Is your startup at the point where it’s time to raise capital? The fundraising process can be intimidating, and if you aren’t sure what you’re doing, you could accidentally break securities regulations and land your company in hot water.
Legal compliance for startup fundraising is about more than just establishing a sound legal foundation, however. When your company is compliant with all applicable fundraising regulations, it inspires investor confidence and puts your company on a path to success.
Are you wondering how startups can stay legally compliant during fundraising rounds? Let’s take a closer look.
Introduction to Legal Compliance in Startup Fundraising
Some industries are more tightly regulated than others. However, no matter what sector you’re in, fundraising comes with strict regulatory compliance obligations.
SEC Startup Securities Compliance
The Securities and Exchange Commission (SEC) establishes clear guidelines for how startups may offer equity to investors. The exact SEC compliance requirements depend on which regulation your company is operating under.
Anti-Money Laundering
Federal anti-money laundering rules require startups to verify investor identities in order to prevent money laundering and other illegal activities.
State Blue Sky Laws
Each state has blue sky laws, which are securities laws that aim to protect against fraud. Before approaching investors, startups should be familiar with the relevant blue sky laws.
To avoid legal pitfalls, sanctions, and fines during the fundraising process, you should seek experienced legal counsel. Your lawyer can explain how federal and state regulations will affect your efforts.
Understanding Key Fundraising Concepts and Regulatory Frameworks
For most smaller startups, the cost and legal complexity of an initial public offering (IPO) make this option impractical. Instead, these companies usually try to raise capital from private investors.
This approach means that the startup does not have to go through the complex process of SEC registration. However, it must still follow a set of securities regulations. The two most common are SEC Regulation A and SEC Regulation D.
SEC Regulation A
SEC Regulation A is sometimes called a “mini IPO.” It allows startups to obtain capital from both accredited and non-accredited investors, but they are limited to $75 million in funds.
The SEC Regulation A fundraising process requires more extensive financial disclosures than Regulation D fundraising, although these are not as complicated as those required in an IPO.
SEC Regulation D
SEC Regulation D offers a faster, cheaper way to raise funds. It’s a good regulatory framework for startups that want to reach out to targeted, accredited investors.
However, before trying to strike an investment deal, a company must decide which Regulation D rules best suit its financial situation. These are some common selections:
- Rule 504: The company is permitted to raise up to $10 million from accredited investors and non-accredited investors
- Rule 506(b): The company may raise unlimited funds from accredited investors and from no more than 35 non-accredited investors
- Rule 506(c): The company may raise unlimited funds, but all investors must be accredited
Accredited investors are those who meet SEC-established criteria for net worth, income, or financial knowledge. Both individuals and entities (like companies or trusts) may become accredited.
Legal Documentation Needed for a Compliant Fundraising Round
Generally, a startup should have at least the following legal documents ready before beginning the fundraising process.
Certificate of Incorporation
A certificate of incorporation proves that your company has been established as a legal entity.
Governance Documents
Your company’s bylaws and other governance documents can help you avoid legal pitfalls. They also show potential investors that you’re prepared to handle the unexpected.
Intellectual Property Rights Agreement
This document clarifies who owns the company’s intellectual property. In most cases, an IP agreement states that the company owns any innovations made by the founders or employees. If a founder leaves unexpectedly, this agreement may be critical to the company’s future.
Term Sheet
A term sheet lays out the basic conditions of investing in the company. Notably, a term sheet is not a legally binding document.
Stock Purchase Agreement
A stock purchase agreement is a legally binding contract that clarifies investment terms and finalizes the deal with investors.
Investor Rights Agreement
An investor rights agreement allows you to explicitly grant certain rights to an investor, such as board representation or access to financial reports.
Nondisclosure Agreement
You can use nondisclosure agreements (NDAs) to prohibit investors and potential investors from sharing sensitive information with third parties.
Protecting Intellectual Property Before and During Fundraising
Your company’s intellectual property represents its very essence. To capture the attention of would-be investors, you must be able to show them your IP to some extent. You also must take meaningful steps to protect it.
The following tools can help you protect your intellectual property, and when used strategically, they can also make your company look better to investors.
File for Provisional Patents
A provisional patent gives an invention “patent pending” status. Along with protecting your intellectual property, it also signals to investors that your startup is actively innovating.
Register Trademarks and Secure Copyrights
Pitching to investors means that your branding materials will reach a wider audience. Trademarks and copyrights can shield the brand you’ve built.
Use NDAs
Before you allow any potential investor to view sensitive materials, you should ask them to sign an NDA.
Limit Details in Your Pitches
When pitching your company to investors, do not disclose highly technical details. Instead, focus on your company’s overall advantages and potential for growth.
Working With Accredited and Non-Accredited Investors in New York
If this is your first time taking a startup through the fundraising phase, you might wonder why the SEC limits the number of non-accredited investors but allows contributions from unlimited accredited investors.
The SEC works to protect investor interests. Accredited investors are people with high incomes, high net worth, or proven financial sophistication. The SEC assumes that these investors understand the risks that come with private placement investments.
Non-accredited investors do not have to meet any of these requirements. To protect their interests, the SEC generally requires companies to make more extensive disclosures when working with them.
Because of the stricter rules involved when working with non-accredited investors (and the fact that accredited investors tend to have more money to invest), many startups prefer to primarily build investor relationships with accredited investors.
Structuring a Compliant Fundraising Round in New York
Are you wondering how startups can stay legally compliant during fundraising rounds? If you’re ready to start raising capital, the following tips can help you put together a compliant fundraising round in New York.
Secure Your Legal Foundation
Before you explore how to structure a compliant fundraising round in New York, you should connect with a business lawyer experienced with NY requirements for startup fundraising. Your lawyer can help you draw up the legal documents needed and determine which SEC rules your fundraising round falls under.
Choose Your Regulatory Framework
No matter which regulatory framework you’re operating under, there are strict rules for raising capital from investors in New York. You’ll need to choose whether you want to make an offering under SEC Regulation A or Regulation D.
If you choose Regulation D, you’ll need to select a specific rule, such as Rule 506(b) or 506(c), that best fits your fundraising process.
Prepare Materials and Take Steps to Protect Intellectual Property
If you haven’t already, apply for patents and secure trademarks. Prepare an engaging pitch deck. Ideally, you should use a secure data room or similar tool to track and limit investor access to your materials and prevent theft.
Market According to the Rules
Different SEC rules place different restrictions on marketing. For example, if you’re operating under Rule 506(b), you may not publicly advertise the investment opportunity. However, if you’re operating under 506(c), you may advertise publicly, but you also must verify that all investors are accredited.
Finalize Investment Terms
Before concluding the funding round, revisit your term sheet and finalize the terms of investment.
Due Diligence Preparation and Managing Investor Relations
Smart investors won’t put money into a company based on a pitch alone. Before committing, a serious investor will conduct due diligence. During this process, they’ll take a deep dive into your financial records, verify any claims you’ve made, assess growth potential, and determine whether your company is worth the risk.
Investor due diligence is more than a formality. If you’re prepared, engaged, and ready to answer questions during this phase, you’ll start your relationship off on the right foot. However, if you don’t have the requisite documents, seem disorganized, or appear to be hiding anything, the deal can quickly go downhill.
Your attorney can help you prepare for investor due diligence. Generally, investors want to review the following materials.
Corporate and Legal Documents
Documents like bylaws, shareholder agreements, business licenses, and active contracts can help investors quickly verify that your company is legitimate.
Financials
Investors will want to take a close look at your financial records. They’ll likely ask for the following:
- Balance sheets, cash flow, and profit/loss statements from the past two to three years
- Tax returns
- Reports for accounts payable/accounts receivable
Many investors will also want to check the accuracy of your financial forecasts. Presenting your year-to-date financial data along with your predictions can help illustrate your forecasting discipline.
Cap Table/Equity
Your cap table shows your company’s equity ownership structure. Each time you issue new shares, ownership in your company is diluted. Investors understandably want to know how much of your company they’ll own. When dealing with potential investors, you should be ready to clearly explain dilution scenarios.
Customer/Market Validation
Market validation proves to investors that there’s significant demand for your company’s products or services. Depending on your sector and business model, consider providing market validation through usage data, surveys, case studies, and testimonials.
Products, Tech, or Intellectual Property
Investors will want to see code, patents, or other evidence that your company’s intellectual property actually belongs to you. They’ll also want to verify that you have sound data privacy and security protocols.
HR Records
An organizational chart will go a long way toward helping investors understand the structure of your company. If you have employees, you should also show investors your employment contracts and your hiring projections for the next year or so.
Insurance and Regulatory Information
Investors will also want to verify that you’re compliant with all industry regulations. You should disclose any past or current litigation and show investors your company’s insurance policies.
Managing Compliance Risks and Avoiding Common Legal Mistakes
For any startup, the fundraising process is filled with potential legal blunders. A qualified legal representative can help you maintain compliance during funding rounds and avoid mistakes like these.
Not Having the Right Legal Documentation
If your company does not have the right legal documentation, investors are likely to stall or turn away from your business altogether. If your failure to have proper documentation violates securities laws, you may face legal penalties.
Failing to Comply With Securities Regulations
Breaking startup funding regulations in NY (or on the federal level) can come with serious penalties like these:
- Legal enforcement action
- Steep fines
- Regulatory penalties (including being banned from raising capital in the future)
- Right of rescission (investors gain the right to demand refunds plus interest)
- Civil liability
- Criminal prosecution
Whether accidental or intentional, a failure to comply with securities regulations can have long-term negative effects. Your company’s reputation may be permanently harmed, and it may face increased legal scrutiny in the future.
Failing to Protect Your Intellectual Property
Taking proactive steps to protect your company’s intellectual property doesn’t guarantee it won’t be stolen, but it does reduce your risk. If anyone steals your IP, you can likely take legal action against them. However, these cases can easily turn into long, expensive court battles.
Need Help Staying Compliant?
Before beginning your fundraising journey, learning how startups can stay legally compliant during fundraising rounds is a good idea. However, this is a complex process, and there’s a lot at stake. The best thing you can do for yourself and your company is to seek out experienced legal help.
At Weberman Business Law P.C., we’re deeply familiar with startup fundraising legal compliance in NY. We focus exclusively on business law, and we’re prepared to guide our clients through the fundraising stage and beyond. If you’re looking for a legal partner to support you and your business, get in touch with us today.