Raising capital in a down market? Beware securities law traps!

by Kurt Schulzke on February 18, 2009

Raising start-up capital is a tough job even in good economic times.  These days, with credit so scarce, it can seem nearly impossible.  Unfortunately, when entrepreneurs want to get things done “in the worst way,” they sometimes run out of patience and do just that.  Raising capital in 21st century America is a bit like taking a road trip across Iraq. The road is strewn with booby traps.

Entrepreneurs hunting for capital should take extra care not to inadvertently violate federal and state securities laws.  The rules are complex and nuanced making it easy to cross the line.  A common scenario these days features a bank that fails or changes hands, leaving technically “non-binding” commitments to fund new companies unfulfilled.  Faced with this dilemma, company founders unfamiliar with the rules may decide to contact just about everyone using all kinds of communications media — e-mail, blogs, website and even phone trees.  This approach can lead to hostile encounters with federal or state securities enforcers.

When funding a new company, a “stitch in time” saves not just 9, but 90 or 900.  Recently, for example, I saw an e-mail similar to the one below:

I am forwarding some information from some close friends.  We originally met them in Any State and became great friends.  Any Name wrote asking us to reach out to anyone that might possibly be interested in an investment opportunity.

Husband was in corporate America for most of his career doing IT as far as I can recall and they used much of the money they saved and invested and partnered with his parents to form this company a few years back and have been very successful.  They recently relocated to a small community in Any State to rehab a building and turn it into their warehouse/distribution center.  I can’t recall which one, but I believe it was one of the top five financial institutions that agreed to back them before they went under this past fall.

Please see her email below.  If anyone can make this venture a success, they can.  They are looking for private investors.  If you or anyone you know might be interested, please forward the very brief overview that she has provided. . . .

What could possibly be wrong with such a friendly, upbeat invitation to invest? In the eyes of the SEC and state “blue sky” regulators, a whole lot. You might think, given the current state of the economy, that governments would encourage just about any sort of entrepreneurial effort. Raising capital is essential to getting businesses going, right? Well, yes, but . . .

In the eyes of the government (and some academics), one of the reasons for our current economic downer is that too many people were too free to raise capital without regulation. They blame regulatory lapses for big banking and investment losses that, in turn, have pushed the stock market south and have cycled back to reduce market liquidity.

As a rule of thumb, company founders should assume that any solicitation to invest is subject to SEC regulation and registration unless they have identified a specific regulatory exemption. This, in fact, is how the law works. All securities offerings — private or otherwise — must either qualify for an exemption or be registered with the SEC and, potentially, state regulators under so-called “Blue Sky” rules.  Even when a registration exemption applies, the anti-fraud provisions continue in force even for “private” offerings.

Unintentional failure to properly qualify for an exemption can trigger severe, business-destroying financial penalties. It may come as a surprise to some readers that an e-mail like that described above can easily turn a “private” offering into a public one.  The line between “public” and “private” offerings is not very clear, so thorough understanding of the rules is essential.

Intentional violations involving stock fraud can result in more serious sanctions including prison time. Small business owners looking for capital should first learn about basic registration exemptions by reading the SEC’s Small Business Q&A.  However, because of the complexity of these rules and similar state-level laws, it is a good idea to talk with a knowledgeable attorney before approaching an investor with that first phone call or e-mail.  It goes without saying (almost) that investment solicitations should never be placed on blogs in classified ads.