Attracting Investors:
A Primer for Small Businesses

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Investment vs Loan

• Loan:  The money must be paid back whether or not a profit is made.  The lender does not get a share of the profits.


• Investment:  The money is not paid back.  The investor becomes a part owner of the company and shares in the profits (or losses)

How Investments are Made

• Investor Becomes a Part Owner:  After making an investment the investor becomes a part owner of the business


• Corporation:  If the business is a corporation the investment is made by the investor purchasing stock


• Limited Liability Company (LLC):  If the business is an LLC the investment is made by the investor making a "capital contribution as specified in the LLC's operating agreement (unlike a corporation, an LLC does not issue stock).


• Legal Structure of the Entity:  Whether the entity receiving the investment is a corporation or an LLC, its legal structure must be closely examined to make sure that can accommodate the needs of the investor.  Here is a partial list of the types of issues that should be addressed


• voice in management (if any)
• percentage of ownership
• preferences (if any) in the distribution of profits
• priority (if any) if the company is liquidated
• will separate classes of corporate stock or LLC membership interests be created to accommodate the investors

Compliance with Securities Law

• What are "Securities"?


• Generally, the "security" is broadly defined to be ordinary stocks & bonds plus countless other schemes.  Generally a "security" has the following characteristics


• the right to receive dividends or distributions
• transferability
• the capacity to appreciate in value.
• CLICK HERE for the legal definition of the term "securities"


• Registration Required .... unless
  
  
  • Securities law kicks in only where the securities are SOLD.
  
  
  • All Securities being offered for sale must first be registered with the SEC unless covered by an exemption
  
  
• Generally, Any Investment by a Passive Investor is a "Security"
  (that is, someone who is not directly involved in the day to day operation of the business)


• The transfer of stock in a closely held corporation (or the transfer of an LLC membership interest) is considered to be a "sale" ONLY if the transfer is made to a passive investor who is not involved in the day to day operations of in the business

BUT


• It is NOT a "sale" if the transfer is of corporate stock to persons who have signed a shareholder's agreement requiring that they actively participate in the operations of the business - or, in the case of a transfer of an LLC membership interest member signs the LLC's operating agreement and the LLC is a "member managed" LLC (as opposed to a "manager managed" LLC)

Registration & Exemptions

• ALL securities that are "sold" must be registered with the federal and state government before being offered for sale UNLESS it covered by an exemption


• CLICK HERE  for information on the registration requirement and the available exemptions


• CLICK HERE  for the SEC's frequently asked questions about exempt offerings

Avoiding Liability for Securities Fraud

• Even if the issuance is exempt from the registration , issuers of securities can be liable if they fail to provide an offering memorandum that discloses all "material facts" including potential risks


• DISCLOSURE OF RISKS:


• Examples of risks needing disclosure


• Examples of company-specific risk factors


• Inadequate insurance coverage.
• Dependence on current management.
• Lack of operating history.
• Success of a growth strategy.
• Risks related to acquisitions.
• Current material litigation
• Challenges posed by competition.


• Examples of industry-specific risk factors


• General economic conditions.
• Environmental risks and associated costs.
• Legal and regulatory requirements and compliance with applicable laws.
• Seasonality of the business and inability to predict cash flow.
• Labor costs and shortages.
• Uncertain supply, and price fluctuation, of raw materials.
• Risk of increasing energy costs.

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Preparing to Solicit Investors

Create a Business Plan


• Potential investors or lenders will not take you seriously if you don't have a quality business plan


• Questions answered in a business plan


• How much funding will the company need.
• What the new funding would be used for (specifically)
• What ownership interest in the company will be offered to the investors.
• Stock? If so, special class? Preemptive rights? Management rights?
• LLC membership interest? If so, split of profits, percent of ownership?


• Business Plan Outline

Prepare an Offering Memorandum


• An offering memorandum serves two purposes:
  
  
  1. Its a marketing tool in that it describes for the potential investor what the business is, why it will make money and what type of ownership interest in the business the investor will get.
  
  
  2. It describes the risks so that if the business loses money (on account of the competition or a downturn in the economy) the person selling the securities does not face personal liability
  
  
  • Danger of not disclosing risks - liability for "fraud by omission" - different from common law fraud - liable not only for affirmative misrepresentations but also failure to disclose material facts
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• Contents of an Offering Memorandum


• The Offering Memorandum includes enough information about your business for an investor to make a decision on whether or not they want meet with you. The Offering Memorandum has the following main sections:


1. Executive Summary
2. Offering
3. Risk Factors
4. Company Description
5. Financials
6. Management
7. Description of Capital Stock
8. Investment Highlights


• CLICK HERE  for an explanation of the information that should be included in an offering memorandum. CLICK HERE for another article on this topic