Five Securities Pitfalls for Founders & CEOs

When it comes to capital formation, equity markets or securities compliance, any mention of the Securities and Exchange Commission (SEC) usually sends entrepreneurs, founders and tech experts ducking for cover. SEC examinations are stressful, time consuming, costly and rarely leave anyone feeling good about the process. The goal of this article is to help small business investors, small and emerging companies and beginners avoid common pitfalls when raising money in the capital markets.

Identifying and locating potential investors can be difficult for small business who are seeking to raise capital. “It becomes even more challenging if the amount sought (e.g., less than $5 million) is below a level that would attract venture capital or a registered broker-dealer, but beyond the levels that can be provided by friends and family and personal financing.”[1] As we exit a period of historically low interest rates and as equity markets tighten, raising capital will likely become harder in the future. “The number of registered broker-dealers has been falling, and few registered broker-dealers are willing to raise capital in small transactions.”[2] Venture Capitalists (VCs), and Broker Dealers (BDs) want big deals with little risk, not deals involving small and emerging companies.

Our dynamic markets and economy significantly benefit from a robust pipeline of new small businesses, which create the majority of net new jobs in the United States[3] and greatly contribute to innovation.[4] That puts a lot of pressure on start-ups to get it right when seeking to raise capital. Get it right and the company may get its funding. Get it wrong and the company could get a call from the SEC because of complaints from angry investors. Below are five common pitfalls to be avoided to ensure your company gets it right.

Common Pitfalls to Avoid

  1. Solid Foundations

Before getting into the nitty gritty of securities violations, it is vital that start-ups are starting off on a solid foundation. Founders or partners should agree early on about the details of the business and the relationship roles between the parties. They should insist on proper formation documents, Bylaws or partnership agreements, and follow basic corporate formalities. Not doing so can cause significant legal troubles down the road. Getting a business set up correctly may slow the deal out of the gate but doing so will only benefit a business in the long run. There are numerous resources[5] for small business seeking get off the ground.

Issues like entity selection play a critical role in making a start-up legally viable: public vs. private company; sole proprietorship or partnership; limited liability company vs. corporation. Some of the most important factors that a newbie Founder should consider while making the decision are tax treatment (corporate vs. partnership), liability (layers of legal protection), legal expenses (start-up cost and filing fees) and growth plans (1202 stock considerations). None of these decisions should be rushed.

The SEC knows and understands that strong equity markets rely on a healthy small business market. The SEC has gone so far as to create The Office of the Advocate for Small Business Capital Formation (OSAB). OSAB’s mission is to advance the interests of small businesses and their investors at the SEC and in the capital markets, from early-stage start-ups raising initial capital, to later-stage private companies whose founders and investors are seeking liquidity all the way to smaller public companies. While getting things started correctly is vitally important, it is outside the scope of this article. Luckily, Parsons Lift can assist in that process.

  1. Don’t Expect Privacy!

Anyone who has ever filled out a mortgage application knows what it feels like to financially undress in front of someone. Investors typically want to know what is in the secrete sauce. Start-ups should expect little to no privacy when investors are looking under the hood. Directors and officers should be ready to disclose whether the company is dependent on one brilliant technician or engineer, what management’s capabilities are, what their shortcomings are, ownership structure and cap tables, how key individuals are compensated, and the company’s marketing and competitive strategies. Entrepreneurs and start-ups should also be ready to hand over personal and corporate financial statements.

Revealing such guarded secrets and financial statements makes entrepreneurs uneasy, and understandably so. However, whatever information a Founder does not want to share with a potential investor is exactly what the SEC will be looking for when things go badly. Illustrative financial statements, disclosure of conflicts of interest, material risks, and updating investors is a must. Reporting companies are required to provide investors with timely, accurate and full information with which investors can evaluate their investment. Private placements should seek to follow the same requirements when it comes to proper disclosures.

Here are some tips Founders can use as guides in that process: (1) provide ongoing and updated disclosures of material company information; (2) provide timeliness in disclosures of such material information and adhere to those timelines; (3) provide simultaneous and identical disclosures across all mediums and to all investors; (4) adhere to State and federal securities disclosure rules; and (5) establish accountability policies.

  1. Finders not Fraudsters

One common path Founders take to get access to critically needed capital is to conduct an offering that relies on an exemption from registering under the Securities Act of 1933 (Securities Act). These exemptions provide small companies access to vital capital and provide a great benefit to our economy.

Companies almost always want to play by the rules and avoid the SEC’s ire, although doing so can be a struggle. When dealing with early-stage start-ups, Founders often try to raise capital from angel investors, friends and family with the improper belief that securities laws do not apply to such transactions. Wrong! If a Founder has well-to-do friends or family members, they can usually call and get an investment without running afoul of securities laws. But what if that same person calls a friend or family member and asks that person to start calling their friends and asking for investments? Can you pay your friend “finders fees,” “referral fees,” “consulting fees” or “success fees” for finding investors? Is there even a difference between those terms? Answers to those questions quickly get tricky.

Despite the many risks to finders, start-ups and their offices often make the mistake of offering questionable finders fees when needing to raise money quickly.[6] It is vital for start-ups to know in which circumstances one can engage a “finder,” or a platform that is not registered as a broker-dealer, to get access to investors. The exceptions to such rules are extremely limited.[7] As mentioned, the rules are complicated. BDs and Investment Advisors (IAs) are required under Section 15 to register with the SEC – unless they can rely on an exception or exemption – because they act as intermediaries between customers and the securities markets.[8] These registered BDs and IAs are typically good at making sure they are complying with securities regulations. However, the SEC does not care about good intentions. They will hold everyone who is involved in a deal accountable where they feel a violation of securities laws has taken place.

The best way to ensure compliance with Section 15 is to use registered BDs and IAs as finders. For most start-ups, gaining access to industry professionals is not an option. In those cases, avoiding any compensation arrangements tied to deal success, investment amounts or other deal-related factors provides the best coverage. In addition, ensuring that finders do nothing more than make initial introductions can help limit exposure.

  1. Insurance

We have all waived the supplemental insurance prior to jumping in our rental car. It only takes one accident while driving your convertible rental car to learn this lesson the hard way. Luckily there are usually layers of protection already in place to help the thrifty traveler.[9]  While start-ups are notoriously thrifty, a Directors and Officers (D&O) insurance policy is not a good place for a founder to trim the fat.[10]

D&O insurance policies are not just for huge, high-profile public companies. A start-up or privately-held company can and should get some protection if it has leaders and stakeholders who interact with customers, employees, investors, competitors and government agencies. Start-ups are far more likely to run afoul of regulators and it is almost inevitable that some scenario will arise requiring additional protection.

It is not uncommon for angry investors to come after the CEO of a company because things did not work out the way everyone had hoped they would – or for a small start-up performing well and nearly ready to pop off only to have investor(s) claim that the founders misused the investor’s funds. Investors may even attempt to sue the CEO, CFO or other directors and officers personally. If the start-up followed the first tip above and was set up on a solid foundation, the company’s Bylaws will protect the officers and directors to a certain extent. Alternately, the cost of these types of actions can tank a start-up before it ever gets started – and directors’ or officers’ liability can skyrocket if SEC regulators get wind of investor complaints and begin to investigate.

This is the point at which D&O insurance steps in. The costs of defending D&O claims are substantial.[11] The average cost to mount a defense against a shareholder claim can quickly rise into the millions. [12] And the millions spend on defense may not even get a company to trial. The ultimate liability determination of directors and officers likely is not what sinks the business. The defense costs associated can be expensive, and the process can take many months – and most likely years – before any resolution. Most start-ups could not survive such a claim without a D&O policy.

Generally, D&O policies can cost anywhere from $3,000 to $7,000 in premium for every $1M in coverage. Just like supplemental insurance for your rental car, premiums seem miniscule in comparison to the costs associated with claims brought after the fact by angry investors, or even worse, the SEC.

  1. Get Good Legal Counsel

While it may seem self-serving for an attorney to write an article that suggests one should “call an attorney,” it would be professional negligence to write anything else. Securities laws, much like tax laws, are extremely complicated.  Not only is good legal counsel vital, but Founders should also be intimately involved in the minutiae of legal and accounting documents associated with capital raises. When paying professionals to handle then for you, it can be easy to forget about the details. If you are going to skim a document, let it be the document that contains something other than your financial statements, disclosure of conflicts of interest or material risk factors. Your attorney should be vigilant in their efforts to vet these documents, however, they will likely not be the one on the hook when it turns out that vital information was withheld from investors.

No deal is perfect. But there are precautions that can and should be taken before and after capital raises to avoid common mistakes. Even the savviest entrepreneurs are at a disadvantage in negotiating with VCs who strike deals for a living. The power imbalance is exponentially higher between SEC regulators and the start-up CEO who is working out of his or her garage. There is strong incentive for entrepreneurs to learn as much as they can and get additional help where necessary. Legal counsel is almost always a necessary element of a successful capital raise.

In addition to obtaining good legal counsel in the beginning, do not wait until you receive a call from an investigator or an SEC subpoena in the mail before you pick up the phone and call an attorney. If you receive a call from an SEC investigator or have any reason to believe you or your company is under investigation, call a competent legal professional who specializes in SEC compliance and regulatory defense work immediately. Securities defense work is complicated and takes a level of expertise many lawyers do not have. Not only is the attorney who helped you set up the company and capital raise likely conflicted out of representing the Founder(s) or the company, they likely do not have the expertise required to engage with the SEC.

The SEC says their mission includes facilitating capital formation for public companies and small businesses that are active participants in private markets. I believe they genuinely want to accomplish their mission. The SEC’s mechanisms for accomplishing their mission are rule making and enforcement. When engaging in capital formation, Founders should engage the rules and avoid the enforcement.

Joseph D. Watkins is an associate attorney who represents and counsels clients in a variety of matters with a primary focus on defending corporate and individual clients in securities enforcement, regulatory, defense litigation, white collar crime, government and independent investigations matters. Mr. Watkins graduated from the J. Reuben Clark Law School at Brigham Young University. He holds a Master of Laws degree in Taxation from Georgetown University in Washington, D.C.; 801.532.1234.



[1] 2017 Treasury Report at 43-44. See e.g., Report and Recommendations of the American Bar Association Business Law Section Task Force on Private Placement Broker-Dealers (“ABA Task Force”) (June 2005), available at (“ABA Task Force Report”) (stating that small issuers are almost “never interesting” to professional capital and will seldom be able to attract fully licensed members to participate in offerings of less than $5 million)

[2] Id.

[3] See U.S. Small Business Administration Office of Advocacy, Frequently Asked Questions (Sept. 2019), available at 1.pdf.

[4] See, e.g., Ufuk Akcigit and William R. Kerr, “Growth through Heterogeneous Innovations,” Journal of Political Economy 126:4 (Aug. 2018), available at (demonstrating that the “relative rate of major inventions is higher in small firms” due to the “outcome of innovation investment choices by firms”).


[6] Release No. 34-90112; File No. S7-13-20

[7] Id.

[8] Registration Requirements for Foreign Broker-Dealers, Exchange Act Release No. 27017 (Jul. 11, 1989), [54 FR 30013 (Jul. 18, 1989)] (“15a-6 Adopting Release”) at 30014-15.



[11] Id.