When it comes to startups’ earliest funding sources, beyond founders’ personal liquidity (or debt capacity) friends and family are usually the first places founders turn to for help getting their startups going. But there are significant risks to tapping those close to you for funds. And I’m not just talking about the obvious possibility of emotions becoming wrapped up in funding decisions or the potential negative impacts to your personal relationships.
Of course, you need to be transparent about the risks and make sure that your family, friends, and close associates understand and only invest money that they are willing to lose.
Startup Fundraising: What You Don’t Know Can Hurt You
The risk I’m thinking of though is running afoul of U.S. securities laws. To be specific, I’m talking about the Securities Act of 1933. It set requirements for companies’ stock issuance.
You might be wondering what that has to do with you and your team of three, hard at work developing your software in a coworking space. The connection is that, with exceptions for stock issued to founders and employees or for agreeing to comply with extensive financial disclosure requirements, private companies can only accept investments structured as outright gifts or as loans unless their funders are accredited investors.
Kristine DiBacco, Associate at Fenwick & West LLP, gave a great overview of this topic during our Startup Seed Funding webinar.
SEC Criteria for Deeming Someone an Accredited Investor
The main SEC criteria for deeming someone an accredited investor are:
- 1. He or she must have earned a minimum of $250k in each of the last two years ($300k for married couples)
- 2. Must have a minimum net worth of $1m, excluding the value of their home
The responsibility rests with startups to take reasonable steps to verify that their investors meet the criteria.
And to add another wrinkle, the SEC is currently reviewing its criteria for accredited investors as a result of Congress’ passage of the Dodd-Frank Act in 2010. The jury is out on whether that will mean a loosening of the standards or tighter restrictions. Joe Wallin gives a helpful status in a post on his StartupLaw blog. Full implementation of the Jobs Act of 2012, which legalized equity crowdfunding, will further tighten the restrictions around who you can accept funds from without having to go through an extensive securities registration filing and/or disclosure process.
The bottom line? Knowing your investors means a lot more than knowing what their favorite things or where they went to school. While you as a founder understandably don’t want to shut off access to any potential funding sources, especially in the critical early days, not complying with regulations governing funding sources, could limit your future capital structure/financing flexibility and funding options — including deterring institutional investors when you’re trying to raise your first priced round or turning off potential buyers of your company.
If you don’t want to, or can’t handle this yourself, and you don’t want to take on loans, look at other funding sources such as angel syndicates and crowdfunding websites, startup incubators and accelerators — or continue to bootstrap if you can, at least until you can come up with a working prototype that you can pitch to investors.
Have you tapped friends and family as part of your startup fundraising efforts? Share your experience and ask us questions in the comments section below or contact Early Growth Financial Services for financial support with your startup fundraising.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.