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Beware of Offering Stock to Friends & Family

Posted by Paul D. Woodard | Nov 17, 2016 | 0 Comments


Many startups and newer companies rely on financial help from friends and family. Some business owners may ask for a loan to start the company. However, others ask for the money to be invested in the company in exchange for some ownership interest in the business. While this may seem like a fair exchange in asking for seed money, new owners may find themselves running afoul of federal securities regulations, which could jeopardize the budding business.

Startups need to raise capital to get their businesses up and running. Many small businesses may not think federal securities laws should apply to their small operation. However, there are only limited situations where security offerings may be exempt from Securities and Exchange Commission (SEC) registration. Without following the strict regulations, investors and business owners may end up facing large fines and possible criminal charges.

Regulation D, Rules 504, 505, and 506 provide limited exemption from Securities Act registration. Some businesses decide to sell to friends and family under Rule 504, also known as the “seed capital” exemption. This provides for a sale of up to $1,000,000 in securities in a 12-month period. This generally provides “restricted securities,” which carry limitations on sale or transfer.

A Rule 506 offering does not have the same limits as Rule 504 in the amount of money the company can raise; however, there is a limit on the number of non-accredited investors allowed. Those investors must also be given specific disclosure documents similar to those required in a registered offering.

One of the problems with offerings under Rule 504 is that the company may be limited in how they seek further fundraising in the short term. The company may find that the $1,000,000 initial security money was not enough to keep the company going. The company may then have to wait for 6 months or longer before they can make another offering under a Rule 506 exemption.

There are a number of other requirements for offering and investing in these Regulation D exemptions. Make sure you talk to your attorney before determining whether your stock offering may comply with SEC regulations and other legal requirements.

Before becoming a public company, owners should consider all the obligations that go along with going public, including filing SEC reports and keeping investors informed of business operations, management, and financial condition. Some businesses may qualify as a “smaller reporting company,” which may make securities compliance easier. However, if these conditions are not met, the company may be liable for securities violations.

In some cases, a company that is about to make its initial public offering (IPO) may be able to offer a limited number of shares to friends and family. This can be a way for those who have supported the business to gain a stake in the company. However, the SEC may keep a close eye on these directed shares to determine whether they may be in violation of federal securities laws. Again, make sure you talk to your attorneys before deciding whether to offer stock shares to family and friends.

Butterfield Schechter LLP is San Diego County's largest firm focusing its law practice on employee benefit legal services, business counseling, and tax law. Our firm can help you ensure your fundraising and stock gifting plans conform with regulatory requirements, represent your best interests, and avoid tax penalties. Contact our office today with any questions on how we can help you and your business succeed.

About the Author

Paul D. Woodard

Paul Woodard practices in the areas of Employee Benefits, Employee Stock Ownership Plans, Pension and Profit Sharing Plans, ERISA, ERISA Litigation, Business Law, Qualified Domestic Relations Orders (QDROs), and Estate Planning.


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