You’ve Got VC Money: Securities Laws

Authors: Andrew Shawber

Since you’ve already raised a significant VC round, you should already be familiar with the process for issuing securities to investors. Here is a refresher if you need it.

Securities Laws Overview

All sales, purchases, and offers to sell or purchase shares of stock or other securities of the company (including stock options, warrants, SAFEs, and notes) must be made in compliance with applicable federal and state securities laws.

The general rule is that any transaction involving the company’s securities will be subject to a registration requirement unless an exemption is available. There are several exemptions available to startups, including in connection with the grant of stock options and other equity incentive awards under qualified equity incentive plans—and issuances of stock to “accredited investors.”

However, strict compliance is required for the company to rely on such exemptions, and prior planning is necessary to confirm an exemption is available before any securities are offered or issued.

Also, there are federal securities laws that apply nationwide (such as the Securities Act of 1933 and Regulation D promulgated thereunder), and all 50 states have mini Securities Acts called blue sky laws that apply to securities offered or sold in their respective states. While some federal exemptions make state-by-state securities compliance (and the related cost) unnecessary, there are many traps for the unwary that can easily be overlooked without careful analysis and the help of outside counsel.

Companies can be found liable for securities fraud and other penalties even if there is no intent to commit fraud. Failure to comply with securities laws can result in civil and criminal charges and prohibit future fundraisings. Further, investors who lose out on their investment based on the company’s failure to comply with securities laws can sue for a return of their full investment amount. Importantly, the company’s limited liability shield will not be recognized for certain debts in violation of securities laws, thereby resulting in personal liability for officers and directors.

You must consult with your Perkins Coie team prior to issuing or offering any securities of the company.

Standard Financing Protocol

Note that your Perkins Coie team should be in the loop well in advance of issuing any securities to investors. Your counsel needs to draft and negotiate legal documentation and necessary corporate approvals, as well as conduct any necessary corporate cleanup and due diligence before any securities are issued.

The typical financing process is as follows:

  • Shop the terms. You may want to shop the terms of the investment to investors before going any further. Investors may have thoughts about the type of security, such as preferred stocks versus SAFEs, convertible notes, valuation caps, discounts, and other considerations such as pro rata rights and management rights. Obtaining feedback from multiple investors before committing to terms can be quite helpful. Plus, it’s ideal to have all investors on the same set of terms (rather than doing one-off deals as you go). If they are on different terms, the future equity round will be more complicated and expensive. At this stage, investors may conduct financial and business due diligence on the company. Please read our series of posts on some of the practical aspects of pitching investors.
  • Lawyers draft the documents and conduct legal due diligence. Once you settle on a term sheet with your lead investor(s), Perkins Coie or counsel to the lead investor will draft the initial investment documents, which may go through multiple rounds of review and edits before being finalized. At the same time, the lawyers will conduct legal due diligence on the company, which may require corporate cleanup and follow-up actions.
  • Board approval. Once the parties settle on final documents and due diligence is complete, the board must approve the forms of definitive agreements, the aggregate dollar amount of the round, the price per share, and other applicable terms. The board should approve a raise large enough to avoid having to consider an increase later but not so large that you’re unable to fill out the whole round. That way you can set realistic expectations and deliver.
  • Important: Securities laws. Company stock, SAFEs, convertible notes, and other investment instruments are securities of the company, and the offer and sale of securities must be made in compliance with applicable federal and state securities laws. Securities compliance involves many important considerations and traps, but the key points are to (1) offer and sell securities only to “accredited investors,” (2) avoid crowdfunding and any publicity or widely distributed communications about your fundraising, and (3) tell us immediately when you have commitments from investors, as your Perkins Coie legal team will need to research and apply for securities laws exemptions on your behalf before you accept investor funds. As part of the securities compliance process, you will need to sign various other documents (e.g., Form D, “Bad Actor” Questionnaires, and other state filings) on which your Perkins Coie legal team will follow up as you get closer to closing.
  • Closing process. After you have firm commitments from investors and the board has approved the round and forms of documents:
    • Each investor signs the investment documents.
    • Investors send funds.
    • Company confirms receipt of funds and sends proof of payment to Perkins Coie.
    • Company countersigns the documents.
    • Perkins Coie sends fully signed copies to the company and each investor and their counsel, as requested by the company.
    • Perkins Coie updates the cap table and makes requisite securities filings.

Avoid General Solicitation

In general, any widespread communications regarding sales or offers of shares of the company (e.g., social media posts, crowdfunding, and startup pitch competitions) will be viewed as “general solicitations” and are prohibited under securities laws, except in very limited circumstances. There are special exemptions for crowdfunding transactions, but these exemptions involve a high degree of risk and material compliance burdens. When in doubt, assume any widespread communication involves a general solicitation and avoid it altogether. If you have questions about what constitutes a general solicitation or if you may have inadvertently engaged in any communication that might need to be remedied, please contact your Perkins Coie team member.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.