Friends and Family Round - Securities Law Compliance (2024)

Tackling the friends and family round can be daunting for entrepreneurs with no knowledge of how to comply with the myriad of state and federal securities laws. Many of our clients have asked us what rules apply, and what the consequences are if they fail to comply properly. To that end, the ladies of Smith Shapourian Mignano PC briefly answer these questions in this blog article to provide high-level insight into the process.

Overview

A friends and family round varies, but typically consists of small investments structured as equity subscriptions, unsecured loans or sometimes convertible loan notes. However, many startups do not fully understand the securities laws which apply to the transaction and neglect to properly document the round, possibly due to unavailability of funds for legal work at the outset. To compound the problem, many friends and family investors are not initially concerned about properly documenting their investment, and/or do not know what proper documentation entails. As a result, many startups wonder whether it is really necessary to comply with securities laws, or to properly document their friends and family round.

The bottom line is that, even though you are doing business with your friends and family, it is important to get the transaction “in writing” and to avoid misunderstandings about equity so that that these investors understand the risks of their investment. This reduces risk of litigation in the future.

Also, doing it right the first time will help a startup to avoid frightening off later-stage, big-money investors who could, upon discovering securities violations in this round, nix the deal altogether or reduce the valuation of the company to take into account the contingent liability for any potential lawsuits or civil penalties by investors.

Securities Law Compliance

Federal and state governments impose restrictions on when companies sell securities and/or take loans. Securities law compliance is aimed at requiring companies, even small startups, to register the sale of securities with the SEC and the securities commissioner of each state where investors or potential investors reside, and to avoid defrauding investors.

Startups may file an exemption to avoid having to register the sale of their securities. However, in order to qualify for the exemption, the startup is required to file notice filings with the SEC and the applicable state securities commissioners. In this process, startups have to be careful with respect to sales conduct, specifically refraining from any advertising, if they are selling stock to unaccredited investors. Third, companies must ensure that they don’t engage in fraudulent selling practices.

Regulation D

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (“Reg D”) contains three rules, specifically Rule 504, 505, and 506, which provide exemptions from the registration requirements. For the purpose of this article, we only discuss Rules 506 and 504, and save the intrastate offering exemption for another blog article.

Rule 506

Under Rule 506, a startup may include up to 35 non-accredited investors in its friends and family round. If the startup includes non-accredited investors, however, it must provide the investors with the same information as it would have provided in a registered offering, which can raise legal costs. Additionally, under Rule 506, any non-accredited investor investing in the startup must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” There is no bright-line test to tell whether a non-accredited investor is sufficiently business savvy and sophisticated under this standard, and legal counsel is often needed in this regard. Finally, as long as the correct notice filings are made, startups need not worry about finding an exemption from state securities registration requirements.

Rule 504

Unfortunately, not everyone has rich relatives and cohorts who qualify as accredited investors. Under Rule 504, investors do not need to be accredited and there is no information provision requirement. A startup may raise up to $1 million over a 12-month period under this Rule, but, like a Rule 506 offering, the startup may not solicit prospective investors. All investors must be pre-existing contacts of the startup and its principals, and the startup must not engage in advertising or widespread promotion of the offering. Where a startup relies on Rule 504, counsel will need to research the state law of every single state in which the company will be soliciting investors in order to find a separate exemption from registration in each state.

Form D

Finally, under both Rules 506 and 504, the startup must file what is known as a "Form D" electronically with the SEC after the sale. Form D is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering, but contains little other information about the company.

California Securities Code Section 25102(f)

Section 25102(f) of the California Securities Code is an exemption from the general requirement that securities offerings must be registered in California. Under this section, a startup may sell securities to an unlimited number of accredited investors (as well as company executives) and up to 35 unaccredited investors. However, unaccredited investors must:

• Have a preexisting personal or business relationship with the company or its principals; or
  
• Have the ability to protect their interests due to their financial experience or the fact that they have experienced professional advisors.
  

Here again, determining the sufficiency of the pre-existing relationship and financial experience of the investors may require a startup to retain legal counsel, as there is no bright-line rule to this effect.

Smith Shapourian & Mignano, PC is available to answer any questions or concerns you may have regarding a friends and family round. You may contact us for a consultation.

This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.

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