Recently I was trying to help a client extricate himself from a mess he had created by taking money for his business from the wrong people. His business was growing but had been experiencing growing pains, and he couldn’t borrow to take things to the next level. So he approached some potential investors about investing in the business. As the deal proceeded, his gut told him there was going to be trouble, but he needed the cash and let them buy in anyway. It wasn’t long before he found them making outrageous demands and even threatening shareholder litigation.
Depending upon the business entity the business uses, you may raise money by selling shares of stock, membership interests, or partnership interests. In selling equity, you and your business must exercise care so as to prevent giving control of the business to investors and to ensure compliance with federal and state regulations affecting such sales.
While you may first turn to friends and family for a capital infusion, it’s important to understand that you can’t sell equity in your company to just anyone. You must comply with federal securities regulations, even if your business is relatively small or young. And one of the crucial distinctions is the difference between accredited and unaccredited investors. An accredited investor is someone who has $1 million in net worth, or in the last three years has earned at least $200,000 a year if he or she is single, or $300,000 a year if he or she is married. With these investors there is far less documentation than there is with unaccredited investors.
You can only sell equity in your firm to 35 or fewer unaccredited investors. But whether you raise money from one or 20 unaccredited investors, you will need audited financials and a private placement memorandum. The cost of preparing these documents can easily run $10,000 or more.
The irony is that it costs more to raise money from people who don’t have a lot of money than it does to raise money from rich people. The U.S. Securities and Exchange Commission figures if you have a significant net worth you don’t need to be protected like “widows and orphans.” Even if your unaccredited investors are family members or friends, you must provide these documents.
That means, for most young companies, the investor of choice is an accredited investor. Generally, accredited investors have the financial resources and knowledge to rationally make business investments. You do not have to provide audited financials or a PPM to an accredited investor. Still, it’s a good idea to share your business plan and financial information to help avert misunderstandings later.
Even if you manage to satisfy the securities regulators, don’t forget the gut check. While equity investment may seem like “free money” (after all, you don’t repay it unless your business succeeds), in reality, turning even part ownership of your firm over to investors can make it the most expensive money you’ll ever take.