24 Sep Common Misconceptions About Start-ups and Capital Raising
There are many misconceptions about fundraising that can get in the way of the business itself. The challenge is to spot and eradicate these misconceptions before they become a problem. It’s an ongoing educational effort for most business owners. Following is a brief summary of the most common misconceptions that sometimes cause problems:
Misconception #1 – Only Big Guy Rules. Some business owners mistakenly assume that the securities laws apply only to public corporations whose stock is regularly traded. It’s the old “Why would the SEC want to mess with little old me?” notion. The misconception is supported by the little they read in the press, it’s all about big companies, and the fact that none of their business owner friends has ever had to deal with SEC. Although many securities law issues are uniquely directed at public companies and SEC efforts are focused on the public markets, the securities laws extend to any private securities transaction between a closely held corporation and individual investors. Size is not a prerequisite for Rule 10b-5.
For most privately owned businesses, the fear is not a call from the SEC. It’s a letter from a hungry plaintiff’s lawyer who armed with 10b-5 and a set of ugly facts is making demands on behalf of unhappy investors at the worst possible time.
Misconception #2 – This Ain’t a Security. The misconception is that the securities laws apply only to public stocks. The term security is broadly defined. The Supreme Court has held that a security exists whenever money is invested in a common enterprise with the expectation that profits will come solely from the efforts of others. Applying this broad definition, courts have found a security and investment contracts involving worm farms, boats, silver foxes, oyster beds, vending machines, parking meters, cemetery plots, exotic trees, vineyards, fig orchards, beavers, and more. A flagship surface whenever someone claims or suggests that money can be raised by offering something that is not a security.
Misconception #3 – The Safe Dumb Poor Crowd. Some mistakenly believe that it is safer to target unsophisticated investors don’t know the law and lack the means and the will to fight back if things go wrong. Plus this group is easier because they don’t enough to ask the tough questions upfront. That is, they can be fooled. Usually, this is bad, dangerous thinking.
First, as previously mentioned, the most important registration exemption requires that the investors, the accredited investors, that is, they have sufficient net worth or income to qualify as accredited investors or be non-accredited investors who are sophisticated in financial matters or who have representatives who possess such sophistication.
Second, the company loses the opportunity to bring in savvy investors who may contribute their wisdom and experience in addition to their money.
Third, and this is the real crux of it all, besides just being a bad thing to do, the whole purpose of the securities laws is to protect the naïve and the uninformed. The dumb poor investors may lack the capacity to valuate what’s being promise upfront, but after things go bad it doesn’t take much to find an aggressive lawyer who is willing to speck the case against a contingent fee because given the undisputed limitations of the plaintiffs, it’s a slam dunk case.
Smart private business owners generally limit their efforts to accredited investors who have experience in financial and investment matters and who can afford the loss of their investment. In rare instances they might consider a non-accredited individual but only if that individual is sophisticated in financial matters and is investing a sum that he or she can afford to lose.
Misconception #4 – Only Real Important Stuff. The misconception is that only the real important information has to be disclosed because Rule 10b-5 speaks in terms of material facts. Often this misconception is aggravated by the notion that the important information is limited to the bottom line conclusions that support the business plan. So they reason there is no need to sweat details that may complicate the money-raising effort. The determination of a material fact within the meaning of 10b-5 depends on the significance the reasonable investor would place on the withheld or misrepresented information. It’s a very broad definition. It’s usually a big mistake to assume that the materiality requirement eliminates the need to provide details.
Plus, there’s another hard reality that always supports the conclusion that more, not less, should be disclosed. If things go bad in a significant contributing factor to the failure was not disclosed upfront, it may be impossible as a practical matter looking back to claim that that factor was not material and worthy of disclosure. As discussed shortly, the wisest and safest approach is to lay out all known risk factors and the related details.
Misconception #5 – My Success Says It All. Many business owners focus only on past successes when talking about their track record. Failures or disappointments are forgotten or amended to look like successes. The misconception is that it is appropriate to paint the best possible track record even when it involves a little fudgy or selective editing.
A key executive’s track record is important to any investor. What one has done in the past often is the best indicator of what might happen in the future. If things go bad, an investor who first learns after the fact that this was not the key person’s first failure may be shocked into action. The challenge is to accurately and fairly summarize the background and experiences both good and bad of the key players in a way that suggests that they now posses the skills and abilities to successfully manage the proposed venture.
Misconception #6 – Good Advertising is the Key. Some mistakenly assume that money-raising is all about advertising. They start a makeshift advertising campaign only to learn that they’ve killed their best shot at a registration exemption. In the world of closely held business and private placements, the word regarding the investment usually must be spread through friends, relatives, and business associates. Slick ads and media placements are out of bounds.
Misconception #7 – Safety in Numbers. The misconception is that it is safer to have a large number of small investors rather than 1 or 2 big players. It’s based on the false assumption that a small investor will be more inclined to swallow a loss and less inclined to fight back. It ignores some basic realities.
First, the size of one’s investment does not govern the capacity to stomach a loss. Many large players are better equipped to understand and suck up a loss than most small investors who have unrealistic expectations from the get-go and can’t really afford any loss.
Second, it ignores the capacity of many small voices to stir up each other and to share the expense and burden of hiring a gladiator to fight their cause.
Third, it ignores the burden, often horrendous, of having to respond to multiple ongoing inquiries all along the way from nervous uninformed investors who just want to hear that everything will pay off as promised and that there are no problems.
Finally, it ignores the significant value of binding a few key players to the effort, inviting a few key players into the inner circle gives the business the benefit of their advice and counsel and often eliminates any securities law exposure because they see it all, hear it all, and are part of it all.
Misconception #8 – Dodge the Downside. Some mistakenly assume that there’s no need to talk about the potential of failure when trying to raise money. They figure that everyone knows there is a risk, so why talk about it. The truth is that from a securities laws perspective, it is essential to spell out the risk factors in writing for any prospective investor. Nothing is more material than those factors that might potentially cause the business to fail.
Thought should be given to risk factors that are specific to the business – competition, market condition changes, supply access, technology changes, skill labor needs, capital and liquidity challenges, that type of thing. And the potential impact of general risks, interest rate changes, tax changes – general changes that may impact the business. Often this risk disclosure task is one of the most difficult tasks for business owners to embrace. As the risk factor list is committed to black and white, they begin to fear that everyone will be spooked away. Just remember that seasoned players are used to seeing these kinds of lists and that they’ve all made money in ventures that started out with risk factor lists that were just as ugly as the one being created.
Misconception #9 – Projections Are Just Projections. The misconception is that since future projections by their very nature are speculative, they create an opportunity to strengthen the money-raising effort by painting the rosiest possible picture of how things might play out in the future. It’s little wonder that such projections have been the driving force behind many securities law claims. The use of projection should be handled carefully. They should not be viewed as an opportunity to oversell but rather as a means of illustrating the business’ potential under a defined set of reasonable assumptions. If overdone, they may create unrealistic false expectations that cause an otherwise good performance to disappoint or worse yet, fuel a legal dispute when things turn sour.
There are a few important precautions that can be taken. First, make certain that the projections are based on reasonable assumptions that are spelled out. The operative word here is “reasonable.” The assumption should not reflect an ideal unrealistic set of conditions.
Second, the projections should be accompanied by a cautionary statement that identifies the projections as forward-looking statements that warns the conditions and risks can cause actual results to differ substantially from the projections and that lists specific risks and conditions that may have such an effect.
Misconception #10 – Puffing works! Some business owners believe that the key to legal money raising is puffing – making vague overstated generalizations that get potential investors excited. Often they have heard about cases where defendants escape securities law liability because the court concluded that the alleged misrepresentations were nothing more than obviously immaterial puffery. Statements like “Our fundamentals are sound. Our product is revolutionary it could change the world” have been dismissed as immaterial puffing.
The problem is when it goes too far. What may appear as harmless puffing can trigger liability under the securities laws if the speaker had no reasonable basis for making the statement. The court will examine whether the speaker really believed that the statement was accurate and had a factual or historical basis for that belief. There is some room for harmless puffing, but in no sense is if a free pass without limits.
Misconception #11 – Let ‘Em Be! The misconception is that investors, once they’ve bought in, should be free to deal with their stock as they see fit. The private offering exemption requires that investors not be used as a device to disseminate the stock to a broader audience and therefore convert what would otherwise be a private offer into some type of public offering. This important factor coupled with the obvious anti-fraud challenges gives the company a huge interest in what the investors do with their stock or more importantly do not do with their stock.
For this reason, it is common practice to ascertain the investment intentions of the purchasers upfront to place resale restriction legends on the stock certificates, to issue stock transfer instructions to those who control the stock register, and obtain written rearticles from all purchasers of stock that they are acquiring the stock for their own account and not for resale with a view towards the distributing to others.
Misconception #12 – Cashing in is the Easy Part! This misconception surfaces when everyone just assumes that an acceptable exit strategy will present itself at the most opportune time. Often a business plan is developed with little or no serious thought given to the ultimate strategy that will be used to realize a return for the owners of the business. No serious effort is made to research the practicality and possibility of specific exit scenarios. The details of operating the business and generating revenues have been though through but the broader picture of exit opportunities is left to fuzzy notions of market option and base ignorance.
The sad reality is that many business owners and managers are shocked and disappointed to discover that there is little or no market for the business. This disappointment can be magnified many times for the outside investor who draws no compensation and has assumed all along that a big payday was within reach.
A primary challenge for many business owners is to develop a realistic expectation of the business’ capacity to create returns for the owners at the right time. Seasoned entrepreneurs do this instinctively. Experience has taught them to always have their eye on the big picture and the entire life cycle of the business. Plus, they understand that conditions can change. What is solid and profitable today can be weak and vulnerable tomorrow.
So timing is often the key when it comes to cashing in their marbles. Less experienced owners particularly those who are wrapped up in their first effort often fail to see let alone focus on the broader picture and never develop realistic expectations for themselves and for those who have entrusted them with their money. As a result, they end up in a situation where they can only disappoint.
That completes our discussion of corporate basics. We hope that the article has been information and that it has been helpful to you. Thanks for your time.