Growth5 Blog

Wednesday, July 7, 2010

Raising Capital: 5 Legal Mistakes to Avoid

Entrepreneur Corner recently posted this article on 5 legal mistakes startups make while raising capital.

These are excellent reminders for entrepreneurs. Check out the article for details, here are the highlights.
1. "Advertising or soliciting investors. With very limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with raising capital."
-Basically, you can't advertise to the general public that you are raising capital via any medium. As far as solicitation, you must have a "substantial and pre-existing relationship" to solicit potential investors via e-mail, phone or any other medium.
2. "Selling securities to non-“accredited investors”. The rule of thumb for startups is to only offer and sell securities to “accredited investors” under SEC Rule 506."
-The most common qualifier for an individual investor is a net worth of over $1 million (can include net worth of spouse to reach this hurdle) OR annual income exceeding $200,000 (joint income with spouse exceeding $300,000) in each of the two most recent years with a reasonable expectation of doing so again in the current year.

It is up to the investor to "check the box" as to which of the eight qualifiers allows them to achieve "accredited investor" status.
3. "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.
-This is a big mistake to avoid. Why? Because if the money is raised without a certified broker, your investors have the right to rescind the sale of their securities and get their money back.

I have an entrepreneur friend who is currently in a lawsuit with a "capital raiser" who was NOT registered with the SEC – it's an absolute mess. He wound up in court when a handful of investors demanded their money back after finding out about the capital raiser's lack of certification, one investor sued when the money didn't come back fast enough, it forced my friend to sue the capital raiser... what a waste of time and energy for all.

Quick question capital raiser, are you registered with the SEC?
4. "Not diligencing the investors."
-You are potentially going to be in business with these people for a LONG time. Have you met them? Do you like them? What is their motivation, their exit strategy? Does it align with yours? Do they bring anything to the company with their investment? Relationships that could be beneficial, industry knowledge? You need to find these things out.
5. "Issuing preferred stock. Unless your start-up is raising $750,000 or more, issuing preferred stock is probably not a good idea. Preferred stock financings are complicated, time-consuming and expensive. Moreover, the company would need to be valued – which is obviously difficult at an early stage and could be extremely dilutive to the founders."
-Using convertible notes to seed investors is often the best way to go when you are just starting out. Why? It keeps the transaction simple, cost effective and avoids having to value the firm at that time. You will need to value the firm at the next round (as the notes will need to be converted at that time), however, there will be much more data available as your company will have been operational (presumably) for that time period – allowing for a much more accurate valuation.

Summary: if you're raising money for your business, hire a decent securities lawyer to help you avoid these potentially disastrous mistakes.

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