Determining the best capital structure for a business is one of the many difficult decisions owners and founders must make. Capital structures vary widely, and what may work best for one company may be completely wrong for another — depending on the industry area, resources available and management team. Different capital structures include bootstrapping (completely financed by the founders), debt financing (either through traditional bank financing or other investors), equity financing or a combination of the above. For many businesses, the first two structures may be impractical, either because of the risk preferences of the founders or due to unavailability of funds from founders or lenders.
Many companies, consequently, pursue equity financing as a means of raising needed capital. There are, however, many legal and practical pitfalls that business owners should be aware of prior to jumping into the process of raising capital through the sale of equity interests. Below is a brief description of a few of these legal and practical pitfalls; however, due to the sophisticated legal issues involved, companies should seek competent counsel when structuring an equity (or debt) financing.
Aligning Expectations
When disputes arise between business owners and investors, it is often attributable, in part, to misalignment of expectations. For example, a founder may expect that all profits from the business in the first several years, if any, will go toward reinvestment, such as opening a second location or developing a new product; investors may be expecting profits to be distributed. Prudent founders take time to learn who their potential investors are to ensure that the expectations of the potential investors and the company’s management team are aligned. Companies should also take time to make sure their potential investors truly understand the business and some of the challenges that the business may face or encounter. Failing to align expectations between management and investors often causes additional cost and strain on a company.
Options and Capital Calls
The contractual provisions governing the relationship between the company and the investors are important. For example, during the slow season or when expanding, additional money infusions may be necessary. Provisions can be put into place that require the equity owners to put additional capital into the business. It is important that all parties understand the obligation under such a provision and what the consequence will be if a party fails to contribute capital. Another important contractual provision is a “right of first refusal.” Before an investor sells his equity investment to a third party, the company may want to require the investor to first offer the interest to the company. This provision can enable the company to limit who its equity holders are.
Securities Laws
Too often, founders don’t realize that, no matter how small an investment, a company is selling a security when it sells equity (or debt) in exchange for capital (either money or other property). Whenever a company sells a security, it must comply with applicable federal and state securities laws. Generally speaking, all securities being sold by a company must be registered with the Securities and Exchange Commission and applicable state securities regulatory agencies, unless an applicable exemption applies. For many reasons, including the cost of registered securities offerings, small businesses typically try to rely on an exemption from registration.
One of the most common exemptions is found in Rule 506(b) of Regulation D, which allows a company to raise an unlimited amount of money from individuals with whom the company has a pre-existing, substantive relationship and who meet a certain wealth threshold.
Recent legislative actions have created additional opportunities for small businesses seeking to raise capital. For example, the SEC and many states, including Arizona, have promulgated or adopted crowdfunding laws, by which companies can raise small amounts of money from many investors, regardless of the wealth status of the investors, subject to certain restrictions and limitations.
Numerous opportunities exist for small businesses desiring to raise capital; however, it is imperative that any small business seek the advice of competent advisors before undertaking any such effort.
R. Steven Reed is an associate with Jennings, Strouss & Salmon’s Corporate, Securities and Finance group. He focuses on advising businesses and investors in a broad range of transactions and relationships, including mergers and acquisitions, securities offerings, real estate and general corporate matters.
