A common mistake that entrepreneurs make when forming a new business, or raising money for an existing business, is failing to recognize the importance of securities laws. The word “securities” evokes images of the New York Stock Exchange and well-known, publicly traded companies, so founders of small businesses often assume the securities laws do not apply to them. This is a mistake. Securities laws apply to businesses of any size, and failing to comply with them can have severe consequences.
The law generally defines a “security” to mean any investment in a common enterprise where investors are led to expect profits from the efforts of others. Where an entrepreneur is soliciting investments from third parties to fund a new or existing business, he or she is almost certainly engaged in the sale of securities. This is true whether the enterprise is a corporation, limited liability company or limited partnership. LLC and partnership interests are securities unless the investor is given bona fide managerial authority (as might be the case with a member-managed LLC or a general partnership). If an investment is substantially “passive,” the securities laws apply regardless of the type of entity involved.
When the securities laws apply, there are two important concepts an entrepreneur must bear in mind. One, is that all securities must be registered (or qualified) with the SEC (U.S. Securities and Exchange Commission) and state securities regulators unless an exemption to the registration requirement is available. There are exemptions for private offerings that cover the modest fund-raising activities that many entrepreneurs engage in, but compliance with those exemptions requires some technical steps. For example, companies must obtain written representations from investors as to their sophistication and ability to bear the risks of the investment. Companies may also need to file exemption forms with the SEC or state regulatory authorities.
Second, those who solicit investments must comply with anti-fraud rules applicable to the sale of securities. These require that before anybody makes an investment decision, he or she must be given all facts material to the potential investment. When done correctly, this disclosure usually takes the form of an offering memorandum that describes the proposed business, management’s background and compensation, the rights attached to the security being offered and all material risks of the investment. Entrepreneurs often fail to understand this requirement and solicit investments on the basis of vague, oral conversations about the proposed business that focus only on profit potential, and not at all on possible risk.
Failure to comply with these requirements can give investors a right to rescind their investments – this means they can demand a refund if things don’t go as expected. There are other potential civil and criminal penalties as well. Violations of securities laws will also complicate any attempt to sell a company or take it public. The basic steps needed to comply with securities laws need not be expensive. Attending to those tasks guards against future liability that can cripple a business.
If you plan to raise money for a new or existing business, contact the professionals at Capobianco Law Offices for assistance in complying with the often technical requirements of the securities laws.