A large part of my practice involves assisting companies as they divide up stock amongst the founders and plan for how to best use equity to incentivize service providers, as well as selling securities to investors. Founders should be knowledgeable of securities exemptions under the SEC security laws that are likely to come into play as their company first forms and continues to grow. As all founders should be aware, every issuance of securities must be registered with the SEC unless a particular exemption applies. The three most common exemptions are discussed below.
“Founder’s Stock” and Rule 4(a)(2)
We should start by saying there is no such thing as “founder’s stock.” Rather, it is simply a term given to promoters and other insiders who work to form the company. In the end, it is simply common stock provided to those who played a crucial role in setting up the company.
Under Securities Act Rule 4(a)(2) an exemption from registering an issuance of securities with the SEC is carved out for transactions not involving a public offering, in which stock is sold to those who “take the initiative in founding or organizing the business” (See SEC Release No. 33-4552). However, even if you are selling shares to founders under this exemption, you must also file any necessary filings under “blue sky” laws, which in California tends to be a 25102(f) notice fling with the California Department of Financial Protection and Innovation.
“Reg D” Offering and Rule 506 (and the less commonly used 504 and 505)
A “Reg D offering” is a term used to describe a private placement offering that allows you to raise an unlimited amount of money from accredited investors under Securities Act Rule 506, or up to $5 million under Rule 505 and $1 million under Rule 504 during a 12-month period, and not register the offering with the SEC.
One important thing to remember is that a convertible note is considered a security and the company must comply with the proper SEC exemptions. The abundance of open source documents around convertible notes, and even series seed rounds, have caused many founders to think so long as they use those documents they are all set, and therefore, forget about complying with the rules that apply to a Reg D offering.
Under Rule 506(b) a company may raise unlimited funds from accredited investors and up to 35 non-accredited investors who are “wealthy and sophisticated,” provided the company does not generally solicit the offering, is available to answer questions from non-accredited investors, and provides audited financials.
The burden of providing audited financials (the type of financials required if you were registering the securities with the SEC) leads many startups to lean on Rule 506(c). Under 506(c) all purchasers must be accredited, which includes taking reasonable steps to verify they are accredited, but there is not the same requirement for audited financials.
Less frequent Reg D offerings include offerings that rely on Rules 504 and 505. These exemptions are less commonly used as they have limits on the amount raised, geographical restrictions, and increase the burden as to disclosures. Using Rules 504 and 505 can widen the investor base from which you can raise capital, but as a general rule of thumb the increased requirements around disclosures and the simple reality that taking money from someone who cannot afford to lose it makes using 506(c) the better option for most companies.
Much like stock issued to founders, even if exemptions apply for a private placement such that you do not need to register with the SEC, you must still look to satisfy blue sky laws within the state you solicit and sell securities within.
Incentivizing service providers under Rule 701
Under Rule 701 of the Securities Act, a startup is permitted to offer equity as part of a written compensation agreement to consultants, employees, and directors without having to comply with complex federal securities registration. In order to stay within the parameters of Rule 701, however, the total sales of stock during a twelve month period must not exceed the greater of (1) $1 million, (2) 15% of the issuer’s total assets, or (3) 15% of all the outstanding securities of that class.
Additionally, the offering of securities must not be included in any other offering of equity (such as for capital raising purposes as discussed above), and all optionees and shareholders must be given a copy of the plan under which the securities are being granted. If total sales exceed $5 million, additional disclosure requirements can come into play. Furthermore, just because the offering fits into an exemption does not excuse the antifraud provisions, which means any and all disclosures cannot be materially false or misleading.
Offerings under Rule 701 must still comply with any applicable “blue sky” laws (noticing a trend?!), and in California this typically involves filing a 25102(o) notice with the Department of Business Oversight when crafting an equity incentive plan.
Informed founders can take the first step to proper upfront planning to avoid downstream complications when it comes to issuing securities to other founders, service providers and investors. Additional rules and requirements may apply to your situation and you are strongly encouraged to speak with an experienced attorney as the penalties can be quite harsh. If you have any questions, don’t hesitate to reach out to us at 415-633-6841, or at info@bendlawoffice.com.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.