Raise money — the right way

Not too long ago the owner of an innovative business asked my advice regarding the most likely channel for raising capital.

Following a product demo and an overview of his marketing strategy, we reviewed his financial condition. He had successfully raised more than $1 million in investment capital from a variety of individuals since founding his company. I was surprised to find that he had never qualified his investors, had largely acquired funds without proper documentation and had never kept his investors apprised of his progress. My advice to him was to clean up his past before approaching a sophisticated investment group regarding raising additional capital.

But it was too late. He never raised the money he needed. It was impossible for him to reconstruct years of neglect.

Several channels exist for capital acquisition, including friends and family, angels, venture capitalists, investment bankers, banks, public markets, strategic partners and my personal favorite, from customers. I'd like to focus on the first three groups.

Many entrepreneurs believe that both federal and state laws that regulate the sale of securities apply only to large corporations. This is incorrect.

These laws -- specifically the Securities Act of 1933, the Securities Exchange Act of 1934 and state "Blue Sky" statutes -- apply to all issuers. The second erroneous belief is that these laws apply only to the issuance of equity securities, most often stock. In fact, they apply to all issuers of securities, including stock, debt offerings, options, warrants, LLC memberships, limited partnership interests and other forms of investments.

Fortunately for the small business, the government has provided a few exemptions from the costly and complicated process of raising money from the sale of securities. The most popular exemption from registration under federal law is the Private Placement Exemption. Regulation D within the law exempts companies from registration on offerings of less than $1 million.

Greater amounts require more disclosure, but the regulation still includes an exemption from registration. Other federal and state requirements must be met, so be sure to consult a professional for advice.

One additional concern often overlooked by entrepreneurs is the type of investor who provides capital to a company. Startups often rely on funds from friends and family to begin operations. Many professionals suggest that subsequent financings come only from accredited investors. Under Regulation D, an accredited investor is defined as an individual who is one of the following: a director, executive officer or general partner of the issuer; or a person with a net worth, together with his or her spouse, of more than $1 million; or a person who has had income in excess of $200,000 in each of the two most recent years (joint income of $300,000).

According to James Greenberger in an article in Business Law, "In connection with the IPO (initial public offering), the SEC will carefully study all prior issuances of stock by the company and demand that it take immediate action to cure any past violation of securities laws. Those remedial actions can delay, stall or even kill the IPO."

Be careful when raising capital. As my associate discovered, cleaning up the mess made by raising capital the wrong way is expensive and sometimes impossible.

Gary Williams is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at [email protected].

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