Are there any laws I need to follow when issuing stock to founders in different states?

Question: One of our founders asked us, “We’re starting the company with founders residing in more than one state.  Are there any laws that we should be aware of?”

Answer by Naomi Kokubo, Editor of Founders Space

I’m a big fan of Startup Law 101 series:  http://www.grellas.com/faq_business_startup.html

You need to look at the securities law surrounding the founder’s stock purchase and what is known as “blue sky” laws:

http://www.grellas.com/faq_business_startup_012.html

My take away from reading this webpage is:  the key securities law concern for any stock issuance by an early-stage startup is to make sure that the offering fits within an exemption to the registration requirements.

You must not only find an exemption under which you can make the offering, but you must find an exemption that applies to each purchase and sale of the stock that is made under the offering.

You will need a federal (SEC) exemption. The easy one is the intra-state offering exemption, which applies where all purchasers in the offering reside in your company’s home state.  Beyond that, the question is fundamentally whether your offering is a private placement under either Section 4(2) or under Regulation D, the former of which is subject to murky legal standards and the latter of which defines “safe harbors” that essentially take away the murkiness.  Finally, Rule 701 exempts qualified issuances under employee incentive plans.

NOTE:  You will also need a state exemption for each state in which any of your purchasers resides. The securities laws of each of the respective 50 states are known as “blue sky” laws. Whenever your company sells stock, you need to do “blue sky compliance” for each state involved in the offering.

This may not be the complete answer to your question, but it’s a good place to start.

If you have a question of your own, just ask our Virtual Board of Advisors.

Note:  Before making any business decisions based on information on this site, it is your responsibility to check with your counsel or professionals familiar with your situation.

ADDITIONAL ANSWER:

by Ethan Stone, Stone Business Law

You should be cautious about this above answer and the link from which it is derived.

Federal securities law preempts state requirements, other than certain notice requirements, as to offers and sales that qualify for the federal exemption under federal “Reg. D.” Within Reg. D, you will make your life much simpler if you stick to the exemption under Rule 506 and make sure that everyone who receives securities is an “accredited investor.” A company’s own executive officers and directors are always “accredited investors” for purposes of issuing its own stock, so it’s usually not hard to comply with Rule 506 in issuing founders’ shares.

If you need to issue stock or options to someone who isn’t an executive officer (incidentally, not all officers are “executive” officers for this purpose) or director, the answer is correct that the appropriate federal exemption is Rule 701. Rule 701 doesn’t preempt state requirements, however, so you have to worry about finding a state exemption. Most states have exemptions that allow employee stock issuances, but the requirements vary considerably.

The answer above suggests relying on the federal intra-state offering exemption. That’s usually a very bad idea, for a number of reasons. First, it will not get you preemption of state blue sky laws. Second, the intra-state exemption only seems simple. There are a lot of ways to get it very wrong. Finally, professional investors (such as angels and VCs) are likely to shun you, for good reason, if you have issued stock under this exemption, both because they’ll suspect (or determine) that you’ve screwed it up or because it might put the exemption for their investment and future rounds at risk. The intra-state exemption can be useful if you absolutely must raise equity investment from unsophisticated friends and neighbors. Raising money that way, however, is usually a bad idea (see my discussion here https://www.foundersspace.com/fund-raising/what-are-the-alternatives-to-vc-and-angel-funding/).

Finally, it’s worth emphasizing that securities law exemptions are not something you should try to do yourself. There are a lot of ways to get it wrong and the consequences of getting it wrong can be ruinous. Find a competent lawyer who is familiar with private securities issuances in your state and involve him/her before you start talking to anyone about issuing stock (there are rules as to offers that you don’t want to violate).