Investing in Local Business...Legally

How to Raise Money But Not Break the Bank
State and federal laws restrict your ability to secure capital. But with imagination, there are ways to do it without spending all your money on experts.
from East Bay Express
By Jenny Kassan

So you're trying to raise money for your business. But banks aren't lending, your savings are inadequate, and borrowing against the credit card isn't optimal. So you decide to raise money from your customers and put a sign in your window inviting people to invest in your business. Congratulations — you have just violated securities law and could face severe penalties.

Raising money from investors can be a great way to create or expand a business. Unlike lenders, investors typically forgo regular payments of interest and principal in exchange for the possibility of a bigger return down the road. But there is a huge barrier to raising capital from investors: securities law.

The regulations governing securities are little understood by most business owners. In my practice, I have seen small business owners who have no idea that their efforts to raise capital violate state and federal securities law.

It's helpful to recall why securities laws were passed. One big cause of the 1929 stock-market crash was the lack of regulation of securities markets. Any charlatan could print stock certificates promising huge returns to investors who had little recourse when the certificates turned out to be worthless. In response, Congress passed the Securities Act of 1933. This act, along with state securities laws, is designed to protect unsophisticated investors from losing their life savings in speculative investments.

The basic requirement is that a security cannot be sold unless it is registered with the Securities and Exchange Commission and regulators in any state where investors reside. Registration requires extensive disclosures and compliance with numerous technical rules. This is what is commonly known as going public, a process that can easily cost hundreds of thousands of dollars in legal, accounting, and other fees and costs. There are some exceptions to the requirement, but even those can involve complicated compliance work and thousands of dollars in legal fees and other costs.

Many people assume that these requirements apply only when selling stock, but this is not the case. A security is any instrument such as a stock, bond, note, or contract that is purchased by someone who is expecting to receive profits generated by the efforts of others. Even if someone lends you money for your business and you promise an interest payment, that transaction can be covered by securities regulations. In fact, the rules apply not just to the sale but to the offering of a security, so even putting up a sign advertising a chance to invest in your business violates the law.

This is very frustrating, not only for business owners but also for people who would love to invest in their local economy. Because of these laws, even if I wanted to invest in a wonderful and hugely profitable business next door, I couldn't do it unless the business spent thousands of dollars for legal compliance. Unless I am a so-called "accredited investor," with a net worth of at least $1 million or a personal income exceeding $200,000, my only option is to invest in companies that have gone public. These companies are primarily giant multinational corporations whose practices I might not support and which contribute very little to my community.

So what is a small business owner to do? Here are some ways to raise funds that do not require extensive securities-compliance work.

Form a cooperative. In California, there is an exemption from securities regulations for investments of up to $300 by members of a cooperative. Cooperatives are businesses formed under a cooperative statute in which the members each have one vote. The members can be employees, customers, or business owners who join together to market their products or services. As long as the cooperative and all of its members are based in California, and the co-op transacts most of its business in California, it also is exempt from federal securities law.

Get donations. A security creates an expectation that the investor will receive a return. If someone gives you money with no expectation of a return, that is not a security and isn't subject to securities regulations. Many entrepreneurs are using so-called crowdfunding web sites such as ChipIn.com and MicroPledge.com to raise money for various causes. Donations of this type are not tax deductible, but lots of people might be willing to chip in to support a great local business.

Sell memberships. If someone gives you money in exchange for something of value, that is not considered a security. An interesting example of this strategy can be found at BeerBankroll.com. This crowdfunding platform is selling $50 memberships to open a brewpub. Membership confers a T-shirt, a chance to win prizes, and the opportunity to participate in a community-managed brewpub. If you can provide a membership package that people are willing to pay for, this can be a great way to raise money without selling securities.

Pre-sell a product. Awaken Café, the much-loved Oakland coffee shop, sold Café Creator cards. Oakland residents purchased cards that entitled them to cafe products valued at more than the purchase price of the card. For example, a $1,000 card entitled the holder to $1,200 worth of purchases once the cafe opened. Like the membership option, this is the purchase of something of value and therefore not a security.

As entrepreneurs know, creativity can go a long way to make a business thrive. This is as true in the legal realm as in any other.