Avoid legal pitfalls when seeking funding for your LLC or small business
Startups seeking investors could run afoul of the law by issuing unregistered securities.
As part of my job with Michigan State University Extension, I assist small business owners in organizing their business and learning best management practices. Sometimes, my clients can teach me a thing or two. I recently advised one of my clients, who is organized as an LLC, to contact a competent business lawyer to write his operating agreement. Following that, he called me back with some disturbing news. Through his visit with the lawyer, he was told that he was breaking the law while trying to secure investors.
How it all started was a discussion between my client and his co-member (of a two-member LLC) on how much each should invest in the business. When they discovered that they would need additional members to get the business up and running, they started soliciting additional member who would contribute an amount equal to a percentage of the profits. They believed this was an appropriate procedure for acquiring equity investments. But what they didn’t realize is that this was actually a security that they were issuing, and the security must be registered.
Obtaining investors requires issuing a security, and issuing a security requires registration with the SEC. Registering with the SEC makes your small business a public enterprise. Most entrepreneurs who are organizing a business as an LLC don’t want to be a public company just to seek investors. For those not wanting to be a public company, seek a competent business attorney to understand the security law exemptions for LLCs.
If you are investing in a multi-member LLC and if you are also going to be an employee of the LLC, security laws do not apply. Here is a quote from Findlaw.com:
By definition, a security is an investment in a profit-making enterprise that is not run or controlled by the investor. Therefore, if you are planning on having more than one owner (member) in your LLC, then you may have to worry about securities laws. When a person invests in a company and expects to make a profit because of the work of other people, the government will consider the company to be a security. It is worthwhile to keep in mind that the converse is true as well. If you plan on investing money in a company, and expect to receive profits, but also plan on working for and in the company, then the investment is not a security.
Regardless of your organizational structure, if you are seeking investors, retain a competent business attorney to guide you through the process. After all, you want to be an entrepreneur not a stockbroker.