When you decide that your business needs to raise money, and you decide to approach outside investors, there are some critical legal issues that you should be aware of.  After 32 years of legal experience and working on well over 100 private and public offerings, I have observed that certain issues often get missed, even by the sophisticated investor.  There are many important considerations, and certainly more than 5 legal “things to consider”, but here are the ones that seem to recur.

To begin, let me state the obvious.  If you accept money from a third party in return for equity in your company, then you are selling a portion of your company for less than you expect it to be worth in the (near) future.  If you were able to get to the same place without outside money, you could sell the equity later for a much higher price.  While an influx of cash may be the stepping stone you need to get your business to the next level, it may be more costly than you wish.  In some cases, accepting slower growth while keeping all of the equity may be the better approach.

The first legal risk often overlooked is the necessity of compliance with the securities laws.  Some people consider the term “securities” to cover just stock. However, both federal and state laws define security to include limited liability and partnership interests, (promissory) notes, debentures and other evidence of debt, as well as many additional instruments.  If you have a security, you must either register it with federal and state authorities, or find an exemption in the often complicated federal and state securities laws.   Many people talk about raising money from “friends and family,” but this does not immunize you from liability under the securities laws.  If you proceed without an exemption, you can only trust that your uncle or best friend is unlikely to sue you if things don’t work out, because technically they have the legal ability to do so.   Unfortunately, there are cases where this trust is not borne out.

What happens if you don’t register or qualify for an exemption?  You may have to pay back the investor, plus interest, possibly from your personal funds if the company is unable to do so.  Fortunately, there are ways to be sure that your capital raising activities are covered by an appropriate exemption, particularly if your investors are accredited (as defined by the SEC) and sophisticated.  However, you should always hire a securities attorney to be sure that you have qualified for these exemptions.

Next, make certain your legal documents are in order.  This is true whether or not you raise money, but sophisticated investors will want to review all of your documents before investing.  This will include basic corporate documents (certificate of incorporation or formation, bylaws, and board and shareholder resolutions), agreements with employees and independent contractors, and shareholder agreements and other agreements affecting ownership of the company.   Pay particular attention to red flags like unsigned agreements, lack of agreements with key employees and contractors, and oral agreements to provide equity.  In some situations, where no promises are made but someone is helping you out for no charge, there can be an implication that he or she is expecting equity compensation.  This will be of concern to potential investors, who will need to know the full ownership structure before they invest.

Thirdly, choose your investors wisely, and understand what role they intend to play in the company.   You may want the good advice and the contacts that an investor can bring to the table.  However, if you like to be in complete control and became an entrepreneur so that you would never have a “boss” again, the advice and connections may come with a very large price.  Be sure you are on the same page with your investors about their role in the company.  Two other things to consider:  1. Returning to the paragraph on securities laws, you will save time and reduce legal risks if all of your investors are wealthy, sophisticated investors with experience in investing.  It is easier to find an appropriate exemption when doing business with this type of investor, and there will be fewer required disclosures.   2.  Be aware of the states (and countries) of residence of your investors.  Most states have securities laws that protect their residents, and if one of your investors lives in, say, Arizona, your counsel may need to check the securities laws there as well as in the state in which you and your company are located.

The fourth recommendation is to create a term sheet early in the negotiation process with investors.  The valuation of your company, the ownership percentages, the restrictions on your right to sell shares, and who has the power to vote and control the company are all matters that will be included in the term sheet.  Many entrepreneurs are surprised to learn that what some investors consider “standard” terms seem to be quite harsh to the entrepreneur.  It is far better to learn this near the beginning of negotiations so that you can determine whether there is a potential deal with these investors or not.  If the investors present you with a term sheet, it is important to have your own counsel review it before you sign on.  Be sure to distinguish which parts of the term sheet, if any, are binding (such as your obligation to pay investors’ legal fees, or any exclusivity period you have to give investors before turning to alternate sources of money).

Last but not least, make sure your company’s assets are protected.  Protect your intellectual property through patents, trademarks and copyrights as appropriate, and consider trade secret protection for matters where a patent (for cost or strategic reasons) is not the way to go.  Always consider whether or not to ask for a non-disclosure agreement before disclosing important sensitive information about the company, whether in contract negotiations or in due diligence proceedings by investors.  Many investors are reluctant to sign these, but may consider doing so in an appropriate case.  If they do not, you must realize that what you tell investors will not necessarily be held in confidence.

I hope that these five warnings will help start-ups, small businesses, and my fellow entrepreneurs make wise decisions when financing their growing companies.  I wish you all the best of luck!

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Rick Ressler of MWR Legal has over 32 years legal experience in the corporate and securities areas. Visit MWRLegal.com to learn more about Rick and the firm.

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