Raising Money for the Small Business
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How to Use These Notes
This is a very tricky issue and the following is not intended in any way to be definitive. The rules are potentially different in every single state, I'm no lawyer, and it would be lunacy to make decisions after read these notes without consulting a lawyer and doing your own research.
The purpose of these notes is strictly limited to providing a starting point for discussions with qualified professionals. I don't mind you looking, but I'm not intending to publish this stuff, it's just that putting it on my wiki is the most convenient thing for me to do.
DO NOT RELY ON ANYTHING YOU FIND HERE.
Overview
Capital is a challenge for any business, but it's doubly so for a small business. There are two primary obstacles to be overcome:
- there are significant restrictions regarding who can invest in a small business
- the business is prohibited from any public solicitation
Both these restrictions stem from the Securities Act of 1933 which was fashioned in response to the rampant sale of fraudulent securities in the 1920s to unwary investors. The basic idea is to keep charlatans in check and to protect the average person from their own ignorance. Whether or not this is a good idea is an entirely different question.
The Securities Act of 1933 is a nearly complete wall that divides the small business from any and all external investment. The is a narrow gap in that wall, which is known as Regulation D.
Regulation D is a section of the act which lays out exceptions to the general prohibition of investment in small business. While very heavily regulated, Reg D does allow a small trickle of investment to reach the small business.
Before continuing on, I should clarify one thing. The term "small business" and "large business" are a perhaps misleading because the law's don't really involve the size of the business. The question is whether the business is registered with the SEC or not. In practice, however, it would be impossible for any but a fairly large business to reasonably bear the burden of registration, so the law effectively draws a line between small and large.
Securities
First, what is a security? The snarky answer is "it depends" because the term is defined at both the federal and state level. In practice, most of the definitions are pretty close and you should look up the statute for your particular state. Section 4 of the Texas Securities Act provides (as far as I know) a typical example example. All the definitions are pretty big and encompass a lot of stuff. The web site for Texas notes that a security can exist even when there is no written document or contract at all. Whats more, the courts have generally held to a rather broad reading of the definition.
My own summary: a security is any instrument which gives the purchaser a material interest in the performance of a business without conferring any significant control over said performance. A bond is a security because if the bond issuer goes bankrupt, the bond is worthless and at the same time, the bond holder has no control over what how the issuing entity is run. Stock, though it confers theoretical ownership in a company, is a security because each individual share is trivial. An interest in a general partnership is not a security because each general partner can theoretically effect the the performance of the business directly.
Even this short discussion brings up some big questions. Certainly a majority stock owner in a company can materially effect the performance of the business, and a general partner holding 1% of a company might effectively have no power at all. Neither the logic, statute, nor the court rulings in this area is clear cut.
Passive and Active Participation
- limited and general partnerships - member managed and manager managed LLCs
Rule 505
Reg D contains a number of rules which lay out circumstances under which it is permissible for a small business and her owners to accept outside investment.
As far as the average small business is concerned, the most important rule
References
- The Texas Securities Act
- Texas Securities Registration Exemptions
- When LLC Interests Are Securities provides an excellent discussion of the precedent and case law regarding securities and LLC interest
- Rule 505 FAQ from the SEC
- Small Business and the SEC Q and A
- Accredited Investor definition from the SEC
- Reg D Offerings from the SEC
- Form D
