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Utah Business

Our experts at Parsons Behle & Latimer discuss capital formation and how to keep things safe.

Capital formation 101: What is a security and how are they regulated?

Businesses in America have always relied on private investment to source capital, particularly in their earliest stages. Yet few business owners fully understand the world they are entering when they decide to accept money from investors. Whether that initial investment comes from a sophisticated private equity fund, affluent angel investor, or close family member, if the capital received was tied to anything more than a simple gift e.g. straight debt, a convertible note, a simple agreement for future equity (SAFE), straight equity, etc., then that business owner has just issued a security to that investor, thereby subjecting herself to a host of statutes and regulations governing the issuers of securities. Failure to adhere to these laws and regulations can result in severe civil and even criminal penalties, which have on numerous occasions torpedoed businesses and individual careers that were otherwise positioned to succeed. 

At its most basic level, a security is an investment contract – an exchange of capital in return for a promise to do something that benefits the investor. Whether the exchange is a stock certificate or a promissory note, if it meets this simple definition, it will likely be regulated by the Securities Act of 1933 (Securities Act) as well as the rules and regulations promulgated by the US Securities and Exchange Commissions (SEC) and its state equivalents. 

According to the Securities Act, every security sold in the US must either be registered, i.e. reviewed and approved for public sale by the SEC, or be otherwise exempt from registration. Due to the immense economic burden registration of securities imposes on businesses, a comprehensive framework has developed around the exemptions available to private securities issuers. Offerings made to investors pursuant to these exemptions are typically referred to as private placements.

In the decades since the Securities Act was passed, a complex framework of rules and regulations has been developed to help issuers stay within the exemptions afforded to private placements to safely raise capital. In more recent years, regulators and legislators – recognizing that not all small businesses have access to robust angel investor networks – have dramatically enhanced some of these exemptions to permit general solicitation and semi-public offerings. In January 2021, updates to many of these exemptions went into effect making it much easier for businesses to raise capital from investors with whom they have little to no prior connection. Nevertheless, while recent actions from the SEC should be encouraging to small businesses sourcing capital, the regulatory framework surrounding private placements has never been more complex.

In summary, whenever a business attempts to raise money from investors they are entering the perilous world of securities regulation. Consequently, it is imperative to ensure businesses take the necessary steps to comply with the numerous state and federal rules surrounding the offering of securities to make sure they are not subjecting themselves to unnecessary risk. To discuss resources, exemptions, and how to safely and effectively source capital or other general securities compliance questions, contact Adam Ott at Parsons Behle & Latimer by sending an email to [email protected] or by calling 801-536-6910.

Adam Ott is an associate attorney at Parsons Behle & Latimer who focuses his practice in all aspects of corporate and securities law. He routinely represents businesses in a wide range of matters, including mergers and acquisitions; complex transactions; capital formation efforts; reorganization matters; contract matters; and corporate financings. He has helped form and counsel numerous venture capital funds, private equity funds, hedge funds and startup incubators.