While many small businesses sell interests in their companies that are "securities," as defined by federal or state laws, the transactions are often exempt from registration regulations because the offerings are sufficiently small in dollar amount, and they are restricted to a limited number and/or type of investors. These exempt offers of securities are called "limited private offerings" and they can avoid much of the cost and delay of a public offering. Unfortunately, to qualify for any of the exemptions, you must fit the criteria for both federal and state security laws.

Limited private offerings can be either debt or equity instruments, or a hybrid of both. For instance, a convertible debt warrant would be a debt instrument that allowed the holder to convert the debt into an equity interest at a certain time. These alternative offerings allow the business to tailor the amount of immediate equity (ownership and control) that it relinquishes, and the amount of debt (cash outflow) that it can safely assume. In this module, discussion of the use of limited private offerings is largely confined to equity financing.

Federal exemptions. At the federal level, the most popular exemption from registration requirements for small businesses is Rule 504, commonly known as "Regulation D." Under this provision, private companies that are selling less than $1 million worth of securities to any number of investors within a 12-month period are exempt from federal registration requirements. Solicitations of investors by a private business may be made through almost any means, including advertisements and seminars, and no specific disclosure requirements regarding the stock or the company are required. Most startups and smaller businesses would fall within this exemption.

Warning Even if a securities offer is exempt from the registration requirements of federal or state law, the anti-fraud provisions of those laws may still apply. Therefore, you must take care to prevent misrepresentations or omissions in the offering that create an overly optimistic picture of the investment. The investor should be provided with sufficient information to make an informed decision regarding the investment.

Another exemption may be available to either private or publicly held companies that sell less than $5 million within a 12-month period, if the sales are made only to "accredited investors" and no more than 35 such investors are involved. Accredited investors include institutional investors (e.g., banks, brokers and dealers, insurance companies), company insiders (e.g., officers and directors), and wealthy investors ("wealthy" meaning they have more than $200,000 individual annual income or, individually or jointly with their spouse, have a net worth of over $1 million).

A lesser degree of exemption from regulation exists for a private or publicly-held company that sells an unlimited issuance of securities to an unlimited number of accredited investors, or to no more than 35 nonaccredited but "sophisticated investors" (sophisticated investors have sufficient knowledge and experience so that they understand the risks of the sale, or the issuer reasonably believes the investors have these qualifications). Finally, an exemption exists for private offerings of stock that is sold only to persons living in the same state where the company is both incorporated and does significant business, although reliance upon this intrastate exemption is subject to continual policing because the securities must remain within the state.

State exemptions. Because each state also has securities regulations, the local exemptions must also be checked. Just because a sale may be exempt from federal registration does not mean state registration is not required.

Did You Know? State securities laws are commonly referred to as "blue sky" laws because the regulations were originally enacted to prevent unscrupulous issuers from selling "speculative schemes that have no more basis than so many feet of blue sky."

The state laws need not match the federal regulatory exemptions and even though a Uniform Securities Act exists for states to follow, that Act has not been adopted by each state nor is it consistently interpreted in those states which claim to follow it. The result is that consultation with a qualified professional is a practical necessity before soliciting investors for sales of securities.

Save Time Most states have relaxed their securities regulations for small business by offering a Small Company Offering Registration (SCOR) procedure. Even if your business is not based in one of these states, you may still register and sell your securities in the states which have adopted SCOR. For a current list of eligible states, contact the North American Securities Administrators Association at 202-737-0900, or at the NASAA web site.