Every corporation issues securities and a growing body of law suggests that non-manager interests in an LLC are also considered to be securities. Even so, most small businesses do not need to be concerned with federal and state security laws. However, if you plan to raise capital through "public offerings" or via the internet, then you should have a basic understanding of securities laws so that you can work effectively with your professional advisors.
You must consider numerous legal issues before starting business operations if you want to effectively limit liability in your business structure. One issue worthy of some discussion is securities law because it can affect the issuance of interests in the limited liability company (LLC) and corporation. An awareness of securities issues is essential to prevent future claims against the business and to allow you to exploit capital markets as the business expands.
Federal and state securities rules are extremely complex.
The goal of this article is to provide some basic information on key topics so that you are aware of when you need to seek experienced, profession guidance from a business advisor or attorney.
At the very least you should have a familiarity with the following topics:
- whether or not the entity is issuing "“securities”
- whether the offering must be registered or may be exempt
- whether you can/should take advantage of Regulation D, Rule 504/SCOR (small corporate offering registration) offering--a common route small businesses use to raise up to $1 million from the public
- whether you would be better served by an alternative route termed a Regulation A/SCOR offering which can be used to raise $1 million from the public, with the added advantage of being able to "test the waters" before actually making the offering
- whether you should get involved with Internet offerings of securities
In addition to the federal securities law, you must also pay attention to the securities law for the state in which your form the business. Unfortunately, each state's securities laws (termed "blue sky laws") are unique—even though they are modeled after the federal laws.
Some states may require that a simple notice of a sale be filed when sales are made to individuals who are not organizers of the business, even though all of the conditions for the exemption described above are met. If you are offering securities under this set of circumstances, it is wise to first check with the state agency that regulates securities offerings in the particular state involved.
From the perspective of limiting exposure to liability in your business structure, it is extremely important that the small business owner either properly register an offering of securities with the federal and state governments, or ascertain that an exemption applies. Failure to comply with federal and state securities laws can result in large civil fines and the likelihood of personal liability for losses suffered by investors.
If a small business owner has raised capital from investors and the business fails, there is a likelihood that the business owner will be sued. One of the first things a plaintiff's lawyer will examine is whether the business owner complied with federal and state securities laws. If there is a failure in this respect, the small business owner will likely lose. Conversely, if the owner has complied with these laws, the small business owner will likely win, even though the investors suffer a total loss.
Is your business entity issuing securities?
Whenever a corporation is formed, "securities" are issued. The term "security" includes covers common stock, which will always be issued by a corporation as evidence of ownership. However, preferred stock and bonds, usually issued by larger businesses, also constitute securities.
A limited partnership interest in a limited partnership (LP) may is a security. More importantly for the small business owner, a non-manager interest in an limited liability company (LLC) may be deemed a security. The key in both of these cases is that the investor puts up capital, expecting a return to be derived solely from the efforts of others (i.e., the manager-owner of the LLC or the general partner in the LP). For example, while Delaware law clearly provides that any interest in an LLC will not be deemed a security unless it is traded on a securities market, this kind of clear-cut rule is lacking in many other states.
A corporation may present a better alternative than the LLC for type of business entity if you intend to make a general and widespread public offering of securities, such as through an Internet offering. There are two reasons why the corporation may be superior:
- Securities law was developed primarily to govern offerings by corporations. Thus, the law there is more settled.
- Both potential investors, and federal and estate regulators, are more familiar with, and thus may be more receptive to, a sale of common stock in a corporation, as opposed to an interest in an LLC.
However, this recommendation would not apply in the case of a small offering made among a group of private investors. In addition, this issue will seldom be a factor for the small business owner.