A subset of the requirements for seed and VC financing is compliance with federal and state securities laws (the latter tend to track the requirements of the former). As a general matter these laws are designed to protect investors by demanding that sellers of securities (like stock) make proper disclosures to investors (about the value of the business) usually by making information about the company and the sale publicly available. Within the context of start-up financing, however, there are exemptions from these statutory demands (which are very expensive to comply with) so long as the start-up follows certain rules.
The chief exemption at issue here is Regulation D, promulgated under the Securities Act of 1933, which provides, through Rules 504-506 of Reg D, the framework typically used by start-ups when selling stock.FN1 These rules principally turn on the i) amount of capital being raised, ii) type of investor and iii) method of conducting the sale but in specific application can get highly technical (mostly due to "if, then" contingencies between state requirements and federal requirements) so take the summary below as an overview subject to caveat.
As a threshold matter there are capital restrictions. Rule 504 is restricted to "offerings" of up to $1 million, Rule 505 to offerings of up to $5 million and Rule 506 to any higher amount.FN2 Note that it's the "offering" amount, not the "sale" amount, that determines the classification.
Second, there are the investor type and investment method limitations and they operate as follows:
-Rule 504 is the most liberal, placing no restrictions on the number of persons purchasing securities or on what the purchaser may do with the purchased securities (so long in the latter case as the investors are "accredited"). There are no disclosure requirements (with respect to the documents provided to investors) under Rule 504 as long as statements in any "offering materials" (including marketing documents such as a power point or business plan or memorandum) do not violate the Security Act's antifraud prohibitions (by being misleading), HOWEVER, it does not allow (absent state registration of the securities) "general solicitations" or advertisements (there's a slew of technical rules on what constitutes a general solicitation but basically it's marketing to investors with whom there wasn't a pre-existing relationship).
NOTE, however, the state securities laws may qualify Rule 504 (California, for instance, limits (via Section 25102(f)) all such non-registered offerings to no more than 35 "unaccredited" investors).
-Rule 505 like the California rule requires that all but 35 of the investor(s) be "accredited" (i.e., i) a company or investment group with over $5 million in assets, ii) founder(s) of the company, iii) or wealthy people (based on a net worth/income test)).FN3 In addition, to the extent an offering is made to any unaccredited investors (here is the huge difference from Rule 504), disclosure documents must be provided that are generally the same as those used in registered offerings (an exercise costly enough that it effectively bars the inclusion of unaccredited investors). Finally, the securities sold must be "restricted" (i.e., resale in the public marketplace is prohibited absent some Securities Act exemption).
-Rule 506 - the most commonly relied upon exemption for Series A financings - is substantially similar to 505 except i) there is no $ cap, ii) the 35 unaccredited investors (if any) have to be "sophisticated", and iii) it preempts state securities laws, so the only form required to be filed with states (in which there is a sale) is a copy of a "Form D" (filed with the SEC).FN4
The upshot of the above is that companies that sell to friends and family use 504 and everyone else uses 506. In both cases, any information given to investors must be accurate and complete, which means that financial data, if any, should as a mater of best practice be audited and certified and the term sheet and purchase agreement be industry standard.
The final step to close the transaction is to file a Form D SEC notice of sale filing (that notifies the SEC that securities are being sold pursuant to Regulation D and provides basic information on the company and the offering).FN5 In addition, all proper materials must be filed with in each state in which there is sale (i.e, where a buyer is a resident) (in the case of a 506 offering, simply send a copy of the SEC Form D and the applicable state Form D "appendix"). In most states such forms do not need to be filed until the money has been received from the relevant investor(s). The typical grace period for filing these forms is 15 days after the transfer of funds.
FN1. Two caveats here. First, start-ups will also need to seek a separate exemption (Rule 701) for the creation of a stock option pool. Second, other sections of the Securities Act (e.g., Sections 4(2) and 4(6)) also provide exceptions to registration that would be applicable to start-ups raising capital, however, these sections are either less straight-forward (due to judicial interpretation) or niche enough that Rules 504-506 have over time become the "best practices" exemptions applicable to most capital raising scenarios.
FN2. Note that these monetary limitations are calculated on a rolling basis within a 12 month period - the "integration rule." The integration rule is one more incentive to use a Rule 506 exemption (which has no monetary limit).
FN3. Specifically, a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase or ith income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
FN4. 506 but not 504 and 505 preempts state laws because the latter were adopted under Section 3(b) of the Securities Act rather than 4(2).
FN5. None of Rules 504-506 require a filing of a Form D - the benefit of doing so is primarily in that if it's a Rule 506 offering then state securities laws are preempted.
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