Providing Startup Financing Solutions Since 2001

A Word of Caution About Soliciting Strangers for Money

I’m not a lawyer, but a businessman, so I’ll say this as best as I can. It’s illegal for you to offer for sale or even solicit investors for any type of security (i.e., your shares) which hasn’t been registered with the federal and state agencies which control such offerings. Even if your offer is exempt under federal and state law, it must still be registered with the proper agencies. If you are based in one state and soliciting an investor from another state, you need to be registered in both states.

This is one place not to scrimp on legal fees.

So what does this mean in plain English, I hear you ask. Well, if you are sending out copies of your business plan, which contains an offer to the reader to sell him or her stock, you are technically breaking the law and could be in serious trouble.

But people do it all the time! How will the government ever find out? It’s a roll of the dice if you do it. If you find an investor and all goes well with your business, with everyone profiting as expected, the investor is highly unlikely to file a complaint against you. Why should he? But if things do not pan out as you promised in your business plan and pitch, the investor will most likely file a complaint against you, claiming that you broke the law, and then sue you for damages.

Let this sink in: you could be in serious trouble if your venture goes south after you accepted investor money without being registered.

I have taken some crazy risks in my day as an entrepreneur but this is one gamble that I would never take.

This is all the more reason to devise a startup strategy that doesn’t require investor capital if at all possible.

Is Your Stock Structure a “Dog’s Breakfast”?

Sophisticated investors, such as venture capitalists, will just as soon walk away from a good deal as take it if the company’s capital structure is a mess. Venture capitalist, Ann Winblad, of Hummer Winblad, sums it up, “More often than not the capital structure is a train wreck which makes it uninvestable by venture capitalists.”

Venture capitalists like nice clean capital structures. If your “startup” has actually been around for a few years and sold shares in various periods to the “3Fs” (i.e., Family, Friends, and Fools) at different prices, you may have a serious problem doing a deal with venture capitalists.

I worked as a consultant with one Seattle dotcom back in 1998 which had this problem. The founder had limped along for the three previous years paying programmers with shares instead of cash for their work on his website, as he looked for investors. Over two dozen individuals had acquired stock, options, or both as a result, which amounted to almost 50 percent of the company’s authorized capital. For a venture capital firm to step in at that point and figure out a valuation which would make everyone happy and eliminate the motivation by the earlier “investors” to sue the company would have been next to impossible. Professional investors do not want to have to worry about your crazy Uncle Ziggy suing the company because he’s not satisfied with the valuation on his shares.

If you feel that you may have a problem here, consult a securities lawyer. It may be possible, in some cases, to roll everything into a fresh corporation and start over before talking to venture capitalists. That is if you can get that motley crew of 3Fs to agree. Good luck.

Lesson: Oftentimes it’s best not to take money from Uncle Ziggy and your dentist. They can be far more trouble than their money is worth over the long run.

Articles on Securities Law

A series of articles provided by Michael T. Raymond, a securities attorney with the Detroit, MI, law firm Raymond & Walsh, and an Adjunct Professor at the Wayne State University Law School.

The purpose of this series is to acquaint readers with the basics of securities law. Securities law governs the raising of capital for business purposes.

1. Overview (starts below)

2. Forms of Business Organization

3. Financing Instruments

4. Non-Public Offering Exemption

5. SEC Small Business Initiatives

6. Intrastate Offering Exemption

7. Regulation D Offering Exemption

8. LLC – Limited Liability Company

9. SCOR Registration

10. Stock Restriction Agreements

11. Anti-Fraud Provisions

12. Dangers of Product Hype

1. Overview

Most people envision stock or bonds when thinking of securities. However, partnership interests, options, warrants, agreements to invest, partnership interests, participations in a pool of assets, certain types of promissory notes and many other arrangements which might commonly be considered an “investment”, involve securities.

Any person who offers or sells any type of a security must comply with the securities laws and regulations of each applicable securities authority. The federal government, through the Securities and Exchange Commission (SEC) and the several states have each promulgated securities laws and regulations. Compliance with the laws of one securities authority does not necessarily constitute compliance with the laws of another.

At a minimum, therefore, sellers of securities must comply with at least two separate set of laws, i.e., the federal law and the law of the state in which the securities are to be offered and sold. If a broker-dealer firm assists in the selling effort, the rules of the National Association of Securities Dealers additionally come into play.

Any time an offering of securities is made the seller must register the offering with applicable securities authorities, or an exemption from registration must be found. One of the first things an entrepreneur should do after deciding to sell securities is to structure the securities offering to comply with a particular form of registration or to satisfy the requirements for an exemption from registration.

For a number of economic, legal and other practical reasons, most entrepreneurs will most likely offer their securities on an exempt basis. From a federal standpoint, the most likely exemption is one for non-public offerings to a limited number of sophisticated persons who have prior business relationships with the seller or who privately negotiate their securities purchases. Another common exemption, known as a regulatory “safe harbor”, involves offerings with specified dollar limitations and/or limitations on the number of “non-accredited” investors. Under certain narrow circumstances, an offering that is entirely intrastate can be exempt.

Either registering an offering or as a condition to establishing an exemption, a seller of securities will almost always be required to make available or prepare and deliver certain disclosures to prospective investors. The breath and content of these disclosures varies depending upon the particular requirements for registration or exemption imposed by the applicable securities authority.

Moreover, a seller of securities will always be subject to the antifraud provisions of the applicable securities authorities, whether the offering is registered or exempt. As a general proposition, the antifraud provisions prohibit deceit and mandate “full disclosure”, i.e., the seller of securities must disclose everything which is material to the proposed investment in the securities. Although most sellers of securities have honorable intentions, it is not uncommon for sellers to experience great difficulty when identifying which matters should be disclosed and which matters need not be disclosed.

Not surprisingly, a seller of securities must be very cautious when making an offering. The implications for failure to comply with the securities laws are severe. For example, noncompliance may result in federal and state securities administrators imposing civil, and possibly criminal, penalties. As importantly, a failure to comply can result in civil lawsuits from one’s investors seeking damages and a return of the invested money.

In most commercial transactions, the rule of thumb is that the “buyer should beware”. Quite to the contrary, under the securities laws, the rule of thumb is that the “seller should beware”. This fundamental difference between securities transactions and commercial transactions should never be forgotten by entrepreneurs considering selling securities.

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