Taking outside investment is a significant step for any founder. The moment you accept a check in exchange for equity (or a future right to equity), you create legal obligations and stakeholder accountability that did not exist before. If you do not set the foundation correctly from the start, you risk liabilities that can threaten the survival of your business. To get this right, you need to navigate the regulations of fundraising and understand the instruments available to you.
Navigating Securities Laws: Limits on How and From Whom You Can Raise Capital
Right off the bat, you cannot just raise money from anyone unless you follow certain rules and laws known as securities regulations. Under these laws, when you offer a piece of your company to an investor, you have two choices: you can either register the offering with the SEC or look for an exemption.
Because full registration is incredibly expensive and time-consuming, nearly all startups seek an exemption. The most common paths are under Rules 506(b) and 506(c). Both allow unlimited fundraising from accredited investors and preempt state registration requirements. The key difference: 506(b) prohibits general solicitation but allows you to rely on investor self-certification of accreditation, while 506(c) permits general solicitation (you can publicly announce your raise) but requires you to take reasonable steps to verify each investor’s accredited status. The vast majority of early-stage companies choose 506(b) for its simpler compliance while relying on inherently less risky personal networks, but companies that want to market their round publicly opt for 506(c) and accept the verification burden.
The conditions of 506(b) specifically:
- General solicitation of investors is prohibited under the rule, meaning you can’t advertise to the world that you’re seeking funding. The rule contemplates participation from investors that have enough knowledge and experience to understand the risk of investing in securities offered by a startup, so the general public cannot be invited to the party.
- Non-accredited investors can participate as long as they’re “sophisticated”, but only up to 35 can invest, and only if you can meet the burdensome disclosure requirements for this class of investors.
- You still have to file Form D to put the SEC on notice about the securities. Form D isn’t necessarily a condition of rule 506(b) itself, but the SEC requires notice when securities are sold under 506(b).
While 506(b) and 506(c) preempt state registration—meaning states cannot block your offering—most states still require notice filings and fees within 15 days of receiving funds from investors in that state. Missing these filings can trigger rescission rights, potentially allowing investors to demand return of their investment plus interest. The practical exposure varies by state and circumstance, but the administrative burden of tracking and completing these filings is real and should not be overlooked.
Selecting the Optimal Financing Instrument
Once the legal structure of the raise is determined, founders must decide what type of security they are selling. Early-stage financings generally fall into three categories: SAFEs, convertible notes, and preferred equity. Each allocates risk, dilution, and control differently.
Simple Agreement for Future Equity (SAFEs) – A SAFE allows an investor to invest capital today in exchange for the right to receive equity in a future financing round, usually when the company later raises a priced round.
- The Advantage: Because a SAFE is not debt, it does not accrue interest and does not contain a maturity date requiring repayment if the company fails to raise another round quickly. Also, SAFE transactions tend to be quicker and less costly than financing rounds, in particular, because there’s generally a lesser diligence threshold.
- The Disadvantage: Multiple SAFEs with differing economic terms (“Stacked SAFEs”) may be difficult to model post-conversion ownership and can create significant unexpected dilution.
Convertible Notes (CNs) – A convertible note is a short-term loan that converts into equity in a future financing round rather than being repaid in cash.
- The Advantage: Convertible notes appeal to a broader group of early stage investors seeking more potent downside protection: the investment accrues interest, carries a maturity date, and technically constitutes debt senior to equity. In practice, both SAFEs and convertible notes almost always convert into equity before any liquidation preference would matter, so the seniority distinction rarely affects outcomes—but for investors focused on structural protections, the note form offers more.
- The Disadvantage: Those same investor-friendly terms are the company’s disadvantages: the interest creates more equity on conversion and the maturity date imposes an artificial deadline for conversion with the potential for the company owing a debt without having funds available to repay.
Preferred Stock – A preferred stock financing is a priced equity round where investors purchase shares at a fixed valuation agreed at the time of investment.
- The Advantage: Valuation, ownership, economic rights, and governance terms are all defined at closing, giving both founders and investors maximum certainty over the deal structure.
- The Disadvantage: It is the most complex and expensive structure, requiring extensive legal documentation, negotiation, and due diligence. There is significant legal expense and more time required to complete an equity financing. Investors also typically join the company’s board in connection with priced rounds, increasing the governance complexity on a go-forward basis.
Getting these foundational decisions right—choosing the appropriate exemption and selecting the right instrument for your stage and circumstances—sets the terms for everything that follows. The specifics will vary with each company’s situation, but understanding these frameworks gives founders the vocabulary and structure to work effectively with counsel and negotiate from an informed position.
If you have questions about forming your business, please give us a call at 317.423.7900 or send us an email at info@gutweinlaw.com.
This blog post is part of our 5-part series on Fundraising for Startups. To view other parts of the series, click the links below:
