Crowdfunding Lawyers

Compliance: Staying on the Straight and Narrow While Raising Capital

February 3, 2023
Compliance: Staying on the Straight and Narrow While Raising Capital

Raising capital is a complex tightrope walk. You must choose the right structure, ensure you have the right team, and understand the rules that apply to your deal. Failure to comply with the rules and regulations can lead to lasting negative impacts – think jail time, not just fines and fees.

This is particularly true if you’ll be working with an organization that you pay to raise funds for you – a broker-dealer. This is the only entity you should pay to raise capital on your behalf. Anything less and you could see some nasty fallout.

But why does it matter? Surely the government won’t throw the book at you if you step a toe out of line, right?

That’s precisely what the SEC will do. The organization has no sense of humor and no willingness to let shenanigans slide.


Three Brief Stories

Let’s look at a few stories to drive the point home about why compliance matters and the lengths that the government will go to if you shirk your responsibilities.


A Successful Real Estate Syndicator

Once, there was a successful real estate syndicator. He had multiple deals on the table, and all seemed to be going very well. Then one of his deals hit trouble and needed money. Unsure what to do, he looked around and realized that another of his deals was more than flush with cash reserves – a stalled construction project with deep cash reserves. It seemed like a perfect match. Without telling anyone, he borrowed money from the stalled project and funneled it into the one that was short of cash.

Eventually, he lost both. The project with cash flow problems was foreclosed on and he lost all the money there. The other project failed because he mismanaged funds.

Ultimately, he ended up going to prison for several years because he decided to rob Peter to pay Paul.


An Oil and Gas Investor

Here’s another example – an oil and gas client wanted to fund a two-well program. He was seeking $2 million per well and raised those funds successfully. However, the program encountered cost overruns and it took all the money he’d raised to drill the first well.

Without money to drill the second well, his project would grind to a halt, so he sought alternatives. He thought that getting creative would be a good solution – he would start a new program, raise funds within it, and use that money to finish the first project. When the two wells were in production, he could then repay the borrowed funds, and no one would be the wiser.

Unfortunately, that is illegal. He ultimately went to prison for it.


FTX – The Example of Sam Bankman-Fried

Few companies had the allure of FTX. Not only was it a cryptocurrency brokerage, but it promised to be green, forward-looking, and altruistic – all the things that seem to be missing from most of today’s brokerages. The problem? FTX was built on a foundation of lies.

The premise of it was this: FTX took investor funds and deposited them into cryptocurrencies. They transacted them and took a spread on the transactions. It was relatively safe, although all such processes have some risks.

The issue is that FTX did not stop there. Instead of upholding their fiduciary responsibility, the company decided that they could trade and take advantage of a bigger spread. They started a hedge fund and built a team that looked good on paper but were ultimately useless.

This happens more often than many people believe. Companies create teams and give important titles to people who have no business being a COO or CMO. They don’t know necessary to fill the role and are usually unregistered. They don’t have the qualifications or licensing to qualify them for the role.

In the end, the team is made up of people with titles but no experience. They have responsibilities but lack the knowledge of how to uphold them.  Then the business ultimately crumbles from within due to problems that could have been foreseen and worked around with the right individuals in key positions, or at least hiring a third party to guide on compliance and legal matters.


The Moral of the Stories

While brief, these stories illustrate a simple moral: don’t misuse investor funds. If you find yourself in trouble, just face the music. Don’t get “cute”. Don’t seek “creative” ways out of the situation.

Of course, it’s best to avoid the situation from the outset, and that’s where doing your due diligence, in the beginning, is critical. Running short of cash is usually a byproduct of poor planning, not researching the variables, and not assembling the right team before launching the deal. Doing things correctly from the start will prevent you from finding yourself in a situation where this type of creative structuring might seem necessary.

It’s also important to hire an attorney before your deal gets underway. Why is it so important that you have an experienced syndication attorney by your side from the start? Here are a few of the mission-critical roles and responsibilities they’re responsible for:

  • They structure deals properly.
  • They document how the deal is supposed to go.
  • They communicate with investors about how the deal will operate and how the company will be managed.
  • They help ensure you’re not mismanaging/misusing funds.


Why It’s Critical to Have the Right Guidance

Haphazard team building isn’t unique to companies like FTX. Sadly, it’s all too common. Someone with little experience or knowledge and no real qualifications gets the title and finds themselves responsible for leading the company and making sound decisions. That usually ends poorly for all involved.

Instead, they should hire someone from outside the organization, even if it’s only for compliance and legal guidance. This is essential to ensuring informed decision-making while the newly minted executive gains the experience and knowledge necessary to lead the company. Running a successful deal requires more than just a dream and the willingness to put in some work.

Achieving success in this space requires a great deal of planning and preparation. For instance, suppose someone wants to dominate the laundromat industry. They have an executive summary in hand, and they’ve spoken with several business owners who are ready to sell to them. However, if they haven’t prepared sufficiently, the document requests list is often enough to persuade them to go another route.

Would-be dealmakers and business leaders must achieve specific knowledge, understanding, and preparation. Making dreams come true is great, but this space isn’t the same as others. You’re not taking insured loans from banks. You’re taking hard-earned cash from real people. You’re committing to giving those investors a return on their money, and if your vision crashes and burns, it might take your investors’ life savings with it.


Be Prepared for Scrutiny

All deals are subject to intense scrutiny. If you think you can get creative and fly under the radar, think again. An incorrectly structured deal or a situation where you’re trying to raise funds with one project to fund another will raise red flags with many observers.

Your deals are being watched by the SEC, FINRA, and state regulatory bodies. That means proving that you’re qualified to raise money is vital. A third-party organization can help ensure that’s the case.


Establishing Credentials

Finally, working with a third party can help establish credibility for your deal. After all, if you’re new to this, why would any investors take a risk on your offer? The potential reward you’re promising is only half of the equation.

What have you done in the past to instill confidence in new investors? Why should they believe that you can do what you say you can?

An experienced compliance specialist can help ensure that you make a compelling case for potential investors. It’s all about establishing your track record and showing proof of past performance. That often means assembling the right team – a financial accountant or bookkeeper to manage investor reporting and holdings, for instance.

With the right team in place, you can avoid the pitfalls we’ve discussed in this post. You don’t have to worry about going bankrupt, and you have expert guidance to help you avoid the potential misuse of investor funds and the prison time that goes along with it.


In Conclusion

You need capital to breathe life into your dream. However, the situation is complex, and you can’t afford to step out of line. “Creative” deal structuring all too often leads to failure and even prison time. The problem that many dealmakers encounter is that they don’t know what they don’t know.

Many outright failures could have been avoided if decision-makers had simply created an experienced team from the beginning or sought out experienced third-party guidance for at least the compliance and legal aspects of their deals.

The most important part is this: if you’re not 100% sure that you know exactly what you’re doing and what’s required of you at every step, you need the right people to support your efforts. Even the most experienced entrepreneurs understand that they cannot go it alone.

Know your needs. Build your team from the beginning. Understand the requirements placed on you for compliance with national and state rules and regulations. If necessary, work with a third party to guide you through business formation and structuring your offer. Reach out to us to schedule a free consultation and we can help get you started.

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