Raising Capital in Early-Stage Startups

Startups constantly need to implement mechanisms to obtain liquidity, pay taxes, and meet their obligations to investors, employees, etc. To achieve this, they must undergo a series of strategic steps that often include raising capital through securities offerings—debt, equity, or both. However, the lack of contacts and the cost of navigating the system can delay this process and pose a risk to inexperienced issuers, as it also means additional expenses, especially if the securities must be registered with the U.S. Securities and Exchange Commission (the “SEC”), which will include continuous reporting obligations. This blog focuses on the most common securities issued by startups, and the registration exemptions available to issuers. “Capital remains among the most impactful ways to strengthen access to entrepreneurship. Today, at least 83% of entrepreneurs do not access bank loans or venture capital when launching a business.”

Most Common Securities Startups Offer to Investors

Startups usually issue equity or debt to investors. Many early-stage companies find it hard to navigate the lending process with banks or these companies don't have enough profitable operating history to qualify for traditional bank loans. As a result, many startups must rely on private securities offerings such as issuing stocks, membership interests, options, restricted stocks, and convertible and nonconvertible debt instruments. A stock represents an ownership interest (“equity”) in a corporation. Corporations can offer common (typically issued to founders) and preferred stock, with the latter often issued to outside investors because preferred stock shareholders have stronger dividend and bankruptcy rights than common stock shareholders. A membership interest represents an ownership interest in a limited liability company (LLC). A stock option provides the holder with the right—but not the obligation—to purchase a certain number of shares of company stock or membership interest at an agreed-upon price (a strike price) after a vesting period. Startups often issue options to employees as part of their overall compensation package. Many companies also offer restricted stock units (RSUs) and restricted stock awards (RSAs) to their employees as additional compensation. RSA's underlying stocks are owned by the recipient on the date of the grant, and the holder can transfer or sell the shares after certain vesting conditions. RSU is a right to receive shares of stock once certain vesting conditions are met. Convertible debt instruments are often the fastest route to raising capital, either by issuing Convertible Notes or a Simple Agreement for Future Equity (SAFE), mostly used during pre- and seed rounds. A convertible note is a loan made by an investor to a company that can be converted into a different security, usually preferred equity. The note will typically convert from debt to preferred equity of the company upon the closing of the next funding round or other agreed-upon conditions. A SAFE is an agreement in which a company offers an investor a future ownership interest if certain triggering events occur, such as equity financing or acquisition of the company. A SAFE does not include a valuation of the equity at the time of issuance but at the time of the triggering event. In addition, companies also issue debt through non-convertible instruments, mostly short-term loan agreements that do not convert into another type of security. Convertible notes and SAFEs are the most common instruments used to complete seed rounds. Convertible notes are often used in place of equity for seed financing before an early-stage start-up's initial preferred stock financing. This method of financing is quicker, less costly, and more attractive to start-ups than preferred stock financing because it involves less documentation and negotiation with investors, does not include the control provisions investors typically receive in preferred stock financing, and the issuance of convertible promissory notes do not require a valuation of the company.

Securities Laws Considerations: Most used exemptions from registration under the Securities Act

In any securities offering, it's critical for a startup to have a valid federal securities law exemption from registration under the Securities Act. Two of the most commonly used federal exemptions for startup financings are:

• The private placement exemption of Section 4(a)(2) of the Securities Act exempts 'transactions by an issuer not involving any public offering.'
• Rule 506(b) of Regulation D provides a safe harbor under Section 4(a)(2) of the Securities Act. Between 2021 and 2022, U.S. issuers raised a total of $148B through 506 c) offerings and $2.3T through 506 b) offerings.

Section 4(a)(2) exemption applies to transactions with a limited number of sophisticated investors who possess sufficient financial bargaining power to compel the issuer to provide them with all of the information concerning the start-up that might be critical to their investment decision. The standard for this exemption is often hard to meet because the term “public offering” is not defined by the SEC, although it has been interpreted in case law, SEC rulings, and SEC no-action letters. In addition, although the number of offerees in a non-public offering must be small, there is not a defined number of offerees, which is open to interpretation by the courts. Regulation D is the most common exemption because its parameters are more certain than Section 4(a)(2) alone. Rule 506(b) allows the company to sell securities to an unlimited number of accredited investors and up to 35 other purchasers. If those other purchasers are non-accredited, they must be sophisticated (i.e., have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment). However issuing securities to non-accredited investors requires exhaustive disclosure and offering documents, which can be prohibitively expensive and time-consuming from a legal and accounting perspective for a startup to prepare. That is why, it's generally advisable for startups to sell only to accredited investors, in which case the company can rely on Rule 506(c) exemption Issuers relying on Rule 506(c) exemption will still need to take reasonable steps to verify that investors are accredited. From July 2021 through June 2022, the U.S. reported a total of 43,102 Regulation D offerings. The states that raised the most capital during this period are Texas, California, Georgia, Florida, Minnesota, Illinois, Pennsylvania, and New York (over $20 billion in each state). Pooled funds account for over 85 percent of the funds raised under Regulation D, meaning startups and other private issuers accounted for the other 15 percent.

Filing Requirement for Regulation D

A company that makes an offering under Regulation D is required to file Form D with the SEC within 15 days of the first sale of securities. Once filed, Form D is available to the public on the SEC's website. Companies should prepare a press release on a parallel path to the Form D filing to manage its public narrative. The below chart shows the steps to file Form D.Available at www.filermanagement.edgarfiling.sec.gov/filermgmt/selectFormId.html.

Alternatives to Regulation D Exemptions

Although Regulation D filings are still the most common exemptions for startups, other new exemptions that are increasingly used by startups include Regulation A and A+ and Regulation Crowdfunding (or Reg. CF). Regulation A+ is commonly referred to as the “mini-IPO” because it allows issuers to raise money publicly, including from non-accredited investors. The benefit of a Reg. A+ offering is there is no post-IPO lock-up period or restrictions on transferability. And issuers that participate in a Reg. A+ offerings can have their securities traded on national stock exchanges, but for the most part, these issues are still illiquid. The downside to Reg. A+ is there are limits on the amount of money a company can raise ($20 million in a Tier 1 offering and $75 million in a Tier 2 offering) and such offerings may not be exempt from state blue sky laws. Overall, Reg. A+ tends to be costly in both time and money. In 2015, the SEC adopted Regulation Crowdfunding, a financing method in which money is raised through soliciting relatively small individual investments or contributions from a large number of people. This means the general public now can participate in early capital-raising activities. Under this exemption, all transactions must take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal, and the issuer must have a specific business plan but the securities purchased in a crowdfunding transaction generally cannot be resold for one year. This type of exemption has been increasingly used by issuers. Only in 2021, over half a million Americans poured $570 million into 1,500+ offerings on Regulation Crowdfunding websites.

Issuing Securities to Non-U.S. Investors

When U.S. companies issue securities to investors that do not qualify as a U.S. person, they can rely on the Regulation S exemption under the Securities Act. Issuers relying on this exemption should avoid placing advertisements with general circulation in the U.S. unless it is required to be published by U.S. law or foreign regulatory authority.

Additional Steps to Consider When Relying on an Exemption from Registration Under the Securities Act

The exemptions from registration available under the Securities Act considerably simplify the offering process. However, compliance with federal securities laws does not necessarily mean the issuer is also compliant with state securities laws (blue sky laws). That is why issuers must look for additional compliance requirements in each investor's jurisdiction. Another necessary element to consider when issuing securities is whether two or more offerings can be considered as one for purposes of a qualifying exemption: Integration. This could potentially reduce costs, transaction intermediaries, and fees because the issuer can include these offerings in one exemption. The doctrine of integration considers two or more offerings as one offering for the purpose of determining whether an exemption from registration has been met. Issuers should consider that two or more offerings can be integrated into the same exemption if the next offering starts within 30 calendar days after the first offering. However, Rule 701-Employee Benefit Plans and Regulation S offerings will not be integrated with other offerings.

Blue Sky Laws

Issuers also need to comply with blue sky laws in the state in which they are located and the states in which each of its investors is located. Often there is either a notice filing if using Section 4(a)(2) or an electronic filing if using Regulation D. Some states require the filing to be made in advance of the sale of securities, which is why issuers should verify the blue sky regime in each applicable state before the securities are sold. The below chart represents the main exemptions from registration under the Securities Act.

Tools and Resources Through FinTech Law

The SEC implemented a comprehensive guide and tools for early-stage companies that provide a better understanding of the available resources for startups. For more information, see the Small Business Capital Raising Hub and Office of the Advocate for Small Business Capital Formation. Although these tools are quite informative for startups, working with legal and financial terms, as well as the deadline requirements for each offering type can pose a compliance risk to issuers if they navigate this process by themselves. It is advisable to hire professionals specialized in this area. This is where FinTech Law can help. The experienced legal team at FinTech Law knows startup culture and the capital-building process. Contact our team to make sure you have the capital and team you need for success.