Articles Posted in Financing your Startup

dollarsNew business ideas and practices spring up all the time. Some, but not all, find a niche that leads to success. Government officials at the city, state, and federal levels often keep a close eye on new or unconventional business practices to see how they fit into existing laws and regulations. If regulators determine that a particular business activity falls under their jurisdiction, they may attempt to rein in what they view as regulatory violations. The businesses, of course, might disagree with this assessment. Any new business should be aware of regulations that apply—or might potentially apply—to them. A lawsuit currently pending in a New Jersey federal court demonstrates this sort of dispute. RD Legal Capital, LLC v. U.S. Securities and Exchange Commission, No. 2:16-cv-05104, complaint (D.N.J., Aug. 22, 2016).

The plaintiff alleges that the Securities and Exchange Commission (SEC), a federal agency charged with enforcing securities laws, exceeded its authority under both federal law and the U.S. Constitution by initiating a regulatory action against it for alleged violations of the Investment Advisers Act (IAA) of 1940, 15 U.S.C. § 80b-1 et seq. While businesses in New Jersey and New York that do not provide financial services of any kind are not likely to find themselves subject to this specific statute, the case is illustrative of how the government can seek to impose an existing regulatory framework on a business, even if the business believes in good faith that it is not subject to that framework.

The statute at issue in RD Legal Capital defines an “investment adviser” in part as someone “in the business of advising others…as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” 15 U.S.C. § 80b-2(a)(11). Congress originally passed this law in the wake of important Great Depression-era statutes like the Securities Act of 1933 and the Securities Exchange Act of 1934. Each law uses a substantially similar definition of a “security,” id. at § 80b-2(a)(18), 77b(1), 78c(a)(10), and each has generated a considerable amount of regulatory opinions and caselaw regarding the scope of this definition.

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By Kevin Hutchinson (Flickr) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia CommonsRaising capital is a critical step in the early stages of starting a business, but federal and state laws set several important limits on this process. Ownership in a business, when given in exchange for a monetary contribution, is generally considered a “security” for the purpose of federal financial law. Federal law requires companies that are offering stock for sale to the public to register the offer with the Securities and Exchange Commission (SEC). An exception to this rule, known as “Regulation D” or “Reg D,” allows companies to offer stock to certain investors without the lengthy and expensive SEC registration process. This allows small businesses and startups to approach angel investors, venture capital firms, and others.

Public vs. Private Offerings

The process of raising capital for a small business or startup is commonly known as “private equity,” since funding comes from a limited pool of potential investors. A company that registers with the SEC and meets all of the requirements of the Securities Act of 1933, 15 U.S.C. § 77a et seq., can offer their stock for sale to the general public on exchanges like the New York Stock Exchange. It then becomes known as a “publicly-traded” company.

When a company offers its stock for sale to the public for the first time, it is known as an initial public offering (IPO). Obtaining SEC approval for an IPO is complicated, expensive, and out of reach for startups and many small businesses. These businesses need to raise capital, but they must do so in a way that does not inadvertently become an unauthorized public offering of securities.

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By Peosoldier photographer [Public domain], via Wikimedia CommonsEvery business may begin with an idea, but without money, a business cannot operate and grow. Most aspiring business owners fund their businesses from their own savings, or from credit cards or bank loans. A wide range of investment sources are available for businesses that can demonstrate a solid product or service, and the potential for growth and scalability, and profitability.

Stages of Business Financing

New businesses often follow several stages in obtaining financing:

– Seed stage:  The business solely consists of an idea or a product.
– Startup financing:  The business is ready to launch its product or service. In venture capital financing, this is sometimes known as the “Series A” financing round.
– Second-stage financing:  The business has demonstrated its viability and needs additional capital. This is sometimes called “Series B” financing.
– Line of credit, additional financing:  The business is nearing profitability and secures a line of credit from a commercial bank for “working capital.” It may also seek additional rounds of financing, beginning with “Series C” and continuing through the alphabet.
– Acquisition or IPO:  The business is acquired by another business or makes an initial public offering (IPO), which makes its shares available for purchase and sale on one or more stock exchanges.

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1.12.02NewYorkStockExchangeByLuigiNovi1.jpgThe number of initial public offerings (IPOs), in which a company first offers its stock for sale on public exchanges, has skyrocketed during the first nine months of 2014. 220 companies went public during that time, raising about $77 billion. The record-breaking IPO of the Chinese company Alibaba alone raised $21.8 billion, but the vast majority of 2014 IPOs reportedly consist of “emerging growth companies” (EGCs), a category established in 2012 by the Jumpstart Our Business Startups (JOBS) Act. EGCs are smaller companies that have often been unable to meet the regulatory requirements for IPOs, but now they account for most or all of the growth in the number of IPOs in recent years.

The JOBS Act was introduced in Congress as H.R. 3606 in March 2012. It quickly passed both houses of Congress, and the President signed it into law that April. The law relaxes various regulatory requirements for smaller public companies and expands their eligibility to go public. It also increases, from 500 to 2,000, the number of record stockholders a company may have before it must register with the Securities and Exchange Commission (SEC).

The JOBS Act amends the Securities Act of 1933 and the Securities Exchange Act of 1934 to include “emerging growth companies.” H.R.3606 §§ 101(a) – (b), 15 U.S.C. § 77b(a)(19), 15 U.S.C. § 78c(a)(80). An EGC is defined as a company that began issuing securities to the public after December 8, 2011, and that had less than $1 billion, adjusted for inflation, in annual gross revenues during the most recently ended fiscal year.
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Fondos_archivo.jpgA business entity created under the laws of New Jersey or another U.S. state is, at the most basic level, a collection of legal rights and obligations aimed at specific business activities, usually with the goal of making a profit. Those rights and obligations depend on a substantial number of agreements that should be reduced to writing and stored where a business owner can easily find them.

The following list includes 15 types of documents you should keep with your business records. You might need any of them if you have a disagreement with a business partner, co-owner, contractor, or employee, if you want to do business with a government agency, if you are looking for venture capital or other new investors, if you are trying to wind the business down, or simply in preparation for the unexpected. A few ounces of paper might be worth many pounds of future regret.

1. Formation Documents

Forming a business entity requires filing documents with the state and paying a fee. In New Jersey, the Department of the Treasury’s Division of Revenue and Enterprise Services handles business formation. A document forming a corporation is often known as a Certificate of Incorporation, while one creating a limited liability company (LLC) is known as a Certificate of Organization.
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teamwork-382673_640.jpgThe New York City Council approved its fiscal year 2015 budget (PDF file) in late June. The new budget includes $1.2 million for the support and development of worker-owned cooperative businesses, commonly known as “worker cooperatives.” The defining feature of a worker cooperative is that the employees own all, or at least a substantial majority, of the company. Advocates for worker cooperatives state that they can benefit local communities by keeping ownership close to home and promoting good employment practices. The allotment of funds by the City Council is reportedly the largest investment ever by a city government in this type of business.

The U.S. Federation of Worker Cooperatives (USFWC), the only nationwide organization for worker cooperatives, defines the business form as an entity that is “owned and controlled by [its] members, the people who work in [it.]” Worker cooperatives have two “central characteristics,” according to the USFWC: (1) investment in and ownership by “worker-members,” who receive distributions of profits; and (2) a democratic decision-making process involving one member, one vote. Profits are often known as “surplus,” which is one of many ways that worker cooperatives seek to distinguish themselves from other models of business ownership.

Article 5-A of New York’s Cooperative Corporation Law allows businesses incorporated in the state to elect to be governed as a worker cooperative. Businesses that make this election are subject to parts of both the business corporation law and the cooperative corporation law. New Jersey does not have a specific business form for worker cooperatives, but businesses can choose to form as a corporation under subchapter C or S, as a limited liability company (LLC), or as other business forms.
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2008-03-13_Rave_crowd.jpgNew federal laws may allow entrepreneurs and small business owners to seek investors publicly without having to go through the complex and expensive process of creating an initial public offering (IPO). New businesses may soon be able to raise capital via social media and the internet, in a process known as “crowdfunding.” Currently, websites like Kickstarter allow people to crowdfund creative projects, but businesses seeking equity investments have had to follow strict regulations enforced by the Securities and Exchange Commission (SEC). New rule proposals recently issued by the SEC, however, may change that.

Entrepreneurs have generally had to limit their efforts to raise capital to private sources. According to Forbes, most startup capital comes from the entrepreneurs themselves, who might invest their own savings, take out loans, or use credit cards. Family members, such as parents and spouses, account for a small percentage of startup capital. “Outsiders,” including government programs, venture capitalists, angel investors, and other businesses, account for some startup financing. Venture capitalists fund 0.04% of all startups, and angel investors fund 0.91%. Despite such a small percentage of businesses, venture capitalists are expected to invest $2.7 billion in New York-based startups in 2013. A startup seeking individual equity investors may only approach people who meet certain criteria as “accredited investors,” such as individuals whose net worth is at least $1 million or whose annual income exceeds $200,000.

The Jumpstart Our Business Startups Act (JOBS Act) became law in April 2012. Its purpose was, in part, to help businesses that are not large enough for an IPO but have difficulty raising capital through private channels. It raises the maximum number of shareholders corporations may have, from five hundred to two thousand, before they are required to register with the SEC. The JOBS Act allows companies to raise up to $1 million per year from individual investors, and it greatly relaxes the restrictions on who may invest. Individual investors with a net worth or annual income below $100,000 may invest up to the greater of $2,000 or five percent of their annual income, while investors with a net worth or annual income above $100,000 may invest a maximum of ten percent of their annual income. Companies must still provide information to the SEC, such as names of directors and officers, but the reporting burden is far less than for fully public companies.
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1QPS.pngLawmakers often use state and federal tax laws to encourage certain types of business activity, or to discourage activities in lieu of banning them. Tax breaks often serve as incentives to investors and entrepreneurs to focus on a particular industry or market. Bills pending in the U.S. Congress and the New Jersey Legislature propose various tax incentives for businesses, including technology investments, infrastructure development, and hurricane relief. Supporters of these bills hope to promote job creation by spurring business activity. Critics contend, however, that similar New Jersey incentives have not had the desired impact on job creation in the past. New Jersey and New York businesses should be aware of pending legislation in order to take advantage of any tax breaks or tax incentives that might benefit them.

On April 9, 2013, a Democratic lawmaker from Maryland introduced H.R. 1415, the Innovative Technologies Investment Incentive Act of 2013 (ITIIA), in the U.S. House of Representatives. The bill would allow a tax credit for qualified investments in “high technology and biotechnology business concerns,” H.R. 1415 § 2 (113th Cong.), equal to twenty-five percent of the investment amount. This would be a direct credit against the amount of tax owed by the investor, as opposed to a deduction from the investor’s total taxable income. The total amount of the credit would be subject to a nationwide limit of $500 million per year, and the Small Business Administration (SBA) would be responsible for allocating credits among qualified investors. To qualify for the credit, the investment must be a stock purchase or other capital investment in a high-tech or biotechnology business with less than five hundred employees. Investors must hold onto their investments for at least three years. The purpose of the bill is to encourage investment in technology and biotechnology companies, which in turn will hopefully promote innovation and job creation.
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310102_6457.jpgA Delaware court found that a corporate director breached the fiduciary duty of loyalty, despite the director’s subjective good faith, in Shocking Technologies, Inc. v. Michael, C.A. No. 7164-VCN (Del. Ch., Sept. 28, 2012). The plaintiff company filed suit against one of its directors, who was also an equity owner of a shareholder. Although this may have created some conflict for the defendant himself, the court held that his duty to the company as director were clear. Even though the defendant believed he was acting in the company’s best interest, the court found that he breached his fiduciary duty of loyalty largely because of the risk his actions posed to the company.

The defendant, Simon J. Michael, was the manager of Balch Hill Capital, LLC (BHC). BHC, in turn, was the general partner of Balch Hill Partners, L.P. (BHP). Both BHC and BHP are named as defendants in the case as well. Michael, through BHP, made three separate investments in the plaintiff, Shocking Technologies, Inc. Michael also became BHP’s designee to the board of directors.

Although the bylaws allowed for six directors, Shocking only had four during the summer of 2011. One of the directors was also the founder, president, and chief executive officer of the corporation, and the other two were shareholder-directors. Michael, as the fourth director, allegedly felt that the other directors were acting in concert and not in the company’s best interests. Communications between the other three directors and Michael broke down, according to the court’s ruling, leading to the alleged acts that formed the basis of Shocking’s lawsuit.
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911378_21359151.jpgThe U.S. Supreme Court will review the Securities and Exchange Commission’s (SEC’s) five-year statute of limitations for civil actions to recover penalties. The question before the Court in Gabelli v. SEC, Docket No. 11-1274, is precisely when the statute begins to run. The SEC contends that the statute begins to run when it actually learns of an alleged violation, a position that the Second Circuit Court of Appeals affirmed in SEC v. Gabelli, 653 F.3d 49 (2nd Cir. 2011). Marc Gabelli, who petitioned the Court for certiorari, argues that the statute should have begun when the SEC’s cause of action actually accrued, i.e. when the alleged violation occurred. For small businesses and startups pursuing financing options, this case could have important implications for how the SEC investigates and prosecutes alleged wrongdoing.

Gabelli was the portfolio manager of a mutual fund known as Gabelli Global Growth Fund (GGGF). The SEC filed a complaint against him and Bruce Alpert, who was the chief operating officer of GGGF’s adviser Gabelli Funds, LLC, accusing them of engaging in a practice called “market timing” in a way that preferred certain GGGF investors over others. The practice involves making rapid trades in order to exploit short-term inefficiencies in pricing. It is not illegal per se, but it can be detrimental to a fund’s long-term investors by, for example, affecting transaction costs and disrupting the overall management of the fund.

The SEC alleged that Gabelli and Alpert allowed a form of market timing in GGGF between 1999 and the spring of 2002. While the market timing was taking place, the SEC claimed, the defendants did not notify the fund’s board, nor did they disclose the activity to the fund’s other investors. The SEC argued that this was “materially misleading” to the fund and its investors. SEC v. Gabelli, 653 F.3d at 55.
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