It’s an issue every entrepreneur and new business must face: raising capital for your business. Even though you may start your business with your own nest egg or your company may be able to operate for a while on its own revenues, at some point you’re likely to need outside funding to grow. While capital can come in many forms — debt or equity, private or institutional – this article focuses on raising equity capital. Additionally, banks are not inclined to lend to startup companies so raising equity capital may be a founder’s only option.
Whether you find the challenge of raising capital exhilarating or anxiety-inducing (maybe both!), you need to tread carefully to not land you and your business in hot water. Complex federal and state laws regulate raising capital and entrepreneurs seeking investors must know about them to prepare for them and keep their company out of legal trouble.
Whether the founders form a corporation, LLC, or limited partnership, the sale of equity in those entities to investors are subject to federal and state securities laws. Under federal and state securities laws, such sales require you to comply with disclosure, filing and form requirements unless you qualify for an exemption. Startups that fail to comply with the applicable securities law requirements expose themselves to substantial financial penalties, rescission of investment agreements, and other civil and criminal fines and penalties.
Given the serious consequences of failing to comply with securities laws, below are some general guidelines for staying clear of trouble.
Be Targeted in Your Search for Investors: No General Advertising
Inexperienced entrepreneurs may be tempted to cast a wide net in their search for investors, but this can lead to serious and costly mistakes. Generally, startups are prohibited from raising capital through “general advertising” or “general solicitation.” The SEC interprets these terms very broadly and they include any communication published on a website, the internet, newspaper, magazine, and other outlet. The SEC 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 posts on social media. However, a DM to a person whom you have a “substantial and pre-existing relationship” might be okay if it complies with applicable securities laws. The devil is in the details. Getting specific guidance from an attorney experienced in securities laws is imperative here.
Target "Accredited Investors" Only
To steer clear of cumbersome and expensive filing requirements required by the SEC, startups should aim to offer and sell their shares to “accredited investors” under SEC Rule 506. Rule 506(b) is the most popular and widely used exemption for raising capital. The rule allows an unlimited amount of money to be raised in a transaction, called a “private placement”, without solicitation or advertising to market the shares, as long as certain requirements are met. There are multiple categories of investors that qualify as “accredited investors” under the current SEC regulations. The most significant of these for startups are a person who has a net worth exceeding $1 million, either individually or with their spouse, or a person who has an annual income exceeding $200,000 ($300,000 for joint income) for the last two years with the expectation of earning the same or a higher income in the current year.
The reasons that it is favorable to target only accredited investors are that written disclosure requirements and required filings are greatly reduced compared to other exemptions 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, targeting such investors is fraught with peril and opens up a Pandora’s Box as the federal and state disclosure and filing requirements quickly become more complex and expensive.
Stay Away From Unregistered Finders
A common mistake startups make is using a “finder” to seek out investors where that finder is not registered as a broker-dealer as classified by the SEC. For example, a well-connected consultant, financial advisor or investment banker 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), he 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.
Choose 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 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 agreements. With a convertible note, the investors would loan money to the startup, which 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. With a SAFE (Simple Agreement for Future Equity), this instrument is very similar to a convertible note, but it is not a loan in that it has no interest rate or maturity date.
Experienced Legal, Tax, and Financial Advisors Are Essential
The right legal, tax, and financial advisors are necessary to prevent making critical mistakes in raising capital. It is imperative that your advisors have securities law experience and you plan your strategy for compliance with SEC rules or to obtain and comply with an appropriate exemption. Receiving funding is an exciting time for your business. Make sure you have the right advisors to guide you through the capital raising process so compliance issues do not dampen your success.
At GARZA, we understand the complexities and many considerations that go into raising capital for your startup. We are here to guide you through the process and make sure your company’s interests are protected throughout.
We offer a complete spectrum of legal services for business owners and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer you a LIFT Your Life And Business Planning Session, which includes a review of all the legal, insurance, financial, and tax systems you need for your business. Schedule online today.