Chapter 11
Using Your LLC to Attract Investors
IN THIS CHAPTER
Taking advantage of what makes LLCs attractive to investors
Getting around securities laws (legally) with SEC registration exemptions
Navigating tricky state laws
If you’re an entrepreneur, one of your most fundamental tasks when starting a company is seeking out and acquiring capital to fund your startup. This process can be as simple as asking friends and family members to pull up their couch cushions and donate some extra change or as complex as raising millions in private equity or venture capital. Regardless of your methods or the amount you’re raising, you have to contend with some hurdles. Namely, the Securities and Exchange Commission (SEC) — a government agency endowed with the task of keeping the little guys from being swindled out of their life savings.
Luckily, when you know the federal and state securities laws you’re contending with and can navigate them with ease, raising financing should be a breeze. Well, aside from the talking people out of their money part; sometimes that’s easier said than done! Thankfully, you were smart enough to form an LLC for your fundraising activities, and with the flexibility in membership rules, management, and profit distributions, you have the freedom to come up with some pretty creative incentives that make the prospect of investing with you much more attractive than, say, with a stiff, old corporation.
In the following sections, I explain why LLCs are one of the most alluring entities to investors. I go over federal and state laws regarding investments and show you ways that you can get around the detailed process of registering your offering with the federal and state securities commissions. These tactics are called registration exemptions. Remember that term, because these exemptions are your lifeline when navigating the securities law minefield.
Structuring Your LLC to Attract Investors
More often than not, upstart capital for budding enterprises comes from the founders and people willing to finance it for a piece of the action (otherwise known as investors), which is why raising capital is a vital aspect of any up-and-coming business. Unlike sole proprietorships or general partnerships, LLCs can actually sell portions of the ownership, the membership shares. Membership shares are normally given to investors in return for cash, property, or other assets. You can also give them to employees or contractors in exchange for their services. Issuing membership is a great tactic to use if you’re just starting out and don’t have a lot of money to pay employees.
In some states you can give promissory notes for future money, property, or services that someone intends to contribute. That way, you can issue the shares first, and then the person can make his contribution. You can always note in your operating agreement that if the individual doesn’t live up to his promises, his shares are confiscated. Promissory notes can be a big incentive for investors to get on board, but be careful! Make sure the investor does in fact have the money to invest and is committed to living up to his end of the agreement.
One of the reasons LLCs are quickly becoming the entity of choice for raising money is because they provide unmatched limited-liability protection for everyone involved in the business. Not only are the members protected from the liabilities of the business, but LLCs also get the benefit of charging order protection — a second layer of liability protection that protects the business from the liabilities of the owners. (See Chapter 17 for more on limited-liability protection.)
Appeasing the SEC with an LLC
As I note in the preceding section, an LLC is the best entity to use when raising capital. Now the question is whether you legally can. After all the hard work of finding investors, you’re nearing the finish line and just need to cut a deal, right? Unfortunately, you may not be able to just take people’s money. Special securities laws protect the innocent from bad investments, and you must comply with these laws before legally raising financing. I know it seems like a pain in the neck — and it is — but trust me when I say that you do not want to mess with securities laws. The penalties for noncompliance are steep and include huge fines and jail time.
Most people think of securities laws and the SEC as only applying to large public corporations trading on exchanges such as NASDAQ and NYSE. Not so! If you sell shares of your small business or real estate property to the general public, then the securities laws apply to you.
The federal government considers anything to be a security if an individual or entity invests cash, property, services, or other assets into a business and isn’t involved in the business’s management decisions. This definition means that whenever you accept any form of contribution in exchange for your membership shares, you’re dealing in securities. And you thought you had to be some big Fortune 500 company to do that!
Two major pieces of legislation control all U.S. securities: the United States Securities Act of 1933 and the Securities and Exchange Act of 1934. Both pieces of legislation have their own sets of rules and regulations and have been amended numerous times over the years. These acts were set up to protect investors, but complying with them is difficult for most small businesses. First of all, the process of registering your securities with the Securities and Exchange Commission not only is lengthy but also comes with some enormous expenses, including registration fees, CPA fees, attorney fees, underwriting fees … the list goes on and on.
So what’s a small business to do if it can’t afford the huge costs of raising just a little bit of money? Well, the feds got smart, and they now allow registration exemptions for businesses that want to raise a limited amount of money and don’t mind playing by some pretty strict rules. I get into exemptions in more detail later in this chapter in “Exploring securities registration exemptions.”
Seeing how the laws apply to you
One of the first ways to legally get around securities laws is to make sure that when you raise capital, the membership shares you offer aren’t considered securities in the first place. The best way to determine whether securities laws apply to your organization is to take a good look at how the management will be structured after you raise the financing.
- If the investors have a full and equal say in the management of the company, then the securities laws don’t apply.
- If the LLC is managed by separate managers or the investors have limited managerial powers, then the securities laws do apply.
I generalize the stipulations of the laws into a few loose rules to determine whether you’re selling securities. If any one of these rules applies to your LLC, you’re automatically required to comply with securities regulations:
- Your LLC is manager-managed.
- Your LLC is member-managed, but some or all of the investors are junior managers and don’t have a full say in the business’s day-to-day operations.
- Your LLC has hundreds of members. Even if they all have a say in the company’s management, they can’t all realistically manage the day-to-day operations.
- You’re widely advertising the investment and looking for multiple investors.
These guidelines are loose and based on federal interpretations of the law. When it comes to states, the laws and the interpretations of what a security is differ greatly. For instance, New Mexico, Ohio, Vermont, and Alaska consider all membership shares to be securities, whether the LLC is manager-managed or not. I discuss state security registrations in “Flying through State Securities Laws (Blue Sky Laws)” later in the chapter.
If you’re just looking to raise a little bit of money, I suggest that you find an investor or two who may have good input in the business operations. This way, you can avoid a lot of the securities laws, but your investor can also be an asset in terms of knowledge and experience.
When you want to create a member-managed LLC for bringing on investors, make sure that the articles of organization and the operating agreement both specify that each member is equally responsible for the operations and success of the LLC. Unlike corporations, your LLC should have no centralized management in which the shareholders elect directors who then elect the officers who manage the LLC. Avoid that structure and instead get used to managing as a team. To make sure the government doesn’t classify your membership shares as securities, all members collectively must be in charge of the major decision making and have the power to select or remove key employees. (Head to Chapter 6 for info on how to form a member-managed LLC.)
If you transfer your membership shares to someone (such as a family member) as a gift, the securities laws don’t apply. However, you can only make such a transfer once; you may not make multiple gifts of unrestricted membership shares.
Exploring securities registration exemptions
If you review the rules in the preceding section and find that securities laws apply to your situation, you may still want to sell membership shares as securities if you don’t want your investors to have control over the operation of the business. If you just want them to sit back and be silent partners, that’s okay. As a matter of fact, because the federal government knows how difficult, costly, and time consuming registering your securities with the SEC can be, it provides some exemptions that mostly apply to small businesses or small projects that are looking to raise a small amount of capital.
The exemptions that I discuss here apply only federally, so you still need to look at the laws for each and every state in which you intend to sell your securities and determine what applies to you and whether you can meet state criteria for an exemption from registration.
To help navigate the laws, I recommend working with a securities attorney who is familiar with conducting searches on securities laws in multiple states. You may be able to work out a money-saving agreement with the attorney in which you take on some of the workload yourself. Just make sure that, no matter what, the attorney specializes in securities laws. A regular business attorney typically won’t cut it.
In the following sections I outline the federal exemptions available to small businesses. Rules 504, 505, and 506 are called Regulation D exemptions, and they all belong to Sections 3 and 4 of the Securities Act. If you’re using a Rule 504, 505, or 506 offering exemption, you must read and follow some corresponding general rules, Rules 501, 502, 503, 507, and 508. You can find them at www.docrun.com/dummies/regulation_d (password is onesmartdummy).
Rule 504 exemption
If you’re looking to raise less than $1 million, you’re automatically exempt from having to register your securities with the SEC. This guideline is the Rule 504 exemption, one of the Regulation D exemptions. In general, you can’t advertise the investment opportunity, and you aren’t required to make any specific disclosures about the investment. However, the money must be raised within a 12-month period. After that time, you must register the securities with the SEC or find another exemption.
After you first sell some of your securities, you have to file a Form D with your state securities commission. This form includes some basic information about the company, such as the names and addresses of its owners and stock promoters. You can download a Form D at www.sec.gov/about/forms/formd.pdf.
You can only use this exemption if your LLC isn’t selling any other securities that are registered with the SEC. For instance, if your LLC has another class of membership that’s being offered for $50 million and is registered with the SEC, the same LLC can’t use this exemption to raise less than $1 million.
The Rule 504 exemption is by far the most popular of all securities exemptions. Not only does it directly apply to most small businesses looking to legitimately raise financing, but it also means your LLC isn’t required to bear the burden of state qualifications if your company is selling its securities with a Rule 504 offering. The LLC simply needs to abide by the exemption rules and make the requisite state securities filings for each state it’s selling its securities in. I show you how to do this in “Flying through State Securities Laws (Blue Sky Laws)” later in the chapter.
Rule 505 exemption
If you plan to raise less than $5 million, you may be able to use the Rule 505 exemption. It has a few more limitations than the Rule 504 exemption in the preceding section (but that isn’t surprising, considering you’re raising more money):
- You can’t use general advertising (any advertising that’s targeted to the public at large, such as newspaper ads, TV ads, and so on) to sell your securities.
- Like the Rule 504 exemption, you can’t take longer than 12 months to raise your funds.
- Your LLC’s financial statements must be certified by a CPA. This step assures prospective investors that the profit/loss and assets/liabilities you state on your financial statement are factual.
- You can only have a maximum of 35 regular-Joe investors (nonaccredited investors).
When selling to the nonaccredited investors, you must adhere to the SEC rules regarding investment disclosures. These disclosures outline the risks inherent in the investment. This includes things such as competition or market barriers to entry — essentially, anything that could hinder your company’s success and stability. You must be completely forthright and disclose everything that the SEC requires you to. Your attorney can help you write disclosure statements that comply with both federal and state laws.
Although you’re limited in the number of nonaccredited investors allowed, you can have as many accredited investors as you like. What’s an accredited investor? It’s a person or institution that meets certain financial criteria. These investors are well-off enough to suffer the financial hit of a bad investment. They normally have a net worth of more than $1 million. They generally are more educated about investing and can make better decisions on where to place their money than the average person can.
Rule 506 exemption
Rule 506 is the golden rule that most companies use to raise funds over $5 million. When offering securities under the Rule 506 exemption, you’re doing what’s called a private placement, and you can generally raise as much money as you like. The guidelines for Rule 506 are very similar to those for Rule 505 in the preceding section:
- You’re limited to 35 nonaccredited investors, but you can sell to an unlimited number of accredited investors.
- If you sell any securities to nonaccredited investors, you must make very specific and comprehensive disclosure statements regarding the investment to all investors.
- You can’t do any general advertisement of the investment.
- Investors are limited in their ability to resell the securities.
To streamline the process of a Rule 506 offering, many companies issue what’s called a private placement memorandum (or PPM, for short), which adheres to the SEC guidelines on what needs to be disclosed regarding the investment. If you ever come across investment opportunities that aren’t listed on the stock exchange, you’ll most likely see them in this format. Or you may see what’s called an executive summary, which is just a summary of the PPM that teases your interest in the investment. After the company has your interest, it gives you the full PPM.
A PPM is normally a complete business plan, 30 to 50 pages long, put into a special format that includes certain disclosures, such as who is involved in the business and what risks are inherent to the investment. I encourage you to be completely forthright when drafting your PPM. Most smart investors look for these disclosures and, believe it or not, are a lot more confident in the investment when they see that the company is being very open and honest about the risks involved.
You can purchase a template for a private placement memorandum online. However, you may want to have your attorney draft a PPM for you instead, even though the cost may be in the thousands. Most templates comply with federal laws only, and your attorney will have to make sure that your PPM and your financing plan comply with the state securities laws as well. Not to mention the fact that your presentation will end up looking much more professional to prospective investors.
Intrastate exemption
The intrastate exemption requires that you find investors or members in only the one state where your LLC operates. This exemption sounds better than it is because it has the following problems:
- All the members of the LLC must be in the same state where the LLC has its business operations.
- The LLC can’t advertise for investors in any state other than the one where it has its business operations.
- The LLC can operate only in this one state. This rule is the worst of all and the one where most LLCs get disqualified because it means that anything related to your business can’t take place in any state other than your home state. You can’t market to people out of state, and you can’t have customers in or purchase supplies from other states.
The world is getting smaller and smaller every year, and raising money under the intrastate exemption is increasingly impossible for most companies. However, if you’re a small mom-and-pop business that operates only locally, this exemption may work for you; just make sure that you don’t do any business out of state. Also, keep in mind that you’ll still be required to file an exemption with your state’s securities commission. To do so, file the SEC Form D (which you can find at www.sec.gov/about/forms/formd.pdf) with your state securities commission. Just make sure to clear everything with a qualified securities attorney first.
Regulation A exemption
If you plan to raise less than $5 million, you may want to consider offering your securities under the Regulation A exemption rather than some of the Regulation D exemptions I discuss in the preceding sections.
With a Regulation A offering, you aren’t limited to the number of investors you bring on board. You still need to do a private placement memorandum (a long-winded form that’s comprised of your basic business plan and some hefty disclosures about the investment); however, Regulation A allows you to advertise the investment in more ways than a Rule 505 or 506 exemption does. For instance, you can use radio or mass mailing to advertise your investment. Also, when registering under a Regulation A exemption, you can advertise your investment before having prepared a private placement memorandum, so long as you don’t take in any money. This freedom allows you to test your response rate before incurring the cost of creating all your disclosure and financial statements.
So if Regulation A offers fewer restrictions and downsides than the Regulation D offerings, why is it so rarely used? As with many things, the Regulation A is great in theory but doesn’t work so well in practice. Unlike with Regulation D offerings, companies taking advantage of the Regulation A exemption must file an offering statement with the SEC. An offering statement is a circular for investors regarding the company’s business, financial, and other pertinent details; the risk factors of the investment; and the management of the company. Not only does this statement result in public disclosure of your company’s private details, but these offering statements can also be expensive to produce. In addition, Regulation A offerings are more difficult than Regulation D offerings to coordinate with state securities laws, which I discuss in the next section
As part of the disclosure, you must show financial statements; however, they can be unaudited if no audited statements are available.
Flying through State Securities Laws (Blue Sky Laws)
Think the federal security laws are a hassle? Well, the ride ain’t over! Not only do you have to comply with federal laws, which are regulated by the SEC, but you also have to register your LLC and follow state laws — often called blue sky laws — in every state where you’re prospectively looking for money. Just hope the investor you’re targeting doesn’t live in a backward, complicated state with expensive filing fees!
The term blue sky laws originated from a judge who said that a certain stock being advertised had “about the same value as an area of blue sky.”
Because the laws differ from state to state, registering your securities in multiple states can be very time consuming and very expensive — especially if you have a securities attorney doing all the research and filing. You can get around the arduous and costly process of registering your offering with every applicable state securities commission, but it still takes some good old-fashioned research on your part. You can use the registration exemption offered by certain states after you find out which states offer it.
Registration exemptions started when the federal government decided to cut small businesses a break and let them raise money without too much red tape. However, even when companies could navigate the federal securities laws, they were still getting hung up by state securities commissions. So to help out the small businesses and real estate transactions that don’t raise a large amount of financing (between $1 million and $5 million), the Uniform Commission of State Laws, with the blessing of the SEC, tried not only to put all the states on the same page but also to offer registration exemptions that matched those of the federal government.
The result was a set of provisions titled the Uniform Limited Offering Exemption (or ULOE), which basically took the federal registration exemptions 505 and 506, made a few simple variations, and then handed them over to the states, ready for the taking. The federal government offered the ULOE to the states on a silver platter, begging them to copy and paste that set of securities laws into their own state statutes. The idea was that if a company complied with the federal registration exemptions, then it’d be in compliance with the state securities laws. Some states agreed, but others copied only part of the code. Therefore, you and your attorney must go through each state’s code to see whether that registration exemption is available in your desired state, and if so, what the specific rules are. If you want to file under the ULOE, you can get the SEC Form D document at www.sec.gov/about/forms/formd.pdf. Just remember: Run things by a qualified securities attorney before filing!
Most states offer some variation of the Rule 505 and 506 exemptions. Check the laws yourself or contact a securities attorney who can check for you. Unless you can find an exemption in the individual state’s laws, you’re required to register in that state if you advertise your investment there or take investment from it.