Be Careful When Issuing Equity
Vinny Gambini: You were serious about dat? Quote from My Cousin Vinny
What prompts this blog comes from a conversation with one of my partners recently. He had been served with his first subpoena on a client where we had only offered some tax advice. Fortunately for us, it had nothing to do with our work, but the story was not the same for the Company. It appears that the Federal authorities were interested in the company’s equity issuances – who got what, when and what paperwork had the Company retained. They were looking for violations of Federal securities laws and the fact that they were seeking our documents indicated their probe was pretty thorough.
We constantly offer advice to startups and almost every conversation centers around the granting of a “piece of the business.” The methods of distribution range from seemingly innocent letters promising some poorly described ownership to actual stock sales. Virtually every conversation is peppered with the advice to get a lawyer involved and yes, we are “serious about dat.” The sale of shares or equity can become subject to Federal jurisdiction, as was the case here, and you do not want to be on the wrong side of that transaction.
I am not a lawyer, but in laymen’s terms, the government is always interested in two aspects of any equity deal. First, is whether or not the investor has the means to sustain a potential loss and, second, is if the investor was provided sufficient information to make a decision. If you have been following the evolution of “crowdfunding” you may have heard the term “accredited investor.” This is how the SEC and others define the first part of the equation – can the investor bear the loss? The famous poster child scenario for this is the mythical widow from Idaho who has $10,000 in life savings being persuaded by a “boiler room” salesman (a la “Wolf of Wall Street”) to invest it all in a tech startup. That is a no–no. The second piece is what the SEC struggles mightily with and that is the issuer providing sufficient information to make a decision. They are trying to come up with something between a Prospectus (a tomb seen by many as one of the most difficult documents to understand) and a pitch deck. I fear this debate will last for some time.
The sale of equity is not the same as selling someone a used car. In the former, you have no real understanding of expectations on the part of the buyer. They may think they just purchased the “next Google” or are expecting dividend checks to start flowing next month; thus the need to communicate the “risk factors” that should serve to temper those expectations. In the latter, people just expect a mode of transport which will get them from here to there. There is risk in equity that should not be taken lightly.
So, please, if you are involved in the issuance of any type of equity instrument, do not do so without appropriate legal counsel. You probably would not sell your house without doing so and your equity is probably worth a whole lot more.
