When issuing “securities,” it is necessary to pay attention to state “blue sky” laws, in addition to federal securities laws. If you are relying on a federal exemption that does not preempt state laws, then you have to make sure that a state exemption applies to the debt or equity transaction as well. This article describes the common California securities exemptions that may apply to an early-stage startup.
Whenever you receive a loan or give equity in exchange for money or services, you have to pay close attention to federal and state securities laws. Both federal and state securities laws generally require a person to register the securities before they are offered to the public unless an exemption applies. The cost of registering securities through an Initial Public Offering, or IPO, is very costly, and the consequences for violation of securities laws are severe (including criminal charges). There are more limited public offerings available through, for example, Direct Public Offerings; however, the most common method of issuing securities is by taking advantage of exemptions from registration requirements.
If I found a federal exemption, why do I need to worry about a state exemption?
To make sure that a debt or equity transaction complies with all applicable securities laws, the best place to start is the federal securities laws. If a federal exemption applies that preempts state securities law (called “blue sky” laws), such as Rule 506 of Regulation D, then the transaction is fine and there is no need to look further into state securities laws. But if the there is a federal exemption that does not preempt state securities laws, then a state exemption must also be found.
An earlier article discussed the common federal securities exemptions that may apply to a startup. Below is a description of the common California securities exemptions.
Common California Securities Exemptions
In California, all of the exemptions from the registration requirements of the securities laws are found in Section 25102 of the California Corporations Code. The most common exemptions for typical startups are:
Section 25102(f) – for founders, friends, and family.
Under Section 25102(f), which is referred to as the Limited Offering Exemption, most issuances to the company’s founders, as well as friends and family of any of its directors and officers will be exempt from the registration requirements of California law.
The key aspect of this exemption is the existence of a prior personal or business relationship between the purchaser of the security (i.e. the investor or lender) and the company’s leadership. The exemption is destroyed if there are more than 35 people purchasing securities, or if there is general advertising or publication of the securities.
There is a notice that must be filed within 15 days of the sale of security, which can be filed online via the Department of Business Oversight’s website.
Section 25102(o) – for employees and consultants.
Under Section 25102(o), an issuance of stock options to employees and consultants is exempt from the registration requirements of California’s securities laws if it satisfies the equivalent federal exemption under Rule 701 (which does not preempt state securities laws). To satisfy Rule 701, an issuance must be made pursuant to an approved option plan, and a company cannot issue more than the greatest of the following in any 12-month period:
(ii) 15% of its total assets, or
(iii) 15% of the outstanding amount of that class of securities.
There is a notice that must be filed within 30 days of the issuance of securities, which must be filed with the Department of Business Oversight.
Why do I need to find an exemption in California when my company is incorporated in Delaware?
The securities laws that apply to a transaction depend on the state where the purchase of securities takes place. This is typically the state in which the purchaser of the securities resides (i.e. the investor or lender or employee). So even if a company is incorporated in Delaware, an exemption must be found in the state where the purchaser of the securities resides, and if there are purchasers in multiple states, an applicable exemption must be found in every state where there are purchasers. This is one of the main reasons for using a federal exemption that preempts state laws.
Contact us to discuss which California securities exemption will be a good fit for you.
DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.