Legal Know-How For Raising Capital

Many growing businesses turn to private offerings, such as angel investments, to raise the capital necessary to accelerate from survival to marketplace arrival. It may be an especially attractive option for business owners to sell interest in their company without giving up management rights or committing to a definite timeline to repay. While these agreements are great alternatives for needed capital, there are many regulatory issues to navigate.  

These types of agreements, some known as securities, are sold through a private offering, which raises money like a public offering, but usually smaller in scale, with key restrictions. Offering documents (contracts, disclosure materials, etc.) are drafted by the company’s attorney and are then filed, along with the proposed figures, with the Securities and Exchange Commission (SEC). When selling a security, the private offering protocols discussed below typically have to be observed. Here is what you need to know regarding the regulatory requirements for raising capital:

Keep it private.

The “private” aspect is a key requirement in order to avoid the expense of a “public offering.” Private offerings are not made to the general public and are limited to parties with a substantial pre-existing relationship with the business. Moreover, once the investors purchase, they typically cannot resell the shares to third parties. 

Securities Filings

The state and federal securities bureaus have to be notified of an offering before monies are taken in. Filings must be made with the federal government and any state in which an investor resides. These papers are usually not reviewed, but kept on file. The state laws that govern these filings are called “blue sky” laws, hence the term “blue sky filings.” Businesses should plan and budget for making these filings, which carry fees at the state level that can range from approximately $100 to $1,200. Failure to file can not only invalidate the offering, but expose the company principals to severe liability/penalties. For example, if the investors raise $250,000 but the company doesn’t file, the principals of that company could be personallyliable for the 250K if there are no filings. This is so even if the money has already been legitimately spent on the venture. For most states, companies must file within 15 days of setting out the terms and giving the investor the materials necessary to make an investment. However, NY is very strict and requires the filing be made before any solicitation.

When raising capital through private offerings, a business must also file Regulation D (codified under SEC Rules 501-508) with the federal SEC. The rules have different paperwork and disclosure requirements for different offering amounts. Rule 501 sets out the income test for the kind of high-net-worth party who can invest in a private offering (so called “accredited investors”). Visit http://www.sec.gov/info/smallbus/qasbsec.htm for more information on Regulation D.

Disclosure and Transaction Documents

Almost all private offerings rely on a suite of documents to satisfy legal and informational requirements. The chief document is the private placement memorandum (PPM). A PPM will lay out fundamental information about the business venture, its principals, its target market, its history, and so on. Critically, it will also clearly communicate all the investment risks. Failure to do so will expose the company’s principals to claims of fraud. The PPM will also lay out the fundamental deal structure. There will also be an agreement (such as an operating agreement for LLC’s) that governs the investors’ relationship with the LLC after investment.  And finally, there will be an agreement to actually transfer ownership of the units or shares to the investor (in an LLC it is known as a “subscription agreement”).

 Raising equity financing can close the gap and enable business owners to capitalize on the strength of their brand, operation, or idea by selling equity to raise funds. However, dotting the I’s and crossing the T’s when it comes to meeting the regulatory requirements is essential.