SEC Compliance for Startups — What You Should Know

What’s the Securities and Exchange Commission?

The Securities and Exchange Commission (SEC), also known as the “Watchdog of Wall Street,” is an independent federal agency that protects investors and maintains orderly markets to sustain economic growth. The SEC dissuades startups from engaging in illegal crowdfunding that leads to fraud, but it also offers tax credits to encourage startups to comply with securities laws. Startups can learn more about these tax credits on the SEC’s website.

However, SEC enforcement is not just a public company concern (a common misconception); private companies must comply with the SEC, too, which has implications for your Directors and Officers (D&O) policy. Regardless of a company’s status (whether publicly traded or privately held), the SEC can investigate all companies that want to raise capital from US investors.

So, it is never too early to get in the compliance game, especially as financial statements that follow SEC regulatory requirements will automatically be more credible for investors. But before diving into SEC compliance, startups should also consider the following:

• The types of investors they’ll accept (accredited or non-accredited)
  • Accredited investors have had a minimum income of $200,000 per year for the last couple of years, and they’ll earn the same this year ($300,000 if they’re married). They also have a net worth of at least $1 million which doesn’t include the value of their primary residence.
• The type of securities they are issuing (equity or debt)

Then, the idea is that investors should have access to all vital information about securities before making investment decisions. This would involve disclosing complete and accurate information about your business, the securities for sale, and the possible risks.

Nevertheless, as you can envision, the registration process can be both expensive and time-consuming, especially for public company D&Os. Unfortunately, many startups simply can’t spare the resources or time to navigate the complexities of registration and compliance. This is precisely why Regulation D (Reg D) was introduced.

Regulation D Filing for Startups

Reg D is an SEC regulation governing private placement exemptions. Typically, when you want to sell securities to investors, you must register them with the SEC. For a public listing, for example, startups must go through the lengthy process of filing Form S-1.

But Reg D filing helps smaller enterprises, private companies, and entrepreneurs skip the long process and obtain funding faster and at a lower cost than a public offering.

The SEC’s Reg D means your startup can raise capital by selling equity or debt securities without registering the securities with the SEC, meaning minimal paperwork. But you have to make sure both your company and the investors meet specific requirements:

• Your company needs to be new and small, not large and well-established.
• You must have raised a priced financing round for your startup, where investors purchase newly issued stock after an agreed-upon company valuation.
• Reg D filing lets you sell securities to both accredited and non-accredited investors. But you may only be able to sell to a limited number of non-accredited investors.
• You must provide a proper framework and disclosure documentation for investors to make informed investments (even if the Reg D transaction involves one or two investors).

You must file a document known as Form D electronically with the SEC after you sell the first securities.

Important Regulation D Filing Exemptions

Three Reg D exemptions mean d&o insurance for startups can raise capital by selling securities without registering with the SEC, but we recommend getting advice from an attorney.

1. Private Fundraising

If you are raising money from friends and family who are not accredited investors and getting investors from your professional network onboard, consider this exemption.

• You cannot use advertising for marketing the securities.
• You can sell securities to no more than 35 non-accredited investors, but unlimited accredited investors.
• You can raise an unlimited amount of capital.

2. Public Fundraising

This exemption is relevant if you want to attract new investors outside your immediate circle.

• Ensure you only sell to accredited investors, although you don’t need prior relationships. You may need to review their tax returns, bank statements, and credit reports.
• You can advertise the securities you sell.

3. Offerings Under $5M

If you need to raise seed capital quickly, this exemption applies to specific equity offerings in private companies:

• You may sell up to $5 million in securities over 12 months.
• All securities are restricted, meaning companies can’t resell them without registering. But you could sell the securities from six months to a year after registering.

What Happens If You Don’t Comply With SEC Laws?

A company’s fundraising can very quickly become its worst nightmare if they don’t stay on the straight and narrow. Avoiding compliance with the registration requirements of the SEC or following the Reg D, investors may have a right of rescission. This means you’d have to return investments to investors, plus interest.

You may also become subject to a “bad actor” disqualification, prohibiting you from raising capital using some of the exemptions from Reg D.

And it gets worse. Facing a civil or criminal lawsuit from the federal or state government is not uncommon. This could include financial penalties or even jail time, depending upon the type and severity of the offense. The SEC filed 760 total enforcement actions in 2022.

Ripple Labs Lawsuit Example

One of the most famous lawsuits is against Ripple Labs, the creator of the XRP token. SEC alleged that Ripple violated the Securities Act of 1933 and engaged in the unlawful offer and sale of securities in exchange for cash and other consideration worth over $1.38 billion. The company’s market capitalization dropped by $11 billion in a month.

A public lawsuit alleging securities violations can damage a company’s reputation and deter future investment, even if the allegations are unfounded. This is why many sophisticated investors demand evidence of D&O insurance coverage with broad exclusions for securities violations.

The key here is to use insurance as a sword, not only a shield. D&O insurance protects directors, officers, managers, and employees if a claim is filed against them, and the policy covers legal defense costs and financial loss. Securing this protection from the get-go also legitimizes your business for investors, so it should be high on your to-do list. Also check our post on d&o fiduciary coverage.

Ultimately, risk management and insurance maintain momentum and make investors trust startups; they aren’t only a safety net. However, understanding the details of what does d&o insurance cover can be confusing while raising capital. At Founder Shield, we specialize in knowing the risks your industry faces to ensure you have adequate protection. Feel free to reach out to us, and we’ll walk you through finding the right policy.