BUSINESS CAPITAL BASICS: LEGAL CONSIDERATIONS OF FUNDRAISING
July 30, 2014
By Jeff Wolfe
In the first two posts from our Business Capital Basics series for startups and small businesses, we’ve explored different types of financing, such as equity, debt, and crowdfunding, as well as different investor constituencies like friends and family, angels, and venture capital firms. For our latest installment, let’s take a look at the legal considerations of fundraising.
First, small business and startup executives must understand the basic principle that every offer and sale of securities—in the form of equity stock offerings or debt financings—must be registered with the federal Securities and Exchange Commission (SEC) unless there is an available registration exemption. The mostly common registration exemptions involve private placements, which are exempt from registration as long as the offer and sale of securities by a company does not involve a public offering. In order to provide some clarity on what will not be considered a “public offering,” the SEC has created several safe harbors that are set forth in Regulation D. For example, Rule 506(b) of Regulation D permits companies to raise an unlimited amount of money from an unlimited number of accredited investors (such as executives, institutional investors, and individuals with certain net worth or annual income) and up to 35 non-accredited investors, provided certain additional requirements are met.
However, companies exempt from SEC registration requirements may still be required to make certain notice filings with the SEC and certain state regulators. In particular, companies completing a private placement pursuant to Regulation D must file a Form D with the SEC and any state in which a notice filing is required by such state’s “Blue Sky” laws.
Raising capital also requires careful considerations of the tax code from a legal standpoint. Small businesses and startups should consult their tax attorneys from the very beginning of a fundraising cycle since the classification of a security as debt or equity impacts the tax treatment of both the company raising the money and the investors purchasing the security.
For example, companies may prefer debt financing since interest payments on issued debt may be tax deductible, saving the company money during the term of the investment. However, investors may prefer an equity financing, since they may be able to receive preferential tax rates on dividends. Of course, there may be other important tax considerations for a specific company or investor that will motivate its preference for the type of security. It is also important to note that a classification of a security for tax purposes may not be the same as the classification for accounting, regulatory, or other purposes.
In conclusion, fundraising for small businesses and startups is a venture that requires careful consideration of both securities law at the federal and state level, as well as the federal tax code. If you’re thinking about raising capital to start a business or fund new growth initiatives, the attorneys at the Forrest Firm are here to help. We can help you carefully navigate the world of fundraising in ways that comply with all legal obligations and meet the strategic needs of your business.