Most businesses need financing at some point in their lifecycle, whether at start-up, to continue to grow or to address financial problems. However, most types of corporate financing are subject to state and federal laws which vary depending on the source of the funding. Failure to comply with these rules can result in significant liability. Good legal advice can help ensure businesses select the best form of financing and that they have the necessary documents prepared for investors and regulatory agencies to minimize legal risks.
When Is Financing Necessary?
Typically, new businesses require financing to set up and run their operations and market their product or service until they become profitable. Established businesses may seek capital for a wide variety of reasons including:
- The business needs funding because of insufficient cash to cover its operations.
- Financial Restructuring. Where the business has too much debt, it may sell equity in the company to pay off the debt.
- Corporate Mergers and Acquisitions or Asset Purchases. Companies looking to expand may need debt or equity financing for a merger, acquisition, or strategic asset purchase.
- Investor Exit. Often, investors seek to “cash out” and recoup their investment after a certain number of years so the business needs money to pay back the investor.
Where Can Companies Obtain Corporate Financing?
Financing can come from many sources. The best choice varies depending on why financing is needed and the circumstances of the business. Options for funding include:
- Financial Institutions. Banks and other lenders can provide debt financing which does not usually require the issuance of securities. Such loans may be secured or unsecured.
- Private Equity and Hedge Funds. These funds may offer debt or equity financing to a business. Fund investors may include both individuals and institutions.
- Venture Capitalists. This funding is for start-up and early-stage companies. Investors purchase preferred stock in the company, which can be later converted into common stock. Insurance companies, pension funds and foreign government-controlled investment funds may provide venture capital financing. However, state and federal law often impose restrictions.
- Angel Investors. These investors usually provide seed financing for start-ups in exchange for common or preferred stock in the company.
- Start-ups may seek funding from non-accredited investors through crowdfunding. However, there are requirements under securities laws.
- Friends and family round. Usually in the form on loans, one of the most common sources of debt financing for start-ups comes from friends and family. It is important to insist on some form of legal documentation that you would prepare if your investor was a total stranger.
What Laws Apply to Corporate Financing?
There are federal and state laws which govern corporate financing. Generally, the purpose of these laws is to protect investors and consumers and ensure companies provide pertinent information about their business and investment risks.
Federal Securities Law
At the federal level, the Securities and Exchange Act of 1933 and the Securities Act of 1934 set forth many of the requirements which apply to the purchase and sale of securities. While most people think of stocks as securities, the definition may also include loans and other financial interests.
Securities that are issued in a “public offering” generally must be registered with the Securities and Exchange Commission (SEC). A registration statement must include extensive information about the company’s operation and financial condition and disclose how proceeds from the sale of securities will be used and specific risks of investing.
Companies can avoid registering with the SEC if the offering falls under an exemption or “safe harbor” provision. However, these rules are complicated and legal advice is essential. The most commonly used exemptions are:
- SEC Rule 504. This exempts the offer and sale of up to $1 million of securities in a 12-month period. Companies may solicit or advertise to the general public. Information provided to investors may not be false or misleading.
- SEC Rule 505. Companies may offer and sell securities totaling up to $5 million in any 12-month period to an unlimited number of “accredited investors” and up to 35 non-accredited investors under this exemption. However, companies may not advertise to the public. The same information must be provided to accredited and nonaccredited investors.
- SEC Rule 506. The rules only applies if the securities are offered to non-accredited investors who meet the requirements of a “sophisticated investor,” meaning that they have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. Where the exemption applies, there are no limits on the amount of capital that can be raised.
- Private Offering. This exemption requires that the securities are not offered to the general public, investors meet certain standards of wealth and sophistication and agree not to resell or distribute the securities to the public. Typically, investors in a private offering are ones with a pre-existing relationship with the company or owner.
To take advantage of any of these exemptions, companies must file exemption paperwork with the SEC – most commonly, a Form D.
Note that offerings which may be exempt under Rules 504 and 505 may nonetheless be required to register under state securities laws unless a state law exemption applies. State securities laws, commonly known as “blue sky laws,” vary, so it is important to research each state’s requirements. Where offerings fall under Rule 506, states cannot require registration. Generally, companies must comply with the blue sky laws of the state where the potential investor lives and file a copy of Form D, a state-specific form, and pay a fee.
Antitrust Laws and Regulations
Federal and state antitrust laws may apply to block a merger. Notably, states may stop a merger even where the federal government lacks the authority.
Financing is often crucial to the success of a business and traditional bank loans may not be available or recommended under the circumstances. As a result, companies must turn to other methods of raising capital. The rules governing corporate finance and the legal documents required are complex. Moving forward without skilled legal advice can result in significant liability, including civil and criminal penalties. Consult an experienced corporate attorney for assistance any time financing is needed.
Romano Law can provide guidance on corporate financing in New York, California and Florida.
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