So you want to start a business or buy a business or buy real estate with other people. And you decide that you want to do this with friends and family. How do you do that legally?
Raising money from friends and family happens every day. It’s very common that people get their start by going to those friends, going to those family members and getting that headstart. Now, whether it is because they are buying a business, or starting a business and just need seed capital, or they’re buying real estate, or they’re doing something else, they’re starting a fund or whatever it is that they’re doing. If they’re raising money, the question then immediately needs to become: well, how can they do that legally?
A lot of people think that they can simply raise money from friends and family by basically taking a loan from them. But that’s not really true. They can get the loan, but what it also requires is that it is a security that they’ve made, and so they need to raise that money, offer those terms successfully, they need to do it in a manner that is compliant with the rules.
In general, there are two kinds of categories that people mostly use in order to raise that money. First off, they come up with some sort of debt. So they say, “Okay, I’m gonna borrow $1 million from my friends and family. And I’m gonna pay that back in five years, and I’m gonna give them 10% interest. And I’m not going to pay them interest, though, until the very end, because we have to get our feet off the ground.” That’s a very common kind of term that may have existed. But that actually is a security because what you’re doing is you’re raising money. So you’re accepting money from people who are expecting a profit, they’re expecting to get that 10% back over what they invested. And it’s relying on you, right? You or your business is the one that’s actually doing the work. So their role is passive. At that point, it immediately becomes a security.
Let’s take the other scenario: they are investing in the equity in the business. So they get a 10% stake in your business by giving you a million dollars. So you’re obviously valuing the business at $10 million. Numbers notwithstanding, you’ve got a $10 million business, you’re borrowing that $1 million by giving them that equity, right. So you’re selling equity to them. Again, it is a security because what’s happening is they’re investing money, relying on you to do all the work.
Now, if it’s the case where your brother-in-law is going to give you that million dollars, but you two are going to work side by side and make this business big, that’s not a security. That’s basically a joint venture, or it’s just the company itself. It’s that passive role that suddenly makes it a security.
The challenge when you’re raising money, especially for businesses more than real estate, is that the amount of money that you’re raising may not meet the actual contractual deals that you have to do, the kind of returns that you have to do in order to pay all the other fees that go with it. I am an attorney. I’m a syndication and private equity fund attorney. I charge money, my costs – I don’t work for free, and neither does any other securities attorney that I know. We charge a good amount of money. So at some point, if you’re raising, say $50, well, my fees are a lot more than $50. So obviously you’re not going to pay me to raise that $50. Unfortunately, also, the odds of getting in trouble over $50 are practically non-existent.
That tipping point really comes when you’re raising 500-600 thousand dollars. It stops making sense to try and do it on your own and try and make it all work. And really, an attorney is your best bet. Now it does cost money, but you’ve been set up properly on the right footwork so that you can continue to grow your business and not worry about something bad happening. That something bad happening is a securities violation. If something like that happens, you’re never going to be raising money again, you’re going to be cut out from the whole private equity system, because you’ll be considered a bad actor. So you don’t want to go down the road of committing a securities violation.
Now, I understand that it costs a good amount of money to hire someone like me, someone who’s best in their game and can really set things up. But you also know at the end of the day, it’s set up right. You also know that it’s set up by somebody who knows. We’ve seen this happen many, many times. We do about 100 deals a year. So I see a lot of deals get put together, I know how every business is structured in terms of those. So we have a very good foundation on that.
Bottom line is this: you want to raise money from friends and family, if they’re gonna be passive, it’s a security. And so figure out a way either to make it work without their money, or find another avenue, or do the right thing and hire an attorney like myself in order to get it done.
The question that also comes up is: well, how does venture capital work? And why are angel investors? Why are they a security? And why don’t I have to do this for them? Well, actually, most of the time, you don’t need to do this for them, because they’re never taking a passive role. An angel investor or a venture capital company is not investing in your business passively. They’re going to be taking board seats, they are looking at not only just giving you money, but they are looking at their investment. They want to protect it and they want to give you advice at the same time. So therefore, it’s not a security, they’re just investing in your business, but they are going to be very active within it.
When it’s not active and when it’s passive, then it’s a security. And when you’re raising money from friends and family, that’s what’s going to happen. It is a security. It’s either got to be registered with the SEC or fall under an exemption.
I hope that helps. My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. If we can help you, don’t hesitate to give us a call.