Are You Ready to Raise Capital for Your Business? Take a Beat to Avoid Problems
Congratulations! You’ve decided to start a business or to be an entrepreneur. Or you’ve decided it is time to grow your business further. Now, if you can just raise the capital to give your business a go…
Perhaps you tapped into your savings or nest egg. Maybe the business is generating enough revenue to get by. But eventually, you may need outside funding – whether from friends and family or from other investors. It could come in the form of debt or equity from private or institutional investors. Today, let’s focus on raising capital.
Beware! Raising capital is fraught with peril. There are complex federal and state laws that regulate raising capital, regardless of whether the business is a corporation, LLC, or limited partnership. Entrepreneurs seeking investors must know about these laws and regulations to keep their company (and themselves) out of legal trouble. In particular, these laws require you to comply with disclosure, filing, and form requirements – with only limited exemptions
The risks from non-compliance are real. Startups that fail to comply with the applicable securities laws expose themselves to substantial financial penalties, rescission of investment agreements, and other civil and criminal fines and penalties.
Here is some general guidance for staying clear of trouble, but consulting the right legal, tax, and financial advisors are necessary to prevent making critical mistakes in raising capital. Taking the time to raise money correctly is important. So take a beat, think it through, and get the help you need now to avoid costly problems later.
Beware of General Advertising – Consider Targeted Investors
Fight your excitement and urge to look far and wide for investors. “General advertising” or “general solicitation” is prohibited as a means to raise capital unless the onerous (and expensive) SEC registration requirements or the additional requirements of Rule 506(c) are complied with. The SEC interprets the term “general advertising very broadly. The term includes any communication published on a website, the internet, newspaper, magazine, and other outlet. No Facebook, LinkedIn, Snapchat or Instagram posts. No TikTok videos either. The SEC generally also prohibits any requests via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the startup and the prospective investor. Thus, for example, entrepreneurs should not solicit investors generally via broadcast mails unless they are prepared to register with the SEC or comply with additional disclosure and filing rules. Direct communications to a person with whom you’ve had a substantial and pre-existing relationship might be acceptable. Getting specific guidance from an attorney experienced in securities laws is imperative here.
To steer clear of cumbersome and expensive filing and disclosure requirements, startups should aim to offer and sell their shares to “accredited investors” under SEC Rule 506.
What is an “accredited investor” under current SEC regulations? An accredited investor is an individual with who had an income in excess of $200,000 in each of the two most recent years or joint income with his/her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; a net worth exceeding $1 million not including the value of the person’s primary residence; or is a director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.
It is favorable to target only accredited investors because written disclosure requirements and required filings are greatly reduced compared to sales involving non-accredited investors and outright full registration of the securities under federal and state law. Although the exemptions do allow for a limited number of unaccredited investors to be targeted, doing so opens up many significant issues and federal and state disclosure and filing requirements quickly become more complicated and expensive.
Using an accredited investor questionnaire is essential.
No Unregistered Finders
In the excitement to get going, some startups make a big mistake. They turn to a “finder” to seek out investors where that finder is not registered as a broker-dealer as classified by the SEC. Beware of the well-connected consultant, financial advisor or employee who might offer to raise capital for your startup. If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), she will generally be deemed a broker or dealer. If the finder is not registered with the SEC or the Financial Industry Regulatory Authority (FINRA) and sells securities on behalf of a startup, the startup will have violated applicable securities laws and the offering will be invalid. Further, the investors have the right to rescind the invalid sale and get their money back. Lawsuits are not a great way to start a relationship with your investors.
The Right Investment Vehicle
Unless you are raising close to $1 million or more, issuing preferred stock is probably not the best idea. Preferred stock financings are complicated, time-consuming and expensive. Furthermore, they may require the startup to get a valuation. Valuing the company at such an early stage is highly speculative, very difficult, and could result in heavy dilution to the founders’ shares which harms their equity position relative to future investors.
A better option to consider for seed investors is issuing convertible notes or using SAFE (“Simple Agreement for Future Equity”) agreements. A convertible note, is a way for investors to loan money to the startup, and that loan would automatically convert into equity in the first professional (the “Series A”) round of financing. Compared to issuing preferred stock, this approach is less complex, relatively inexpensive, and defers the company’s valuation until the Series A round. A SAFE is another instrument that is similar to a convertible note, but it is not a loan because it has no interest rate or maturity date.