Beyond Crowdfunding: What New Businesses Need to Know About Securities Law Compliance




Last year, much fanfare was made over the Jumpstart Our Businesses Startup Act, or “JOBS Act” for short.  The JOBS Act’s intent was to create more funding opportunities for startup businesses by easing securities regulations; specifically, the JOBS Act permitted greater use of funds from non-accredited investors through “crowdfunding” mechanisms.  Despite the hype, the JOBS Act has done little to nothing to help fund new business ventures.  Why?  Because the Securities and Exchange Commission failed to meet its January 31, 2013 deadline to enact regulations establishing how crowdfunding can legally be accomplished.


In the absence of SEC regulations under the JOBS Act, new businesses are left to rely on the existing securities laws, which provide for one of two options when you look to sell securities – registration or find an exemption from registration.  Registration (meaning you’re going to “go public” and register with the U.S. Securities and Exchange Commission and with any state securities division where your securities are sold) is extremely expensive and it requires you to file annual and quarterly reports thereafter; it’s not a cost effective strategy at all, and that’s why we look for exemptions.


You can be exempt in one of two ways: either the securities you’re selling themselves are exempt (in which case you have an “exempt security”, or the law provides for certain means of sale to be exempt; these are what are known as “exempt transactions.”  To be legally compliant, you have to find an exemption at both the Federal and State levels (and by “State” I mean every state in which your investors are located). 


Most Federally exempt transactions fall under what’s known as Regulation D (“Reg D” for short).  Reg D establishes three exemptions from Securities Act registration: Rule 504, Rule 505 and Rule 506.


Rule 504

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. General offering and solicitations are permitted under Rule 504 as long as they are restricted to accredited investors. The issuer need not restrict purchaser’s right to resell securities.

Rule 505


Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, securities may be sold to an unlimited number of “accredited investors” and up to 35 “unaccredited investors” who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are restricted, in that the investors may not sell for at least two years without registering the transaction. General solicitation or advertising to sell the securities is not allowed. Under Reg D, Rule 505, the SEC must be notified within 15 days after the first sale of the offering.  Issuers seeking exemption under Rule 505 must also comply with certain financial statement requirements; namely:




  • Financial statements need to be certified by an independent public accountant;



  • If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s balance sheet, to be dated within 120 days of the start of the offering, must be audited; and



  • Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.


Rule 506

A company that satisfies the following standards may qualify for an exemption under Rule 506:




  • Can raise an unlimited amount of capital;



  • Does not use general solicitation or advertising to market the securities;



  • Sale of securities can be an unlimited number of accredited investors and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated – that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;



  • Seller must be available to answer questions by prospective purchasers;



  • Financial statement requirements as for Rule 505; and



  • Purchasers receive restricted securities, which may not be freely traded in the secondary market after the offering.


Exempt offerings under Regulation D do take time to prepare and are not cheap.  However, the cost of compliance pales in comparison to the consequences of non-compliance which include civil and criminal penalties.  Also, be sure to ask if your attorney is insured to perform securities work.  If not, you should find one who is (hint – I know of a firm that is).

Posted in Blog, Business Law, Startups