5 legal mistakes startups make while raising capital

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks:  We’ve been bootstrapping our startup and have pretty much run out of money.  We have a few friends and family members who said they would buy some stock to help us out.  We also thought we could put something up on our website and tweet about selling our stock.  Are there any legal troubles in doing this? What should we watch out for as we try to raise capital?

Answer:  Any time you are raising capital you need to make sure you’re complying with applicable securities laws, which are very complex.  Here are the five biggest mistakes I’ve seen startups make while raising capital:

Advertising or soliciting investors.  With very limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with raising capital. Both of these terms have been broadly construed by the SEC.

“General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or on a website or broadcast over television, radio or the Internet.  “General solicitation” includes any requests via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the startup and the prospective investor – one that’s sufficient enough for you to determine that the person or company receiving that communications would be a suitable investor.

Based on this, don’t add anything to your website about your startup selling its stock. And don’t solicit investors via Twitter (unless it’s a DM to a person with whom you have a “substantial and pre-existing relationship”).

Selling securities to non-“accredited investors”. The rule of thumb for startups is to only offer and sell securities to “accredited investors” under SEC Rule 506.  There are two significant reasons for this. First, there’s no prescribed written disclosure requirement. Also, Rule 506 preempts state law registration requirements – meaning, in general, that the startup merely must file a Form D notice with the applicable state commissioners.

There are eight categories of investors under the current definition of “accredited investor.” The most significant of these for startups is an individual who has a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or income exceeding $200,000 (or joint income with a spouse exceeding $300,000 ) in each of the two most recent years  – and a reasonable expectation of doing so again in the current year. 

If a startup offers or sells securities to non-accredited investors, it opens a Pandora’s box of compliance and disclosure issues under both federal and state law.

Using an unregistered finder to sell securities.  Startups often make the mistake of retaining unregistered finders (commonly referred to consultants, financial advisors or investment bankers) to raise capital for them. If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker.  If he’s not registered with the SEC and sells securities on behalf of a startup, though, the offering will not be valid and the startup will have violated applicable securities laws.

That makes it subject to serious adverse consequences, including giving the securityholders the right to rescind the sale and get their money back.

Not diligencing the investors.  In the course of my 16+ years of practicing corporate law, the most common mistake I have seen startups make in any dealmaking context is the failure to investigate the guys (or gals) on the other side of the table.  If a startup is selling stock to investors, it will, in effect, be married to these investors for a number of years.

Accordingly, the founders (at a minimum) should break bread with them and speak with other founders who have done deals with them in order to make an informed judgment as to whether they are appropriate investors.

Issues to consider include:  What is the investor’s motivation to invest?  Is the investor a good guy/gal or a jerk?  Will the investor add significant value (through his or her contacts, technical expertise, etc.)?

Issuing preferred stock.  Unless your start-up is raising $750,000 or more, issuing preferred stock is probably not a good idea. Preferred stock financings are complicated, time-consuming and expensive.  Moreover, the company would need to be valued – which is obviously difficult at an early stage and could be extremely dilutive to the founders.

Startups are better served by issuing convertible notes to seed investors, not equity. In other words, the investors would loan money to the startup, which would automatically convert into equity in the first professional (the “Series A”) round of financing.  This approach keeps the financing relatively simple and inexpensive and defers the company’s valuation until the Series A round.

If an investor insists on equity, issue shares of common stock — which will place the investor in the same boat as you (though it will still require a valuation and cause potential problems with respect to stock option grants).

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.