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Convertible Securities -- Navigating the SEC's Exemptions to Registration



Whether you are a startup looking to raise capital or you are an investor interested in investing in a startup, there are a variety of routes you can take. You could utilize a convertible security instrument such as a Simple Agreement for Future Equity (SAFE), a KISS, or convertible debt (among other types of convertible securities) to lay out the terms of the offering or investment, including how the amount of the offering or investment, and what “trigger events” need to occur for payouts or conversions. Depending on a variety of factors, registration with the SEC may be required; however, certain exemptions to registration may be applicable.


Who has to apply for registration with the SEC?

Before we get into potential exemptions, we’ll first talk about where the burden of registering with the SEC lands. As defined by the SEC’s website, every offer and sale of securities must be registered with the SEC unless exemptions apply (which we will discuss further below). So, unless exemption criteria are met, the startup is responsible for registering with the SEC.


The purpose of the investment

SAFEs (as well as other convertible securities) were created to standardize and streamline the capital raising process in early seed, seed and bridge rounds to raise capital, launch and provide continued funding for startups and growing companies. Depending on the terms of the SAFE and the company’s stated goals, the method of raising capital, and (at time) the classification of the target investor(s), different exemptions to registration may apply to the investment.

Please note that even if a specific federal exemption is utilized, states still have authority to require notice filings and collect state fees. Therefore, it is important to check applicable state laws regarding any additional notices or filings relating to offerings issued pursuant to any of the exemptions that will be discussed in this article.


Common Exemptions

A. Private Placements – Rule 506(b) of Regulation D

Section 4(a)(2) of the Securities Act exempts from registration transactions by an issuer (e.g., a startup) not involving any public offering.

Rule 506(b) of Regulation D is considered a “safe harbor” under Section 4(a)(2). It provides objective standards that a company can rely on to meet the requirements of the Section 4(a)(2) exemption. Companies conducting an offering under Rule 506(b) can raise an unlimited amount of capital and can sell securities to an unlimited number of accredited investors. An offering under Rule 506(b), however, is subject to the following requirements:

1. no general solicitation or advertising to market the securities

2. securities may not be sold to more than 35 non-accredited investors (all non-accredited investors, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment)

If non-accredited investors are participating in the offering, the company conducting the offering:

1. must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in Regulation A offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well)

2. must give any non-accredited investors financial statement information specified in Rule 506 and

3. should be available to answer questions from prospective purchasers who are non-accredited investors.


Investors in a Rule 506(b) would be offered to receive “restricted securities." “Restricted securities” means that the securities are not freely tradeable.

A company is required to file a notice with the SEC on Form D within 15 days after the first sale of securities in the offering.


B. General Solicitation – Rule 506(c)

Rule 506(c) permits issuers to broadly solicit and generally advertise an offering, provided that:

1. all purchasers in the offering are accredited investors

2. the issuer takes reasonable steps to verify purchasers’ accredited investor status and

3. certain other conditions in Regulation D are satisfied.

Like the Private Placement Exemption, investors in a Rule 506(c) offering receive “restricted securities.” A company is required to file a notice with the SEC on Form D within 15 days after the first sale of securities in the offering.


C. Exemption for Limited Offerings Not Exceeding $10 million – Rule 504 of Regulation D

Rule 504 of Regulation D exempts from registration the offer and sale of up to $10 million of securities in a 12-month period. A company is required to file a notice with the SEC on Form D within 15 days after the first sale of securities in the offering. In addition, a company must comply with state securities laws and regulations in the states in which securities are offered or sold.

There are, however, several types of companies that are not eligible to use Rul 504, such as investment companies and companies that have no specific business plan (among others).


D. Regulation Crowdfunding Exemption

Regulation Crowdfunding enables eligible companies to offer and sell securities through crowdfunding. The rules:

1. require all transactions under Regulation Crowdfunding to take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal

2. permit a company to raise a maximum aggregate amount of $5 million through crowdfunding offerings in a 12-month period

3. limit the amount individual non-accredited investors can invest across all crowdfunding offerings in a 12-month period and

4. require disclosure of information in filings with the Commission and to investors and the intermediary facilitating the offering.

Securities purchased in a crowdfunding transaction generally cannot be resold for one year.


E. Regulation A Exemption

Regulation A is an exemption from registration for public offerings. Regulation A has two offering tiers: Tier 1, for offerings of up to $20 million in a 12-month period; and Tier 2, for offerings of up to $75 million in a 12-month period. For offerings of up to $20 million, companies can elect to proceed under the requirements for either Tier 1 or Tier 2.

There are certain basic requirements applicable to both Tier 1 and Tier 2 offerings, including company eligibility requirements, bad actor disqualification provisions, disclosure, and other matters. Additional requirements apply to Tier 2 offerings, including limitations on the amount of money a non-accredited investor may invest in a Tier 2 offering, requirements for audited financial statements and the filing of ongoing reports. Issuers in Tier 2 offerings are not required to register or qualify their offerings with state securities regulators.


F. Intrastate Offering Exemption

Section 3(a)(11) of the Securities Act is generally known as the “intrastate offering exemption.” This exemption seeks to facilitate the financing of local business operations. To qualify for the intrastate offering exemption, a company must:

1. be organized in the state where it is offering the securities

2. carry out a significant amount of its business in that state and

3. make offers and sales only to residents of that state.

Notably, unlike Rule 504 of Regulation D and Regulation A, the intrastate offering exemption does not limit the size of the offering or the number of purchasers. A company must determine the residence of each offeree and purchaser. If any of the securities are offered or sold to even one out-of-state person (including international persons), the exemption may be lost.


G. Employee Benefit Plan Exemption – Rule 701

Rule 701 exempts certain sales of securities made to compensate employees, consultants, and advisors through benefit plans. A company can sell at least $1 million of securities under this exemption, regardless of its size. A company can sell even more if it satisfies certain formulas based on its assets or on the number of its outstanding securities. If a company sells more than $10 million in securities in a 12-month period, it is required to provide certain financial and other disclosure to the persons that received securities in that period. Securities issued under Rule 701 are “restricted securities.”

Whether you are a prospective investor or a company seeking to raise capital, speak with a legal professional at Privatus Counsel.

This article is meant to act as a reference and not as legal advice. To determine if any exemptions are applicable to your SAFE (or other convertible security) investment or offering, speak with an experienced legal advisor. Reach out to Privatus Counsel for more assistance on your potential offering or investment so you always know what to expect.

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