How Small Businesses Can Avoid Securities Issues in Financing Activities

Most small businesses, whether at the start-up phase or when seeking to grow and expand, will inevitably need capital infusions to obtain their corporate objectives.  Aside from personal funds or loans from governmental or commercial lenders, entities often times seek to raise additional funds through selling “securities” (i.e., stock or other forms of equity or debt) to potential investors.  What many small business owners do not realize is that the sale of securities is heavily regulated by both federal and state laws and failure to comply with such securities laws may have serious repercussions on an entity and its owners.

A “security”, as defined under both federal and state statutes, encompasses a wide variety of instruments, including but not limited to notes, stock, treasury stock, bond, debentures, warrants, evidence of indebtedness, participation in profit-sharing agreements and investment contracts.  When an entity sells a security, such sale must either be: (i) registered with the United States Securities and Exchange Commission (“SEC”) and the appropriate state securities authorities, or (ii) exempt from registration under federal and state securities laws.  These requirements apply to all businesses in all securities offerings, ranging from small private companies selling securities to friends and family, to global public companies selling securities to a large base of potential investors.  Every securities transaction must comply with both federal securities laws and the securities laws of each state of residence of an investor.


Registration and Exemption

Registration with the SEC or state securities agencies can be complex, time consuming and expensive process that includes the preparation and filing of a disclosure prospectus that must be provided to all potential investors.  Therefore, issuers usually seek to avoid the registration process by structuring securities offering in order to qualify for an available exemption from registration under both federal and securities laws.  Structuring an offering to comply with an available exemption may include imposing certain restrictions on the monetary amount of securities offered, sophistication of the investors (i.e., accredited investors) and number of investors the securities are offered.  Certain exemptions at the federal and state level may be self-executing (i.e., no additional follow-up information required), while other exemptions may require notice and other related filings at the federal and state level.  Certain exemptions may also require the additional preparation of other disclosure related materials to be provided to the investors and/or the federal and state governing authorities.


Failure to Comply with Securities Law

Failure to properly comply with federal and state securities laws in connection with the sale of securities could result in serious repercussions for an entity.  Depending on the nature and severity of the securities law violation, the company and its principals could face criminal charges at both a federal and state level. Further, the SEC and/or state securities authorities may pursue claims for civil penalties, ranging from monetary fines to temporary or permanent prohibitions on the company from conducting future capital raising activities.  In addition, investors may seek to rescind their purchase in the offering and receive the principal amount invested in the company with interest.  It is important to note that those principals who control the company may also be personally liable to the investor for rescission or damages if the company no longer has available cash to reimburse such investors.


Long Term Impact

Aside from the potential legal ramifications noted above, securities laws violations could have negative long lasting effects on a company in connection with future financing activities.  As a company grows, it may ultimately seek to raise additional capital from more sophisticated investors, such as angel investors and investment banking firms.  Such sophisticated investors, as part of the due diligence process, will analyze the company’s capitalization table, including prior sales of equity and debt in the company.  If a security violation (or a potential violation) is revealed in the diligence process, then the investors are more likely to avoid investing in the company due to the uncertainty of future potential lawsuits and penalties.  In the event a company elects to conduct financing activities that includes the sale of securities, regardless of the size of the offering or target investors, it is recommended that such company consult with a securities professional to ensure that such securities offering complies with all federal and state securities laws.


About the Author:  Chris Seamster

Chris focuses his practice on Corporate and Securities Law