Securing a source of capital for a new or existing business can be a challenge. Consider a common scenario: Diana has a promising idea for a new business and possesses the necessary experience and expertise to make it successful. She starts a business and recognizes some success. However, she requires funding to take her business to the next level. Diana discusses her business idea with her friend Ben, who believes in its potential. They decide to form a partnership, with Diana managing the business operations and Ben providing the necessary funding to fuel growth. The question then arises: How should Ben provide the funding? Should Diana seek funding from Ben as an investor, where Ben exchanges his money for an equity (stock) interest in the venture, or should Diana seek funding from Ben in the form of a loan?
Funding the business with a loan instead of an investment in exchange for stock is simpler both in terms of the initial deal structure and the ongoing rights and obligations of the parties. Let’s consider each in turn.
First, the simple way. Assume that Diana and Ben agree that Ben will lend Diana $100,000 to allow the business to grow. Ben will likely have Diana sign a loan agreement and a promissory note and maybe even take some form of collateral (e.g., a second mortgage on Diana’s house). The downside is that Diana is burdened with debt. However, presumably the terms are well thought out and allow Diana the likelihood of paying both principal and interest payments as required by the terms of the loan and based on Diana’s smart business plan. Importantly, Diana has not sacrificed her role as the sole owner of the business. She needn’t worry about adding additional shareholders or decision makers to her business. The transaction is simple. The ongoing business structure and management is likewise simple.
Alternatively, assume a different set of facts. Diana and Ben agree that Diana will be the brains of the business, retaining 50% ownership of the joint venture and provide management for the business. Ben will be the financial backer for the affair in exchange for the remaining 50% of the joint venture. Ben is an investor providing money to the entity in exchange for an equity interest (stock). Are there any legal challenges inherent in this transaction? There are many, and those trying to raise capital in this manner should tread carefully. The sale of stock is subject to strict state and federal securities regulations, even for the average small business.
Ever since the stock market crash of 1929 and the resulting securities laws in 1933 and 1934, the exchange in this second situation implicates securities laws. The federal statutory scheme provides a methodology for lawfully obtaining financing for these enterprises. And, all states have followed the federal lead and have implemented state securities laws as well. The common misconception is that the securities laws only apply to the big, publicly traded companies, but the truth is that the laws apply regardless of the size of the business.
Any security (which is broadly defined) that is being offered for sale must typically be registered with the SEC, unless it qualifies for an enumerated exception. However, for closely held businesses, the cost of registering with the SEC is just too high. Therefore, the crucial factor to ensure compliance is to utilize an exception and avoid the need for costly registration.
There are two big exemptions to the registration requirements of the Securities and Exchange Act. The first is the private offering (detailed in Rules 504 and 506 of Regulation D of the 1933 Act). The second deals with intrastate offerings under Rule 147 and 147A. Either requires the use of an attorney skilled in securities laws. Further, failure to comply with these rules subjects the issuer (Diana) to potential liability, usually in the form of a plaintiff’s attorney citing failure to comply with disclosure and antifraud provisions of the Act and demanding compensation for the lost value of the investment (effectively making Diana guarantee the return on the investment).
The second transaction is much more complex, but it does carry substantial upside. That is, if the stock is issued to Ben correctly, Diana has no debt to repay. Instead, Ben is an owner of the entity subject to the same opportunity for profit or loss as Diana. This makes early cash flow especially easy for Diana.
Though the cash flow is better for Diana, not only is the initial deal more difficult to structure than a loan, but the organizational structure and management becomes much more complex as well. Ben has rights as a shareholder and might have rights to govern the business management as well. It would be prudent then for the two owners to come to an agreement on a vast array of planning challenges for an entity…from tax considerations, to the distribution of profits, to business plan changes, to work requirements, to non-competition agreements, and much more.
The bottom line is that if you are seeking financing for your venture, the traditional loan (financed through a bank or from individuals) is the simpler route. Anyone contemplating trading equity in the business for money should consult a lawyer knowledgeable in securities laws.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.