As you might guess from this old picture from my days in the SEC’s Enforcement and Corporation Finance divisions, I’ve been thinking about these issues for a few years….
Before we dive in, remember that it’s “securities law, ” not “security law” – plural not singular. With that cleared up, here are my top tips for startups and founders to safely navigate the complexities of securities law.
1. Know the Definition: What Is a Security?
Securities are not just limited to stocks, bonds, options, convertible notes, and SAFEs. Those things are all securities, but so are less obvious things called “investment contracts.” Under the Howey test, an investment contract exists if there is:
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an investment
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in a common enterprise
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with an expectation of profit
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from the efforts of others
Under Howey, even something as unusual as a plot in an orange grove or an interest in an armadillo farm can qualify as a security.
In recent years, many of the SEC’s actions against crypto companies have been criticized for applying an overbroad reading of this test.
So, as the SEC does, err in favor of a broad reading of the Howey test in any context where the following securities law concerns might apply.
2. Avoid Material Misrepresentations and Omissions When Selling Stock
Top Tip: do not commit securities fraud under Rule 10b-5!
Overly zealous founders sometimes trip over state and federal prohibitions against making any knowing or reckless statements or omissions of material fact in connection with the purchase or sale of any security.
Fraud can be alleged by state and federal regulators and by individual investors regarding any sale of stock, notes, SAFEs or any other security when puffery crosses the line to misstatements or omissions of “material” facts.
Materiality is judged based on a “reasonable person” standard, asking whether a reasonable person would consider the fact material to the investment in light of the entire mix of information.
A material omission is any fact necessary to make statements made not materially misleading.
Tesla and Elon Musk beat securities fraud allegations in October of 2024 when a federal judge concluded that Musk’s numerous tweets about the imminent arrival of self-driving automation were mere “puffery” and not statements or omissions of material fact that a reasonable investor would have relied on.
That was a somewhat surprising result, and not a Supreme Court decision, so I recommend that non-billionaire founders not test the boundaries of the “puffery defense” when pitching. Here’s an article on the decision – Elon Musk Celebrates Winning Lawsuit Over Tesla Self-driving Claims with Embarrassing Defense.
In general, avoid misstatements or omissions relating to factual things like:
the product or service is ready to ship
the product or service produces certain results
the product or service has passed certain tests or approvals
manufacturing can be easily and cost-effectively scaled up
the product or service meets all regulatory requirements
the product or service is completely safe
Other high-risk areas include misstatements about the sourcing of raw materials, access to suppliers, or the absence of actual or threatened litigation or intellectual property issues.
And avoid “promised rates of return,” which the SEC might view as inherently fraudulent. Except for interest rates in notes or other debt instruments – avoid promising investors anything sounding like a specific rate of return or return on investment – whether that return is a specific number, a percentage, or a range.
And don’t try to hide behind hedging language like “we believe you will receive a 20% return on your investment.” That could still be a red flag for regulators.
3. Don’t Blow Your Offering Exemption
Unless you’re doing an IPO and filing an offering registration statement with the SEC, you need to offer and sell securities under an “exemption from registration.” The most common exemption is Rule 506(b) of Regulation D.
Compliance with 506(b) is easy unless you involve a non-accredited investor.
Accredited investors are persons with $1 million in net assets or income greater than $200,000 per year for three years running, or $300,000 per year for married couples.
If just one non-accredited investor participates, you’re required to prepare and distribute a complex and quite expensive disclosure document, or the entire round could be unwound under a concept called “rescission.”
Rescission is a right that springs from the absence of an exemption. The blown exemption essentially invalidates all of the financing contracts, as a contract in violation of the securities laws is deemed illegal and thus void.
An investor’s demand for rescission is a demand that the company return all the money from a round to all of the investors. Such a demand to a startup is generally catastrophic, as the startup has generally spent the money raised and cannot meet the demand.
The risk of a demand for rescission, though, is usually less of a concern than the possibility that future investors or acquirers will discover the potential liability in due diligence and either walk away or reduce the company’s valuation to account for the risk. Rescission issues can also be raised by the SEC in a company’s IPO.
4. Avoid “Bad Actors”
A company cannot raise money under Rule 506(b) if “bad actors” are involved officers, directors, control persons, or owners of more than 20% of the company’s stock, or simply as investors in the round.
A bad actor under Reg D is any person with a judgment, order, or conviction against them from an action brought by the SEC, any state securities regulator, any state or federal banking regulator, FINRA, or the US Postal Service.
Interestingly, bankruptcy does NOT make one a bad actor.
If it is later determined that a financing under Rule 506(b) included a bad actor, that financing is subject to the same rescission risks discussed earlier, as the involvement of the bad actor has blown the exemption.
5. Keep Your Cap Table Simple
The fewer investors, the better. VCs prefer clean cap tables, generally with no more than 15-20 investors, and no non-accredited investors. Large numbers of investors can create administrative headaches and potential liabilities.
Viewed through a cynical lens, every investor is a potential “point of failure,” in that they might make trouble for the company if they become unhappy. It costs nothing for an aggrieved investor to file a complaint with the SEC or a state regulator.
Swollen cap tables are also painful in an IPO or the sale of a company. Closing a sale requires tracking down every investor, getting deal documents to them, obtaining some signatures, and paying out deal consideration.
The only exceptions to the “tiny cap table” ideal might be (i) consumer-facing companies that want to make their customers investors and their investors customers and (ii) companies that have no other choice than to raise money from lots of investors.
6. Avoid Illegal Referral Fees
Startups often encounter third parties who offer to help raise funds for a fee. Be careful. Only registered broker-dealers can legally raise money for you in exchange for performance-based compensation, such as a percentage or bonus for a successful financing.
Paying non-broker-dealers based on performance can violate Section 15 of the Securities Exchange Act of 1934, again leading to rescission risks.
A third party can, however, receive a flat fee for simple introductions to potential investors. Just ensure they don’t go beyond that.
Here’s a popular blog post I wrote on referral fees, also called finders fees – “Finders Fees” Raise Thorny Securities Law Issues.
7. Expert Oversight for Stock Option Plans
Equity compensation plans (e.g., stock option plans) are tricky and require expert administration in order to avoid legal, regulatory, tax and financial risks. Key points:
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The board must approve any equity incentive plan before grants are made, and then must also approve individual grants, including key details such as exercise price, vesting schedule, any provisions for accelerating vesting, and the life/term of the option.
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Shareholders must approve a plan if Incentive Stock Options (ISOs) will be issued.
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Each option must be priced at fair market value (FMV) on the grant date.
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A current 409A Independent Valuation Report is required to establish FMV.
Here’s an article I wrote on avoiding common equity plan mistakes – Avoid These Ten Equity Compensation Mistakes.
AI-powered 409A platforms like 409.ai are reducing the cost and turnaround time for 409A valuations, making it easier for startups to avoid red flags that can derail or complicate financings and M&A deals.
8. Secondary Sales of Restricted Stock
A secondary sale refers to a sale of stock by anyone but the issuing company. Startups should keep tight reigns on their founders, officers, board members, employees, and even their outside investors to prevent stock sales that violate securities laws or contractual covenants.
Given the low pay often received by founders and others involved with startups, the question often arises – “hey, can I sell some of my stock?” It’s a complicated question involving a mix of issues – some regulatory, some contractual, and some about perceptions.
Beginning with perceptions, founders expecting to obtain VC funding should expect them to ask uncomfortable questions about any prior sales of the founder’s shares. For example, “why should I invest if you’re bailing out on the company?” Not a good look.
From a contractual perspective, stock issued by most properly formed companies will be subject to “rights of first refusal,” giving the company and often other key persons the right to first buy any shares that another might want to sell. Violation of these rights can result in financial liabilities and also cause sale transactions to be nullified.
From a regulatory perspective, as stated at the outset, all sales of securities must be registered or subject to an exemption from registration. Securities purchased under an exemption like Rule 506(b) are called “restricted shares.” The resale of restricted shares is governed by rules that are best interpreted by securities lawyers – especially when insiders are doing the selling.
Unregistered resales of restricted shares by founders and other insiders can trigger a host of issues, including claims for rescission, allegations of fraud, and perception issues that just might drive away future investors or acquirors.
Summary
Any transaction involving stock, options, notes, warrants, SAFES, cryptocurrencies, or any other kind of securities requires great care and consideration, and likely also the assistance of a securities law expert.
The adage of “ask for forgiveness, not permission” rarely works with the SEC, state regulators, or angry investors, much in the way apologies don’t help once you’ve grabbed the proverbial hot third rail.