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 these laws, you’ll need to provide your investors with detailed documentation regarding why you want their investment and the potential risks associated with them investing with you. You’ll also need to make many complicated filings with federal and state authorities depending on what types of investors you’ll be pursuing. If you don’t comply with these requirements, you could be liable to hefty civil and criminal penalties, and you may be required to pay back all of the money investors invested with you.
Given the serious consequences of failing to comply with securities laws, below are some general guidelines for staying clear of trouble when raising capital:
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 communications published on your website, the internet and numerous other outlets. If you have a “substantial and pre-existing relationship” with a potential investor, you may be able to comply with the regulations, but you should not, for example, send a broadcast post on social media seeking investors. The devil is in the details, and what you can and cannot do depends greatly on your particular situation. Getting specific guidance from an attorney experienced in securities laws is critical here.
Target “accredited investors” only
To steer clear of cumbersome and expensive filing requirements required by the federal and state laws, startups should aim to offer and sell their shares to “accredited investors” under federal securities laws. Although federal securities laws have multiple definitions for what constitutes an “accredited investor,” one of the most prominent is a person who has a net worth over $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 reason it’s favorable to target only accredited investors is that written disclosure requirements and required filings are much less than targeting non-accredited investors. Indeed, targeting non-accredited investors is fraught with peril and opens up a Pandora’s box of federal and state regulations that come into play.
Stay away from unregistered finders
A common mistake that startups make is using a “finder” to seek out investors when that finder is not registered as a broker-dealer as classified by the SEC. 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. This violation will lead to the investment offering being invalid, and your startup may have to refund the investors all the money they invested in addition to civil and criminal liability.
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.
Disclaimer: This post is informational and educational purposes only. It is not intended to provide any legal advice.