It has become fashionable for startups to operate in “stealth mode” for as long as they can. While this can mean different things in different contexts, the aim is typically to limit what the outside world knows about the startup’s operations. But this aim can be frustrated by existing legal structures.
Securities laws, with their emphasis on disclosure, are one structure for startups considering operating in stealth mode to be aware of.
Securities Law And The Need For An Exemption From Registration
Any time startups take money from investors, securities laws come into play. Under federal securities law, the general rule is that any time a company sells securities (e.g., stock, convertible notes, SAFEs) to investors, the sale has to be registered with the SEC. But registration isn’t feasible for early stage startups: it’s too expensive and time consuming.
So, early stage startups that want to raise money have to find an exemption from this registration requirement.
Regulation D Safe Harbor Exemptions
Fortunately, there are safe harbor exemptions available under Regulation D, a collection of SEC rules (e.g., Rule 506) designed to make it easier for small businesses to raise money. These safe harbor exemptions provide clear eligibility requirements for startups. Importantly, they also preempt state securities laws, meaning that startups don’t have to worry about complying with individual state requirements for securities offerings to investors located in those states (at least not beyond straightforward notice filings). This feature alone can offer a dramatic reduction in time and legal fees.
Given these benefits, startups which are not operating in stealth mode will usually choose to rely on one of the safe harbor exemptions without need for much strategic deliberation.
While these safe harbor exemptions can offer peace of mind to startups that they’ve qualified for an exemption and sidestep the need to worry about state securities laws, there is a problem for stealth mode startups. A startup relying on one of these safe harbors needs (or at least has a strong incentive) to file what’s known as a Form D with the SEC within 15 days of its first sale to investors.
Unfortunately, Form D requires the startup to disclose information about the company, which most stealth mode startups would not want to disclose, including the fact the startup is raising money, the amount its raising and amount sold to date, and the identity of its directors and officers. Once filed, Form D is accessible to the public. That means a startup’s competitors, tech journalists, any anyone else with an Internet connection can find out that it’s raising money. This is not stealthy.
Section 4(a)(2) Exemption
To avoid this, some stealth mode startups consider alternative approaches that don’t require a public filing with the SEC. One such approach is to rely on the Section 4(a)(2 exemption.
This approach often trades one problem for another, though. For starters, the requirements for qualifying for the Section 4(a)(2) exemption are less clear than for the Regulation D exemptions, creating potential uncertainty for the startup as to whether they’re actually eligible for the exemption. And even for startups that are confident they satisfy the Section 4(a)(2) exemption requirements, there is another problem: Section 4(a)(2) doesn’t preempt state securities laws.
That means the startup (or more realistically, the startup’s lawyer) has to examine the securities laws of each state where securities are being sold and make sure the startup can find an exemption to rely on in that state; if the startup can’t find an exemption, it will likely need to register the offering in that state. This process can get expensive fast, especially if securities are being sold in multiple states. It also tends to slow down the momentum of the raise, which can jeopardize the entire process.
It’s always important for startups to work with a lawyer who understands securities laws when they’re fundraising, but it’s especially critical that a stealth mode startup relying on the Section 4(a)(2) exemption is getting good and timely legal advice. This not a DIY kind of task.
The structure of securities law tends to makes it more challenging to operate in stealth mode when raising money from investors. Startups should, with the help of their lawyer, weigh the benefits of operating in stealth mode against its costs when considering its approach to securities law compliance.