Raising Money From Investors: A Legal Nightmare for Small Businesses

Photo by Pepi Stojanovski on Unsplash

Raising money is a critical concern for most start-ups and small businesses. Whether it's seed funding to get the business started or raising capital to take the business to the next level, every business needs money (and probably more of it). But it's not as simple as offering potential investors an opportunity and then letting the money pour in. Anytime a business seeks to raise money by promising a return of some sort on the investment, then securities laws apply. This includes offering an ownership interest in the business (whether that's stock in a corporation or a membership interest in an LLC) and even debt obligations like promissory notes. In this series, we'll break down these securities laws and how they apply to small businesses.

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Two-Tiered System: Both Federal Law AND State Law

The two primary federal securities laws that apply when a business wants to raise money from investors are the Securities Act of 1933 and the Securities Exchange Act of 1934. If your business is selling securities through interstate commerce, then these federal securities laws apply. For example, let's say you have friends from college who live out of state that you believe might be interested in investing in your business. If there is an expectation that those friends could potentially earn a return on their investment in your business, then regardless of what you and your friends call the investment, it is a securities transaction. Because your friends are out of state, your business would be selling securities in interstate commerce (i.e., across state lines), and you must comply with federal securities laws. In addition, your business must comply with the securities laws in the state where the securities are being sold.

Securities Must Either be Registered or Exempt From Registration

In addition to complying with both federal and state law, every securities transaction must either be registered with the Securities and Exchange Commission (the "SEC") or exempt from registration. And because state securities laws also apply, you then have to determine whether the transaction must also be registered in the state where the securities are being sold or whether the securities transaction is exempt from registration in that state. Generally, a federal registration will mean that the state does not have to review and approve the transaction, but the state may still require a notice filing and registration fees with the state's regulatory body (here in Ohio, the Division of Securities, or "ODS").

Securities Fraud: Small Businesses Beware

Regardless of whether the securities transaction must be registered with the SEC and/or a state agency or is exempt from the registration requirements, all securities transactions are subject to anti-fraud provisions. This means that the small business and its principal owners and managers cannot make any false or misleading statements (whether orally or in writing) about the business, the securities being offered, or the offering itself. Put simply, you must tell the truth, the whole truth, and nothing but the truth about every aspect of your business and the potential investment in that business. If you do not, then both you and the business could face criminal, civil, and administrative enforcement actions. In addition, the investors can sue both you and the business for securities fraud and potentially recover their entire investment. (Note: This is one of the exceptions to "limited liability" regardless of the entity type you established for your business. If you commit securities fraud, you can be held personally liable for the entire investment.)

So how do small businesses raise money?

With this dual regulatory system and the potential penalties for getting it wrong, you may be wondering, "How can my small business raise money? This seems too complex." Yes, it is an incredibly complex area of law. Most small business raise money by trying to fit within the exemptions to registration. In Part 2 of this series, we'll start with Ohio's exemptions from registration with ODS (including the rules for promissory notes so that our hypothetical college friends can loan your business money). Later, we'll get into the federal exemptions (and how those college friends might actually invest in your business) and even turn to the hot topic of crowdfunding.

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