Regulation D is a critical framework under the U.S. Securities Act of 1933 that allows issuers to raise capital through the sale of securities without registering the offering with the Securities and Exchange Commission (SEC). It does so by providing “safe harbor” exemptions—essentially clearly defined conditions under which an issuer can be confident that its offering qualifies for exemption from registration.

The primary objective of Regulation D is to reduce the regulatory burden and associated costs for issuers, especially startups and private companies, while still maintaining essential investor protections through disclosure obligations, limitations on resale, and restrictions on solicitation in certain cases.

Regulation D comprises three main rules—Rule 504, Rule 506(b), and Rule 506(c)—each designed to accommodate different types of issuers and capital-raising situations. These rules vary in terms of offering limits, types of eligible investors, whether general solicitation is permitted, and what information must be provided to investors. Despite their differences, all Regulation D offerings share several foundational characteristics (see below).

On June 17, 2025, the U.S. Senate passed the Guiding and Establishing National Innovation for U.S. Stablecoins Act—better known as the GENIUS Act—marking a watershed moment in the legal treatment of digital assets. With strong bipartisan support, the bill lays the foundation for the first comprehensive federal regulatory regime governing the issuance and operation of payment stablecoins.

At its core, the GENIUS Act answers a long-standing question: who may issue a dollar-backed digital asset, and under what conditions? Until now, U.S. law offered no uniform framework for stablecoins, despite their rapid growth into a multi-billion-dollar market and increasing relevance in global payments. This regulatory gap raised concerns about consumer protection, systemic risk, and financial integrity.

The new legislation seeks to close that gap by establishing clear federal and state pathways for entities wishing to issue “payment stablecoins“—digital assets pegged to fiat currency and used primarily for transactions. It restricts issuance to licensed banks or newly designated “qualified issuers” that meet stringent requirements for asset backing, transparency, AML compliance, and redemption rights. It also provides a process for state-level oversight if the state regime meets federal standards.

The Act has significant implications not only for crypto-native companies, but also for banks, fintech firms, and multinational platforms exploring tokenized payments. Additionally, it clarifies legal boundaries, introduces criminal and civil penalties for violations, and—perhaps most importantly—creates a federal mechanism for certifying stablecoin regimes and overseeing issuers.

This article breaks down the GENIUS Act’s key provisions, the legal structures it creates, and the strategic considerations for issuers, platforms, and regulators going forward.

On May 28, 2025, the U.S. Securities and Exchange Commission (SEC) released new data and analysis that shine a light on how private markets are evolving—especially in three key areas that affect both investors and companies looking to raise money.

The goal of this release was to give the public, regulators, and market participants a better understanding of how capital is being raised outside of traditional public markets, and what kinds of risks or patterns are emerging. The SEC’s analysis is based on filings made by investment advisers, private funds, and companies that have used special exemptions from public registration rules to raise money.
The release covers three distinct topics.

First, it looks at hedge funds—specifically at who owns them and how concentrated that ownership is. The SEC defines “concentration” as a situation where just five investors hold more than 70% of a fund’s equity. This matters because if too few investors hold too much power, it could affect how the fund operates, how risky it is, and how it responds to market changes.

Second, the SEC reviews a decade of activity under Regulation A, a type of legal exemption that allows companies—usually small or early-stage ones—to raise money from the public without going through the full process of an IPO. The analysis shows trends in how this tool has been used, who uses it, and how much capital has actually been raised compared to what companies originally sought.

Third, the report focuses on Regulation Crowdfunding, another exemption created under the JOBS Act that lets small businesses raise money directly from the public through online platforms. This part of the data examines how the market has grown, how much funding companies have raised, and what kinds of businesses are using this exemption.

Together, these areas provide a snapshot of how private capital formation is changing—what’s working, what isn’t, and where risks might be building. The legal insights from this release point to the growing complexity of private markets and the need for smart regulation that balances investor protection with access to capital.

When a company wants to raise money by selling shares or bonds, it usually has to “register” that sale with the U.S. Securities and Exchange Commission (SEC). But sometimes companies don’t go through this public registration process. Instead, they rely on certain legal exceptions that let them sell these investments privately—these are called unregistered offerings.

The legal foundation for these private sales comes from the Securities Act of 1933, which normally requires registration unless the sale falls under a specific exemption—such as Section 4(a)(2) or Regulation D.

Here are the main types of unregistered offerings:

• Rule 144A offerings. These are large sales of securities, typically made to big financial institutions (called “qualified institutional buyers” or QIBs). The company sells the securities to a bank or other middleman, who immediately resells them to those institutions. This is a fast and efficient way to raise large amounts of money without registering the securities.
• Regulation S offerings. These allow companies to sell securities outside the U.S. without registering with the SEC, as long as the sales follow certain rules. When combined with Rule 144A, these are called 144A/Reg S offerings, where U.S. institutions get the 144A side and non-U.S. investors get the Reg S side.
• Traditional private placements. This means selling directly to a small group of investors, often wealthy individuals or institutions. These can be done under:
  • Rule 504 (small offerings up to $10 million),
  • Rule 506(b) (no advertising, but allows up to 35 non-accredited investors),
  • Rule 506(c) (you can advertise, but only sell to verified accredited investors).
• Medium-Term Notes (MTNs) and Commercial Paper. These are short- or medium-term loans raised by companies from institutional investors, often done continuously over time without registration.
• PIPE transactions (Private Investment in Public Equity). These are special deals where public companies privately sell stock at a discount to raise quick capital, usually with a promise to register the shares later.

What’s not included?

This overview doesn’t cover:

• Regulation A+ offerings (a hybrid between public and private),
• Crowdfunding, or
• Startup fundraising rounds like seed or angel investments.

Private offerings are faster and cheaper than public offerings, but they still have to follow the law. The SEC sets rules to prevent fraud and protect investors—even in private deals. Companies must also keep up with new regulations and legal updates, such as changes to the definition of “accredited investor” or what qualifies as general solicitation.

So, while unregistered offerings skip some steps, they’re still a tightly regulated and structured way for companies to raise money from select investors without going fully public.

A term sheet is a simple document that outlines the basic terms of a deal before the full contract is written. It’s like a roadmap that helps both sides see if they’re on the same page before spending time and money on detailed negotiations and legal work.

People often call it a Letter of Intent (LOI) or a Memorandum of Understanding (MOU)—these are just different names for the same idea: putting the main deal points in writing early on.

The goal of a term sheet is to show that both sides are serious about the deal and agree on the big-picture terms. Most of the time, a term sheet isn’t legally binding, which means either side can still walk away. But sometimes, it includes a few binding promises—like keeping the deal confidential or not negotiating with anyone else for a certain period.

Term sheets are most common in private business deals, like buying or merging companies (M&A), starting joint ventures, or raising private investment money. They’re usually not used in public deals because that might require public disclosure before the parties are ready.

Going public, whether for a budding startup or an established company seeking to expand its horizons, is a momentous milestone in the life cycle of any business. But going public on a multi-tiered exchange like the NYSE or Nasdaq is more than just a celebration. It requires precision in complying with complex technical, legal, and corporate governance criteria outlined by the Securities and Exchange Commission (SEC). This article outlines the listing requirements and processes leading up to a public offering that is marketed differently for subsequent sales for both domestic and foreign companies.

I.  Primary Listing Requirements on Major U.S. Exchanges

If a company wants to list its shares on a U.S. stock exchange—like the NYSE or Nasdaq—to access public investors and trade in the open market, it needs to clear two big hurdles:

1. Register with the SEC. This is the U.S. government’s securities watchdog. The company has to file a detailed registration statement that discloses everything investors need to know: financials, risks, business model, and more. This process is designed to protect investors and make sure the market has accurate, up-to-date information.
2. Get Accepted by the Exchange. Each stock exchange sets its own minimum standards to decide whether a company is eligible to list. These standards are meant to filter for size, stability, and market interest.

NYSE Listing Requirements

The NYSE (New York Stock Exchange) sets slightly different rules for U.S. companies and foreign companies.

For U.S. Companies

The company must show it has a strong base of investors and some meaningful financial size:

• At least 400 U.S. shareholders, each holding 100+ shares
• At least 1.1 million shares held by the public (i.e., not insiders or controlling shareholders)
• Those shares must have a market value of at least $40 million
• The stock price must be at least $4 per share
• Financially, the company must pass one of two tests:
  • Earnings test (based on recent profits), or
  • Global market capitalization test (based on total company value)

For Non-U.S. Companies (Foreign Private Issuers or FPIs)

The NYSE adjusts its criteria to account for global shareholder bases:

• 5,000 shareholders worldwide, each holding 100+ shares
• 2.5 million shares publicly held worldwide
• Market value of those shares must be at least $100 million (or $60 million in some special cases)
• Must meet one of four financial standards, each tailored to different business types (e.g., earnings-based, valuation-based, or based on affiliation with another NYSE-listed company)

Direct Listings on NYSE

A company can also go public without an IPO—this is called a direct listing. To do this, the company must:

• Sell at least $100 million of its own shares in the opening auction on the first trading day, or
• Show that the combined value of the shares it plans to sell and the ones already held by the public totals at least $250 million

Nasdaq Listing Requirements

Nasdaq has three separate market tiers—each with its own standards. From most to least rigorous:

1. Global Select Market – for large, established companies.
2. Global Market – for mid-sized companies.
3. Capital Market – for smaller or growth-stage companies.

Each tier has a slightly different mix of requirements, but all focus on the same key areas:

• Public float (number and value of shares held by public investors).
• Number of shareholders, usually 300–450 minimum.
• Minimum share price, typically $4 per share.
• Financial strength, measured through income, revenue, assets, or equity.
• Trading history, especially for companies that were previously private or traded over-the-counter.

Direct Listings on Nasdaq

Nasdaq allows direct listings too—but only on its Global Select tier. To qualify, a company must:

• Have at least $110 million in market value of freely tradable shares (or $100 million if it has $110 million in stockholders’ equity).

II.  What Are Qualitative Listing Standards?

When a company wants to be listed on a major U.S. stock exchange, it’s not enough to meet certain financial benchmarks mentioned above. The company also has to prove that it has the right internal structures in place to be publicly accountable. This is what called qualitative listing standards.

These standards focus on how a company is governed: who’s overseeing it, how transparently it communicates with investors, and whether its leadership is subject to independent oversight.

Corporate Governance: Independence and Oversight

One of the first things the exchanges look at is whether a company has a board of directors that is not dominated by insiders. Most of the board should be independent—meaning the individuals have no meaningful ties to the company or its executives that could cloud their judgment.

Two committees must always be composed entirely of independent directors:

• An audit committee, which oversees the accuracy of the company’s financial reporting and liaises with external auditors.
• A compensation committee, which sets executive pay and ensures that it’s tied to performance, not favoritism or personal ties.

These committees play a real role in guarding against fraud, excessive risk-taking, and conflicts of interest.

In the case of the NYSE, there’s a third required committee focused on nominations and governance, also made up entirely of independent directors. Nasdaq offers more flexibility on this point, allowing companies to assign these responsibilities to a group of independent directors even without a formal committee.

Another important governance feature is the requirement that independent directors regularly meet without management present. These private meetings—sometimes called executive sessions—give the board a chance to candidly evaluate company leadership and raise concerns, if needed, without pressure.

Ongoing Disclosure: Keeping Investors Informed

Once a company is listed, it has to keep the public informed—not just once a year, but continuously. This means publishing annual reports and interim (typically quarterly) financial statements that comply with both SEC rules and stock exchange standards.

In addition to these regular reports, companies are expected to immediately disclose major developments that could affect their stock price—things like mergers, executive departures, investigations, or big shifts in strategy. These updates typically come through filings like Form 8-K, and they’re a critical part of how markets function fairly.

Companies are also required to adopt a Code of Conduct or Code of Ethics that outlines expectations for ethical behavior, legal compliance, and integrity in financial reporting. This code must apply to directors, officers, and employees, and must be disclosed to investors.

What About Foreign Companies?

The U.S. stock markets are global, and many companies that list on the NYSE or Nasdaq are based overseas. These foreign private issuers (FPIs) are allowed some flexibility in how they meet governance standards.

Rather than forcing them to fully adopt U.S. governance rules, the exchanges let FPIs follow the corporate governance practices of their home countries—if they clearly explain to investors how those practices differ from U.S. standards.

So, for example, if a European company doesn’t have a separate compensation committee (because its local laws don’t require one), it can still list in the U.S.—as long as it discloses that difference and explains how compensation decisions are made instead.

III.  Secondary Listings and Follow-On Offerings in the U.S. Markets

Once a company completes its initial public offering (IPO), its journey as a public company is just beginning. Over time, it may need to raise additional capital to fund growth, refinance debt, or pursue strategic opportunities. This is where follow-on offerings—sometimes called secondary offerings—come into play. These offerings involve the public sale of shares after the IPO and are governed by a well-established regulatory framework in the U.S. overseen by the SEC.

What Are Follow-On Offerings?

A follow-on offering is a way for a company to return to the public markets and sell shares after its initial listing. These offerings can involve:

• Primary shares, which are newly issued by the company to raise fresh capital.
• Secondary shares, which are sold by existing shareholders (such as early investors, founders, or insiders) who are liquidating part of their holdings.
• Or a combination of both.

Follow-on offerings can be large and high-profile (as with major tech companies raising billions post-IPO) or more modest, depending on the company’s capital needs and market appetite.

While often associated with U.S. domestic companies, foreign private issuers also use this route to expand their investor base or fund U.S.-based operations—typically after completing a primary listing via American Depositary Receipts (ADRs) or direct share offerings.

Key SEC Forms: Form S-1 vs. Form S-3

To conduct a follow-on offering, a company must file a registration statement with the SEC. This ensures that investors have access to current, accurate, and complete information about the company and the securities being offered.

There are two main types of forms used for this purpose:

1. Form S-1 is the full-length registration statement used for IPOs and for follow-on offerings by companies that do not yet qualify to use the shorter Form S-3. It requires extensive disclosures, including detailed financial statements, risk factors, management discussion and analysis, executive compensation, and business operations—following Regulation S-K Form S-1 is also the default form for companies making their first foray into the U.S. public markets, and for younger or smaller public companies that haven’t yet built a filing track record with the SEC.

2. Form S-3 is a short-form registration that allows companies to streamline the process by incorporating by reference previously filed SEC reports (like 10-Ks, 10-Qs, and 8-Ks), rather than repeating information already made public. This makes Form S-3 faster and more efficient for follow-on offerings. Even better, it can be used as a “shelf registration”, meaning the company can register a large block of securities once and then issue them incrementally over time—taking advantage of favorable market conditions without having to re-file each time.

Who Can Use Form S-3?

The SEC imposes specific criteria to ensure that only established, compliant companies use this streamlined form. To qualify:

1. The company must be a U.S. domestic issuer (foreign private issuers must use Form F-3 instead).
2. It must have a class of securities already registered under the Exchange Act (typically as a result of an IPO or direct listing).
3. It must have filed all required SEC reports on time for the previous 12 months—this shows a track record of compliance.
4. It must have no defaults on material debt or long-term leases.
5. It must not have missed any dividend payments on preferred stock since its most recent fiscal year.

Finally, the company’s public float—the market value of its publicly traded shares held by non-affiliates—determines how much it can raise using Form S-3:

• If the float is $75 million or more, the company can generally use Form S-3 to register any size offering of equity or debt.
• If the float is below $75 million, the company can still use Form S-3 for limited offerings, but only under specific conditions:
  • For secondary offerings (i.e., by existing shareholders), there are fewer restrictions.
  • For primary offerings (i.e., by the company), they must relate to non-convertible securities and the company must meet one of several alternative criteria—such as having issued $1 billion in debt over the past three years, or being a wholly-owned subsidiary of a well-known seasoned issuer.

IV.  Domestic vs. Foreign Companies: How Listing in the U.S. Works

Going public on a U.S. stock exchange is a major step for any company. Whether the goal is to access deep pools of capital, raise the company’s global profile, or provide liquidity for early investors, listing in the U.S. comes with both prestige and regulatory obligations. But the path to listing depends in part on where the company is based.

While the core process is similar for all companies, U.S. domestic issuers and foreign private issuers (FPIs) often take slightly different routes—especially when it comes to disclosure formats and share structures.

The Primary Listing Process

At the most basic level, a company must register its securities with the SEC before they can be publicly traded on a U.S. exchange. This process involves filing a registration statement—a legal and financial disclosure package that lays out everything investors need to know.

The registration statement consists of two parts:

• A prospectus, which is the formal document provided to investors that describes the company’s business, financial performance, risks, and use of proceeds.
• A set of exhibits, which includes additional legal, financial, and organizational documents filed with the SEC but not necessarily shared with the public in marketing materials.

Once submitted, the SEC reviews the filing and provides comments. The company responds, and once the SEC is satisfied, it declares the registration effective. Only then can the shares be sold or listed for trading.

Importantly, a listing doesn’t always require a public offering. A company can go public through a direct listing, where no new capital is raised. Instead, existing shareholders are simply allowed to sell their shares on the open market. Direct listings have become more common in recent years—especially for high-profile tech companies—and are now permitted on both the NYSE and Nasdaq under certain conditions.

Foreign Companies

For companies based outside the U.S., the listing process follows the same basic legal and regulatory structure—but with some important differences designed to accommodate international practices.

Foreign Private Issuers (FPIs)—a category under U.S. securities law that includes non-U.S. companies with limited U.S. shareholder or management presence—can list either their actual shares or American Depositary Receipts (ADRs). The choice between the two depends on a mix of regulatory, strategic, and market considerations.

An ADR is essentially a proxy for a foreign share. It’s a negotiable certificate issued by a U.S. bank, representing one or more shares of the foreign company. These certificates are traded just like U.S. stocks and offer U.S. investors a convenient way to invest in foreign companies without dealing with foreign exchanges, currencies, or settlement systems.

ADRs are often favored by FPIs because they:

• Simplify cross-border trading logistics.
• May be more familiar to U.S. retail and institutional investors.
• Can enhance visibility in the U.S. without requiring full corporate restructuring or duplicative financial reporting.

On the other hand, direct listings of foreign shares (without ADRs) are sometimes used when the issuer wants tighter integration with its global shareholder base or is already well-known among U.S. investors.

The decision to use ADRs versus direct shares typically comes down to cost, complexity, investor perception, and the company’s long-term capital markets strategy.

Secondary Listings: Follow-On Options for FPIs

Just like U.S. companies, foreign issuers that have already gone public may later decide to raise more capital or allow insiders to sell—through what’s known as a follow-on offering.

In these cases, the company generally files a Form F-1, which is the foreign counterpart to the Form S-1 used by domestic issuers. It’s a full disclosure document that includes detailed financials, risk factors, business operations, and governance practices, all in compliance with U.S. regulations.

The FPI may again choose to structure the offering using ADRs or its underlying ordinary shares, depending on which structure it used for its primary listing and what best suits the strategy for the secondary raise.

Imagine you and a group of friends start a company together. Over time, you bring in outside investors to help grow the business. These investors provide the funding you need, but in return, they get a say in how the company is run. Now, fast forward a few years. The company has grown, and a big corporation offers to buy it for a significant amount of money. Everyone is excited, but there’s a problem: one of your original co-founders doesn’t want to sell. They believe the company has more potential and want to hold out for a better deal. What happens now? This is where a drag-along agreement comes into play.

A drag-along agreement is a legal provision that allows majority shareholders to force minority shareholders to join in the sale of a company. In simpler terms, if the majority of shareholders agree to sell the company, the minority shareholders are legally obligated to go along with the decision, even if they personally disagree. This might sound harsh, but it serves an important purpose. It ensures that a small group of shareholders can not block a deal that benefits the majority and the company as a whole.

In the world of startups and venture capital, drag-along agreements are especially important. Startups often have multiple classes of shareholders, such as founders, employees with stock options, and outside investors who hold preferred stock. Each group might have different priorities. For example, founders might be emotionally attached to the company and want to keep growing it, while investors might be looking for a quick return on their investment. A drag-along agreement helps align these interests by making clear everyone is on the same page when it comes to major decisions like selling the company.

Let’s go back to our example. Suppose your company has three co-founders: you, Sarah, and Mike. You also have a venture capital firm, TechInvest, as a major investor. TechInvest owns 60% of the company, while you, Sarah, and Mike each own 10%, and the remaining 10% is split among employees. If TechInvest decides to sell the company, they can use the drag-along agreement to force you, Sarah, Mike, and the employees to agree to the sale, even if some of you would prefer not to.

Types of Drag-Along Agreements 

Drag-along agreements come in different forms, each designed to address specific situations that can arise in the life of a company. Let’s break down the two main types.

First Flavor: Preferred Investors Dragging Common Shareholders

In many startups, investors like TechInvest hold preferred stock, which often comes with special rights and privileges. One of these rights is the ability to drag along common shareholders—typically the founders and employees—when it comes to selling the company. Here’s how it works: if TechInvest, as the majority preferred shareholder, decides to sell the company, they can force you, Sarah, Mike, and the employees to agree to the sale, even if some of you would rather not.

This type of drag-along agreement is especially common in venture capital deals. It’s designed to prevent a small group of common shareholders from blocking a deal that the majority of investors believe is in the company’s best interest. For example, if TechInvest negotiates a $50 million acquisition offer, they do not want one co-founder holding out and demanding $60 million, potentially scuttling the deal. The drag-along agreement helps that everyone moves forward together.

The language in these agreements is usually straightforward. It might say something like: “If a majority of the preferred shareholders approve a sale of the Company, all holders of common stock shall be required to consent to the transaction and shall have no right to object, challenge, or otherwise impede the sale.”  This gives the preferred investors the power to make decisions without being held hostage by minority stakeholders.

Historically, this type of drag-along agreement became more common after the early 2000s dot-com bubble burst. During that time, many startups were sold for less than their investors had hoped, and founders often resisted these sales because they wouldn’t receive any proceeds after the investors’ liquidation preferences were paid out. To avoid these conflicts, investors began insisting on drag-along provisions to push they could exit their investments when needed.

Second Flavor: Dragging Along Departed Founders

The second type of drag-along agreement deals with a different but equally tricky situation: what happens when a founder leaves the company but still owns shares? Let’s say Mike, one of your co-founders, decides to leave the startup after a disagreement. He still owns 10% of the company, and now he’s no longer involved in day-to-day operations. If the company later decides to sell, Mike might refuse to agree out of spite or because he has different ideas about the company’s future. This could create a major roadblock.

To prevent this, many companies include a drag-along provision specifically for departed founders. Under this agreement, if Mike leaves the company, his shares are automatically “dragged along” with the majority in any sale or major decision. In other words, Mike no longer has the power to block a deal. Instead, his shares are voted in proportion to how the other shareholders vote. For example, if 90% of the shareholders vote in favor of a sale, Mike’s shares will be counted as 90% in favor and 10% against, even if he personally disagrees.

The language for this type of agreement might look like this: “Upon the departure of any shareholder who was an original signatory to this agreement and held common stock at the time of its execution (a ‘Departing Shareholder’), all shares held by such Departing Shareholder, including common stock or any preferred stock acquired through conversion, shall be subject to a drag-along provision whereby they shall be voted in the same proportion as the aggregate vote of all other outstanding shares in any sale, merger, or liquidation event.” This assists that a departed founder can’t hold the company hostage or disrupt important decisions.

This second flavor of drag-along agreement has become increasingly popular in recent years, especially as startups face more complex dynamics between founders and investors. It’s a way to protect the company from the potential fallout of a founder’s departure, whether it’s due to personal differences, burnout, or other reasons.

Key Considerations and Negotiations

Let’s assume your company, which you co-founded with Sarah and Mike, has grown significantly. TechInvest, the venture capital firm that owns 60% of the company, is pushing for a sale to a larger tech company. You, Sarah, and Mike each own 10%, and the remaining 10% is held by employees. As founders, you’re emotionally invested in the company and want to make sure your voices are heard.

The size of your ownership stake plays a big role in how much drag-along terms matter to you. If you’re a small shareholder—say, you own just 1% of the company—your ability to influence the outcome of a sale is very limited. In most cases, a single small shareholder will not have much leverage to block a deal, even without a drag-along agreement. However, if there are many small shareholders like you, collectively holding a significant portion of the company, your combined influence could become a problem for the majority shareholders. This is why drag-along agreements are often included in term sheets—to prevent a fragmented group of small shareholders from derailing a deal.

But ownership isn’t the only factor. Where your company is incorporated also matters. Different jurisdictions have different rules about shareholder consent. For example, in California, a sale typically requires a majority vote from each class of shareholders (common and preferred). In Delaware, which is a popular state for incorporating startups, the rules are slightly different. There, a sale usually requires a majority vote of all shares on an “as-converted” basis, meaning preferred shares are treated as if they have been converted to common stock for voting purposes.

When negotiating drag-along terms, there is often room for compromise. One common approach is to align the drag-along rights with the majority of common stockholders rather than the preferred investors. In our example, this would mean that TechInvest could only force a sale if a majority of the common shareholders (you, Sarah, Mike, and the employees) also agreed. This gives the founders and employees more control over the outcome, while still making clear that the company can move forward if there is broad consensus.

Another strategy involves preferred investors converting some of their shares to common stock. This might sound counterintuitive, but it can actually benefit everyone. By converting preferred shares to common, investors can increase their voting power in a way that aligns with the common shareholders. For example, if TechInvest converts enough shares to common, they can help push through a sale that benefits both them and the common shareholders. This also reduces the overall liquidation preference, meaning there’s more money to go around for everyone in the event of a sale.

Negotiating drag-along agreements can get complicated, which is why having a good lawyer is a good idea. In our example, let’s say you hire a lawyer to negotiate the term sheet with TechInvest. During the discussions, your lawyer might push back hard against the drag-along provision, arguing that it limits your rights as a founder. While this might seem like they are protecting you, it could actually harm the company’s ability to secure funding or execute a sale down the line.

This is where conflicts can arise. If your lawyer is too focused on protecting your personal interests, they might overlook what is best for the company as a whole. For instance, if TechInvest walks away from the deal because they feel the drag-along terms are too weak, the company could lose out on critical funding. A good lawyer should strike a balance.

Practical Implications and Conclusion

Drag-along agreements come into play in situations where a company is being acquired, merging with another business, or going through liquidation. In these high-stakes moments, the last thing a company wants is for one or two shareholders to block the entire deal. Without a drag-along clause, even a single minority shareholder could refuse to sell, creating delays, legal battles, or even scaring off potential buyers.

For small shareholders—especially those who own only a fraction of the company—it’s important to recognize when a drag-along clause is actually worth fighting over. If you own just 1% of the company, your ability to stop a sale is already limited, even without a drag-along. However, if you and a large group of small investors collectively own 30% or more, then these provisions matter a lot more because together, you might actually have the power to influence a sale. In these cases, understanding the specific voting thresholds and how drag-along provisions are structured can make a real difference.

These agreements exist because different types of shareholders have different priorities. Preferred investors, usually venture capital firms, want flexibility when it comes to selling the company. They invested with the expectation of a strong return, and they don’t want a few dissenters standing in the way when the right buyer comes along. Common shareholders, including founders and employees with stock options, might have a different perspective. As mentioned earlier, founders are often emotionally attached to the company and may want to hold out for a better deal-or not sell at all. Employees who own stock may not be enthusiastic about a sale if it does not include meaningful payouts for them. In most cases, these agreements are structured to favor investors because they have more bargaining power. However, founders who understand their options can sometimes push for fairer terms that give them a stronger voice in the decision-making process.

If you’re a small shareholder, it’s worth asking yourself: Does this really affect me? If your ownership stake is tiny, there may be more important things to focus on in the negotiations. But if you hold a significant portion of common stock—especially as a founder—you should make sure the terms are fair and that you are not giving up too much control.

At the end of the day, drag-along agreements are designed to keep things moving when a sale is on the table. Whether that is a good thing or a bad thing depends entirely on your position. If you are an investor, you probably want strong drag-along rights to prevent holdouts from blocking a deal. If you are a founder or employee, you’ll want to make sure you’re not being forced into a sale under terms that do not work for you.

The best way to protect yourself is to read the agreement carefully, ask the right questions, and, if needed, negotiate better terms before signing anything. Once the deal is done, you’re bound by those terms—so make sure you know exactly what you’re agreeing to.

When a company offers stock options to employees, it does not hand over all the shares immediately. Instead, the process of becoming fully entitled to these shares happens gradually over time, which is known as vesting.

The most common arrangement for vesting spans four (4) years. However, there is typically a condition called a “one-year cliff,” which means that employees must work for at least one year before earning any shares. Once they reach that milestone, they receive 25% of their stock options. After that, the rest of the shares are divided and awarded evenly each month over the remaining three years. This structure motivates employees to stay longer and remain invested in the company’s growth.

For founders of a company, the story can be a bit different, especially when venture capital investors get involved. Venture capitalists often require founders to also have a vesting schedule for their shares. This is partly to confirm fairness—founders need to stay committed to the company for the long haul—and partly to protect the investors’ interests.

Standard Vesting Clauses

Once the standard vesting arrangement is in place, there is usually also a safeguard known as a repurchase right. This means if an employee leaves before becoming fully vested, the company can buy back those unvested shares at a set price, often whichever is lower between the original cost or the current market value. This facilitates that any unearned equity returns to the company and can be reallocated to other employees or stakeholders.

Over the years, these practices have settled into a familiar pattern. Most early-stage companies stick to a one-year cliff and a four-year total vesting period. This schedule, now considered the industry norm, brings a sense of fairness and predictability to both employees and founders. For employees, it is clear exactly when their share of the pie stops being theoretical and becomes theirs to keep. For founders, it helps maintain balance by preventing large chunks of the company from walking out the door with someone who lost interest after a few months.

Sample Stock Vesting Clause (for illustrative purposes only, not legal advice)

Section [X]: Vesting of Shares

1. Vesting Schedule. The Recipient’s right to ownership of the Shares granted under this Agreement (the “Shares”) shall vest over a total period of four (4) years, subject to the conditions set forth herein. The vesting shall include a one-year “cliff,” followed by monthly vesting thereafter. Specifically, no Shares shall vest for the first twelve (12) months from the Vesting Commencement Date. On the first anniversary of the Vesting Commencement Date, twenty-five percent (25%) of the total number of Shares shall vest. After this initial one-year period, the remaining seventy-five percent (75%) of the Shares shall vest in equal monthly installments over the following thirty-six (36) months, with one thirty-sixth (1/36) of the remaining Shares vesting on the last day of each month thereafter, until all Shares are fully vested at the end of the four-year period.

2. Vesting Commencement Date. Unless otherwise stated in the Recipient’s offer letter or a separate written agreement, the Vesting Commencement Date shall be the Recipient’s first day of employment with the Company or another mutually agreed-upon date set forth in writing.

3. Continuous Service Requirement. Vesting of the Shares is contingent upon the Recipient’s continuous employment or service relationship with the Company or any of its subsidiaries or affiliates. If the Recipient’s employment or service terminates for any reason—whether voluntary or involuntary, and including resignation, termination with or without cause, death, or disability—no further Shares shall vest after the termination date.

4. Repurchase Right for Unvested Shares. In the event of the Recipient’s termination of employment or service for any reason prior to the vesting of all Shares, the Company shall have the right, but not the obligation, to repurchase any and all unvested Shares at a price per Share equal to the lesser of (i) the original purchase price paid by the Recipient, if any, or (ii) the fair market value of such Shares on the date of repurchase, as reasonably determined by the Company’s Board of Directors. The Company may exercise this repurchase right by providing written notice to the Recipient (or, if applicable, the Recipient’s estate) within ninety (90) days of the termination date, and completing the repurchase transaction within thirty (30) days thereafter.

5. Cliff Vesting Provision. During the initial twelve-month cliff period, the Recipient shall not vest in any Shares. If the Recipient’s employment or service terminates prior to the one-year anniversary of the Vesting Commencement Date, the Recipient shall forfeit any and all rights to any Shares that would otherwise have vested on or after that date. If, however, the Recipient remains continuously employed or engaged by the Company through the one-year anniversary, twenty-five percent (25%) of the total Shares shall vest immediately on that date.

6. Acceleration of Vesting [Optional]. In the event of a Change in Control, as defined in the Company’s governing documents, the Company’s Board of Directors may, at its discretion, accelerate the vesting of some or all of the Recipient’s unvested Shares. Any such acceleration of vesting rights shall be documented in a separate agreement or Board resolution and may be subject to additional conditions, such as the Recipient’s continued employment for a specified period post-transaction.

7. Adjustments and Amendments. The Company may, from time to time, adjust the number of Shares subject to this Agreement and/or amend the vesting schedule due to stock splits, reorganizations, or other corporate events, provided that any such adjustments shall be made in accordance with applicable law and shall not unfairly reduce the Recipient’s vested interests without the Recipient’s written consent.

8. No Guarantee of Continued Service. Nothing in this Agreement or the grant of Shares shall be construed as a guarantee of continued employment or service. The Recipient acknowledges that their employment or engagement is “at will” (except as otherwise provided by written contract), and that their status may be terminated at any time, with or without cause, subject to applicable law and any written agreements to the contrary.

Where things can diverge is in how these rules apply to founders versus everyone else. Founders, after all, often pour their time and energy into the business long before it is anything more than an idea scrawled on a whiteboard. When outside investors appear on the scene, they usually want to lock in the founders’ commitment with a vesting schedule, but it’s common for founders to negotiate some kind of “head start.” Often this comes as vesting credit, which treats them as though they’ve already put in a year or more of service. That way, when their shares begin to formally vest, it acknowledges the tough, risk-heavy work they did early on, before salaries were stable or a product even existed.

For regular employees, if they depart before hitting those crucial milestones, their unvested shares return to the company. This replenishes the option pool, making it easier to attract new recruits down the line with the promise of equity. For founders, a similar outcome arises if they leave too soon, except that the unvested shares do not simply return to a general pool. Instead, those shares effectively vanish from the departing founder’s allocation. This, in turn, slightly increases the percentage stakes of everyone else—other founders, employees, and investors—who remain with the company. Known as reverse dilution, this process facilitates that nobody gains or loses unfairly and keeps the overall ownership structure balanced and orderly.

Special Cases and Considerations in Vesting

Even though the founders usually own their shares from day one—the company still treats these shares as if they are subject to a potential buy-back. In other words, instead of waiting for the shares to “vest” like an employee would, the founder’s shares are all there immediately, but the company keeps the right to purchase back any portion that is not considered “earned” if the founder leaves early. The end result is basically the same as vesting: if the founder departs too soon, they don’t keep all their shares. However, the legal setup is different enough that it can affect how taxes are calculated.

There are also alternatives to standard vesting that founders and key employees can explore to protect their positions in the company. For example, they might negotiate for the right to purchase their unvested shares at the same price as the financing round if they leave the company. This protects their stake even if they are no longer actively involved.

Another strategy involves filing what’s known as a Section 83(b) election. This allows individuals to pay taxes on the value of their shares at the time they are granted rather than when they vest. The advantage is that if the company’s value grows significantly over time, they can lock in lower tax rates early on and potentially save a substantial amount by qualifying for long-term capital gains treatment.

The Impact of Mergers and Acquisitions

When a company goes through a merger or acquisition (M&A), it can significantly affect how vesting works. One important aspect to consider is acceleration—this refers to speeding up the vesting process so individuals gain access to their unvested shares sooner than originally planned. Acceleration comes in two main forms: single-trigger and double-trigger.

Single-trigger acceleration instantly vests all remaining shares the moment a company is bought, making it an attractive idea for those holding shares. However, most VC deals prefer double-trigger acceleration. In this setup, two things must happen before the unvested shares are fully vested: the company has to be sold, and the individual must either lose their job without a valid reason or have their role significantly altered. This approach makes sure that key players are motivated to stay and support a smooth handover after the acquisition, rather than simply cashing out and leaving as soon as the deal is done.

The reason double-trigger acceleration is popular is that it finds a fair middle ground. It keeps both founders and employees protected by making sure they do not suddenly lose their potential future gains, but it also satisfies investors and the new owners who come in after the acquisition. From the buyer’s perspective, having some unvested shares still on the table encourages the key people running the company to stick around and work hard even after the sale. If all shares were fully vested right away, the new owner might have to come up with separate plans to keep those important employees motivated, which can make the deal more complicated.

In effect, double-trigger acceleration serves everyone’s interests at once. Founders and employees do not feel short-changed if they are let go after an acquisition, and the acquirer still has a tool to ensure that the company’s team remains committed. Because of these advantages, this structure is common in venture-backed companies, helping maintain a solid balance between rewarding those who built the business and ensuring it can thrive under new leadership.

What Research and Best Practices Show

Over the past two decades, a de facto standard has emerged in the U.S. startup community: four-year vesting with a one-year cliff. This standardization itself is a product of trial, error, and refinement as startups, founders, and investors learned what works best to maintain balance and fairness.

Though formal academic studies on vesting’s direct impact on turnover are limited, anecdotal evidence and survey data from startup ecosystems (for example, “Global Startup Ecosystem” reports) suggest that reasonable vesting schedules help reduce early voluntary departures by aligning personal incentives with medium-term company milestones.

Early legal scholarship and guidance from seasoned startup attorneys frequently emphasize vesting as a mechanism to prevent “dead equity”—equity held by individuals who no longer contribute but still have voting rights and ownership stakes. A balanced vesting schedule mitigates this scenario.

Conclusion

By putting a clear vesting plan in place right from the start, everyone knows what to expect and understands that staying committed over the long run really matters. There is no need to start from scratch—tried-and-true guidelines from respected sources like the NVCA or Y Combinator can give a solid foundation.

Of course, one size does not fit all. The parties can adjust the vesting schedule for certain key players or senior team members, and even speed it up in special situations, making sure it’s fair to everyone involved. When each person’s equity matches the time and effort they have put in, they are not only reducing the chances of conflicts but also fostering a culture where the team works together smoothly.

In the long run, having a clear and fair vesting system will not just keep the team happy and in sync—it can also make the company more attractive to investors and buyers. This means simpler negotiations, better valuations, and an easier time if they ever decide to sell or bring in new partners down the road.

Imagine you’ve invested in a company, and now it’s being sold or its assets are being liquidated. A liquidation preference determines who gets paid first and how much they get before others receive anything. Think of it as a safety net for investors. If the sale price is lower than what they initially put in, this clause makes sure they get their money back before anyone else does.

There are two key parts to a liquidation preference: the preference itself and something called participation. The preference part means that, in a liquidation event, certain investors get paid a specified amount before others. So if you’re an early investor, you might be entitled to a 1× liquidation preference—meaning you get back exactly what you invested before others get paid.

Then, there’s the participation part, which comes into play after the initial preference is met. Depending on the terms, some investors not only get their money back but also share in any remaining proceeds, which adds an extra layer to their return.

Overall, liquidation preferences are there to protect investors, especially if things don’t go as planned and the company’s value doesn’t meet expectations. It’s a way for investors to manage risk while hoping for an eventual upside if the company does well.

I. Components of Liquidation Preference

Liquidation preference has two main parts that determine how money gets divided when a company is sold: (i) Actual Preference and (ii) Participation.

Actual Preference

This part, called the “actual preference,” is about giving certain investors—usually those who invested first or hold specific types of shares—priority to get paid before others when the company is sold. Think of it as a line where some investors get to go to the front and claim their share before anyone else.

For example, if investors hold what’s called “Series A Preferred” stock, they’re first in line to receive an agreed-upon amount—often the amount they originally invested—before common shareholders get anything. The reason for this setup is simple: these investors took an early risk by putting money into the company, and this priority treatment helps protect that risk.

An example of how this might be worded in an agreement is: “In the event of liquidation, Series A Preferred shareholders are entitled to receive their original investment back before common stockholders receive any payment.”

Participation

The Participation part of liquidation preference determines if certain investors can receive additional money beyond their initial preference. Once they’ve received their priority payout (the “actual preference”), some investors might also get to participate in any remaining proceeds. There are three main types of participation:

• No Participation. In this setup, investors receive only their initial preference amount and nothing more. For example, if someone invested $4 million with a 1× liquidation preference, they would receive just their $4 million back, even if there’s more money left after that. This type is sometimes called “nonparticipating preferred” stock.
• Full Participation. Here, investors get their initial preference amount and a share of any leftover proceeds. For example, if an investor has a 1× liquidation preference with full participation, they get back their initial $4 million, and then they also share in the remaining proceeds based on their ownership percentage, as though they held common stock. This allows them to benefit both from their priority payout and from any additional upside.
• Capped Participation. Capped participation lets investors receive their preference amount and a portion of the remaining proceeds, but only up to a specific limit or “cap.” For example, if an investor’s cap is set at 2.5× their original investment, and they invested $4 million, they can receive up to $10 million in total ($4 million preference plus up to $6 million more from participation). Once they reach this cap, they don’t receive any additional payout, regardless of how much more is available.

II. Conversion and Participation

In liquidation preferences, conversion allows investors with preferred shares to switch their shares to common stock under certain conditions. This option gives them flexibility, as they can choose to convert if it will result in a higher payout. The decision to convert usually depends on a conversion ratio, which specifies how many common shares an investor receives in exchange for each preferred share.

Let’s break it down with an example.

Imagine an investor owns preferred stock with a 1:1 conversion ratio, meaning each preferred share can be converted into one common share. If the company is being sold, the investor can either (a) stick with the liquidation preference and receive their original investment back first or (b) convert their preferred shares into common stock and receive a share of the total sale proceeds based on their ownership percentage.

Here’s a scenario to illustrate how conversion might work:

1. Example 1 “No Conversion Needed”. Suppose the investor put in $3 million and has a 1× liquidation preference. The company is being sold for $4 million. In this case, the investor would likely choose not to convert, as sticking with the 1× liquidation preference guarantees them $3 million back before anyone else is paid. Converting would only dilute their payout, so they opt to keep their preferred status.
2. Example 2 “Conversion for a Higher Payout”. Now, let’s say the company is sold for $10 million, and the investor has 25% ownership in preferred shares. With a 1× liquidation preference, they could take back their original $3 million, but converting their shares to common stock would give them 25% of the $10 million sale price, or $2.5 million. In this case, they might choose to keep their preferred stock for the guaranteed $3 million payout, rather than converting to common and receiving a lower amount.
3. Example 3 “High-Value Sale and Conversion Advantage”. Finally, imagine a big exit where the company is sold for $20 million. Now, if the investor has 25% of the company, converting to common stock would result in a $4 million payout (25% of $20 million). In this case, conversion is beneficial because they can receive more than the $3 million from sticking with the liquidation preference.

III. Examples of Participation Scenarios

Let’s go over four different scenarios that show how participation terms impact investor and common stockholder payouts in a company sale. We’ll use examples with different types of liquidation preferences: 1× nonparticipating, 2× nonparticipating, 1× fully participating, and 1× capped at a 3× multiple.

Assume:

• The investor originally invested $2 million, holding 40% of the company.
• The common stockholders own the remaining 60%.
• We’ll look at company sale values of $3 million, $10 million, $20 million, and $50 million.

Case 1. 1× Nonparticipating Preference

Terms: The investor has a 1× nonparticipating preference, meaning they can either take their initial $2 million investment back first or convert to common shares to receive 40% of the sale if it’s higher.

Sale Scenarios:

• $3 million sale: The investor takes their 1× preference, getting $2 million, leaving $1 million for common holders.
• $10 million sale: The investor could take their 1× preference ($2 million) or convert to receive 40% of $10 million ($4 million). They choose to convert, taking $4 million, while common stockholders get $6 million.
• $20 million sale: The investor converts to common to take 40% of $20 million, or $8 million. Common holders receive $12 million.
• $50 million sale: Again, the investor converts to common, receiving 40% of $50 million, or $20 million, with the remaining $30 million going to common holders.

Case 2: 2× Nonparticipating Preference

Terms: The investor has a 2× preference, which entitles them to twice their initial investment ($4 million) before common holders get anything.

Sale Scenarios:

• $3 million sale: The investor’s 2× preference entitles them to $4 million, but since the sale is only $3 million, they take the entire amount, leaving nothing for common holders.
• $10 million sale: The investor takes their 2× preference of $4 million, leaving $6 million for common holders.
• $20 million sale: The investor takes $4 million, with common holders receiving the remaining $16 million.
• $50 million sale: The investor converts to common to take 40% of $50 million ($20 million), which is higher than their $4 million preference. Common holders receive $30 million.

Case 3: 1× Fully Participating Preference

Terms: The investor has a 1× preference with full participation, meaning they first receive $2 million, and then share in the remaining proceeds based on their ownership.

Sale Scenarios:

• $3 million sale: The investor takes their $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million, while common holders get $4.8 million.
• $20 million sale: The investor takes $2 million first, then 40% of the remaining $18 million ($7.2 million), for a total of $9.2 million, with common holders getting $10.8 million.
• $50 million sale: The investor receives $2 million, then 40% of the remaining $48 million ($19.2 million), totaling $21.2 million, with common holders getting $28.8 million. 

Case 4: 1× Preference with a 3× Cap

Terms: The investor has a 1× preference with participation capped at 3×, meaning they get back their $2 million investment and can participate up to a $6 million maximum payout.

Sale Scenarios:

• $3 million sale: The investor takes the $2 million preference, leaving $1 million for common holders.
• $10 million sale: The investor receives their $2 million preference and 40% of the remaining $8 million ($3.2 million), totaling $5.2 million. Since this is below the 3× cap, they keep it all, and common holders get $4.8 million.
• $20 million sale: The investor takes their $2 million preference and 40% of the remaining $18 million ($7.2 million), totaling $9.2 million. However, they’re capped at $6 million, so they stop there, and common holders receive the remaining $14 million.
• $50 million sale: Here, the investor also reaches their cap of $6 million, as their participation amount would otherwise exceed it. Common holders receive the remaining $44 million.

IV. Impact of Multiple Investment Rounds on Liquidation Preference

As a company raises more rounds of investment, liquidation preferences can become more complex. When multiple rounds (like Series A, B, and C) have different investors with varying priorities, there are two main ways these preferences can be structured: Stacked Preferences or Blended Preferences (also known as pari passu).

Stacked Preferences

With stacked preferences, each investment round has priority based on when it was made, with later rounds getting paid first. This structure is sometimes favored by newer investors who want assurance that they’ll recover their investment ahead of earlier rounds. Here’s how it might work in practice:

• Imagine a company has raised three rounds: Series A ($3 million), Series B ($7 million), and Series C ($10 million), for a total of $20 million in investments.
• If the company is sold for $15 million, Series C investors, having the latest round, would be paid back first. They receive their $10 million investment, leaving $5 million.
• Series B investors would then receive up to their $7 million investment from the remaining $5 million, but since that’s all that’s left, they only recover $5 million.
• Series A investors would receive nothing because the sale price doesn’t cover earlier investors’ stacked preferences.

Stacked preferences make each subsequent investment round riskier for previous investors, as they move further down the payout line if the company doesn’t achieve a high sale price.

Blended Preferences (Pari Passu)

In blended preferences, or pari passu structure, all rounds share the proceeds proportionately based on their investment amounts, without one round being prioritized over another. This approach spreads the risk more evenly among investors in different rounds.

• Using the same investment amounts as above, let’s say the company is again sold for $15 million.
• With blended preferences, the proceeds are distributed pro-rata. Here’s how it might work:
  • Series A, which contributed $3 million, would receive a proportionate share of the sale price: 15% of the $15 million, or $2.25 million.
  • Series B, which invested $7 million, would receive 35%, or $5.25 million.
  • Series C, with the highest investment of $10 million, would receive 50%, or $7.5 million.

In this scenario, all rounds of investors get some return, rather than later investors getting prioritized. Blended preferences are often seen as fairer when the company has a diverse set of investors who all took risks at different stages.

The choice between stacked and blended preferences often depends on the investors’ bargaining power and the company’s needs. Later-stage investors, like Series C, may prefer stacked preferences to maximize recovery if the exit is small. Meanwhile, blended preferences are more equitable and can appeal to early investors by giving everyone a fair share of proceeds, regardless of the investment sequence.

V. Negotiating Liquidation Preferences

When setting up liquidation preferences, companies and investors must find a balance that protects investors while also keeping employees and management motivated. Liquidation preferences should ideally provide security for investors without overly limiting the potential rewards for the team running the company.

Investors typically want liquidation preferences to secure their investment, especially in the early stages when the company’s future is uncertain. However, setting high or complex preferences can limit the amount left over for employees and management, who are usually holding common stock or options. If team members feel they won’t see significant rewards unless the company has a very high sale price, their motivation to drive the company forward may decrease.

For example:

• Suppose an early-stage company raised $1 million in a seed round with a 2× liquidation preference, guaranteeing the seed investor $2 million in a sale before any proceeds reach common shareholders.
• If the company later sells for $3 million, the investor would take $2 million, leaving only $1 million for all common shareholders, including employees and management.
• In this scenario, the small remaining payout may discourage employees, as they see limited upside unless the company achieves a very high exit.

Finding a balance often means negotiating preferences that protect investors without excessively reducing potential returns for the team. For instance, a 1× preference, rather than 2× or 3×, can offer investors downside protection while still allowing meaningful upside for common shareholders in smaller exits.

Best Practice: Keeping Preferences Simple and Lightweight in Early Rounds

In early rounds, it’s generally advisable to use straightforward and low-level liquidation preferences, such as a 1× nonparticipating preference. This simple structure ensures that investors get their initial investment back but doesn’t add layers of complexity or significantly impact the returns available to employees and management.

For example:

• A company raises $500,000 in its seed round, with a 1× nonparticipating liquidation preference. If the company is sold for $2 million, the investor would take back their $500,000 first, leaving $1.5 million to be shared among common shareholders, which includes employees and founders.
• This simple approach gives early employees and management a strong incentive, as they can see a meaningful return in even moderately successful exits.

VI. Defining a Liquidation Event

A liquidation event is any situation where a company undergoes a significant change in ownership or control, triggering the payout rights defined in the liquidation preference terms. Liquidation events often include mergers, acquisitions, and changes in control, but they can also cover situations like the sale of all or most of the company’s assets. These events are essential to define in investment agreements because they determine when and how investors receive their payouts.

Types of Liquidation Events

1. Merger. When a company combines with another entity to form a new organization. For example, if Company A merges with Company B, creating a new merged entity, it can trigger a liquidation event for shareholders.
2. Acquisition. When one company buys out another, either through a purchase of shares or assets. For instance, if Company X acquires all shares of Company Y, this acquisition is a liquidation event for Company Y’s shareholders.
3. Change of Control. When there’s a significant shift in who holds controlling interest or voting power within the company. This could be through a sale of majority shares or a voting power transfer. For example, if a new investor acquires 70% of the voting shares, it may be classified as a liquidation event, allowing other investors to receive their payouts.
4. Sale of Major Assets. If a company sells off most of its assets or business units, this can also trigger a liquidation event. For example, if a tech company sells all its intellectual property and core assets, this sale could be treated as a liquidation event.

Standard Language for Defining a Liquidation Event

To ensure clarity, investment agreements often include precise language to define what qualifies as a liquidation event. Here’s an example of standard language:

“Liquidation Event. A liquidation event includes (a) any merger or consolidation of the Company with another entity in which the Company’s existing shareholders do not retain a majority of the voting shares in the surviving entity; (b) the sale, lease, or transfer of all or substantially all of the Company’s assets; (c) the sale or transfer of more than 50% of the Company’s voting stock to a single entity or group acting together; or (d) any other transaction in which the Company’s shareholders receive cash, stock, or other securities in exchange for their shares.”

The term “security” may sound straightforward, but in law, it carries significant weight. Knowing what qualifies as a security might become critical, as it determines whether a transaction must comply with securities regulations. This distinction does not just affect buyers and sellers. It also involves brokers, advisors, and other intermediaries who play a role in these transactions. 

For businesses and individuals, identifying whether a financial instrument is classified as a security shapes how they operate. Adhering to securities laws can be complex, time-consuming, and expensive. Failing to comply can lead to severe penalties, including hefty fines or legal action. That is why it is essential to have a clear understanding of when these regulations apply and how to stay compliant. 

The Importance of Definition

When an instrument is classified as a security, several significant legal requirements and protections come into play:

• Companies issuing securities must register them with the SEC unless an exemption applies. This process involves providing detailed information about the company’s business, finances, and management to the public (See Securities Act of 1933, Sections 5 and 7).
• Issuers and related parties are subject to heightened antifraud provisions. Misleading statements or omissions of material facts can lead to severe legal consequences. For example, Section 10(b) of the Securities Exchange Act and Rule 10b-5 prohibit fraudulent activities in connection with the purchase or sale of any security.
• Brokers, dealers, and other intermediaries involved in securities transactions must register with the SEC and are subject to its rules and supervision. This oversight aims to protect investors from unethical practices (Refer to Securities Exchange Act of 1934, Section 15).
• Violations of securities laws can result in civil lawsuits, SEC enforcement actions, and even criminal charges. Penalties may include fines, disgorgement of profits, and imprisonment. The Sarbanes-Oxley Act of 2002, for instance, increased penalties for corporate fraud and imposed stricter regulations on corporate governance.

Legal Foundations of a “Security”

Federal Securities Laws

The federal securities laws, primarily the Securities Act of 1933 and the Securities Exchange Act of 1934, provide a comprehensive list of financial instruments considered to be securities. The statutes specifically enumerate certain instruments as securities. These include stocks, bonds, debentures, notes, and transferable shares. Each of these instruments represents a form of investment where individuals provide capital with the expectation of receiving financial returns.

In addition to these specified instruments, the laws include catchall terms to encompass a broader range of financial arrangements. These terms are “evidences of indebtedness,” “investment contracts,” and “certificates of interest in profit-sharing agreements.” The inclusion of these categories ensures that the laws remain adaptable to new and innovative financial products that may not fit neatly into the traditional categories. For example, an “investment contract” is a flexible term that can apply to various schemes where people invest money with the expectation of profits derived from the efforts of others. This term was intentionally left broad to prevent promoters from evading securities laws by creating novel investment vehicles not explicitly listed.

An important feature of these definitions is the phrase “unless the context otherwise requires.” This clause means that even if an instrument falls within one of the enumerated categories, it might not be considered a security if the specific context suggests otherwise. This provision allows for flexibility, ensuring that the application of securities laws aligns with the intent of the legislation and the realities of the marketplace.

Judicial Interpretation

While the statutory definitions provide a framework, courts often play their own role in interpreting these definitions, especially when dealing with unconventional investments. Two key questions arise in judicial interpretations:

1. When do unorthodox investments fall under catchall terms like “investment contract”?
2. When might instruments that fit an enumerated category not be considered securities?

To answer these questions, courts examine the economic realities of the transactions rather than relying solely on the formal titles of the instruments. This approach helps prevent individuals or companies from circumventing securities laws through creative labeling.

One landmark case that addressed the first question is SEC v. W.J. Howey Co., 328 U.S. 293 (1946) – Howey case.” In this case, the Supreme Court established the “Howey Test” to determine whether a particular scheme qualifies as an investment contract and, therefore, a security. The test considers whether there is an investment of money in a common enterprise with an expectation of profits derived primarily from the efforts of others. If these elements are present, the investment arrangement is considered a security, regardless of its form.

Regarding the second question, courts recognize that some instruments might superficially appear to be securities but, in substance, are not. For example, not all notes are securities. In Reves v. Ernst & Young, 494 U.S. 56 (1990), the Supreme Court introduced the “family resemblance” test to determine when a note is a security. This test presumes that a note is a security but allows for exceptions if the note closely resembles instruments that are not securities, such as short-term notes secured by a lien on a small business or consumer loans.
Courts consider several factors in this analysis, including the motivations of the buyer and seller, the plan of distribution, the reasonable expectations of the investing public, and the presence of alternative regulatory schemes that reduce the risk of the instrument.

The absence of a unified judicial approach arises because courts may emphasize different aspects of these factors. Some courts focus on the level of commonality among investors, distinguishing between horizontal commonality (where investors pool their resources) and vertical commonality (where a single investor’s fortunes are linked to the promoter’s efforts). Others may prioritize the degree of control investors have over their investments.

A central theme in judicial interpretations is the role of investors entrusting their money to others. When investors lack control over the management of their funds and rely on the expertise or efforts of others to generate profits, there is a heightened need for regulatory oversight to protect their interests. This situation gives rise to agency problems, where the managers (agents) may not act in the best interests of the investors (principals). Additionally, when there are many investors, collective action problems make it difficult for them to coordinate and monitor the managers effectively.

The Howey Test for “Investment Contracts”

Understanding what constitutes an “investment contract” is essential in determining whether a financial arrangement is subject to federal securities laws. One of the most significant developments in this area, as we mentioned above, is the establishment of the Howey Test, which originated from the“Howey case.”

In the Howey case, the W.J. Howey Company sold parcels of citrus groves in Florida to investors, offering them optional service contracts where Howey would cultivate, harvest, and market the citrus on their behalf. Many investors were not farmers and had no intention of working the land themselves. The Securities and Exchange Commission (SEC) argued that these transactions were “investment contracts” and should be registered as securities.

The Supreme Court agreed with the SEC and established a four-pronged test to determine when a transaction qualifies as an investment contract:

1. An investment of money;
2. In a common enterprise;
3. With an expectation of profits;
4. Derived solely from the efforts of others.

The Court emphasized that the determination should be based on the “economic realities” of the transaction rather than its form or terminology.

Detailed Breakdown of the Howey Test

Investment of Money

The first element requires that an individual invests money. This investment is not limited to cash; it can include other forms of consideration, such as services or property. The critical aspect is that the investor provides something of value with the intention of receiving a financial return. The investor is seeking profits, not merely purchasing a consumable commodity or service for personal use.

In a Common Enterprise

The second element involves a common enterprise. Courts have interpreted this in two primary ways:

1. • Horizontal Commonality. This is the majority view, where multiple investors pool their funds into a common venture, and their returns are tied to the collective success of the enterprise. For example, if several investors contribute to a fund managed by a company, and their profits depend on the overall performance of that fund, horizontal commonality exists.
   • Vertical Commonality. Some courts, though in the minority, accept vertical commonality, where an individual investor’s success is directly linked to the promoter’s efforts. There are two types:
     • Broad Vertical Commonality. The investor’s fortunes are linked to the efforts of the promoter, but not necessarily to the promoter’s profits.
     • Narrow Vertical Commonality. The investor’s profits are directly correlated with the promoter’s profits.

Regardless of the approach, the essence is that the investor is part of a venture where their financial outcome is connected to the performance of the enterprise or the promoter.

Expectation of Profits

The third element requires that the investor enters the transaction with the expectation of earning profits. These profits can come from income (like dividends or interest) or capital appreciation. The motivation should be financial gain, distinguishing investment contracts from transactions where the primary intent is to consume a good or service. Importantly, profits should be derived from the earnings of the enterprise or appreciation in the value of the investment, not merely from the contributions of additional investors (as in a Ponzi scheme).

Derived Solely from the Efforts of Others

The fourth element focuses on who is responsible for generating the profits. The investor’s expected profits must come predominantly from the efforts of someone other than themselves. Although the original wording uses “solely,” courts have interpreted this element flexibly, recognizing that investors may have some involvement. The key factor is that the managerial efforts of promoters or third parties are the essential factors in the success or failure of the enterprise. The investor’s role is largely passive, relying on the expertise and efforts of others.

The Howey Test has also been applied in various cases to determine whether certain schemes qualify as investment contracts:

• In Smith v. Gross, 604 F.2d 639 (9th Cir. 1979), promoters sold earthworm beds to investors, promising to repurchase the worms and provide marketing assistance. Investors were enticed by the prospect of high profits without needing expertise in worm farming. The court found this arrangement to be an investment contract.
• In SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974), participants paid to join a multi-level marketing scheme selling cosmetics. Profits were primarily derived from recruiting new participants rather than retail sales. The court held that such schemes are investment contracts because participants invest money with the expectation of profits from the efforts of others in the recruitment chain.

Extending Howey’s Principles Beyond Unorthodox Investments

The Howey Test is not limited to unorthodox or novel investment schemes. Courts have also applied its principles to more traditional financial instruments when assessing whether they qualify as securities. The federal securities laws list specific instruments as securities, including stocks, bonds, debentures, and notes. However, the statutes include a provision stating that these instruments are securities “unless the context otherwise requires.” This clause allows for flexibility, recognizing that not all instruments labeled as “stocks” or “notes” function as securities in practice.

Instances Where Instruments May Not Be Securities

Notes

While notes are generally presumed to be securities, the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990) established the “family resemblance” test to determine when a note is not a security. Under this test, a note is considered a security unless it bears a strong resemblance to a type of note that is not a security, such as:

1. • Short-term notes secured by a lien on a small business or its assets.
   • Notes evidencing a character loan to a bank customer.
   • Notes secured by a home mortgage.
   • Short-term notes secured by accounts receivable.

Reves v. Ernst & Young involved demand notes issued by a farmer’s cooperative. The Court held that these notes were securities because they did not fit into any recognized exceptions and investors were led to expect profits from the cooperative’s efforts.

Stocks

Although stocks are the quintessential example of securities, there are rare instances where an instrument labeled as “stock” may not be a security. The Supreme Court in United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975) examined “stock” in a cooperative housing corporation. Investors purchased shares to obtain the right to lease an apartment, not for investment purposes. The Court concluded that the shares were not securities because they lacked the characteristics of traditional stock, such as the expectation of dividends, transferability, and appreciation in value.

The key principle in securities regulation is that substance prevails over form. Simply labeling an instrument as a “note” or “stock” does not automatically make it a security. Courts scrutinize the actual characteristics and purpose of the instrument:

• If the primary intent is to use or consume the item purchased (as in purchasing cooperative housing for living purposes), it may not be a security (investor’s intent).
• Transactions resembling commercial loans or consumer financing are typically not securities (nature of the transaction).
• Securities laws aim to protect investors in situations where they are at a disadvantage due to lack of information and control over their investments (level of risk and information asymmetry).

The Risk Capital Test as an Alternative Approach

While the Howey Test is the primary method used by federal courts to determine whether an investment qualifies as a security, some state courts have adopted an alternative approach known as the Risk Capital Test. This test is particularly relevant under state “blue sky” laws, which are state securities regulations designed to protect investors from fraudulent investment schemes.

The Risk Capital Test focuses on whether an investor’s funds are placed at risk in a venture over which they have no managerial control. Unlike the Howey Test, the Risk Capital Test centers on the vulnerability of the investor’s initial capital.

This approach originated from the California Supreme Court case Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811 (1961). In this case, promoters sold memberships in a planned country club to finance the development of its facilities. The court held that these memberships were securities under California law because the investors’ funds were used to finance a speculative venture, and the investors had no control over how their money was used.

The Risk Capital Test has been utilized by courts in several states to interpret their securities laws, often leading to a broader definition of what constitutes a security compared to federal law.

The Risk Capital Test differs from the Howey Test in significant ways:

• The Risk Capital Test does not necessitate a common enterprise or the pooling of funds among multiple investors. A single investor’s capital at risk can suffice (no requirement of commonality).
• Unlike the Howey Test, which requires an expectation of profits primarily from the efforts of others, the Risk Capital Test focuses solely on the risk to the investor’s initial capital, regardless of who is responsible for generating returns (no need for profits derived from others’ efforts).
• The test centers on whether the investor’s funds are subject to the risks of an enterprise over which they have no managerial control, making them dependent on the promoter’s honesty and competence (emphasis on capital at risk).

In another case (State v. Hawaii Market Center, Inc., 485 P.2d 105 (Haw. 1971) investors purchased memberships in a discount buying club that promised future benefits contingent on the club’s successful establishment and operation. The Supreme Court of Hawaii applied the Risk Capital Test (economic realities) and concluded that these memberships were securities because the investors’ funds were used to finance the venture, and they lacked control over how their money was utilized.

Conclusion

As new financial instruments emerge—such as cryptocurrencies, alternative assets, and innovative investment schemes—they often blur the lines of traditional definitions. These advancements challenge regulators and courts to reassess and interpret the term “security” in contexts that were unimaginable when the original laws were enacted.

The dynamic nature of these investment vehicles/instruments means that courts must continually adapt. They strive to balance the need for investor protection with the encouragement of market innovation. On one hand, stringent definitions may stifle creativity and the development of new financial products. On the other hand, overly lax interpretations can leave investors vulnerable to fraud and abuse.

Looking ahead, there is potential for legislative updates or new judicial standards to address the changing and developing landscape of financial instruments. The rise of decentralized finance (DeFi), non-fungible tokens (NFTs), and other digital assets may prompt lawmakers and regulators to refine or expand existing definitions.

The need for clarity is paramount. Clear guidelines help investors make informed decisions, assist issuers in complying with regulations, and enable legal practitioners to provide accurate advice. Regulatory bodies like the SEC continue to issue guidance and engage in rulemaking to address novel financial products. For example, in recent years, the SEC has provided insights into when digital assets may be considered securities under the federal securities laws. 

The journey to define a “security” is ongoing and reflects the dynamic interplay between law, finance, and innovation. While the complexity presents challenges, it also offers opportunities for the legal system to adapt and protect investors in new ways.