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Legal Issues In Raising Capital (Second in a Series)

On Behalf of | May 5, 2014 | Business Transactions

The Evolution of a Company


The first stage in the evolution of a company is founding or forming the company. The second and third stages may be combined and in some cases the second is skipped, but for many the second stage is angel investment or friends and family investing and the final or third stage is venture funding. While some companies skip steps or never reach all of them; for the purposes of today we can briefly discuss each. While some companies by the nature of what they do or the goals of the founders, never raise money from third parties, most growth companies require capital to fund operations and new products or services.

When the company is formed, there are founders. The founders are issued stock or member interest based upon the money invested as well as the time that will be spent in the endeavor. In New Hampshire for instance the stock issued upon formation is exempt from registration, if the equity is issued within 60 days from the date of formation and there are less than 10 founders. In Massachusetts there is no such exemption as to founders, but there are restrictions to the number of sales with any 12 month period. The number is 25. In New Hampshire the number of investors allowed pursuant to the exemption post formation, is 5 in any 12 month period. (NHRSA 421-B:17)

As you can see, just in these two states alone there are different rules and if you have just one person in either state, your company is subject to the rules of both states for the sales which occur in that state.

When you form the company, you authorize a number of shares say, 100,000. For the purposes of this example you and the other founders if there are any, decide to issue 50,000, that means you have 50,000 to sell or save for employees (the issues of options is a long discussion as well). If you need more shares, you have to amend the company’s formation documents with the state of formation and authorize more shares. You also have the option at formation of authorizing different types of stock, common and preferred. Usually the founders get common, and investors get preferred, but it varies. You can also determine voting rights and liquidation preferences as well as dividends.

You have formed the company and issued stock to the founders and now you need money beyond what the founders can invest.

Angel or Friends and Family

At this stage many of the potential investors are not going to be accredited investors and may be friends and family members. Do not make the mistake of being casual about documentation. Even if it your mom giving you $10,000, make sure there is a purchase agreement, with the number of shares clearly defined and that the issuance of the shares authorized by a corporate vote.

Mistakes as to documentation at early stages can hamper fund raising later on in the company’s growth or worse blow an exemption and subject the company to a rescission, that is the requirement to pay back to investors all the money raised. I have seen this happen and it cost the company money and time. The CFO, thought that as long as stock was being issued to accredited investors pursuant to a safe harbor exemption under the Federal rules that the company did not have to worry about state law. The issue was raised by the next round of investors. The company had to give all the money back and the investor moved on to other deals.

The definition of an Angel Investor is not an exact one, but can loosely be defined as a person or group of persons who have some money that they are willing to invest in early stage companies. Typically these people started and sold companies of their own and have decided to help other entrepreneurs. Some of these people can be helpful as to the technical or business issues you may be facing, but for the most part they are sources of small amounts of capital, usually less than $1,000,000. When talking to angels, always make sure that you are not giving them too much of the company. The biggest problem people make at this stage is overvaluing the money and negotiate away too much.

While some angels want to be informal, make sure there is a term sheet and make sure you understand everything. The issue of dilution is key, not only with this investment, but with future investment as well. For instance, make sure that they are diluted in the same manner as the founders. Also, be aware or provisions that require the company to issue additional shares if you happen to sell shares later on for less money.

When dealing with an Angel, you will need to determine whether they are an accredited investor and as part of any purchase document, you will need them to fill out a questionnaire, much like the one attached to these materials.

If they are, and you meet all the state requirements, you also need to determine if you can complete the sale under federal law as well. In the next installment we will deal with the last stage of the evolution of a company

If you have any questions or would like additional information on this issue or other corporate challenges, please contact Paul D. Creme.

Paul D. Creme is an attorney with Hamblett & Kerrigan PA. His practice is focused on business and corporate law. Of particular interest are the areas of software and emerging technologies. You can reach Attorney Creme at [email protected].