Nearly every entrepreneur has faced the same problem early in the life of their venture: the need for more capital. Some entrepreneurs make the mistake of taking the “do it yourself” approach to raising money from investors. Unfortunately, if the multitude of state and federal securities regulations are not carefully followed during early fundraising events, the value of the new company itself can be greatly diminished. If securities regulations are not followed during the early stages of the company, future sources of funding like venture capitalists or angel investors will see the risk associated with the earlier fundraising activities and devalue the company, or decline to invest at all. The risk may also become apparent during the due diligence phase of a merger or acquisition, and ruin that opportunity, too.
So how does it work? Securities regulations are broader than most entrepreneurs think. A “security” can be common stock, preferred stock, bonds, investment contracts, LLC membership units, limited partnership units, and even some debt obligations, including promissory notes. Any time a person invests money in a business that he or she does not run, in expectation of future returns, securities are being sold. Every sale of a security must either be registered with the Securities Exchange Commission (and the applicable state securities commission) or be made pursuant to a specific exemption from registration. There are no other options. Registration is typically prohibitively expensive and, thus, most sales of securities are made pursuant to an exemption from registration, such as one of the exemptions for a “private offering.”
There are many exemptions from registration available that allow an entrepreneur to raise capital. Each exemption has its own set of requirements, such as the timing of the sale, the total amount of capital that can be raised, where the securities can be sold, restrictions on advertising, and to whom the securities may be sold, just to name a few. In addition, an entrepreneur must decide what information to disclose to investors that will not later be deemed misleading. “Puffing” the likelihood of success of the business to investors could be considered misleading. On the other end of the spectrum, the issuer ends up over-disclosing every possible risk no matter how unlikely it is to occur. To say that compliance with an exemption is time-consuming and expensive is an understatement.
If an exemption from registration is not meticulously followed, severe consequences await. In a worst-case scenario, the issuer (the company whose securities are being sold) and its principals can face criminal charges. Even if no criminal charges are brought, the state and federal securities commissions can impose civil penalties for non-compliance, such as hefty fines or injunctions against raising capital in the future. In nearly every instance of non-compliance, however, the purchasers of the securities get “rescission rights,” meaning, the right to force the issuer to return the money it received from investors. If the issuer no longer has the funds, the principals may be forced to repay investors out of their own personal assets.
A serious and often overlooked consequence of raising money without registering the security or strictly adhering to the exemption requirements is encountered when the issuer seeks to raise additional capital from larger, more sophisticated investors such as venture capitalists or angel investors. During the due diligence phase of these later fundraising events, the venture capitalist or angel investor will want to know about any prior fundraising the company has conducted. When these sophisticated investors learn of past fundraising events that were not properly conducted, they will likely devalue the company by adding a large contingent liability to the company’s balance sheet to account for possible fines or litigation costs.
A similar fate awaits the company when seeking to conduct a merger or acquisition because the risk and associated liability are the same to the potential purchaser. This risk is often overlooked by eager entrepreneurs who are desperate to quickly raise money and are not concerned with following the law.
Bottom line: Being aware of the securities laws and following them carefully during the early stages of a company’s growth can make it easier to raise capital in the future when it really counts.