Financing Your Startup with Security: Securities Law Basics

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Financing Your Startup with Security: Securities Law Basics

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If your company plans to raise money by selling stock or convertible notes (also known as “securities”), then your company must comply with federal and state securities laws. If not, the company and its promoters could become subject to adverse legal consequences. You don’t need to become an expert, but you do need to understand that selling securities is a highly regulated activity and your company should not sell any securities until speaking with a lawyer experienced with capital raising transactions. 

Securities Law Basics

What is a security? A security represents an investment in a business. Shares of stock, convertible notes and stock options are all securities.

What are securities laws? Securities laws exist both at the federal and state level and govern the sale and issuance of securities. The Securities and Exchange Commission is the federal agency charged with enforcing the federal securities laws. Each state has an equivalent agency charged with enforcing each state’s securities laws (sometimes referred to as “Blue Sky Laws”).  

Why do we have securities laws? The main objective of securities law is to protect investors from being swindled out of their money by requiring disclosure of material information about a company to investors and establishing laws against misrepresentation and fraudulent activities.   

What could happen if my company does not comply with securities laws? Some possible ramifications include:

  • The SEC, the state securities agency or an investor could bring a criminal or civil lawsuit for securities fraud against the company or those officers involved in marketing the securities.
  • Investors could exercise “rescission rights” and get their money back.
  • Potential investors or acquirers – when they realize the company’s lack of securities law compliance – might forego investing in or acquiring your company out of concern about the legal risks.

So how do you raise money in compliance with securities laws?

While the legal requirements are intricate, compliance should be entirely manageable. The basic framework is as follows: when selling securities to investors (also known as an “offering”), the offering must be “registered” with the SEC and applicable state securities agency, unless an “exemption” to the registration requirement applies. For startups, a “registered” offering is prohibitively time consuming and expensive. Consequently, most private companies will conduct an “exempt” offering. There are multiple types of exempt offerings, each of which are based on different regulatory requirements. For now, it suffices to say that most of our clients will rely on the “4(a)(2)” private placement exemption by complying with the requirements of “Rule 506(b)” (a safe harbor to compliance with 4(a)(2)). At a high-level, to comply with Rule 506(b), the company must disclose material information about the company to qualifying investors and make certain government filings within fixed timeframes.


When growing a company, there are certain perils outside of your control (industry changes, global economic trends, etc), but compliance with securities law does not need to be one of them. Complying with securities law is not an area for the DIY founder. Let an experienced lawyer guide you through compliance issues, so that you can focus on your capital raise.

Author: Jeremy Freifeld

The blog content should not be construed as legal advice.

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