You recently started your business and have been slowly building it through a combination of reinvested revenues, credit cards nearing their limit, loans from your diminishing personal savings and maybe even a bank loan or line of credit.  It has become all too clear that, if you’re going to take your great idea to the next level, you need a better source of capital.  It may be time for your business to raise capital through an offering of securities.

The world of securities offerings is a complicated regulatory environment full of countless cautionary tales of businesses and individuals who have gotten into serious trouble for not understanding and following the seemingly endless list of rules and regulations.  Before you consider undertaking a securities offering, you will need to find an advisor who understands the regulatory framework.  The importance of consulting with an experienced securities lawyer cannot be emphasized enough.

What is a Security?

First, let’s clarify what a security is.  Many business owners have unknowingly violated securities laws without even realizing they have sold a security.  In broad terms, a security is a negotiable instrument by which a person takes a stake in a business in exchange for something of value.  Securities include stocks, bonds, limited liability company interests, notes, participations, options, profit-sharing agreements and similar arrangements in which the investor is reliant on the future prospects of the company in order to get paid back.  If you’ve offered your friends or family members a stake in your company in exchange for money or services, you’ve likely sold unregistered securities.  Before you get heartburn, read the following overview of federal and state securities regulations and the various exemptions that may save you from potential liability.

Securities Regulation

The sale of securities is regulated by the Securities and Exchange Commission (“SEC”) as well as individual states.  Regulations focus generally on three areas:  (1) the security and the transaction; (2) the people or entities selling the security; and (3) the disclosures made to investors about the security and the company issuing the securities.

Every security sold in the United States must either be registered with the SEC or qualify for an exemption from the registration requirements.  In addition, the security must be registered or be exempt from registration in all states in which it is offered or sold.  Regulations differ significantly from state to state and the availability of an exemption on the federal level, or in a particular state, does not guarantee that an exemption will be available in any other states.

Registering securities with the SEC is an incredibly expensive and time-consuming process that involves ongoing reporting requirements that by themselves can cost tens, if not hundreds, of thousands of dollars per year.  For this reason, most emerging companies offer and sell securities through “private placement” offerings.  These offerings are generally based on an exemption found in Section 4(2) of the Securities Act of 1933, which provides that a transaction of securities “not involving a public offering” is exempt from the registration requirements.  The Section 4(2) exemption is self-executing, meaning a sale not involving a public offering does not require any filing or payment of fees.  However, because the exemption’s vague language provides scant guidance to issuers of securities, and rulings regarding its application have been inconsistent, relying on the Section 4(2) exemption can be a risky proposition.  As a result, the SEC created Regulation D, which provides certain “safe harbors” from the federal registration requirements for limited offerings of securities.

Regulation D

Regulation D offers three alternatives by which a securities issuer can obtain an exemption from registration requirements.  If an issuer substantially complies with the requirements of Regulation D, the SEC and disgruntled investors are prevented from asserting a violation of the registration requirements.  The requirements of Regulation D are complex, but the peace of mind offered to the company issuing securities is generally worth the hassle.

The three alternatives under Regulation D, found in Rules 504, 505 and 506, are complex, but can be summarized as follows:

Under Rule 504, a company may offer and sell up to $1 million of its securities within a 12-month period to an unlimited number of investors, without any limitations on such investors’ net worth or sophistication and without any prescribed form of disclosure document.  Generally, securities offered under Rule 504 may not be offered to the public, meaning that a company generally must seek investors through existing relationships.  Additionally, the securities are “restricted,” meaning investors can’t resell the securities without registration or an available exemption.

Under Rule 505, a company may offer and sell up to $5 million of its securities within a 12-month period to an unlimited number of “accredited” investors and up to 35 “non-accredited” investors.  Accredited investors are those who the SEC deems to have sufficient experience or net worth so as to be able to fend for themselves in the higher-risk world of private securities offerings.  Accredited investors include institutions that typically participate in the private placement market, as well as wealthy individual investors.  To be “accredited,” individuals must have either (1) a net worth, individually or with their spouse, of at least $1 million, excluding the value of their principal residence; or (2) individual income in excess of $200,000, or joint income with their spouse in excess of $300,000, in each of the two most recent years and a reasonable expectation of the same income level in the current year.

Securities offered and sold under Rule 5.5 may not be offered or advertised to the public and are “restricted,” meaning they can’t be resold for at least six months without being registered.  A company may decide what type of information to provide to accredited investors, as long as the Company doesn’t violate the antifraud prohibitions of federal securities laws (generally, no misrepresentation or omissions of material facts).  Information provided to any non-accredited investors must be similar to the type of information provided in registered offerings.

Rule 506 is a safe harbor to the Section 4(2) exemption.  Under Rule 506, a company may offer and sell an unlimited amount of securities to an unlimited number of accredited investors and up to 35 non-accredited investors.  Unlike Rule 505, all non-accredited investors in a Rule 506 offering must be “sophisticated,” meaning they have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the investment.  Under Rule 506, securities may not be offered or advertised to the public and are “restricted,” meaning they can’t be resold for at least one year without being registered.  As in Rule 505, a company has great latitude with respect to the information it provides to accredited investors (as long as it doesn’t violate the antifraud prohibitions of federal securities laws), but any information provided to non-accredited investors must be similar to the type of information provided in registered offerings.

In order to claim any of the Regulation D exemptions, a company must file a Form D with the SEC within 15 days of the first sale of a security in reliance on any of the three rules.

State “Blue Sky” Laws

As mentioned above, the availability of a federal exemption does not necessarily mean that an exemption will be available in the state in which you want to sell your securities.  Each state has its own collection of “Blue Sky” laws that set forth the registration and exemption requirements for securities offered and sold to their residents.  This can be particularly problematic for companies seeking to offer securities under Rules 504 or 505, as not all states have exemptions similar to those two.  However, nearly all states (the notable exception being New York) exempt securities validly offered and sold under Rule 506, so long as the company submits a copy of the Form D and pays a filing fee (generally $200 – $300) within 15 days of the first sale of securities in that state.  Due to the complexity and inconsistency of state Blue Sky laws, it is important that you consult with a securities lawyer before offering securities, and that you gain a solid understanding of the rules and regulations of each state in which your potential investors reside.

Who Can Sell Securities?

To sell securities, a company or individual generally must be registered with the SEC as a broker/dealer.  However, a federal exemption is available for executive officers, directors and certain full-time employees of the company issuing the securities.  A seller that is not a registered broker/dealer may not receive commissions or compensation based on the sale of securities, so don’t plan on paying success fees to your officers or directors.  In addition, if a person has been a broker/dealer, or was associated with one, in the 12 months prior to the offering, the exemption may not be available.  State rules with respect to broker/dealer registration may differ from federal rules so, again, the advice of an experienced securities lawyer is critical.

Disclosure Requirements

State and federal securities laws require a company issuing securities to provide investors with full, fair and complete disclosure of all material facts about the offering and the company, its management, business, operations and finances.  Information is considered “material” if a reasonable investor would consider the information important in making an investment decision.  When determining whether a piece of information is material, a good rule of thumb is that if its disclosure would cause an investor not to buy the securities, then the information is material and must be fully disclosed.  Making false or misleading disclosures, or failing to sufficiently disclose material facts, can result in civil and criminal liabilities for individuals involved in the securities offering.  Material information can include past criminal offenses, civil suits, bankruptcies and even a history of substance abuse or a diagnosis of a serious medical condition.

To satisfy disclosure requirements, your securities lawyer will likely prepare a Private Placement Memorandum (“PPM”), confidential information memorandum or similar document that will include various disclosures about the company, a summary of the material terms of securities and a lengthy discussion of the various risks associated with an investment in the securities.  Generally, this language will be wrapped around your company’s business plan.  The PPM serves two main purposes:  (1) it is a marketing document highlighting your company and its business prospects, and (2) it is a disclosure document meant to protect the company and its officers from liability in the event the investment is unsuccessful.  These two purposes are inherently in conflict with each other, so your securities lawyer will pay close attention to the wording of the representations made in the PPM so as to avoid creating unwarranted expectations.

Finally, you will need to be careful what you say or write to potential investors.  Having a carefully crafted PPM won’t protect you from liability if you or other officers or employees of your company make oral or written representations different from those contained in the PPM; particularly if your representations create exaggerated expectations regarding the company’s prospects.  Accordingly, you must take appropriate steps to ensure that all investor presentations and communications are consistent with the representations and disclosures of the PPM.


Unless you are independently wealthy, odds are that you’re going to need outside funding to get your business to the point of profitability.  A private securities offering can be a powerful tool to enable an emerging company to tap into an exponentially greater source of capital.  If not done properly, however, an offering of unregistered securities can bring criminal and civil penalties upon a company’s officers and directors.  An experienced securities lawyer will be able to guide you through the complex securities regulatory environment and help your company reach its full potential.