There are basically three places where you can get money to start or grow your business. The first is bootstrapping, the second is debt, and the third is equity financing. Each of these financing options has positives and negatives associated with it.
Bootstrapping is great because you’re funding the business based out of either the cash flow or your personal investment. The nice thing about bootstrapping is it’s easy, it’s straight forward, and you keep everything for yourself—all the profits and all of the value in the business.
Debt financing involves taking loans from lenders. Your ability to get a loan will be based on cash flow and your personal history of paying previous loans, basically your credit. Lenders will ensure that your business has sufficient debt service coverage or their loans to you will be considered too risky.
Unfortunately, if you’re an early stage business, you will not be able to demonstrate historical cash flow. From a startup’s standpoint, traditional debt financing may be a less-viable option, and you’d have to look at SBA guaranteed financing (although that isn’t certain either).
Qualifying for debt financing can be difficult because, when you need it the most, your risk is too high. Also, even if you do qualify and receive the financing, the payments on the loan must be paid first, rain or shine. The payments tend to be constant, though, so proper planning can go a long way.
That being said, securing debt financing frees you from the burden of having additional business partners. Also, once the loan is paid in full, all profits go directly to the owners.
Finally, equity financing means you sell off a piece of the ownership interest (e.g. stock) of your company to an investor. This investor then becomes a partner (i.e. co-owner) in the business. Partners, in the case of corporations and limited liability companies (the most common business entities when equity financing is being sought), gain certain management and ownership rights over the company: They are allowed to participate in certain decisions, receive a portion of the profit, and vote on important company matters.
There are several advantages to equity financing, one being that you have flexibility with allocation of the company’s cash flow. Everything that comes into the company can be put back into growing the company. As such, this is a lower risk for the company overall because money doesn’t have to be devoted to paying bad debt.
Most startups will use a combination strategy of bootstrapping and equity funding. The founders will use personal funds as seed money to get the business venture off the ground and seek investor funding shortly thereafter to grow the business.
There are four key characteristics that investors will look for in companies and entrepreneurs that make them suitable for equity investment.
The types of investors fall into three broad categories, which generally correspond to separate funding rounds for the startup.
Regardless of the type of investor, compliance with state and federal securities laws is vital. Violation of these laws can carry heavy consequences including rescission of purchased securities and even criminal penalties—both for you personally and your business.
The federal government and each of the states have securities laws that limit a company’s ability to sell securities to investors. The Securities and Exchange Commission (“SEC”) administers the federal securities laws, but the state laws, also called Blue Sky Laws, are administered by the securities administrators of each state, which may or may not track the laws at the federal level.
The two general aspects of securities governed by both the federal and state laws are:
Anti-fraud is a key provision of both state and federal securities laws. Generally, we think of fraud as an active deceit on the part of someone—a con artist actively defrauds someone. However, in the securities context, the definition of “fraud” broadens beyond our normal definition to encompass a more passive idea of fraud by omission. It can be not sufficiently identifying the risks for your investors. You never want them to come to you later on and say, “If I’d have only known.”
Registration laws require that, before a company can sell stock, it must register that stock with either the state securities administrator, the SEC, or both. The registration process requires the company to provide certain disclosures and financial information and can cost hundreds of thousands of dollars.
For most small and medium businesses, this process is prohibitively expensive. Instead, these businesses rely on exemptions from registration to do what are called private placements. Federally, the most common exemption from registration is Regulation D. Most states have analogous exemptions.
Regulation D is what’s known as a safe harbor exemption. The SEC created this safe harbor rule to describe the steps a company can take to offer and sell its securities in a way that does not violate the federal securities laws.
Rules 504, 506(b), and 506(c) of Regulation D detail the basic types of offerings, the most fundamental difference being the maximum offering amount. The rules also address the ways in which investors can be solicited, the number of investors that are allowed, the standards for the financial sophistication of the investors, and the information that must be provided to investors.
When securities offerings are made to potential investors, the issuers of the securities are required to make extensive disclosures on the nature, character, and risk factors of an offering in order to comply with the private placement exemption in Regulation D. This disclosure is regularly made via a private placement memorandum (PPM).
The PPM features multiple aspects of the offering, including the terms of the offering, the price(s) for the securities, the management team of the business, the tax implications for the investor, the risk factors, among others.
The PPM should be professionally prepared by a securities lawyer to ensure that proper protections for you and your company are included, and that it provides prospective investors with clearly-stated terms and conditions. Comprehensiveness is vital to protect against future liability at the federal level from unhappy investors.
As always, an off-the-rack document is not the way to go here. The risk factors, capitalization and dilution rates, terms and conditions, etc. will be specific to your offering. Remember, fraud in the securities context includes lies of omission. You should avoid anything that could jeopardize your exemption from registration.
Here at Alexander Abramson we focus exclusively on business-related legal matters. Mr. Alexander and Ms. Abramson have represented and advised business owners for decades on structuring and negotiating financing transactions, preparing securities offering documents, and compliance with federal and state securities laws.
We work with entrepreneurs and real estate promoters seeking to raise capital through private placements of securities (Regulation D), including, stock, LLC membership interests, convertible notes and profit participation arrangements. We deal with required state and federal filings, prepare the purchase and disclosure documents necessary to reduce the risk of securities fraud claims, and guide you through the proper method for offers and sales.
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