Getting financing to go into business for yourself can be the most daunting part of the job, and there is more than just raising the money to be concerned about. Many business owners may be violating federal and state laws through their efforts to raise funds. Steven Reed of Jennings, Strouss & Salmon will talk about avoiding those pitfalls.
TED SIMONS: Financing for start-ups can be a daunting task, and it's more than just raising the required funds. Many new business owners could be violating federal and state laws as they work to raise capital. Here to talk about the pitfalls involved with raising money for start-up businesses is Steven Reed of Jennings, Strouss and Salmon. Good to have you here. Welcome to "Arizona Horizon."
STEVEN REED: Appreciate it.
TED SIMONS: Start-up businesses, great ideas and plans, you're saying you have to know what's going on out there, don't you?
STEVEN REED: Absolutely. There are lots of pitfalls that companies need to look out for. I work with businesses all over the state of Arizona and they're all different. Because of that they have different capital structure needs. One business might be running a restaurant, completely different from a technology company. So I would think one of the biggest legal pitfalls is understanding what your business is and what the capital structure should look like. What works for one company might not work for a different company. For example, one company might need debt versus actually selling equity or shares of stock or interest in a limited liability company. Regardless of whether it is debt or equity, corporation, limited liability company, it is important for companies to know that they are selling a security. And when you are selling a security, you need to comply with both the federal and the state laws that go along with that.
TED SIMONS: You mentioned defining a business structure here, sole proprietorship, talking about selling secure, you have to know going in, don't you? Every single avenue literally is its own street.
STEVEN REED: Correct. Correct. You know, whenever you bring in an investor, you need to be aware that you are putting together relationship there and that is more likely than not a long-term relationship. I think, one, it is important for the company and the investor to align expectations. They know what the exit event looks like. They both understand what the company does and what it is doing and, you know, whether that company will be selling the business down the road or whether this is a long-term business and somehow the investor gets money one way or another. It is important to align the expectations. I think that is an important key component that businesses sometimes overlook. They're so quick to want to get the money in the door, they stop -- they don't step back and think is this investor a good fit for me. Does this investor understand what my business is? Does this investor have the same expectations that I have for my business? Otherwise often you end up with messy situations down the road. That's why it is really important to maybe try to think of the legal pitfalls before you take the money in so that you can try to hedge against some of the risks or think about things you should do to hedge against that.
TED SIMONS: How binding are some of the expectations? If I want to open Ted's Hamburger Hamlet and I see it as a little mom and pop thing down the road, it's still going to be a little mom a pop thing, I tell you about it, and you think Ted's Hamburger Hamlet is going to have 50,000 franchisees all over the country and it doesn't happen. It stays a mom and pop, how binding are the original conversations? What kind of paperwork is involved?
STEVEN REED: I think there is a couple of different things going on there. One, you're subject to federal and state securities laws. Depending on what you say, it is important that you don't use untruthful information or you don't lead an investor -- you don't give them false information or false expectations. That is a statutory component. Another component is the contract law area where if you're going to bring in an investor, and there is going to be that relationship there, it is important probably that there is contract provisions in there. What are some of the provisions? Possibly I sell a security to you and I want to be your partner. A year down the road, all of the sudden you want to sell your security and get rid of it and sell it to somebody else. I might not be excited about having that individual as my business partner. It is important that you have contractual provisions in there that either limit or restrict someone's ability to get rid of their security or what happens on death or those different situations. You as a company are knowing who your partner is and you are working with the people you want to work with.
TED SIMONS: Are these common errors or common oversights. It sounds like -- it almost sounds like you can't prepare too much for this sort of thing.
STEVEN REED: I agree. Absolutely. The common saying of, you know, an ounce of prevention is worth a pound of cure is absolutely true here. It is important that a business does step back -- how are they going to fund the company? How are they going to raise that money? It's important to step back and think through all of the different issues. Once the security is sold, you might have federal and state security problems, but you also might have an arrange that is not optimal for the company before you jump into it.
TED SIMONS: Federal and state law on these types of things, have these laws changed much in recent years especially after the big recession?
STEVEN REED: Absolutely. There has been some exciting developments. There was in the jobs act at the federal level, the government instructed the FEC to put forth crowd funding rules. The FEC did that. Unfortunately about 500 pages of proposed rules that have -- it is cumbersome, difficult to comply with and difficult to understand. States have gotten involved. They think that crowd funding is an exciting way to raise capital for small, young companies. So there have been a few states who have gone through and started, put together their own crowd funding laws, and Arizona is actually one of those. Signed by the governor in April, and went into effect in July. Arizona now has a crowd funding bill. How that works, you know, crowd funding is different from the typical or historical way that companies have raised capital. Usually you raise -- well, I should step back and say all securities need to be registered with the FEC or state agencies. A lot of companies raising smaller funds are trying to find an exemption to fit within. Usually you do that by raising a significant amount of money from a few investors. Crowd funding is a complete change in that. You're raising small amounts of money from lots of people. Arizona now has a bill that allows -- there is a law that allows that. Exciting development, but it is new. We are not sure what is going to happen there. Additional limitations and restrictions in the crowd funding model that are not applicable to the other historical ways that companies have raised money.
TED SIMONS: Whether it is crowd funding, or your uncle with the big paycheck or your uncle and his buddies, all want to get into the idea, just in overall terms, if you have the idea, you're ready to go with it and ready to raise money, just like -- what - easiest advice for folks watching right now and think I have this dream, I want it to happen, I got to get some money for it but I don't want to get messed up.
STEVEN REED: Absolutely. My biggest piece of advice is to be aware when you are bringing in money, you are selling a security. Just being aware of that, and then taking the next steps. You know, which might need to be -- you might need to talk to a legal advisor on what you need to do to comply with those. It's often encouraged. But once again, it is that old saying, prevention is better than the cure. If you get down the road and a relationship that is not working out or unfortunately if the investment didn't work out people often get upset and that is when it turns to litigation and it can become quite costly.
TED SIMONS: Good information. Thank you for joining us. That's it for now. I'm Ted Simons. Thank you so much for joining us. You have a great evening.
VIDEO: "Arizona Horizon" is made possible by contributions from the friends of eight, members of your Arizona PBS station. Thank you.
Steven Reed: attorney with Jennings, Strouss & Salmon