Raising capital for your business should be an easy process, but when you are selling securities (equity or promissory notes), you can quickly fall into a whole web of legal issues that really can be prohibitive for very small raises. These are ten things that can help guide you to the right decision, but it is not meant to be a how-to guide. Use accordingly.
1. Do Not Google-Fu This Stuff
Do not be one of those naive business owners who think that they need only a business plan and a boilerplate stock purchase agreement to raise capital for your business. Not only are these contract forms a complete joke in their adequacy, but using them without understanding the rules and regulations of buying and selling securities is frankly just unnecessarily dangerous. Do-it-yourself legal services can be very helpful, but this is one area that doing it yourself just does not make sense. Worst case scenerio is not just civil liability, but actual criminal charges for noncompliance with securities law.
2. Structure Your Corporation, LLC or LP Before You Start Selling Equity
In the beginning, your entity is likely set up with a basic corporate structure for you and your founders. If you already have multiple founders or owners, then your entity should already be structured to contemplate issues of distributions and control, but it is when you add more owners, especially minority owners, that these issues become more consequential. Any substantial investor will have their own demands in addition to the collective demands of all outside investors.
This matter can get a little complex depending upon the sophistication of your investors and what you are willing to give up. From a company’s perspective, strict control given to the founders and making outside investors virtual silent partners is usually the most preferred and easiest way to structure your entity. This is why the Limited Partnership structure is very common among many significant capital raises–it is a perfect structure for founders who want to maintain control of their operating entity and still give up even a majority in equity interest.
3. Know the Basic Terms You Want and Investors Want
Some of the common issues that are considered by an investor include (1) liquidation and sale restrictions; (2) dilution issues; (3) voting preferences and classes of shares; (4) participation, control, and information rights; and (5) vesting, shareholder, management agreements restricting founder ownership and salary.
4. Raising Funds for Equity is Governed by Federal and State Securities Law
If you are offering to sell a security, such as the sale of stock of your corporation or membership units of your LLC, you must comply with Federal and State securities law. For Federal law, Regulation D of the Securities Act of 1933 is a federal law that requires you to register any offering with the Securities Exchange Commission (SEC). Each state has its own agency for registration, reporting, and notice requirements, but the application of state law for purposes of registration or other requirements beyond the Federal law are limited.
For the most part, promissory notes and especially convertible promissory notes for raising funds for businesses are also governed by securities law.
5. Find an Exemption to Avoid Costly Security Registration Under Federal and State Securities Law
Registration for any offering is exceedingly expensive and are intended for public offerings or very large raises. Accordingly, virtually all small and medium business capital raises are under an exemption of Regulation D (and applicable state’s exemption). An exemption will permit you to make your offering without having to go through the costly process of making a federal registration. Such exemptions still require companies to file what’s known as a “Form D” after you first sell your company’s securities or when first commencing general solicitation.
These are the federal securities exemptions:
- Maximum Raise: $1 Million (within 12 month period)
- Number of Investors: No Limit
- Resale: Restricted (not for resale) or Unrestricted (if exempted)
- Mandatory Disclosure: Generally None; Disclaimers
- General Solicitation: Only to Accredited Investors (self-certified)
- State Law: State law and registration usually apply
- Maximum Raise: $5 Million (within 12 month period)
- Number of Investors: Unlimited Accredited Investors (self-certified); 35 Unaccredited Investors
- Resale: Restricted (not for resale within 6+ months)
- Mandatory Disclosure: Disclaimers, Financial Statements, etc. to Unaccredited Investors
- General Solicitation: None
- State Law: State law and registration sometimes apply
- Maximum Raise: No Limit
- Number of Investors: Unlimited Accredited Investors (self-certify); 35 Unaccredited Investors
- Resale: Restricted (not for resale within 1 year)
- Mandatory Disclosure: Disclaimers, Financial Statements, etc. to Unaccredited Investors; Available for Questions
- General Solicitation: None
- State Law: No State Law Registration (but notice usually applies)
- Maximum Raise: No Limit
- Number of Investors: Unlimited Accredited Investors (reasonable steps to verify)
- Resale: Restricted (not for resale within 1 year)
- Mandatory Disclosure: Disclaimers, etc.; Available for Questions
- General Solicitation: Only to Accredited Investors
- State Law: No State Law Registration (subject to challenge)
6. An Exemption Still May Require State Notice Requirements
Federal law is the governing authority for private offers that cross state lines; however, even if falling in one of the previously mentioned exemptions, many states still require you to disclose or notice the state’s security commissioner of the use of the exemption (often within 15 days of your first sale and in same or similar form as Form D).
Federal law generally limits the ability of the states to review, limit, or otherwise restrict the sale of securities. Most states, however, still require notice and filings even if the offering falls under a Federal exemption. Before offering any security in any state, each state’s securities law must be evaluated for compliance in order to make proper filings or even registrations.
7. Rule 504 Exemption is Attractive for Investors, but Usually Coupled With State Filing (Small Corporate Offering Registration – SCOR)
The vast majority of states require registration of offerings exempt under Rule 504. Such offerings are typically coupled with a uniform state small corporate offering registration (SCOR) filing. Not all states follow these SCOR procedures, though Rule 504 offerings are intended to be regulated by the states.
SCOR filings are not an exemption because it requires you to actually file a full registration, but the benefit is that those states participating in SCOR have uniform forms.
There are many states that do not even accept SCOR forms, such as Alabama, Delaware, Florida, Hawaii, Kentucky, and New York. Some states will automatically approve the forms if complete and accurate without a merit review; such states include Connecticut, Georgia, Illinois, Maryland, New Jersey, Vermont, and Washington. Some states are known to be specifically difficult in its merit-review process; such states include Arizona, South Carolina, Iowa, and Washington. And of course, there just some states that are hostile to these types of filings, including California, Massachusetts, and Texas.
8. Disclose As Much as You Can Through A Private Placement Memorandum
The general rule is to disclose everything that a potential investor would reasonably want to know before making the investment decision. Regardless of the exemption and the disclosure requirements, having a private placement memorandum (PPM) prepared to disclose the risks and prospects of the investment to the potential investor is an essential way to protect the business from future liability from both the SEC and jaded investors.
A PPM is an expensive document to prepare, but it is a part of the professional presentation of a your business’ offering. Often you have to include its associated costs in the raise itself; additionally, many law firms and even accounting firms that prepare audited financials may be willing to delay payment in the right circumstances.
A PPM includes material that is designed to disclose essential information to potential investors; such material often includes: cover sheet, table of contents, key disclosures, executive summary, risk factors, purpose and use of proceeds, capitalization and dilution, financial data and analysis, business management and plan, term sheet description, subscription agreement, and investor questionnaire. Again, be very careful of boilerplate PPM’s that you may find online–much of the actual content is case specific and this is not a plug-and-play process.
9. General Solicitation Includes Solicitations to People You Do Not Know
Pretty much all mass advertising is considered general solicitation. This includes cold calling, e-mail spamming, mass mailing, seminars, or open website offers. This typically does not include solicitations to people you know like your business contacts and relatives. Even online sites that are “private” for pre-qualified investors and are password protected are typically not considered general solicitation.
10. Retail Crowdfunding Is Still Being Developed
As noted above, there does not yet exist any general solicitation for unaccredited investors, but the comment period for these proposed regulations has ended a while ago. An issuer could raise up to $1,000,000 without having to register with the SEC. The provisions provide different rules depending upon how much is raised. All investors must receive educational materials to insure that they appreciate the risk involved, but for offerings of $100,000 to $500,000 would have to provide additional financial data, and offerings of between $500,000 and the $1,000,000 cap would have to provide audited financial statements. The general public, accredited and unaccredited alike, could invest, subject to individual investment limits based on an annual income of $100,000. Everyone can play, but the wealthy get to play a little more. Like the rest of Rule 506, investors would have to hold securities for one year.
Securities might be offered either through a registered broker-dealer or a “registered funding portal,” but it’s not entirely clear what the latter is. Guidance on that issue will probably not be available until the end of the summer. In the short-run, the only option is to use a registered broker-dealer, as is the case with accredited crowdfunding.