Advice: Provide disclosure when raising capital

Many small-business owners with great ideas, products, or services form a business entity (such as a corporation or limited liability company) and begin operations, but do not have enough capital to fully develop, market, or expand their business.

With banks and other financial institutions being subject to heightened scrutiny and increasing government regulation and oversight, these owners find it hard to obtain loans or other debt financing from traditional lending institutions.

Even if debt financing were available, those funds have to be paid back (usually with monthly or other regularly scheduled payments), and the payments are an additional burden on (and may hamper the growth of) the business. In contrast, funds obtained from an investor buying a common ownership interest in the business entity typically do not need to be paid back (except for an ownership interest having some type of preferential treatment, such as a right to a preferred distribution).

The investors are generally paid back when the business is sold or are able to sell all or part of their interests if the company becomes a publicly-traded company. In light of the foregoing, these business owners often seek funds from family and friends when in need of capital, especially in the early stages of the business. In doing so, the owners often fail to consider or address the legal issues involved, particularly issues under federal and state securities laws.

The owners may not realize that the interest offered or sold is likely a “security,” especially when the investors will not be actively involved in the business entity. Even if the owners realize that they are offering or selling a “security,” they may not understand the implications of the offer or sale or the legal risks or requirements involved. They are simply trying to obtain funds to develop or otherwise expand their business and are doing so through the source most readily available to them ‒ their family and friends.

In general, an offer or sale of a security is unlawful unless it is registered under federal securities laws and registered or qualified under applicable state securities (or “blue sky”) laws or unless it is exempt from such registration or qualification.

If not exempt, a prospectus that contains comprehensive information about matters such as the offering, the company (including its business, products or services, assets, financial information, management, competition, and other detailed information), and the risks involving the investment is required to be delivered to investors prior to making their investment. Misrepresentations and other fraud and deceit in connection with the offer or sale are prohibited. The goal is to protect the public, and the idea is that full and accurate disclosure will provide investors with the information necessary to make an informed (and, hopefully, prudent) investment decision.

In addition to federal law compliance, the burden of compliance is imposed in every state in which the offer or sale is made, not just the state in which the business is located. The failure to comply with these requirements can be severe at both the federal and state levels. Penalties (commonly up to $10,000 per violation, in addition to criminal penalties) may apply to violations. Needless to say, the cost of defending a violation or trying to cure a violation can be very expensive, both in time and money, not to mention the damage to one’s reputation.

For a business owner seeking capital, a primary exemption under federal securities laws is an exemption for transactions by an issuer “not involving any public offering.” This exemption is frequently referred to as a private offering or private placement. Colorado has a similar exemption, as do a number of other states.

If structured properly, the offering and sale to family and friends will likely qualify for an exemption. However, the exemption does not provide an exemption from the anti-fraud provisions of federal securities laws. Those provisions give investors significant recovery rights if all-important information about the business was not disclosed or if the information disclosed contained misrepresentations or was otherwise deceitful or fraudulent. A claim may not arise if the business prospers and the investors obtain a satisfactory return, but if the investors lose all or a substantial portion of their investment, claims of fraud or material misrepresentations or omissions may well surface.

While risks of these claims cannot be totally eliminated, a document frequently referred to as a “private placement memorandum,” if properly prepared, can substantially reduce the risks associated with such claims.

The preparation of such a disclosure document is often unwisely neglected for a number of reasons, including the costs and delays involved and the lack of knowledge regarding its importance. When seeking capital, business owners would be prudent to seek competent legal advice and assistance and prepare and provide a disclosure document containing accurate and complete information regarding the investment and its risks, even to family and friends.

Gerald H. Hansen is an attorney with Stinar & Zendejas, LLC, a full-service business and estate planning firm. Find more information at or call 719-635-4200.