California Law
California Securities & Venture Finance Law
Securities & Venture Finance Law
A brand new business that survives more than a few years is bucking the odds. The vast majority of new businesses do not reach their first anniversary and only a handful reach their fifth. Lenders are keenly aware of these statistics, and thus they view funding startup businesses as highly risky. Conventional banks generally are wary of lending money to new businesses and usually require a large capital investment by the prospective business owner as well as a personal guarantee from him or her to repay the loan if the business cannot. In practice, therefore, securing money for a new venture largely depends on what owners can raise on their own. There are two basic ways for a new business to raise money--borrowing money and selling shares of ownership in the company. The following is a discussion of some options for those looking to finance new ventures.
Securities
An option for business owners in need of capital but unable or unwilling to go into debt is to sell equity stakes in the business. Securities such as stocks and bonds are different from other commodities because they have no value by themselves. Rather, they are evidence of a debt owed to their holder. They are written secured promises to pay back money or other payment. All offerings of securities can be placed into one of two categories depending on the regulations that govern them. Securities that are exempt from the registration requirements of the Securities Act of 1933 are called private placements, while all other sales of securities are called public placements. Although the majority of business issue securities are exempt from registration requirements, it can be very difficult to discern whether a specific business is exempt.
Stocks and Bonds
There are two different types of securities: stocks and bonds. Bonds are documents that signify a debt owed. Selling a bond is like a loan agreement in which the bond holder is promised the return of the original sum loaned out plus interest over time. Generally, a bond is secured with collateral, which ensures that the debt will be satisfied even in the case of default by the party that issued the bond.
Stocks signify an equity or ownership interest in a company. The unit of ownership is the share, and the holder of one or more shares in a company has some say in how the company is run, how profits are spent, and how the company's assets should be divided upon dissolution of the company. Some companies distribute profits to shareholders by paying dividends. Other corporations reinvest the profits within the business, thereby theoretically increasing the value of the stock.
Securities Markets
The vehicles through which sales and purchases of securities are conducted are called securities markets. These markets do not necessarily have a physical location; sometimes they are just informal networks through which buyers and sellers of securities make transactions. The largest securities market--in terms of the value traded--is the bond market. The bond market is the means through which the United States government, state and local governments, and corporations borrow money from the public. Because bonds generally are less attractive to individual buyers and are more likely to be purchased by professional investors, bond markets are less widely regulated than are markets for common stock.
There are two kinds of markets for stocks--over-the-counter markets and exchange markets. An over-the-counter market is the less rigid of the two. This type of market exists via a network of transactions, with no permanent physical location. Instead, the market uses telephone and computer connections. This kind of market allows a wider variety of firms to participate in the trading of securities.
Exchange markets differ from over-the-counter markets in several important ways. Exchange markets operate in a facility in which actual transactions occur between parties on a trading floor. The New York Stock Exchange is the largest such exchange. Exchange markets differ further from over-the-counter markets in that they operate under stricter guidelines that govern who may and may not trade on the exchange. The distinction between over-the-counter and exchange markets is blurring because of new technologies that call into question the need for "floor" trading.
A securities firm makes its money in several different ways. In an exchange transaction, the firm charges a commission on the purchase or sale of the stock. In the case of over-the-counter stock, a firm is hired to create a market for a certain stock. In this case, the firm will sell the stock to customers at a price higher than the sale price to other brokers. The firm makes its profit from the difference between its cost for the stock and the price of stock as offered to the public.
Private Placements
Private placements or private offerings are sales of securities that are not subject to requirements for registration under the Securities Act of 1933. As these exemptions are fairly complex, and the punishment for breaking securities regulations is severe, legal advice from an expert in the field of securities regulation is highly recommended for a business person with an interest in private placements.
Initial Public Offerings
A business "goes public" when it solicits or concludes a sale of securities from a group of public investors. Although there are exemptions available under both federal and state laws, public offerings generally must comply with registration requirements set forth by the federal Securities and Exchange Commission (SEC) and state authorities. An initial public offering, often referred to as an IPO, is the first such public sale by an organization.
Regulation
Largely because of the nature of securities--they do not have a value in and of themselves and therefore can be created and sold in unlimited amounts--there has developed a fairly sophisticated network of laws governing their use and sale. Securities transactions are governed by both state and federal laws, but all these laws have four main purposes:
- To ensure that investors have an accurate idea of what (and how much) they are getting when they purchase securities
- To ensure disclosure of information concerning corporations or other entities that are trading in securities
- To prevent fraud, insider trading, abuse of non-public information, or other price manipulation
- To govern those who buy and sell securities on the secondary market to investors
Securities regulations can be extremely technical. A business seeking to issue securities to finance its business should consult an expert. If the business is not exempt from registration, meeting the registration requirements can be quite expensive. On the other hand, public placements offer distinct advantages over private placements. Though complicated, securities regulations protect the investor or buyer of the securities. For this reason, sales of securities in violation of state and federal rules are subject to strict civil and criminal penalties, even if the violations are inadvertent or the result of ignorance.
Federal Laws
There are numerous federal laws upon which much of the regulation of the sale of securities is based. The Securities Act of 1933 deals with the initial public offering of securities. The aim of this legislation is to prohibit fraud or deception in the sale of the securities by providing for full disclosure of facts concerning the securities for sale and the business and finances of the issuer.
The Securities Exchange Act of 1934 regulates trading in the secondary market. Like the earlier Securities Act of 1933, it requires disclosure of information about the offering. This Act established the Securities and Exchange Commission, the principal regulatory body policing securities markets. It also instituted several other restrictions on publicly held corporations, such as a restriction on the amount of credit that can be extended for the purchase of securities. The Act further requires brokers, dealers, and businesses that deal in securities to register with the SEC. It was amended in 1975 to give the government even broader powers over securities exchange and the structure of the market system.
The Trust Indenture Act of 1939 regulates large public issues of securities. The Investment Company Act of 1940 regulates publicly owned businesses that deal primarily in the buying and selling of securities. The Investors Advisers Act of 1940 sets down rules for the registration and regulation of investment advisors, similar to those used in the Securities Exchange Act of 1934. The Securities Investor Protection Act of 1970 established the Securities Investor Protection Corporation, which has the authority to oversee the liquidation of securities firms and to pay off debts owed to their customers.
California Laws
In addition to federal securities laws, there are state securities laws, generally known as "blue sky laws." Like federal laws, blue sky laws provide for registration of brokers and dealers, require information to be made available about securities open for trading, and mandate penalties for fraudulent or deceptive practices. The California securities laws are administered by the Department of Corporations through the Commissioner of Corporations. Violation of state securities laws can result in injunctions and administrative and civil fines. If the violation is wilful, criminal penalties may be assessed.
Qualification of Securities
California provides a detailed listing of securities that are exempted, including issuer transactions, recapitalizations, reorganizations, and nonissuer transactions. A sale of securities, unless exempt, is unlawful unless the securities are properly qualified. Qualifications are valid for 12 months from the effective date, unless a different period is assigned or a stop order is in effect. The Commissioner often requires a proxy statement as a condition for qualification. Applications for securities qualification are subject to the same standards and review, whether they are issuer or nonissuer securities. Particular qualification requirements apply to offerings of debt securities by churches, real estate programs, real estate investments, oil and gas interests, and small business issuers. In determining qualification, the Commissioner considers many factors, including suitability of the investment, fairness of offering price, level of speculation, and financial position of the issuer.
Exemptions
Exemptions reduce the paperwork required before a sale of securities can be made. An exemption for issuer and nonissuer transactions, for example, allows small business issuers to seek offers by a preliminary offering circular, without consummating sales. Some of the notice requirements, under certain circumstances, may be filed by the National Association of Securities Dealers (NASD). The Department allows "expedited review" for some reorganizations that involve a change of securities in connection with a merger, consolidation, or sale of assets. The expedited review is used to determine whether the issuer complies with the proposed amendment to the merger, consolidation, or sale of assets exemption. Agreements involving offers to sell a franchise are exempt. There is also a "qualified purchaser" exemption, which allows for the announcement of some proposed offers of securities. In addition, offers and sales of unit investment trusts are exempt from registration under specific conditions. Clearly, the interpretation of these laws requires the professional assistance of an attorney experienced in securities issues.
Filing fees
The State of California regulates its filing fees based upon the application. A small company application by permit is $2500. If the actual cost of processing the application exceeds the fee, an addition $1000 may be charged. If the application is by coordination, the fee is $200 plus one-fifth of one percent of the aggregate value, to a maximum of $2500. Applications by permit in recapitalization or reorganization are $200. If the application is in connection with a merger or consolidation, the fee is $200 plus one-fifth of one percent of the value, to a maximum of $2500. An attorney experienced in securities issues can calculate other filing fees.
Debt Financing
Selling securities is difficult and highly regulated. The cost of complying with these regulations, as well as the difficulty in convincing buyers that a business is a good investment, makes offering securities impractical for many startup companies. Another way of selling ownership in a company--by admitting partners into the deal for a cost (called a limited liability company)--is an option, but a business owner must be willing to forgo some of the profits and must convince prospective members they will make money. Further limiting the appeal of memberships in limited liability companies is the fact that they are not freely transferable to third parties. Thus, it is a somewhat easier task to raise money through debt financing from a bank, credit corporation, or local or state loan program. There are various ways a business can go about finding venture capital from public and private sources.
Anyone trying to use a lender to raise money for a new business will need to give a prospective lender detailed information about the form the new company will take. At a minimum, a prospective business owner will have to provide information about his or her current financial situation, including all business and personal assets and debts. Also, an applicant must be prepared to provide information about how the money requested will be spent and a full description of the intent of the business, along with information about the experience and management capabilities of the owner and those expected to be employed in top positions. A lender also will want to know how much money the owner plans to invest in the business and any projections of how much the business is expected to earn in its first year.
Retail and service-oriented businesses often have more difficulty obtaining financing because the funding for these types of businesses is used for expenses such as inventory, fixtures, and working capital--collateral that usually does not meet a lender's criteria for resale recovery. Often, these endeavors are financed primarily, if not fully, through equity. With that background in mind, following are various types of debt financing options that are available.
Conventional Bank Loans
Bank loans are a common way of financing new ventures. The most advantageous to young businesses, but toughest to obtain, are unsecured loans. These are usually available only for short-term loans to borrowers with strong balance sheets, ample cash flow, and low debt-to-equity ratios. Unsecured loans usually are made for less than one year, and the interest rate is based on the size of the loan, the financial health of the borrower, and the type of industry or business in which the borrower engages. Easier to obtain are secured loans, which can be structured in a variety of ways and can give the lender a security interest in accounts receivable, inventory, or raw materials.
It is almost impossible to finance a business with 100 percent debt. Cautious bankers--and bankers are a cautious bunch--typically require that at least half of the startup costs be covered by the owner, and nearly any source of financing will require at least a 20 percent equity stake by the owner.
As noted above, financiers are more willing to provide funding for projects in which there is collateral that can be easily sold if necessary to recoup their investment. Thus, manufacturing and industrial operations historically are easier ventures to finance than retail and service businesses.
A Bank is a corporation that earns money by maintaining savings and checking accounts, issuing loans and credit, and dealing in negotiable securities for governments and corporations. Banks invest the money entrusted to them by their customers. The investments that banks are allowed to make are regulated, and banks are defined by the limitations put upon them. The types of banks (in order from least to most regulated) are commercial banks, savings banks, and savings and loans.
Commercial banks are the most common and least regulated type of bank. These banks must have more deposits on hand than other types of banks in order to handle daily transactions and prevent money shortages (and the panic that can result). These types of banks are often publicly held corporations.
Savings banks, a rarer form of bank, are limited-service banks that originally were formed to encourage people to save their money. To this end, savings banks traditionally offered as their major service "time" savings accounts that prevented withdrawal of deposited money until a set period of time had elapsed. In modern times, the services of this type of bank have expanded somewhat. A businessperson looking for a lender should note that a savings bank sometimes offers higher interest rates on accounts than a commercial bank. This is because a savings bank does not have to keep as high a portion of its deposits in reserve as commercial banks. Savings banks usually are owned in the form of a partnership of depositors who receive dividends in the form of interest on their accounts.
The third type of bank is a Savings and loan association. Despite news of scandals and problems in recent years, savings and loan banks traditionally have been highly regulated, conservative organizations whose primary purpose--other than encouraging savings--is to provide loans for homes and businesses. Other information about banks can be found in the Banking & Financial Institutions Law Chapter.
Asset-Based Lenders
Asset-based lenders use assets as collateral to lend money to businesses that would not ordinarily qualify for bank loans. A business that is growing fast but has not established a credit history with a bank might find these lenders helpful. Generally, businesses that seek asset-based loans are high risks, so asset-based lenders charge a premium for their service. Some asset-based lenders will use a business' receivables and inventory as collateral. Others may prefer to use real estate or equipment as collateral.
Commercial Finance Companies
Commercial finance companies specialize in financing high-risk applicants unable to obtain conventional bank financing. Their interest rates tend to be substantially higher than those offered by conventional banks because of the increased risks. Because commercial finance companies have more experience evaluating the liquidation value of failed businesses, they often are more willing to finance riskier applicants.
Venture Capital Companies
Venture capital companies specialize in lending to startup companies or established companies expanding into new risky markets. Venture capital companies provide capital to businesses that might not be eligible for straight bank loans but have high potential in their market. These companies assess the viability of an emerging business and fund it by taking a stake in the company. They may prefer to acquire stock in the company as a way to finance the loan and insist on playing a substantial role in managing the company. Thus, the success of the venture capital firm depends on the success of the business. Many investors demand a say in management decisions in exchange for their investment capital--a demand that is an anathema to some entrepreneurs.
Only about one out of every ten investments reaps profits for venture capital companies, so they are choosy about where they place their money. Many firms specialize in certain areas in which they have expertise. Before approaching a venture capitalist, a business owner should prepare a solid business plan that takes into account marketing plans, cash flow, and research needs.
Public Financing
There are many government programs charged with helping businesses succeed. One of the ways the government encourages new businesses is by making loans easier to obtain. The United States Small Business Administration (SBA) helps qualified small businesses get loans by offering lending banks guarantees on the loans. The SBA will guarantee 85 to 90 percent of a loan depending on the size of the loan (the maximum is $750,000). It is difficult to receive the SBA's help, however, without sizable investment capital from investors.
In addition to the SBA, there are a number of other government programs, at the local, state, and federal levels, designed to help specific kinds of businesses. For example, some programs are designed to assist minority owned businesses.
Franchises
Strictly speaking, franchising is not a type of new venture financing, but it can be a way for an existing business to expand rapidly and move into new markets for a reasonable cost. A franchise is a right given to a private person or corporation to market a given product within a certain area. When a business with a trademark sells the right to use that trademark to a distributor of products or services, the business distributor may be a franchise. Usually the business selling the franchise also provides market assistance to the buyer.
Franchises are governed by both state and federal law. It is extremely important to know these laws before starting a business that may franchise or if considering becoming a franchisee for another business. The laws are drafted using broad language and some people find themselves in violation of the laws, even though they are not engaged in activities they consider to be franchising.
The Federal Trade Commission (FTC) enforces laws and rules regulating franchises. These rules do not require a business to register with or seek the approval of the FTC before offering or selling a franchise; they only apply to franchises that are "in or affecting interstate commerce." Although there are differences between state and federal franchise laws, it is most important to remember that the name of a company is not important as long as the relationship meets the definition of a franchise. This means that if a business is entering into a limited partnership, it also may be entering into a franchise agreement. The FTC rules define a franchise as a "continuing commercial relationship" between two or more parties. This continuing relationship is further defined as one in which supplies for reorder are made available to the purchaser after the first required inventory is purchased.
There are three basic types of "continuing commercial relationships" covered by the rules:
- Package franchises, or "business format" franchises, which are defined as prepackaged business programs developed and identified by the franchisor. McDonald's is an example of this type of franchise.
- Product franchises, in which the franchisor sells goods that bear his or her trade name to a franchisee, who in turn sells them to the public under the same name. The dealer company maintains some degree of control over the selling of the goods by the franchisee in this arrangement.
- Business opportunity ventures, in which the franchisor retains more control than in either of the previous arrangements. In this type of franchising agreement, the franchisee is required to buy and sell the goods or services of the franchisor or another business. The franchisor also arranges the location of the business, seeks out business for the junior partner, and even provides employees. An example of this type of arrangement is a vending machine route. The franchisor company finds a place to put the machines and sells the candy to the franchisee, but the franchisee collects the money and restocks the machines.
Franchises also are discussed in the Closely Held Business Law and Franchise & Dealership Law Chapters.
Resources
Federal Trade Commission, 6th & Pennsylvania, Washington, DC 20560, (202) 326-2000;
Los Angeles Region, 11000 Wilshire Boulevard #13209, Los Angeles, CA 90024, (310) 235-7575 (serves southern California); San Francisco Region, 901 Market Street #570, San Francisco, CA 94103, (415) 356-3270 (serves northern California).
United States Securities and Exchange Commission (SEC), 450 Fifth Street N.W. #31024, Washington DC 20549, (202) 942-8088; Pacific Regional Office, 5670 Wilshire Boulevard, 11th Floor, Los Angeles, CA 90036-3648, (213) 965-3998; San Francisco Regional Office, 44 Montgomery Street, #1100, San Francisco, CA 94104, (414) 705-2500.
United States Small Business Administration (SBA) Region IX, 211 Main Street, Fourth Floor, San Francisco, CA 94105, (415) 744-6820.
The California Department of Corporations, through the Commissioner of Corporations, administers California's Securities laws. Contact the Department at 3700 Wilshire Boulevard, #600, Los Angeles, CA 90010-2901, (213) 736-3481.