Most founders focus heavily on federal regulations when they begin raising capital. They worry about the Securities and Exchange Commission and spending money on federal compliance. While this is necessary, it ignores a second layer of complexity that exists in the United States.
Individual states have their own sets of rules regarding the sale of securities. These are known as Blue Sky Laws.
Defining the Regulations
#Blue Sky Laws are state statutes designed to protect the public from securities fraud. The term originated in the early 20th century. Judges wanted to prevent speculative schemes that had no more substance than so many feet of blue sky.
The primary goal is to force sellers of new issues to register their offerings and provide financial details to investors. This ensures that investors have verified information before they part with their money.
These laws vary significantly from state to state. Kansas was the first to enact one in 1911. Today, all 50 states have their own unique versions. This creates a fragmented regulatory landscape for any business operating across state lines.
Federal vs. State Authority
#It is vital to understand the relationship between federal and state laws. In 1996, the federal government passed legislation that preempts many state laws for certain types of securities. This includes most private placements that startups use, such as those under Rule 506 of Regulation D.
However, preemption does not mean you can ignore the states entirely. States generally retain the authority to require notice filings and collect fees.
This distinction is critical. While the SEC might regulate the structure of the deal, the state wants to know who is selling what within their borders. They also want their filing fee.
We must ask ourselves if we are accounting for the cost of compliance in every state where a potential investor resides.
Raising Capital in Multiple States
#A common scenario for a startup is a seed round with angel investors located in different parts of the country. You might have an investor in California, another in Texas, and a third in New York.
Even if your company is incorporated in Delaware and headquartered in Austin, you are subject to the Blue Sky Laws of every state where you sell securities.
This means your legal counsel needs to review the specific requirements for each of those jurisdictions. Some states require filings within 15 days of the first sale. Others have different timelines or fee structures.
This increases the administrative burden of closing a round. It forces a founder to weigh the value of a small check from a new state against the legal costs of complying with that state’s regulations.
The Risks of Noncompliance
#Ignoring these laws is dangerous. If a startup fails to comply with Blue Sky Laws, investors may have the right of rescission.
Rescission allows the investor to force the company to buy back their shares at the original purchase price, plus interest. If your company has already spent the capital, this obligation can lead to bankruptcy.
State regulators can also issue fines or bar the company from raising capital in that state in the future. It creates a messy legal history that will scare off future venture capital firms during due diligence.
Founders should view these laws not as mere bureaucracy but as a rigid framework that requires precise navigation to build a lasting entity.