“Draw the Law” is a weekly short post where I try to visualize a legal concept. It is designed to be helpful to small business owners and give them a quick overview of various aspects of the law that affect them. For the next couple of posts I will detail how to finance a start-up. In the prior post we discussed personal sources of getting money for your start-up. However, let’s say you have exhausted all personal sources that you know to get money from. You have drained all your bank accounts on Oahu, asked all your siblings on the mainland, and asked your Aunties and Uncles on the Big Island, and you are still short for your dream bakery. What do you do now to raise capital?
You should start consider contacting private lenders and/or investors.
Your typical lender will be a bank. While there are other types of lenders I am going to mainly focus on what the banks do. The process of securing a loan is typically a lengthy one involving a lot of paperwork and discussion with your banker. Especially, given the state of the economy many banks are wary to loan out money to endeavors they deem to risky. It is here that a solid business plan is key to convincing banks. If you are more an idea person, I do suggest seeking consultants, such as attorneys, financial advisors, accountants, and experts to help your business planning needs. If the bank approves the loan it will still seek personal guaranties and collateral from you.
What is Collateral?
Collateral is the borrower's (you, the business owner’s) pledge of some specific property that you own to the lender in order to secure loan repayment. Basically, they typically want some sort of assurance that they can get back the value of the loan should your business go under. Typically, it is going to be your house. This means if your business goes under and you have no ability to repay the loan the bank could foreclose on your house to recover its money.
Investors, in exchange for their money, will have you give them a “slice of the pie” and you will consider them a partner, member, or shareholder depending on the type of entity organization you have chosen. Investors fall into two general categories of co-ownership. They are either active or passive.
The active investor is the owner that comes in and runs the shop. They run the day-today operations and are active in managing the business. They don’t just throw money at you and make check back on you later when they are seeking their return they are actually helping you run. Raising money this way is more flexible because you don’t have to worry about state and federal securities laws. When securing money this way you should have someone help you negotiate how much ownership you are willing to give up for what amount of money, what the duties are of each partner or member, and reduce many of these conditions to an agreement.
Passive owners or investors do not help run the business. They give you money for ownership, and typically you pay them back in dividends of off the stock you have issued. Stock represents ownership of your corporation.
However, there are many securities laws designed to protect investors from frauds. Look at it from the public’s view, they do not want someone to say they are starting a business, sell them shares of a business for thousands of dollars, and then skip out on town never starting the business or giving a return to those people. If this is the route you are seeking to raise capital, which is generally for very, large scale projects. The laws and processes are extremely complex and you should seek an attorney for help.
A Word on Crowdfunding on the Internet
In this day and age of the Internet a new trend has taken place for many small businesses. They turn to the Internet to raise funds for them. Crowdfunding is a concept that many politicians are familiar with; it is basically asking for a small donation from a lot of people to raise large amounts of money. With the Internet’s reach that becomes easier and many online businesses have based their model on this concept.
Most of the crowdfunding websites are not investment type sites, where you would put your business up and sell ownership. Most of them are donation-based or allow you to conduct a pre-sale of products or services to the people who give you money. Typically, businesses give specials to these people who helped them start-up. While, generally easy to do you should be aware that these sites charge small fees to set you up, your business model while getting marketing, also is exposed to a large group of people, and the amount of money you raise is typically low, around $2000 - $10,000.
Many of these crowdfunding sites though are great for charities, non-profits, arts projects, and the like if you are seeking to do something to that effect.
Some Helpful Definitions of Financial Terms
In business you have probably heard certain words use time and time again, like “angel investor.” Those terms tell you a lot about how the business interacts with its financing. To help round out the legal information I have given you are some of the definitions of those terms. Please note that certain words in financial terms do not have the same meaning in legal terms.
Angel Investor – generally, a wealthy individual who provides capital for a startup in exchange for convertible debt or equity
Equity – in financial terms, equity is the ownership interest by shareholders of a corporation
Securities – in financial terms, a certificate of creditorship or property carrying the right to receive interest or dividend, such as shares or bonds
Seed Money - capital needed to set up a new business or enterprise
Venture Capital – is financial capital provided to early-stage, high-potential, high-risk, growth startup companies. Venture capital funds or capitalists make money by owning equity in the company. Usually, this type of investing occurring after the seed money and the investor hopes to make a return by being a part owner when a company sells the company or sells stock of the company on a stock exchange.
Next post will be about getting money from the government for your business. Don't forget to subscribe to have new posts e-mailed to you and I will see you on the next draw!
*Disclaimer: This post discusses general legal issues, but does not constitute legal advice in any respect. No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction. Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.