Written by Attorney Joe Boucher
Small businesses are cash-powered locomotives; without enough working capital, startups are doomed before they even begin. Although venture capitalists, angel investors and institutional lenders make it easier than ever for entrepreneurs to find and get money, nearly every business faces a steep ramp-up period between inception and revenue.
So, what’s the best way to keep the coffers full before the business becomes self-sustaining? For many business owners, the temptation to trade a stake in their nascent company in exchange for relatively small amounts of capital is extremely tempting. Friends and family might be willing to part with $10,000 or $20,000 in exchange for a piece of a pie that may someday yield many delicious slices.
But entrepreneurs need to be aware of some dangers that lurk behind the friends and family model of equity investment.
First, it may not seem like much at the time, but even a small minority share of a company carries with it certain rights, both financial and governance-related. Entrepreneurs need to really consider whether Uncle Jim will make a good member or shareholder when the company is worth $5 million instead of $500.
Second, contrary to what a lot of people think, there is no exemption under the SEC’s Regulation D for sales of securities to friends and family, no matter how much they love you. Unless they are accredited investors – a significant hurdle – or fall under another exemption, selling equity to family members may have serious logistical, regulatory and, ultimately, financial consequences for a business.
Instead of giving away the business while simultaneously risking the SEC’s ire, small business owners often benefit from the path of least resistance. Namely, they can feel confident taking relatively modest amounts of cash – the lifeblood of their ventures – in exchange for simple promissory notes. Promissory notes memorialize the loan of cash to the business in exchange for repayment plus interest. It’s a win-win scenario: Grandma Jean gets her $10,000 plus 5% over 5 years, and the company has the money it needs to feed the engine.