Raising Capital Legally

Numerous federal and state laws and regulations govern how you can solicit and accept money from investors. Penalties for violating the law can be severe. Most startups and early-stage companies need to raise capital at some point, usually by selling stock or other securities, so it is important to know what you can and cannot do under the law to avoid costly future problems. Interestingly, what constitutes a "security" is not specifically defined in the law, but courts have held that a security is any form of investment contract where the investor puts up money or property for an enterprise that is managed and controlled by the promoters of the business, and where the investor has little or no say in the management.

Under the securities laws, the default rule is that any offering of securities must be "registered" with the U.S. Securities and Exchange Commission ("SEC"). Filing a registration statement is complex and can be quite expensive, even cost-prohibitive for startups and early-stage businesses. But the public policy in the U.S. is to encourage the formation of new businesses, so Congress has provided certain "exemptions" from the registration requirements for qualifying investment transactions. These exemptions allow you to raise capital from investors without registering the offering provided that the conditions for an exemption are met. An "exempt offering" is typically referred to as a "private placement."

A primary purpose of the securities laws is to protect investors by ensuring that the investors have the information they need to properly evaluate the merits and risks of an investment. Accordingly, issuers of stock or other investment securities in a private placement must satisfy the requirements for an exemption, which includes such things as disclosing the financial condition of the issuer, how the invested funds will be used, risks involved in investing in the securities, and information about the people who manage the business. Essentially, the U.S. regulatory scheme for selling investments revolves around "disclosure." Theoretically, a company could sell its stock so that the management can use the proceeds to retire to an island in the Caribbean, so long as the fact is disclosed to the investors (although it's doubtful that anyone would invest in that particular business plan). But the public policy is that prospective investors are entitled to be informed of exactly how their invested funds will be used, and should be given enough additional information to make an informed decision on the chances of earning a return on the investment or losing it all.

In order to raise capital under an available exemption from registration, a company must provide a disclosure document (often called an "Offering Statement" or "Private Placement Memorandum"), that discloses the information that a "reasonable" investor would want to know before deciding to invest. This includes information about the management, the industry in which the company operates, the company's financial condition, the company's business plan, its competition, how much stock or other securities have already been sold to investors and issued to the founders, and other factors relevant to the value of the investment, including the fact that under the securities laws the "restricted" stock cannot be resold until a minimum holding period has passed. [ See article on "Selling Restricted Securities" ] Having received and read such a document, the investor can make an informed decision on investing. The law provides severe civil and criminal penalties for an issuer who withholds relevant information or provides false information to investors.

In addition, the company must have a contract signed by the investor wherein the investor agrees that he/she has received the required disclosures, and understands that there is a minimum holding period before the securities can be sold or transferred. This document is typically titled a "Subscription Agreement" (sometimes "Stock Purchase Agreement"). The Subscription Agreement , properly drafted, protects the company against investor claims should the investment not work out as expected.

Private placement securities are the most common way of financing a startup company, or the early-stage growth of a company. They are also commonly used by "development-stage" companies that already have publicly-traded stock, but for whatever reason do not currently have revenues from operations. There are a great many wealthy investors interested in financing new companies that have the potential to become great companies, or development stage companies seeking to acquire a potentially profitable business. Also, "friends-and-family," even if not wealthy, can be a great source of private capital. But in any case, your documentation is crucial to treating your investors fairly and avoiding regulatory problems for the company. Nevada Business Law attorneys are equipped to help you navigate the minefields and ensure that regulatory problems will not impair your ultimate business success. If your startup or small/development stage business needs investment capital, contact us for the best available information and resources.