Raising $$: Equity

*This article is part of an on-going multi-part series on venture financing.

Just like the Monopoly man, sometimes you turn your pockets inside out and find that there is nothing inside them. You’re only partially through the initial stages, you are just getting started, and have hit another major roadblock that always seems to come at the wrong time: cash is low.

There are several options in order to finance operations. Today, we will be focusing on one the most misunderstood and complex issues: Equity.

What is “Equity” anyways?

In simplest form, it is selling a portion of the ownership of the company to another individual or group for a set sum. This can be in the form of shares of stock, a partnership interest, or membership interest in an LLC context. This can be used as part of a compensation plan for initial team members and employees, to raise capital in order to produce a viable prototype or product, or to scale and grow an already established business.

How does it work?

In the financing context, a backer, venture capital fund, or an angel investor may already have established minimum terms in order to procure financing. These are generally highly sophisticated businesspersons with legal counsel and finance acumen. They may require a seat on the Board of Directors, veto power over major transactions, or other potential levers of power within the company.

Simply put, you do not want to go in blinded by your need for capital. Knowing what you are willing to offer in exchange for funds is essential. Just like you wouldn’t sell a house for $5, you don’t want to sell your company away for that either.

There are a number of ways that shares can be characterized and made more appealing to investors or to founders: rights of first refusal, liquidation preferences, and waterfall provisions (sadly, they are not actual waterfalls). An experienced attorney can help navigate you through these decisions so that your interests are protected now and in the future.

For employees, this can be more manageable and to the advantage of the founder. However, if an employer-employee relationship deteriorates, things can get complicated. There are a number of tax considerations for the company and for the employee to consider when accepting equity as part of a compensation package. Would you want an angry group of former employees voting on a major acquisition? Simply put, you want to be careful how much power you vest in employees that may not be “in it for the long haul”.

Additionally, equity can be a way to provide compensation to contractors who provide services to a venture. However, while this may be enticing because of its lower cash cost upfront, businesses need to be careful. In order to ensure that the work is properly executed and the contract is fulfilled, it is prudent to require completion of the work before the rights to ownership of the stock vest rather than issue the equity interest upfront. If a potential contractor refuses that ideal, it may be a sign of problems ahead.

Aren’t there a lot of rules and laws involved in this?

Yes. Securities are a highly regulated industry and may require registration with the applicable state and federal agencies. However, the Securities and Exchange Commission (SEC) has provided a number of avenues in order to facilitate faster capital growth while balancing consumer protection.

First, as a general rule, all securities transactions must be registered with the SEC. However, many if not most transactions can qualify for an exemption under what is known as Regulation D. Like the Vitamin D found in milk, a good strategy for maintaining growth and keeping costs down include fitting in one of the many exempt categories.

Many of these exemptions require only selling securities to “accredited investors.” While this category is subject to change, currently that is an individual who has an annual income exceeding $200,000 for the previous two years, or a net worth greater than one million dollars when not including the primary residence. Additionally, many institutions such as banks, pension funds, trusts, and businesses are considered accredited investors. Clearly, vetting potential investors after developing a plan is critical to maintaining compliance.

It is very important to consult legal counsel and determine a plan of action before seeking to raise capital. Failure to properly consider the applicable laws can have series consequences, including prosecution by state or federal authorities.

What about Crowdfunding?

Crowdfunding is a relatively new phenomenon. Many who engage in crowdfunding promise contributors a reward such as the product or service the business is going to create with the funds received. However, other forms of crowdfunding provide equity in the company. In order to comply with SEC rules established last year, certain limitations on the amount of capital raised from each investor and the total amount per year must be considered. A company is only allowed to raise $1 million within 12 months via crowdfunding. While many ventures may see this as a great way to raise money without the scrutiny of more savvy investors, it exposes more risk to the company in the way of publicity and public reputation. In the creative and tech industries, building brand loyalty is essential and failure to consider the potential backlash from an unsuccessful venture could be damaging to further ventures.

How do I know what’s best for the company (and me) now is also going to work in the future?

It’s a tough question. Carefully designed stock plans can lead to successful outcomes. Particularly if the company ever seeks funding from sources that may require SEC or state securities board approval or plans on being publicly traded. Because of the complex regulatory system that corporate financing works within, it is imperative to not do this alone. Too many founders try to do this alone and end up having serious headaches later.

If you want to save yourself the aspirin and get it done right the first time, contact the SAVaGE lawyers at Chester PLLC.

 

The SAVaGe Entrepreneur Knowledge Base (“SE-KB”) is part of a series of articles written and published by CHESTER PLLC, a Dallas-based law firm that advises innovation-based entrepreneurs, and emerging companies regarding their core legal issues (www.chester-law.com).   Information provided is for informational and entertainment purposes only, and is not legal advice.