A question asked frequently is why a young, energetic group of founders should worry about complying with securities laws. A lawyer’s standard answer is that every officer, director, and principal shareholder of a company risks criminal and civil sanctions for violating state or federal securities laws.
Put simply, to stay out of jail and protect your personal bank account, you are wise to make compliance with state and federal securities laws a paramount concern.
The standard response may be a bit more bluster than reality, however. Criminal or civil sanctions from securities regulators, while a real possibility, is seldom wielded against those flying below the radar. Its like speeding on the freeway at “5 over.” Yea, you’re breaking the law, but will law enforcement notice? (I say this and, yet, just last week the owner of a local movie theater found itself on the wrong side of state securities regulators.)
In reality, the standard “scare response” tells only half the story, and it may be the least important half from the perspective of founders driven to success.
Here’s the important half.
While early investors tend to be more cavalier concerning a company’s compliance with various rules and regulations, later investors, especially those in an underwritten initial public offering, demand absolute vigilance.
And they will flatly refuse to make any investment unless the issuer can demonstrate a solid history of compliance, or repair past mistakes.
Why is that? A company’s previous investors who buy securities in violation of the law have a right to receive their money back — a right of rescission. This means that investors who buy securities offered in violation of the securities laws are really buying an option: they’ll keep their money in so long as there is the promise of upside but may demand its return when things sour.
And here’s where the rubber hits the road. A later group of savvy investors are not anxious to put their money in just to see it go back out ahead of them to a company’s earlier investors. This is true whether the later offering is an IPO, a late stage private equity round, or an early VC round. What matters is that the professional investors and their advisors know better — while the founders did not.
But that’s not you. Now you know, too.