January 19, 2017

Small Business Fundraising Ideas: Avoiding Complex Securities Regulations

April Fabregat-LeBlanc

Raising seed capital is not easy. Most entrepreneurs raise capital by using up savings, soliciting donations or small loans from friends and family, or convincing a local bank to provide a loan, which usually requires personal collateral and years of cash-flow projections, which are fairly arbitrary for a business that has not even started yet.

Many entrepreneurs seek out angel investors or, at later stages, consider going public, but even for more mature start-ups, going public is not always feasible. There are substantial legal and accounting costs associated with taking a company public, not to mention the complexity of facilitating and keeping up with ongoing reporting and disclosure requirements.

The goal of this article is to give small businesses some creative and viable financing ideas that do not require expensive legal filings, complicated securities regulations, or even angel investors.

Subscriptions and Preselling Products

So far, preselling a product generally is not considered selling a security in most states; therefore, regulators have not interfered with these rewards-based funding ideas. United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975) (the Supreme Court reasoned, “What distinguishes a security transaction […] is an investment where one parts with his money in the hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption […].”). See generally 15 U.S.C. § 77b(a)(1). The key to ensuring that preselling does not attract the attention of securities regulators seems to be making sure that customers who purchase the product do not receive any extra financial return in exchange for their payment (in addition to the product itself, that is). Buyers can receive their purchased products weeks or months after paying for their order. Put another way, funds can be raised from the public, in advance, without restrictions on the amount of money raised or the number of customers, and without subjecting the business to securities registration, reporting requirements, and the associated fees.

KICKSTARTER, for example, lets you set up a company project and accept money from any person in exchange for products, services, or other copies of the work produced. Indiegogo offers donors VIP perks in exchange for their donations. Awaken Café in Oakland California raised money to open a new store by preselling its coffee. Michael H. Shuman, 24 Top Tools for Local Investing (Oct. 11, 2013), available at http://michaelhshuman.com/wp-content/uploads/2013/12/Top-Tools-2.0.pdf. Some co-ops, like Weaver Street Market, a natural foods grocery store in North Carolina, offer their members a t-shirt, bag, and coupons to buy the market’s food products in exchange for their membership fee.

Allowing investors to prepurchase goods and services is a good way to attract more investors and, more importantly, customers all in one go; whereas, simple requests for donations are a one-way street—donors receive nothing in return for their contribution, and they may or may not decide to become a customer.

As mentioned previously, another benefit of this financing option is that federal securities laws generally do not apply to this kind of transaction because products, rather than securities, are sold. Forman, 421 U.S. at 852 (1975). State securities regulators, however, may have a different point of view. For example, in 1959 a country club in California presold club memberships and used the membership funds to start the business. Under federal securities laws, these memberships likely would not be considered securities, but a California court found that there was a significant risk that the business might fail before members got a chance to use their membership benefits. Because of the risk of loss involved, the memberships were deemed securities, and the club was found to be in violation of state securities laws for not registering the membership sales with California’s state securities regulator. Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 814–16 (1961). But see Moreland v. Dep’t of Corp., 194 Cal. App. 3d 506, 522 (1987).

Roughly 17 states, including California, use the risk-capital test to determine whether a presold good might be considered a security (Alaska, Arkansas (1987), California, Georgia, Guam (Appellate Division, 1981), Hawaii (1971), Illinois, Michigan, New Mexico, North Carolina, North Dakota, Ohio (10th District, 1975), Oklahoma, Oregon (1976), Washington, Wisconsin, and Wyoming). Cutting Edge Capital, What is a security, and why does it matter? (last visited Dec. 2016). The risk-capital test focuses on whether there is a possibility that an investor will lose value (i.e., money) rather than whether the investor might make a profit from the investment, and has three elements: “(1) an investment, (2) in the risk capital of an enterprise, and (3) the expectation of a benefit.” Joseph C. Long, 12 Blue Sky Law § 2:80 (2014). For example, an investor in a risk-capital state might prepurchase 100 widgets. If the investor never receives the 100 widgets, then the investor has lost money, which potentially would make the transaction a security in a risk-capital state. In states that do not follow the risk-capital model, however, the investor never expected to receive a profit when paying for the widgets; consequently, the transaction likely will not be classified as a security. Therefore, it is important to understand how your state defines a security.

In addition to understanding securities regulations, budgeting and planning will be a critical part of preselling your product. Costs like taxes on the income and the shipping, packaging, and manufacturing expenses should be kept in mind when the orders start rolling in.

Further examples of this financing model in action include Credibles, an online food voucher company that lets anyone prepay a local restaurant for food that they will eat in the future. When the customer makes payments, they receive credits to use at their favorite restaurant. The restaurant owners receive those payments in advance and use the funds to grow their businesses. This strategy is not news to local farmers, who commonly have customers pay in advance for a year’s worth of produce, giving the farmer enough money to cover planting costs.

Gift Cards and Coupons

As far as securities laws go, selling regular gift cards is very similar to preselling products. In fact, one start-up called Stockpile actually allows customers to buy stock and place it on a gift card to give to someone else. Discounted gift cards, however, may be cause for concern from a regulator’s perspective. For example, if you sell a gift card with a purchasing value of $20 for only $15, then the gift card owner technically has the expectation of receiving $5 worth of extra value for his or her money. Unfortunately, this looks to regulators fairly similar to hedging futures on Wall Street.

As a general rule of thumb, securities regulators usually look to the substance and characteristics of a transaction, rather than the label you use for it. Sec. & Exch. Comm’n v. Howey Co., 328 U.S. 293, 298 (1946). See also Tcherepnin v. Knight, 389 U.S. 332, 339 (1967). Anything that creates an expectation of an increased value or profit, over and above what was given in exchange for it, can be characterized as a security. For instance, if you issue coupons that can be used later to buy a product, the market value of the product that will be purchased might increase in value between the time for which the coupon is paid and the time the product is actually purchased. Getting a deal like this arguably encourages people to buy coupons to get extra value (i.e., as does any other investment).

When it comes to selling gift cards and coupons, some ideas for avoiding regulator attention might include limiting gift card maximum values, having a fixed value, and having very clear disclaimers to purchasers that the gift card is not a security. In addition, there are other legal considerations. These include federal limits on card fees that may be charged to customers, if and when the card should expire, and what should be included in any required disclosures. See Kaufman v. Am. Express Travel Related Serv. Inc., 283 F.R.D. 404 (N.D. Ill. 2012) (wherein American Express failed to notify purchasers of the full terms and conditions applicable to its gift cards). For example, money on a gift card cannot expire in less than five years after purchase under the Credit Card Accountability Responsibility and Disclosure Act of 2009 (commonly referred to as the CARD Act), 12 C.F.R. § 1005.20(e)(2), and card service fees generally cannot be charged under 12 C.F.R. § 1005.20(c)(3) and (d) unless there is no activity on the card for at least one year and prior disclosure of the fee is made. In addition, gift cards that are issued in amounts greater than $2,000 may be subject to certain additional recordkeeping and reporting requirements under the Bank Secrecy Act (otherwise known as the Currency and Foreign Transactions Reporting Act of 1970, 31 C.F.R. § 1010.100(ff)(4)(iii)(A) (2011)).

Each state also has its own separate restrictions and requirements as well, which preexempt the CARD Act rules described above (e.g., expiration is not permitted at all in about half of all U.S. states). Emily Atkin, 3 Tips to Keep Gift Cards from Bestowing Legal Trouble, Law360 (Sept. 24, 2013); National Conference of State Legislatures, Gift Cards and Gift Certificates Statutes and Legislation (last updated Apr. 22, 2016). Some states prohibit imposing fees on gift cards. Also keep in mind that, if the gift card is purchased in one state and used in another, there may be two different sets of gift card laws with which to comply.

Keeping within a few guidelines, gift cards are a good way to avoid costly regulatory fees and, according to some marketing research, tend to make customers who shop with gift cards less sensitive to price and spend more money, not to mention the potential for referral business. A gift card vendor can offer information about what type of gift card might be most suitable.

Cooperatives

A cooperative is a group of members that pool their capital to make a common purchase, such as a piece of real estate. All members usually are co-owners of the collective purchase and are entitled to take advantage of any services provided by the cooperative and to use the purchased item, which an individual might not be able to afford alone.

Cooperatives do not just work in real estate. Equal Exchange is an example of a successful produce cooperative that has over 100 owner employees. Though Equal Exchange also raises money through selling securities and using an exemption from securities laws, a primary source of funding comes from employee contributions that do not require going through securities regulators. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015). Similar to many other types of businesses, each owner periodically gets a share of profits and losses, one equal vote in making decisions for the business, and an opportunity to serve on the managing board. Employees each put half of their annual profit earnings into a joint account used to reinvest in the co-op. Other cooperatives, like Coop Power, a consumer-owned energy cooperative in Massachusetts, pool funds from customers (who contribute and become members) and use the pool of capital to run their businesses, which involves investing in other sustainable energy businesses and developing job training programs.

The SEC has given certain cooperatives an exemption from registration requirements under federal securities laws. 17 C.F.R. § 240.15a-2. See Forman, 421 U.S. at 858. For example, collectively buying an apartment building through a licensed real estate agent generally is not subject to securities laws, even if each investor’s ownership interest takes the form of a share of stock, so long as the primary purpose of the purchase was not to make a profit from increases in the property value. Forman, 421 U.S. at 851. See also Grenader v. Spitz, 537 F.2d 612 (2d Cir. 1976), cert. denied, 429 U.S. 1009 (1976). Typically, the primary purpose of such a purchase is to have a place to live.

Based on court rulings thus far, a cooperative is more likely to qualify for an exemption if:

  • members are prohibited from selling or transferring their membership interest to others;
  • voting rights are equal, rather than directly proportional to the amount contributed;
  • membership interests do not appreciate in value over time;
  • the primary purpose or motive of the contribution is not financial gain (Forman, 421 U.S. at 851–54); and
  • all members are actively involved in management of the cooperative (Howey, 328 U.S. at 301). 

State securities laws vary. Some states have an exemption from securities laws for all cooperatives, some do not have an exemption, some have a limited exemption if certain conditions are met (e.g., a maximum contribution amount is imposed), and others only have exemptions for certain kinds of cooperatives (e.g., farmer’s cooperatives). See Ariz. Rev. Stat. Ann. § 10-2080 (2015); Ariz. Rev. Stat. Ann. § 10-2146 (2015); Cal. Corp. Code § 25100(m) (West Supp. 1983); Ark. Stat. Ann. § 67-1248(a)(12) (1980). Also see Colo. Code Regs. 11-51-307(1)(j) (2015); Mass. Ann. Laws ch. 110A, § 402(a)(12) (Michie/Law. Co-op. Supp. 1983); Tex. Rev. Civ. Stat. Ann. art. 581-5(N) (Vernon Supp. 1982–83). Therefore, it cannot be stressed enough how important it is to be familiar with your state’s point of view.

Revolving Loan Funds

Another way to attract investors is to offer loans that pay a reasonable interest rate. In addition to borrowing funds from the community and/or members, some organizations take loans from investors and then use those funds to make microloans to other businesses and earn interest. For example, the La Montanita Grocery Co-op in New Mexico uses its members’ capital to financially support local farmers and food processors. Mountain Bizworks, a small business lending company headquartered in North Carolina, borrows money from investors, lets the investors choose their own loan terms, and loans the pooled funds to other small businesses.

Generally, a loan is represented by a promissory note. The definition of a security under the Securities Act at 15 U.S.C. § 77b(a)(1) includes any “note.” However, the law is not black and white about whether a promissory note is a security; the question is whether the note resembles a security close enough. For example, some ways to differentiate a loan from a security include:

  • providing some collateral for the loan (offering collateral also attracts more lenders);
  • disclosing to all lenders: (1) that the loans are not intended to be securities or registered pursuant to securities laws; (2) what laws would apply to protect the lender in the event of default (e.g., FDIC laws); and (3) the specific purpose of the loan;
  • advertising primarily through private networks, rather than to the general public;
  • keeping the number of lenders to a minimum;
  • using the funds for specific business purposes, rather than general business use;
  • offering investors that contribute to your loan fund services perks or products instead of interest in return (which is evidence that the lenders’ main interest is to make the business grow, not to earn a profit on an investment);
  • offering a very low interest rate (i.e., well below the prime market rate) if you do decide to pay interest;
  • borrowing from a bank or credit union rather than individuals (when possible); and
  • setting the loan term for less than nine months. 15 U.S.C. §§ 77c(a)(3), 78c(a)(10); See also Exch. Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137–38 (2d Cir. 1976) (created a rebuttable presumption that a note with a maturity greater than nine months is a security unless it bears a strong family resemblance to an item on the judicially crafted list of exceptions); Reves v. Ernst & Young, 494 U.S. 56, 64–65 (1990); Lee Lashway, Promissory Notes as “Securities”—A Trap for the Unwary? (July 16, 2013); HG.org, When Is a Promissory Note a Security? (last visited Dec. 2016).

As with all other types of fundraising, keep in mind that both federal and state laws should be followed. Lending laws in both the lender’s state and borrower’s state may apply.

Certificates of Deposit

Regular bank CDs generally are considered bank deposits rather than securities, which keeps CD issuers relatively safe from securities registration and reporting. Marine Bank v. Weaver, 455 U.S. 551, 555–61 (1982); 15 U.S.C. § 78a(10); 12 U.S.C. § 1813(l). See Lloyd S. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP, (2015), at 4. As many small business owners already know, local banks and credit unions are not eager to make business loans without full collateral. That is not only because conservatism often makes good business sense, but also because, by law, banks are required to be conservative with their assets.

Some local businesses have created a financing model that involves a three-way partnership with banks and investors essentially to get fully collateralized loans from banks using CDs. For example, Equal Exchange created its own private CD. Equal Exchange advertises its CD publicly, and anyone who wants to invest in its purpose simply buys the CD from Eastern Bank. In exchange, like a normal CD, investors get the future return of their principle plus reasonable interest. Eastern Bank then loans the funds back to Equal Exchange to help finance its business. Essentially, investors who buy the CDs are agreeing to allow the CD funds to be used as cash collateral for the line of credit to Equal Exchange. In the event that Equal Exchange defaults on its loan to Eastern Bank, Eastern bank keeps the investor’s deposit. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015).

Similarly, Alternatives Credit Union in Ithaca has formed a partnership with several local, environmentally focused businesses. The Credit Union offers CDs to any investor interested in contributing to the betterment of the environment. The investor’s deposits are pooled and distributed as loans to various businesses that share this common purpose. Alternatives Credit Union not only facilitates the CD/loan set-up for small businesses, but also helps nonprofits by matching the nonprofit’s funds raised dollar-for-dollar and issuing microcredit loans with the combined amount. For example, if investors purchase a total of $5,000 in CDs, Alternatives loans out a total of $10,000 to the intended beneficiaries of that nonprofit.

A regular CD usually is FDIC-insured (or NCUA-insured in the case of credit unions), and the investor is entitled to a return of his or her deposit if the bank goes under. 12 U.S.C. § 1821(f)(1); Federal Deposit Insurance Corporation, A Guide to What Is and Is Not Protected by FDIC Insurance (last visited Dec. 2016); Federal Deposit Insurance Corporation, When a Bank Fails—Facts for Depositors, Creditors, and Borrowers (last visited Dec. 2016). This insurance protection may be what keeps securities regulators from seeing the need to get involved. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP (2015). However, the insurance recovery is only available in the event that the bank becomes insolvent. Default of the small business on its loan to the bank will not qualify for FDIC insurance coverage under 12 U.S.C. § 1821(b), (f)(1). Therefore, the investor’s funds are still wholly at risk if the business defaults, just as any other collateral would be.

This model requires that the investor be aware that he or she is putting up collateral on behalf of a small business owner who may not be able to do so. The risk for the investor is essentially the same in a CD-loan set-up as it would be if the investor had made a loan directly to the small business. The benefit of this set-up, however, is that the bank acts as a facilitator and administrator of the transaction, adding a sense of legitimacy and formality to the deal. In addition, banks and credit unions are experts at processing loan paperwork, handling cash, and providing regular reporting statements to both the investor and the small business borrower.

Conclusion

In short, there are many creative funding structures, including the few discussed above, that can allow small businesses to access a wider number of contributors without spending large amounts of money on legal and accounting fees and without becoming overburdened with extensive reporting and disclosure requirements.

April Fabregat-LeBlanc

April Fabregat-LeBlanc is an attorney at Barton Gilman, LLP in Boston, a member of the ABA’s Community & Economic Development Committee, and has worked with several start-ups and small businesses.