The fundamental rule of U.S. securities law is that every transaction involving securities must be registered or exempt from registration. Otherwise it’s illegal.

For a reminder of what exactly constitutes a security, see What is a Security?

Registration is a presumed requirement in every securities transaction. Section 5 of the Securities Act of 1933 makes it illegal to sell, offer to sell, or offer to buy any security unless a registration statement has been filed for the transaction. Sections 3 and 4 of the Act set out the exemptions to the registration requirement. Unless one of those exemptions applies, registration is required. It is the issuer or offeror’s responsibility to prove that an exemption applies.

The primary transactional exemptions are found in Section 4 of the Securities Act.

Section 4(a)(1) exempts transactions by “any person other than an issuer, underwriter, or dealer.” That covers the millions of unregistered re-sales that take place between investors every day. Transactions by dealers, other than those in conjunction with a sale by an issuer, are exempt under Section 4(a)(3) and 4(a)(4). That leaves transactions by issuers—the company issuing the securities—and underwriters.

Section 4(a)(2) exempts “transactions by an issuer not involving any public offering.” This is the private-placement exemption. It enables angel investment, venture capital, private equity, and most hedge-fund transactions. It applies when a startup sells stock to friends and family, or issues stock to the company founders. Section 4(a)(2) enables around $1 billion of private-company investment every year.

Section 4(a)(6) is the “crowdfunding” exemption. This exemption is not yet effective because the SEC is still working on finalizing its rules.  When the crowdfunding exemption goes into effect it will permit an issuer to make a limited public offering of securities without registration. Section 4(a)(6) imposes sharp limits on the amount of funds that can be raised by crowdfunding, and creates substantial logistical challenges.

While Section 4 exempts a wide range of transactions from the Securities Act registration requirements, Section 3 excludes certain securities themselves from Securities Act coverage. The reason that Section 3 securities are excluded is that they are all subject to other regulatory regimes, political oversight, or fall outside the jurisdiction of the Securities Act. Examples include some types of bank securities, government securities, and securities issued exclusively within a single state by a resident of the state.

Section 3 is an abnormality in that it exempts securities from the Act, where the act otherwise applies only to transactions. This is an important distinction. Remember that unless you are running a government or a bank, securities themselves are never registered or exempt. It is only a specific transaction in those securities that is registered or exempt from registration. And every single transaction must be reviewed under this rubric of registration and exemption.

If an offering does not fit within an exemption, it must be registered with the SEC. Since registration is often impractically expensive and time consuming, Section 4 is vital to the flow of capital to startups, investment funds, and closely held businesses.

The primary risk in attempting an exempt offering—an unregistered re-sale or a private placement—lies in failing to fit the transaction within an exemption. Once an offer is made, if not properly exempt, it is already too late to register. The transaction is illegal. It must be stopped, unwound, and tried again after a lengthy cooling-off period. This process can be fatal to a shoestring startup.

Proceeding with a broken transaction is even worse. Because the unregistered offering is illegal, the SEC or any state regulator may order it stopped, fine the offeror, and even bring criminal charges. Even if the regulators leave it alone, any buyer or investor may rescind an illegal transaction, even years later, after seeing how the deal plays out. In a rescission, the offeror must come up with the cash to unwind the sale, even if the original cash was all spent on business expenses like salaries and overhead.

Faced with these options, there is no good solution. The only way to avoid the Scylla and Charybdis of killing the offering or breaking the law is to ensure that every securities transaction is registered or soundly within an exemption–like the safe-harbor rules of Regulation D.