March 10, 2022

Planning Your Investor Capital Raise: Part I – Laying the Foundation

If you’re building a business, you’re going to eventually need to raise funds. That means getting investors to part with capital. It’s not a simple task at the best of times, but some things can complicate the process. This is the first in a multi-part series that will take you through some of the most important things you’ll need to know about planning your investor capital raise.

If you’re building a business, you’re going to eventually need to raise funds. That means getting investors to part with capital. It’s not a simple task at the best of times, but some things can complicate the process. This is the first in a multi-part series that will take you through some of the most important things you’ll need to know about planning your investor capital raise.

Understanding the Need for Structure

One of the first things you need to consider when it comes to raising investor capital is this: how will your investors see their return? With loans, there’s a fixed interest rate. In other situations, a percentage of the profits might serve.

Some acquisitions and startups use convertible notes, which can be a great strategy to provide your financiers with a debt position. It can be secure, but it’s a priority position above just the regular shareholders. That’s very attractive to potential investors. However, understand that this gives them conversion rights, which means that if things work out well, they can still take ownership right along with you in your company.

The Right Structure – A Harder Choice Than You Might Realize

There are probably 10,000 ways to structure deals, and each offers its own pros and cons. It’s not an area where you can take a DIY approach. You need a great lawyer on your side who understands the investor mindset and what marketing you can do, as well as the restrictions placed on you. So many people think they can just get in and get out because they’re just raising capital. They think, “Well, I’m not making a securities offering. I’m not making an investment offering. I’m just raising capital – raising some money from my friends and family.”

There is a big problem with this way of thinking. There are no family and friends “Get Out of Jail Free” cards. Suppose your deal meets the test of security. That means it’s an investment, and you have to pay attention to the regulations that apply to investments.

What is the security test? It actually dates back about 70 years or so. If you are raising capital from multiple people, you’re combining the capital, and they’re hoping to get profits through your efforts. Then it’s a security in almost all cases (unless you are starting a nonprofit organization). You’re dealing with securities even if you are strictly doing loans. Suppose you’re borrowing money from your friends and family. It’s still a security. Suppose multiple people contribute the funds for your joint enterprise – your business. They’re hoping to get interest rate returns from your efforts.

The key takeaway here is that you can’t use these types of gimmicks to get out of your legal responsibilities. And make no mistake – the SEC does not play around when it comes to securities fraud (which is the charge that you would be facing if you tried to play this particular game).

It’s also worth noting that there’s nothing wrong with getting on the regulators’ good side. That goes for both the SEC and the FBI. It helps you build a reputation for honesty, integrity, and transparency.

Important Notes on Investor Types

If you are raising $20 million or less, which is often the case, you can acquire some sizable businesses with just SBA or traditional financing on top as a complete capital stack. About 98% of the time, people are working with a cause.

Regulation D: Regulation D is just part of the Securities Act, talking about its requirements. But one of the most important things is the quality and suitability of the investors. What does suitability mean, though?

Simply put, you need to attract the right investors. We’ll begin our discussion with a quick look at accredited investors – the dream investors for many people putting together deals.

An accredited investor is somebody worth more than a million dollars. They made $200,000 for the last few years, expecting it to continue to $300,000. If they want to include spousal equivalents in their spouse’s income, that's a significant standard.

You'll hear it all the time when you start dealing with investors and investments. Accredited investors are kind of exciting and make no sense to me at all. We also need to consider unaccredited investors – the smaller investors with a lower net worth and less practical experience.

The SEC has a lot of restrictions that apply to unaccredited investors and provide a lot of protection for them. Accredited investors see much less in the way of protection, which makes sense since they’re sophisticated and can afford to lose their investment without it affecting their day-to-day existence.

Now, even though somebody isn't a millionaire and doesn’t make $200,000 or $300,000 a year, they're allowed to invest. An important thing is always their level of sophistication. To assess sophistication, you need to answer a few questions.

Do they understand what they're doing? Are they suitable for the deal? What does suitability even mean?

If you take the big check from the little lady living on a fixed income, it doesn’t matter what you thought was right or how guaranteed the investment seemed to be (never use the word “guaranteed” when it comes to investments, either, because there is always risk and NOTHING is guaranteed). Individuals living on fixed incomes are not suitable investors. The little old lady on the corner who depends on her Social Security check is not a suitable investor. Why is that, though? If your deal is solid and you know there’s a good chance that your investors will see a sizeable return, why can’t you encourage anyone and everyone to jump in?

Generally, if you’re going to acquire a business or start one from the ground up, you expect to pay a return to investors. However, they’re not getting their money back until it’s time to exit, go public, or refinance. That’s a long time for some people to go without access to their funds. You must pay attention to whether or not an investment is suitable for whoever your investors are.

A Word on Private Placements

Now, everybody's heard of a private placement. You’ll even find a series of posts published here that details what you need to know about them[wyw21] . All it means is you're relying on Regulation D, which, again, is the most common investment exemption/securities exemption. What I mean by an exemption is that you don't register it with the SEC.

There's a designated process that governs filings with the SEC. There are filings with the states, but it's not a registration. It's not like an IPO. What that means is there are also a lot of restrictions on:

a) The suitability and status of the investors, specifically as accredited or nonaccredited and what they're allowed to do.

b) The limits. Well, there are no required financial disclosures most of the time. What this means is if you are accepting unaccredited investors and it's a small offering of a new company, there are no financials to provide to begin with, and you're never legally required to provide financing in the future. However, that being said, it is always best practice to keep your investors knowledgeable; this involves regular reporting through what’s called a private placement memorandum. Simply put, it protects you. It also protects the investors, and whatever we can do to keep them happy limits the liabilities. 

A private placement memorandum is a summary of your investment. It describes who controls it. Your bio gets to be included. What regulations surround the company you formed?

a.) LLCs: An operating agreement

b.) A Limited Partnership: partnership agreements

c.) Corporations: Bylaws

All of this has to be described and summarized. Then there are generally six to 16 pages that describe the various ways that investors may lose their money. Yes, it makes it seem like you’re telling potential investors to run the other way, but that’s not the case. Look at private placements more like insurance policies. You’re putting it out there that there are risks and investors are not immune from them. The business might fail. The business may not receive all the capital necessary. The market may not be there for some reason. It gives you a way to say, “Mr. Investor, you’ve been warned.”

Private placement is in the laws to protect the investors from the many risks out there, but it also protects the sponsors and the company itself.

Wrapping Up for Now

We’ll wrap up our introduction at this point. In the next installment, we’re going to dig deep into securities exemptions. We’ll discuss a wide range of critical things to know, from Reg D Rule 504 and 506B to Regulations CF and A, and everything in between. For now, understand that raising capital requires in-depth planning.

You need to know your goals, but you also need to be honest enough to admit that no matter what your deal might be, chances are good it falls under the investment umbrella, which means SEC involvement. Facing charges of securities fraud is not how you want this particular journey to end.

You also need to ensure that you know your investment and the ideal audience. Understand the difference between accredited and unaccredited investors, as well as investors who simply are not suitable for the deal for whatever reason. Finally, get to know private placement memorandums and their value – not just for protecting investors, but also sponsors and the company.  

If you're looking for an experienced legal team to assist with your next offering, Crowdfunding Lawyers is here to help. Click here to schedule a free consultation and we will follow up with you promptly.

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