It’s a classic chicken-and-egg problem for an early-stage company: you need to raise money to help with operations (including getting your paperwork in order) but before you can get any money you have to have your paperwork in order!
And now with new ways to raise money from investors, like the ability to “generally solicit” investments from “accredited” (rich) investors, which will be legal on September 23, crowdfunding hopefully coming soon and new online investment platforms standing up to help small companies raise funds, it’s never been easier to get in over your head. Fortunately, there are resources out there to help small entrepreneurs stay safe.
First thing to bear in mind is this: selling securities is a serious business. And that’s what you are doing when you seek outside investors, selling securities. It’s strictly regulated, the rules about what you can say and when you can say it are complex and if you violate them . . . that old saying about it being easier to get forgiveness than permission? It doesn’t apply.
Second thing to bear in mind is this: when you seek investors over the internet you are heading out on your own. If you are an entrepreneur seeking old-style angel investing, potential investors often sit down with you and hold your hand through the investment process. They’ll have a “due diligence” list of things you need to produce for them, but in many cases they’ll understand if there’s something you haven’t gotten around to yet. They might even be able to help you get some of the formalities sorted out. When you are seeking funds from the internet, people aren’t going to be so forgiving, and might even think you aren’t legit if you don’t have all your paperwork done.
So, drawing on CrowdCheck’s experience with early stage LLCs seeking to raise funds online, here are some of the most common issue we see, and how to address them:
Does the platform you want to list on accepts LLCs?
While a company can be organized as an LLC and seek outside investors over the internet, we should note that some online platforms will not work with LLCs, so check first with the platform you want to list your offering on.
Do you have an operating agreement that lets you manage your own company?
If you incorporated your LLC the simplest way possible you probably have an “operating agreement” (the document that says how your company is to be managed) that includes the standard (“default”) rules for LLCs in your state. The default rules for an LLC are more like that of a general partnership than a corporation. These rules provide tax benefits, but require investors to manage some of the day-to-day affairs of the company. That means your new investors might have a right to be involved in some of the decisions you’d want to take yourself. LLCs are flexible, and you can create a very detailed LLC operating agreement that separates investors from day-to-day management, so that you won’t be forced to include all members of the LLC in every hiring decision.
Are the securities you want to offer to investors already authorized by your operating agreement?
If the operating agreement does not provide for selling anything other than general membership interests, you cannot sell anything other than that. If you want to sell a membership interest without management rights, the operating agreement must expressly set out those terms.
Does your operating agreement set out how major decisions will be made and have you followed those requirements?
Investors will want to know that major decisions — issuing securities or entering into significant contracts, for example — have been made in accordance with the company’s governing documents. These decisions should be clearly documented.
Does your operating agreement give your original investors rights to be included in future offerings?
Many states grant investors in LLCs “preemptive rights”, which are rights to be included in follow-on offerings so that they don’t get “diluted” by future investors (i.e., own a smaller portion of a larger pie). However, for an early stage company, preemptive rights become a barrier to new investors, and they won’t invest unless the original investors waive, or give up, those rights. The proper way for preemptive rights to be waived requires each current investor to enter into an agreement with the company. This is not something that can be done after the fact.
Have you filed amended documents with the state?
If you’ve amended your documents to address some of the issues mentioned above, you may need to re-file them with your state. Each state has its own procedure for how amendment has to happen.
Have you registered to do business in your state?
If you were incorporated in a state that’s different from the one you are based in, you might need to file for permission to do business in your home state. Many states call this “registration as a foreign corporation.” You may also need to file to do business in your county or municipality, depending on your location and type of business.
Our best advice? A little preparation now can help you avoid trouble later.
Sara Hanks, co-founder and CEO of CrowdCheck, is an attorney with over 30 years of experience in the corporate and securities field. CrowdCheck assists entrepreneurs seeking to sell securities online through the disclosure and due diligence process.
For info on funding your business, watch and learn from angel investor Judy Robinett. For more more on crowdfunding, click here.