Are you a founder looking to fundraise for your company? Are you unsure about what laws and rules need to be followed when raising funding from your friends, family, and angel or venture capital investors? If so, this fundraising guide is for you.

The following provides fundamental guidelines for founders regarding the laws that need to be complied with and the options that are available to raise money from investors. The first thing that founders should understand is that when asking for money from others to fund their business ventures, that transaction will likely be classified as an issuance of equity under an investment contract (i.e., a security for the purposes of applicable laws) and, as a result, will come under the purview of the U.S. Securities and Exchange Commission (SEC) and, under certain circumstances, the applicable state securities laws (also known as “blue sky” laws).

What is the U.S. Securities and Exchange Commission?

Congress passed two acts that have laid the groundwork for the regulation of securities markets: the Securities Act of 1933 (Securities Act) and the Exchange Act of 1934 (Exchange Act). The SEC was formed as a result of Congress’s passing of the Exchange Act, making it the primary regulatory regime of securities markets. The Exchange Act gave the SEC broad powers over the securities industry, including securities exchanges (i.e. where the securities are actually exchanged such as the New York Stock Exchange), public company reporting requirements, and other important compliance matters. The Securities Act’s purpose is two-fold: (1) it ensures that accurate disclosure of financial and other information is provided to investors, and (2) it prohibits deceit, misrepresentations, and fraud by the issuers.

Why are investments considered securities?

The U.S. Supreme Court created a test for determining whether a transaction meets the definition of a security in its famous case, SEC v. W.J. Howey Co. In Howey, the Court formed a four-pronged test, commonly referred to as the Howey Test to determine whether a transaction meets the definition of a security. Those four prongs are as follows:

  1. Investment of money;
  2. In a common enterprise;
  3. The purchaser has an expectation of profits; and
  4. The profits are derived from the entrepreneurial or managerial efforts* of others.

* As a result of subsequent case law.

How do I comply with securities laws?

In the United States, offers or sales of securities are required to be registered with the SEC unless they can meet an applicable exemption therefrom.

Registering a securities offering is an extremely costly and time-intensive process involving detailed public disclosures on sensitive business information such as the company’s financial condition, operations, and risk factors to name a few. For emerging growth companies seeking to find product market fit and scale their businesses, this option is largely impractical. Therefore, we look for securities exemptions that allow our clients to not have to register their securities with the SEC.

That requires us and our clients to look for and assess available registration exemptions from the registration requirement. Taking advantage of securities exemptions saves significant time and money and allows emerging growth companies to move quickly and maintain privacy during critical early growth phases.

Which registration exemptions are available to choose from?

Exempt offerings enable founders to bypass the registration requirement by complying with lighter compliance requirements set forth in various exempt offering rules. Startup companies should be aware of exempt offering rules that include accredited investor mandates, solicitation restrictions, and fairly simple disclosure requirements depending upon the chosen exemption.

What are Accredited Investors?

In order to qualify as an Accredited Investor, an individual must meet either financial or sophistication criteria. Some, but not all, of the financial criteria include: (1) having a net worth of over $1 million (excluding the individual’s primary residence or the primary residence jointly owned with his or her spouse), or (2) having an individual income of $200,000 or a joint income of $300,000 with his or her spouse in each of the two previous years with the reasonable expectation of receiving the same income for the then current year. Individuals can also meet the definition of an accredited investor by meeting professional criteria such as holding Financial Industry Regulatory Authority (“FINRA”) securities licenses, including Series 7, Series 65, and Series 82 licenses. For more information on Accredited Investors, please refer to Understanding Accredited Investors: Why It’s Critical to Your Startup’s Fundraising.

The following section provides an overview of what founders should know about some of the most commonly used exempt offering rules, including Regulation D – Rule 506(b), Regulation D – Rule 506(c), Regulation S, and Regulation Crowdfunding. Note that there are other exemptions available for fundraising, however, some are more burdensome (such as Reg A) and rarely used, particularly for early stage companies.

What Founders should know about Regulation D – Rule 506(b)

Rule 506(b) is a private placement exemption under Section 4(a)(2) of the Securities Act. Rule 506(b) is the most common exemption used by emerging growth companies. It allows for companies to raise an unlimited amount of money in private offerings from accredited investors (a crucial point for founders to keep in mind). A limited number of sophisticated investors who do not meet the definition of an accredited investor may participate in an exempt offering under 506(b), but their inclusion increases the demands on the company as additional disclosure requirements must be provided to these investors.

  1. How much money can I raise? Unlimited amount
  2. Are there restrictions on the types of investors that I may offer an investment opportunity to? Yes, all investors must be accredited but for 35 that must be sophisticated
  3. Can I advertise and/or discuss (such as in the press or social media) the financing publicly? No, general solicitation and advertising is prohibited
  4. What are the disclosure requirements? Companies must file Form D with the SEC within 15 days after the first sale of securities in the offering
  5. Do state securities laws apply? No, state laws are preempted

What Founders should know about Regulation D – Rule 506(c)

Implemented as a result of the passing of the Jumpstart Our Business Startups Act (the JOBS Act), Rule 506(c) is a safe harbor that allows companies to make public statements about their fundraising (known as general solicitation and advertising). This rule is one that founders may find useful if raising large checks from investors.

If raising minimum investment amounts of at least $200,000 from an individual or $1 million from legal entities, emerging growth companies can satisfy the rule’s “reasonable steps” verification of the accredited status of investors by obtaining a written representation that (1) the purchaser is accredited and (2) the cash investment is not financed in whole or in part by any third party. Founders should be aware that they should also not have any knowledge of fact that would indicate that the written representation is not in fact true.

For investments that do not meet the minimum investment amount threshold, companies must take additional “reasonable steps” to verify that the investors are accredited. These reasonable steps require obtaining written representations and reviewing Internal Revenue Service forms, bank statements, brokerage statements, and other documentation to personally verify or have confirmation from a licensed attorney or certified public accountant that the investor is actually accredited.

  1. How much money can I raise? Unlimited amount
  2. Are there restrictions on the types of investors that I may offer an investment opportunity to? Yes, all investors must be accredited
  3. Can I advertise the financing publicly? Yes, general solicitation and advertising is allowed
  4. What are the disclosure requirements? Companies must file Form D with the SEC within 15 days after the first sale of securities in the offering
  5. Do state securities laws apply? No, state laws are preempted

What Founders should know about Regulation S (Abroad Fundraising)

Companies that are seeking to raise capital from outside of the United States, to non-US persons, have the option of utilizing this safe harbor “Reg S” without the need to register their offering with the SEC. To comply with the requirements of Regulation S, there must not be a substantial market interest for the offering in the United States, along with additional offering specifications. This safe harbor does, however, offer more relaxed rules concerning the accredited status of foreign investors. Investors do not need to meet the definition of an accredited investor to participate in the offering, but there are tight restrictions concerning offering participation and keeping it separate and distinct from any other fundraising activities.

  1. How much money can I raise? Unlimited amount
  2. Are there restrictions on the types of investors that I may offer an investment opportunity to? Yes, all investors must be located outside of the United States, but they are not required to be accredited
  3. Can I advertise the financing publicly? No, general solicitation and advertising is prohibited
  4. What are the disclosure requirements? Not mandated
  5. Do state securities laws apply? No, state laws are preempted

What Founders should know about Regulation CF (Crowdfunding)

Also stemming from the JOBS Act, Regulation Crowdfunding (aka Regulation CF) allows companies to raise an aggregate amount of $5 million per year from both accredited and non-accredited investors via SEC-registered crowdfunding portals. Unlike the offering exemptions above, Regulation CF requires heightened disclosure requirements, investment thresholds based on income for non-accredited investors, and restricted advertisements.

  1. How much money can I raise? An aggregate total amount of $5 million
  2. Are there restrictions on the types of investors that I may offer an investment opportunity to? Yes, offering limits are implemented for non-accredited investors
  3. Can I advertise the financing publicly? Advertisement is restricted to tombstone ads that direct investors to the crowdfunding portals and issuers may communicate with potential investors directly through the portals
  4. What are the disclosure requirements? Companies must file an offering statement using Form C
  5. Do state securities laws apply? No, state laws are preempted

Final Thoughts

Emerging growth companies operate in fast-paced environments that require efficient pathways to legal solutions that meet their business needs. Understanding what your company needs to do to fundraise under the right legal framework is critical to its success.

By prioritizing legal and regulatory compliance from the start, founders can focus on what matters most: building and scaling their business. Bowery Legal can help your startup navigate these regulations successfully and ensure a smooth fundraising process.