporate Offering Registration) filing with your offering. The SCOR program can be helpful to small business owners because it allows for a simplified process of state registration.

First, you'll have to determine if you can use the form associated with the SCOR filing. To use this form, your business must be a corporation or LLC, and:

  • Not subject to the reporting requirements under the Exchange Act
  • Not an investment company
  • Not involved in the petroleum industry
  • Not a blank check company

Penalties for Violations

There are several penalties that individuals may face for failure to comply with federal and state securities in securities transactions. Fines or criminal charges could result from violations of securities laws.

Additionally, investors who have suffered a loss due to misleading or false statements may be entitled to a refund. If an investor is entitled to a refund and the business funds aren't available, a business owner might be held personally liable. For this reason, it is vital to ensure that you meet the requirements for registration or exemption under federal and state laws and that you make all required disclosures to potential investors.

Thinking About Offering Securities? Consult With an Attorney

Securities laws are complex, and it can be challenging to decide if offering securities is the right move for your company. There could be a lot to gain, but you could also take on new legal obligations and responsibilities.

Before you decide to offer securities, you may want to consult with someone about your unique situation. Don't hesitate to contact an attorney.

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