Any company seeking to raise capital from investors should explore the use of a proper securities offering to accomplish that task. While compliance options vary – most small and medium size private companies will choose a Regulation D exempt offering to solicit investors and execute the resulting securities sales in compliance with State and Federal rules. While there are many pitfalls to raising capital improperly – in this blog we will highlight three that entrepreneurs may not be aware of:
1. Complications in Later Rounds of Funding
If you raise capital improperly – it can negatively impact executing additional rounds of funding. An example of this would be:
Company X raises a $2mm first round of equity from individual investors that is completed out of compliance and outside of a traditional and proper offering. Company X operates and two years later is now in need of expansion capital and seeks funding from a private equity (“PE”) firm. The PE firm will invariably complete due diligence on the original round of capitalization and will uncover that those sales were executed improperly. This not only points to executive mis-management of the entity (not attractive to the PE firm) but is also a capitalization and investment risk for the PE firm. If the PE firm invests, and there is a subsequent rescission issue for the first round capital, it may well be the PE firms capital that goes to pay for the rescission. Further, such a rescission could damage the company operations going forward and damage the returns for the PE firm (or individual investors).
2. Lack of Concise Terms
Many times the complexities of transaction structure do not become apparent to an issuer or investor until that issuer experiences operating difficulties. Normally investors investing into an early stage company (or, for example, a real estate project) would be provided a liquidation right that provides certain rights upon a liquidity event or dissolution of the issuer company. This is especially true if the investors are providing the bulk of risk capital. Raising capital improperly tends to involve poor structuring and poor documentation reflecting this structure. Thus, many out of compliance early rounds do not have specific terms for the securities sold to investors. Many times investors find out they have weak liquidation rights upon a liquidity event or the company failing in its operations.
3. Leveraging Institutional Debt
This pitfall is similar to the first – except here it is an institution contemplating providing a debt facility to the company and engages in due diligence on its prior capitalization rounds. No bank or institutional lender will want to provide leverage and credit to a company that has the potential for a rescission of equity capital that may result in damaging operations and potentially causing a default on the financing provided.
While many pitfalls of raising capital improperly are well known – there are plenty that are lesser known but just as important and just as damaging if they come to fruition. Interested in executing your capital raise properly? Call us today to discuss a Regulation D exempt offering for you company.
Tuesday June 17, 2014
Category: Capital Formation and Regulation D
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