This post discusses the five most common mistakes entrepreneurs make in raising capital: (i) playing securities lawyer; (ii) selling securities to non-“accredited investors”; (iii) advertising or soliciting investors; (iv) using an unregistered finder to sell securities; and (v) selling preferred stock to angel investors. There's also a video version of this article.
Mistake #1 – Playing Securities Lawyer
A company may not offer or sell its securities unless (1) such securities have been registered with the Securities and Exchange Commission and registered/qualified with applicable state commissions; or (2) there is an applicable exempt from registration. The most common exemption for start-up companies 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.
Mistake #2 – Selling Stock to Friends and Family Who Are Not “Accredited Investors”
The rule of thumb in connection with private placements is to sell securities only to “accredited investors” (as defined in Rule 501 of Regulation D) in reliance on Rule 506 of Regulation D. There are two significant reasons for this: (1) Rule 506 preempts state-law registration requirements pursuant to the National Securities Markets Improvement Act of 1996 – which means, in general, that the issuer merely must file with the applicable state commissioners (i) a Form D, (ii) a consent to service and (iii) a filing fee; and (2) there is no prescribed written disclosure requirement if the investors are “accredited” – though it still may be prudent to furnish to investors a private placement memorandum (or at least a summary and a set of risk factors). There are eight categories of investors under the definition of “accredited investor” – the most significant of which for entrepreneurs 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. Indeed, if a company 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.
Mistake #3 – Advertising or Soliciting Investors
Subject to certain limited exceptions, Regulation D of the Securities Act of 1933 prohibits issuers from “general advertising” or “general solicitation” in connection with a private placement. These terms are not defined under the Securities Act, but 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 similar media or broadcast over television or radio or on a website; “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. That’s the test: there must be a “substantial and pre-existing relationship” -- and there are a number of SEC no-action letters which discuss what that means; simply put, it means there must a business relationship that is in place prior to the offer sufficient for the issuer to determine that the offeree would be a suitable investor.
Mistake #4 – Using an Unregistered Finder to Sell Securities
Entrepreneurs 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 will be subject to serious adverse consequences (as noted in paragraph #1 above), including giving the securityholders the right of rescission.
Two caveats: (1) In 2004, California enacted a law specifically addressing this issue, which provides for (i) an express right of rescission to any investor who purchases a security from a person or entity that acted as a “broker-dealer” but was not registered; and (ii) the right of the purchaser to sue the unregistered seller for money damages. (2) In 2008, the SEC adopted a new Form D (which, as noted above, is the official notice of a private placement under Regulation D), which must include the identities of all brokers and/or finders engaged in the offering of securities of the issuer. This will obviously result in increased scrutiny of finders that are not registered as broker-dealers.
Mistake #5 – Selling Preferred Stock to Angel Investors
Unless a start-up is raising at least $750K for an angel financing, it may not make sense from a practical standpoint for it to issue preferred stock. Indeed, preferred stock financing are complicated, time-consuming and expensive – plus the company would need to be valued, which could be extremely dilutive to the founders. Accordingly, entrepreneurs are better served by issuing convertible notes to angel investors, which keeps the financing simple and inexpensive, defers the valuation until the Series A round and gives the investors a discount on the conversion price (or a warrant) as a sweetener. Needless to say, if superstar angels are interested in investing in your company, but insist on preferred stock, bite the bullet and take the money; great partners trump all rules.
Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs. Mr. Walker has 15+ years of broad corporate-law experience, including nearly eight years at two prominent New York law firms, where he represented a number of major multinational corporations (e.g., Sony and Daimler), financial institutions (e.g., J.P. Morgan) and private equity firms (e.g., Apollo) in transactions valued in the billions of dollars.