Is There a “Friends and Family” Securities Laws Exemption?

“Friends and family” are often a critical part of the seed funding round for many startups. Indeed, I’ve read statistics that claim that funding from friends and family outpaces private equity funding 3 to 1. However, I’ve been asked by entrepreneurs — and this is a question every entrepreneur seeking equity financing from friends and family should ask and known the answer to — whether there is a “friends and family” exemption in the securities laws. The short answer: not really. The long answer: maybe.

As I have previously noted, EVERY sale of securities, by default, is required to be registered with the Securities and Exchange Commission and state regulators. If the issuer wishes to avoid registration it is up to it to find an exemption to registration. Even if an offering is exempt from the onerous process of registration, there are often documents that still must be submitted to the SEC and/or state regulators along with disclosures that may need to be made to prospective purchasers.

It is also important to note again that there are both federal securities laws as well as state securities laws that must be complied with. For example, if your company is raising a “friends and family” seed round, you must ensure that your company is in compliance with the federal laws and the laws of each state where you are selling securities. Let’s say you’re raising $10,000 from mom and dad here in Massachusetts, another $5,000 from Aunt Millie in Minnesota, another $5,000 from your cousin Jeff who is a successful doctor out in California, and another $20,000 from Uncle Lou who is sitting on a mountain of money down in Florida. Not only must you comply with federal securities laws, but you must also comply with the securities laws of Massachusetts, Minnesota, California, and Florida.

Now, to give the long answer: it may be possible to exempt a sale of securities to friends and family. This can be accomplished through a private placement offering, usually through one of the Regulation D exemptions, which I’ve previously discussed in detail. It is possible with many of the Reg D exemption to rules to sell securities to person who are not accredited investors (persons with a net worth over $1 million, minus the value of their primary residence, plus annual income over $200,000); however, those non-accredited investors often must be sophisticated investors — persons who can bear the economic risk of the investment and possess the business and financial knowledge, experience, and skill, either on their own or through consultation with an independent investment advisor, to evaluate the risks of the particular investment. And where the exemptions do not require the non-accredited investors to be sophisticated, state registration or extensive disclosures to the purchasers are often required instead.

You may be asking what happens if you don’t comply with the securities laws and sell to Aunt Millie and Uncle Lou. Technically, by committing a breach of the securities laws you open yourself and your company to enforcement by the SEC or state securities regulators, which can include fines as well as criminal penalties. In addition, each purchaser of securities that are unregistered or not issued pursuant to exemptions has the right of recision — the purchaser can sue to reclaim the purchase price plus interest. Practically speaking, Aunt Millie and Uncle Lou aren’t likely to sue you, but this liability can be a problem if you go for private equity funding. As a rule of thumb, no one wants to buy a lawsuit, and the fact that securities have been issued whose sale can be rescinded can discourage private equity investment.

If at any time you intend to offer equity to investors or as part of an employee equity compensation plan, it is necessary to speak with an attorney to discuss your options and ensure that your offering complies with all federal and state laws.