By Dave Berkus, Chairman Emeritus, Tech Coast Angels

Oh, I know. When an entrepreneur started the business, s/he took investments from friends and family in small amounts just to get  started.  Of course, that worked at the time.  But…

Enter the need for larger investments

When an entrepreneur seeks professional investors, whether organized angels or venture capitalists, one of the early questions asked is “How have you financed the business so far?”  Investors love to see entrepreneurs who have used their own money to ignite their businesses.  But often, entrepreneurs turn to others for initial capital. Describing that capital using the phrase “friends, family and fools,” or “FFF,” has become as common as to be just plain trite.

Crowd sourcing as a tool

More recently, “crowd sourcing” has become one more way to finance a business, whether by forming a single investment vehicle (“AngelList.com”) or non-equity financing (“Kickstarter.com.”)  These are newer ways to find relatively small amounts using these Internet tools and combining groups of many investors at a small amount per investment.

What would the SEC say about your investors?

The problem with taking friends and family money rests in the legality of taking money from non-accredited investors, people who do not meet the SEC standard for making non-public company investments.  Currently that standard requires a minimum of $200,000 in annual income or over one million in net assets, including the value of the investor’s principal residence.  Since many small investors in a young business do not meet that standard, there is a chance that the company has taken money that it should not have taken, according to SEC rules.

An important exemption

There is an exemption for members of the entrepreneur’s family and in some cases for close friends with intimate knowledge of the entrepreneur and of the plan and, of course, for employees of the company.  It is worth checking with an attorney to see if such investors are truly exempt.

Does creating a PPM mitigate the risk?

Some small companies work to create “private placement memorandums,” attempting to protect themselves against this problem, couching the proposed investment in legal language stating the risks involved in making the investment.  The PPM does nothing to mitigate that problem when the investor is not accredited.

To compound the problem, often stock is issued by the entrepreneur without filing any report of such issuance with the state of issue.

The risk of the “dirty cap table”

The sum of these problems is that a disaffected investor can sue the entrepreneur or the entrepreneur’s company for a rescission of the investment and return of the money invested if the money was taken improperly, especially when the business has failed and the investment lost, putting the entrepreneur at risk for the loss of additional personal assets.

And the cure…

The cure for this, when professional investors enter the picture, is for the company to craft a “rescission offering” to those shareholders who invested illegally, offering to repurchase their shares at full value invested.  This is sometimes difficult since it often happens just at the time a company needs new money most and is in the process of seeking that money for growth.  If a previous investor does not accept a rescission offer, there is some insulation provided to the company against a future lawsuit by that investor.

How this could affect the future for you

So, plan to take money only from qualified investors. Check with your attorney if there is any doubt.  The risks of a problem rise with unmet investor expectations, and fade with success.  But sometimes, such behavior will cause a subsequent angel or venture capitalist to pass on an otherwise good opportunity, and that would be a shame, one that could have been avoided by diligent process in the early investment cycle.