MONEY MATTERS: Raising capital for early-stage companies

By Jeffrey Woodcox The Daily Record Newswire Most young companies will need to raise capital to pay for product development and operations. In the earliest stages, owners may rely on personal savings and credit cards. But sooner or later, an owner may need to seek additional capital from outside sources, whether friends and family or professional investors, to grow their company to the next level. While this is an exciting stage of development for fledgling businesses, it also can be tricky. When taking other people's money to grow a company, it is important to be aware of the options available and the legal obligations involved. Companies raising less than $1 million might consider offering investors convertible notes, which are debt instruments of a specified amount for a specified duration -- usually one or two years. Nobody expects the notes to be repaid. Instead, the company and investors expect that the company will conduct a stock offering before the notes mature and then notes will convert into shares of the stock type issued, usually at a premium of 10 to 20 percent. A key benefit of convertible notes is that an owner avoids valuing the company in connection with a typically small investment and at a time when valuation would be difficult. On the downside, if the company does not embark upon a stock offering before the notes mature, the notes will become due and payable. Other companies, particularly those that have already undertaken a convertible note offering, may raise capital by selling stock - usually a series of preferred stock. Investors in preferred stock will become shareholders of the company, have voting rights and usually have preferential rights to proceeds when the company is sold or liquidated. Although any young company can offer stock, a preferred stock offering may be most appropriate for one that has already established some presence and needs more than $1 million in new capital to grow to the next level. Whenever a business offers to sell securities to investors -- whether convertible notes or stock -- state and federal securities laws come into play, and these get complicated fast. With few exceptions, any transaction in securities must be either registered with the Securities and Exchange Commission or exempt from registration. A founder of an early-stage company should be sure to conduct a securities offering in a manner that allows an exemption from registration. The most commonly used exemption for young companies is Rule 506 under Regulation D of the Securities Act of 1933. Rule 506 was created specifically to give small companies access to capital markets without the financial burden and complexity of SEC registration. Rule 506 also offers the benefit of pre-empting state registration requirements. A business that is careful how and to whom it offers securities can comply relatively easily and inexpensively, raise needed capital and move forward. However, carelessness or sloppiness can lead to trouble. Here are a few things to keep in mind about Rule 506: * Offer securities only to people you have a reasonable basis to believe are "accredited investors." An accredited investor can be someone who has a net worth of at least $1 million (not including a primary home) or an annual income of at least $200,000 ($300,000 with spouse), and can be a business owned completely by accredited investors. * Securities can be sold to as many as 35 non-accredited investors under Rule 506, but doing so requires delivering information to those non-accredited investors that may negate the speed and financial savings that can be achieved via a Rule 506 offering only to accredited investors. Additionally, selling to non-accredited investors may increase the risk involved in the offering because, as a result of their more limited experience, non-accredited investors may have unrealistic expectations. * Don't solicit investments via advertisements or mass mailings either to people you don't know or on Facebook or Twitter. Doing so is likely "general solicitation" prohibited by Rule 506. While Congress recently passed legislation that will lift the ban on general solicitation in Rule 506 offerings to accredited investors, that legislation does not become effective until the SEC adopts final rules. So for now, offer securities only to: people with personal or otherwise pre-established ties, people referred by business advisers (such as attorneys or accountants) and organized angel or seed-financing organizations. Over the course of any company's life, there are points of significant opportunity and significant risk. Raising capital is one of those points. It pays to work with business, financial and legal advisers to be sure the right strategy is being implemented, appropriate capital-raising vehicles are being used and complex state and federal regulations are being followed. ---------- Jeffrey Woodcox is a business and corporate finance attorney at Tonkon Torp and a member of its entrepreneurial services group. Contact him at 503-802-2039 or jeffrey.woodcox@tonkon.com. Published: Tue, Apr 24, 2012