Startups and early-stage companies often ask us when they need securities law advice (other than when obviously dealing with securities). Our answer is: as soon as you start thinking about raising capital or bringing in investors. Here’s why.
Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. The legal definition of “security” is extremely broad and includes, among other things:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, . . . , investment contract, . . . , or in general, any instrument commonly known as a “security”; . . . .”
In 1946, the U.S. Supreme Court defined “investment contract” as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” In other words, if a company seeks to bring in a passive investor and there is an expectation of profits, the interests offered would be considered securities. For example, membership units in a limited liability company (LLC), the favored form of entity for startups and small businesses, might constitute securities if the investor would have little or no control over the management of the company. Mind you, though, there is no bright-line rule and the analysis is inherently fact-specific, which is why you need an experienced securities lawyer to determine whether the interests offered might be considered securities under your particular circumstances.
Once you know you are offering securities, you will want to know if any exemption from registration is available. Exempt offerings are generally not subject to some of the laws and regulations that apply to registered offerings, including comprehensive disclosure requirements and the SEC review, so they are particularly useful for startups and small businesses. An experienced securities lawyer can help you determine the availability of exemptions. For example, an offering might qualify for an exemption as a private offering, depending on the number of investors and their accreditation status, or as an employee compensation plan. (For more information on exempt offerings, please visit our blog here.) Exemptions, however, must meet very specific conditions, and we see them inadvertently blown all too often because nobody thought to verify investors’ accreditation status, look at historical offerings for integration, etc. Many companies also fail to comply with the Form D (notice of sale) filing requirement. While Form D filing is not a condition to the availability of the exemptions under most commonly used rules, it is not without liability consequences, and issuers would be well advised to stay on top of their federal and state filing obligations.
The overarching purpose of securities laws is protection of investors. That is why there is a complicated web of laws and regulations at the federal and state levels, designed to provide material information to investors and to prevent deceit, misrepresentations, and other fraud in the sale of securities. The SEC takes this mission seriously and pursues violators vigorously through criminal, civil, and administrative proceedings, and there are no exceptions for small businesses. Which brings us back to the question as to when you need securities law advice—every time you think about raising money or bringing in investors. This is one area not to skimp on legal fees by relying on DIY kits on the Internet or inexperienced legal counsel.
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This posting is intended to be a planning tool to familiarize readers with some of the high-level issues discussed herein. This is not meant to be a comprehensive discussion and additional details should be discussed with your transaction planners including attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. This article should not be treated as legal advice to any person or entity.
Steps have been taken to verify the contents of this article prior to publication. However, readers should not, and may not, rely on this article. Please consult with counsel to verify all contents and do not rely solely on this article in planning your legal transactions.
 15 U.S.C. § 78c(a)(10) (emphasis added).
 See generally SEC v. W.J. Howey Co., 328 U.S. 293 (1946).