“Ask the Business Attorney” – What Are the Biggest Legal Mistakes Startups Make Raising Capital?

by Scott Edward Walker on July 7th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  I know this stuff tends to be very technical (and perhaps boring), but it is nevertheless critical that entrepreneurs have a basic understanding of the securities laws.

Question

We’ve been bootstrapping our startup and have pretty much run out of money.  We have a few friends and family members who said they would buy some stock to help us out.  We also thought we could put something up on our website and tweet about our need for funds.  Could you please give us a little guidance about these issues.  What are the biggest legal mistakes you’ve seen startups like us make trying to raise capital?

Answer

Any time you are raising capital you need to be very careful – and make sure you’re complying with applicable securities laws.  Below are the seven biggest mistakes I’ve seen startups make.

Mistake #1: Advertising or Soliciting Investors

Subject to certain limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with the private offering or sale of securities.  These terms have been broadly construed in SEC no-action letters.  “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or on a website or broadcast over television, radio or the internet.  “General solicitation” includes any solicitations via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the issuer and the prospective investor sufficient for the issuer/startup to determine that the offeree would be a suitable investor.

Thus, the bottom line is that you may not advertise on your website that you seek funding nor may you solicit investors via Twitter (unless it’s a DM to a person with whom you have a “substantial and pre-existing relationship”).

Mistake #2: Playing Securities Lawyer

A company may not offer or sell its securities unless (1) the securities have been registered with the Securities and Exchange Commission (SEC)and registered/qualified with applicable state commissions; or (2) there is an applicable exemption from registration.  The most common exemption for startups is the so-called “private placement” exemption under Section 4(2) of the Securities Act of 1933 and/or Regulation D, the safe harbor promulgated thereunder.  This is very complex stuff – and now is not the time for entrepreneurs to play securities lawyer.

Non-compliance with applicable securities laws could result in serious adverse consequences, including a right of rescission for the securityholders (i.e., the right to get their money back), injunctive relief, fines and penalties, and possible criminal prosecution.  That being said, no matter how many times I advise otherwise, there are always a handful of clients who decide they don’t want to pay legal fees to comply with securities laws and they handle the issuance themselves.  In a word: reckless.

Mistake #3: Selling Securities to Non-“Accredited Investors”

The rule of thumb for startups in connection with a private placement is only to offer and sell securities to “accredited investors” under SEC Rule 506.  There are two significant reasons for this: (i) Rule 506 preempts state-law registration requirements – which means, in general, that the startup merely must file a Form D notice with the applicable state commissioners; and (ii) there is no prescribed written disclosure requirement.

There are eight categories of investors under the current definition of “accredited investor”– the most significant of which for startups is an individual who has (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. 

If a startup offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues, under both federal and state law.  Yes, there are ways for entrepreneurs to sell stock to non-accredited investors under SEC Rules 504 and 505 (and perhaps other exemptions), but it requires that specific disclosure requirements be met and registration/qualification under applicable state law, both of which are very time-consuming and costly.

Mistake #4 – Using an Unregistered Finder to Sell Securities

Startups often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them.  The problem is that finders must be registered with the SEC if they operating as a “broker,” which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others.”   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-dealer and thus will be required to be registered with the SEC and applicable state commissions.

If he is not registered and sells securities on behalf of an issuer, the private placement will not be valid (i.e., will not be exempt from registration), and the issuer will have violated applicable securities laws – and thus could be subject to serious adverse consequences, as noted above (in Mistake #2).  I discuss this issue in detail in my “Beware of Finders” post.

Mistake #5: Not Diligencing the Investors

In the course of my 15+ years of practicing corporate law (including nearly eight years at two major law firms in New York City), the most common mistake I have seen entrepreneurs and inexperienced deal people make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  Indeed, in the angel financing context, the entrepreneur will, in effect, be married to the angel for a number of years.

Accordingly, at a minimum, the entrepreneur should get references and speak with other entrepreneurs and founders who have done deals with the angel in order to make an informed judgment as to whether the angel is an appropriate individual with whom the entrepreneur should be partnering.  Issues to consider include:  What is the angel’s motivation to invest?  Is the angel a good guy or a jerk?  Can the angel be counted-on and trusted?  Will the angel add significant value (e.g., through his contacts, technical expertise, etc.)?

Mistake #6: Issuing Preferred Stock

Angel investors will sometimes request shares of preferred stock for their investment; however, unless the start-up is raising at least approximately $750K, it generally is not in the entrepreneur’s interest to issue such shares.  Indeed, preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued, which is obviously difficult at such an early stage and could be extremely dilutive to the founders.

Accordingly, startups are better served by issuing convertible notes to angel investors, not equity — i.e., the angels would loan money to the company, which would automatically convert into equity in the first professional (the “Series A”) round of financing; this approach will keep the financing relatively simple and inexpensive and will defer the company’s valuation (i.e., the pricing) until the Series A round.  If an angel insists on equity, the company should issue shares of common stock — which will place the angel in the same boat as the founders (though still requiring a valuation and causing potential problems with respect to stock option grants).

Bill Reichert, Managing Director of Garage Technology Ventures,  briefly discussed the “note vs. equity” issue on The Frank Peters Show (starting at the 22:51 mark) and expressly advised that: “If you’re putting a few hundred thousand [dollars] in, it’s just not worth all the brain damage to price the round. . . [and] it’s not worth spending too much on the lawyers.”

Mistake #7: Selling the Same Shares at Different Prices

Finally, another big mistake that startups make is selling shares of common stock at the same time to its founders and investors, but charging them different prices; in other words, valuing the shares differently depending upon the purchasers.

This issue often comes-up when a startup has waited to incorporate until it has found investors and then issues a majority of the shares of common stock to the founders for a de minimisprice and a minority stake to investors for a few hundred thousand dollars (if not more).  Simply put, startups cannot do that without triggering potential tax problems.

Indeed, the IRS will take the position that the shares were properly valued at the price sold to the investors, and that the difference between what the founders paid and their actual value will be deemed compensation to the founders – triggering not only income tax liability to the founders, but also withholding tax liability to the startup.

Conclusion

I hope the foregoing is helpful.  Again, I know this stuff is very technical and hard to digest.  I think the takeaway, however, is to make sure you talk to an experienced securities lawyer before you start offering or selling securities to anyone.  In fact, you can feel free to call me directly if you have any questions (415-979-9996).  Many thanks, Scott

Tags: , , , , , , , , , , , , ,

4 Responses to ““Ask the Business Attorney” – What Are the Biggest Legal Mistakes Startups Make Raising Capital?”

  1. Eddyelo says:

    Hi, I am working on a tech startup (registered as an LLC) and we are facing a tough decision with a potential investor (Accredited). We tried to issue him a convertible debt note, but he insists on getting an equity stake in the firm…..the problem is complicated because we can't exactly issue shares since we are registered as an LLC….what do you advice???

  2. This is a business issue, not a legal one. Feel free to give me a call to discuss (415.979.9998). Thanks

  3. SS says:

    Hi, I am currently working at a software startup and have been asked by the CEO to research issuing ISOs to certain employees and stocks to a non-accredited investor (whom already invested roughly $50K into the company). Your postings on this issue has been very informative, but I am still confused about whether the Regulation D exemption applies to a non-accredited investor, as it states that stocks could be issued to up to 35 such investors. Much thanks in advance for any guidance you can provide.

  4. I would suggest that you ping me at scott@walkercorporatelaw.com and we can set-up a time to chat. Indeed, this is a complicated area. Thanks