(Part 2 of 2)
Sadly, the securities laws don’t make it easy for small startups to raise capital from lots of “little” investors. So how do you structure a startup when you’ve got lots of people involved, some putting in money, others putting in “sweat equity” and still others providing both; when you’re looking to raise only a small amount of money (less than $250,000) to launch the business; or when you can’t afford the services of a qualified securities attorney? Here are some suggestions:
Identify your founders and get them on board. These are the key people who will either work 90 or more hours a week helping you to build your business and/or furnish you with most of your startup capital. Anyone who does not meet this two-part test is not a “founder.” Founders are usually not considered investors if they do not put money in to the company, if they are recorded on the company books as owners from the company’s inception and if they are brought on board before later investors who put in real capital. Technically, when founders sign on to a company, the company has no value. Once people start putting in real money, the company has a value, so you can’t bring in any more founders at that point. There should be no more than two or three founders. If you find yourself with lots of founders, ask yourself if they are all really essential. It bears repeating: If someone is likely not to be around in a year or two, he or she should not be a “founder.”
Give your “sweat equity” people options instead of shares. Any sweat equity investor who is not a founder should not receive shares upfront. Instead, give them an option or warrant to acquire shares at least one year in the future at today’s price, with some conditions. If they do not perform their services to your satisfaction, they do not get their shares. By doing this, you ensure that they will deliver what they promised you, and because they don’t get their shares until a year from now, there’s a chance they may not be “aggregated” with other investors in determining the permitted number of purchasers for securities law purposes.
Limit your investors to “big ticket” purchasers. When I was working on Wall Street, many years ago, there was a saying: “You cannot eat like a bird if your goal is to excrete like an elephant.” It takes serious money to make serious money. You are not going to achieve your business goals with $1,000 investors. You need some big players and the fewer the better. Also, there’s a much better chance these people will be considered “accredited investors” and therefore not counted as purchasers, for securities laws purposes.
Avoid concentrating your investors in a single state. Many states limit the number of offers or sales of securities you can make to residents of that particular state. The number of permitted in-state offerees or purchasers can range from three to more than 40. If you have more than five investors in the same state, there’s a significant risk you will exceed the permitted number. By spreading your investors over a number of states, that risk is reduced.
Make a friend at your state securities office. When in doubt, don’t be shy about calling your state securities office and asking to speak to one of their “securities examiners.” They are usually quite friendly folks who will take the time to walk you through the necessary state paperwork. Trust me, yours is not the first startup that has called them with questions about a complex process.
Look for law firms specializing in early stage ventures. When all else fails, look for a local or regional law firm that specializes in technology startups and other early state ventures. These will usually be larger firms (more than 10 lawyers), but because they specialize in startups, they will understand, better than most lawyers, that you are operating on a shoestring budget and will try to work with you. If they are impressed by your business plan, they may be willing to do the necessary filings for a reduced fee or perhaps accept some (nonvoting) equity in your company in lieu of a fee.
Just be aware that you will not be working with their “prestige” partners. Since they are putting in lots of hours for a reduced fee, they are likely to refer your matter to a junior lawyer who is still “learning the ropes.” If they do, make a friend of the junior lawyer. Every prestige partner began his or her professional life as a junior associate, and all it takes is one highly successful startup to make your company a much more influential client of the firm and that junior lawyer a much more influential player in the firm’s hierarchy.