A convertible promissory note is a type of convertible security or debt that start-ups utilize to raise capital. Start-ups often need working capital to launch but investors are wary of purchasing equity at such an early stage because of difficulties in valuation. Perhaps more importantly, money invested in exchange for equity is considered at-risk and is not likely to be recovered if the company fails. Alternatively, loans are not considered to be at-risk and can be recovered if the company fails. At the same time, investors want the option to convert the loan into equity in case the company becomes successful. In other words, investors prefer to put their capital at-risk once the company is further along in it’s development and on track to succeed.

Enter the convertible promissory note, an attractive solution for investors who want to limit risk while preserving an opportunity to own equity should the company become successful.

How Does A Convertible Promissory Note Work?

Here’s an example of how a typical Convertible Promissory Note financing happens:

1. Company A has a great idea and needs $100,000 to launch and cover expenses. The founders of Company A approach family and friends with a business pitch and ask them to invest. John, a family member, decides to invest $100,000 but is worried that if the company fails, he will not get his money back. John knows that start-ups are risky business so he requests a convertible promissory note. John is also unsure how much the idea is truly worth, since Company A does not yet have a track record. John is unsure how much equity he should receive for $100,000.
2. Company A understands John’s concerns and offers a convertible promissory note. John and Company A negotiate terms and arrive at the following deal: John loans $100,000 at an annual rate of 7-10%, interest payable on a monthly basis. The classification of funds as a loan is important because loans must be repaid regardless of the performance of Company A. Often times, an investor will ask the founders to personally guarantee repayment of the loan. Investors also like loans because in the event of default, loans have higher priority over equity holders should Company A claim bankruptcy. Company A and John finalize and sign the promissory note and then John wires the money.
3. Company A continues to build-out and reaches a point where it is now ready to raise capital by making a Series A offering to potential investors. The Series A offering is also known as a Qualified Financing and is often the trigger point where investors such as John can convert a promissory note into equity shares. In John’s case, he’s negotiated an option to convert his $100,000 loan into shares at 75% of the asking price per share. In other words, John can buy Series A shares at a 25% discount.
4. Company A is successful raising $1,000,000 with a valuation of $1 per share for 1,000,000 shares. Here, John can purchase shares for 75 cents each up to the amount of $100,000. Upon conversion, John’s loan of $100,000 is no longer collectible and the funds are now considered to be at-risk. If Company A becomes successful, John is happy because his $100,000 is now an investment in a successful start-up and his shares could be worth considerably more.  However, if Company A fails at some point in the future, the $100,000 is no longer recoverable because it is considered to be put at-risk.
5. Company A turns out to be successful and is acquired by a large corporation, and John is now a multi-millionaire. Okay this isn’t always the typical scenario but it’s certainly the scenario that every investor dreams about!

As a caution to entrepreneurs, do not attempt to issue a convertible promissory note without consulting an experienced corporate or securities attorney. Convertible promissory notes are considered securities and are highly regulated by the SEC. Any failure to comply with SEC rules could expose founders to personal liability for the corporation’s debts and obligations.

Equity crowdfunding means raising capital from the crowd in exchange for equity in a company. The current SEC rules permit businesses to raise capital online from accredited investors only. However, once the SEC releases its new rules, small-to-medium sized businesses will soon be able to raise capital on the internet from non-accredited investors in exchange for equity. The game is about to change – enter the JOBS Act.

What is the JOBS Act?

In April 2012, President Obama signed into law the Jumpstart Our Businesses Act (JOBS Act) which will allow businesses to raise capital from non-accredited investors online in exchange for equity. In more technical terms, Title III of the JOBS Act amends Section 4 of the Securities Act to create a new exemption for offerings of “crowdfunded” securities.

The SEC is currently trying to figure out a way to regulate equity crowdfunding for non-accredited investors. There are many problems associated with this new medium for capital formation including the risk of fraud. Hence the SEC is being very careful before releasing regulations permitting equity crowdfunding from non-accredited investors.

What are some of the Rules?

1. Companies will be permitted to raise up to $1 million per twelve-month period;
2. Non-accredited investors may invest the greater of $2000 or 5 percent of the annual income or net worth of such investors, if either the annual income or the net worth of the investors is less than $100,000;
3. The transaction must be conducted through a licensed broker-dealer or funding portal that complies with section 4A of Title III;
4. Companies seeking to raise capital must register with the SEC and meet strict disclosure requirements including the purposes for which the funds will be used, valuation methodologies, and many other important business and risk factors. The disclosure requirements are similar to a private placement offering memorandum which requires the services of a competent corporate attorney;
5. To reduce the risk of fraud, each officer, director, and any shareholder owning more than 20% of the outstanding equity of the company must submit to a background check;
6. Companies must provide a 21-day safe harbor period for investors to review disclosures and marketing materials;
7. No funds will be transferred until the company meets it’s fundraising target;
8. Companies cannot pay referral fees to agents, promoters, or lead generators who find investors;
9. Companies must also provide investors with an annual report of financial performance;
10. Investors cannot transfer their equity within 12 months of purchase subject to limited exceptions.

This is not a comprehensive or finalized list. The SEC will release specific rules and regulations in the near future.

How will Crowdfunding Change the Game?

The power of the crowd is undeniable. Just look at non-equity companies like Kickstarter and Indiegogo and the success that people have achieved in raising funds for projects. Sites like Kickstarter and Indiegogo allow people to transfer monetary gifts but the donors do not receive equity because it is not yet permitted.

Once the SEC releases regulations, equity crowdfunding will provide one of the largest infusions of capital into the entrepreneurial small-business community in history and fundamentally change the way small and medium-sized business raise money.

Many small-to-medium sized businesses have struggled with access to capital in a tight lending market which has hindered economic growth. Qualified entrepreneurs need capital to hire more workers, increase operations or expand marketing. Yet even the most qualified of borrowers have encountered a cold lending environment with no end in sight.

When will the SEC release new regulations?

The SEC originally set a target date of early 2013 to release equity crowdfunding regulations. However, it now appears that the release date will be delayed at least until the second half of 2013 and possibly 2014.

Crowdfunding for equity from non-accredited investors is not yet permitted. Do not attempt to crowdfund in exchange for equity from non-accredited investors until the SEC releases regulations.

What is an Accredited Investor? Non-Accredited Investor?

The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

1. a bank, insurance company, registered investment company, business development company, or small business investment company;
2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
3. a charitable organization, corporation, or partnership with assets exceeding $5 million;
4. a director, executive officer, or general partner of the company selling the securities;
5. a business in which all the equity owners are accredited investors;
6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
8. a trust with assets in excess of $5 million, not formed to acquire the

If you do not fall into one of the categories above, you are considered a non-accredited investor and you cannot currently invest in companies online.

Why do I Need a Crowdfunding Attorney?

Entrepreneurs seeking to raise capital via crowdfunding must structure their companies in a way that will appeal to investors while minimizing risk to the corporation. The SEC will require strict disclosure requirements similar to a private placement offering memorandum which requires the services of an experienced corporate attorney. The SEC will require strict compliance with securities laws and any missteps could result in the entrepreneur being personally liable for the entire amount of capital raised. The Lloyd Lee Law Group, PC is tracking the latest developments and will be well-positioned to facilitate and execute crowdfunding transactions once the SEC releases funding regulations.

Currently the SEC is attempting to create regulations to minimize the risk of fraud to investors. It is expected that investors making less than $100,000 per year will be limited in the amount of money they can invest on an annual basis. Moreover, companies and crowdfunding platforms are expected to be highly regulated as well. It will be extremely important for a business seeking to raise capital to hire a knowledgeable business attorney to help navigate the legal issues surrounding a successful capital raise.

What is the Best Legal Structure for Crowdfunding?

It will be of paramount importance for entrepreneurs to setup their investment opportunities with a clean legal structure that is favorable to investment. Investors will not invest in a company that is not properly setup to receive capital investment in exchange for capital. C-Corporations will be the entity of choice, and many of them will be setup in Delaware to attract investment. Delaware is well-known for having the most favorable corporate laws.

Once a corporation has successfully raised capital, the corporation must issue shares to the investors and then observe all corporate rules of governance to satisfy rules and regulations. New shareholders as well as existing ones will demand strict compliance in exchange for their investment.

Any entrepreneur seeking capital through crowdfunding must meet all strict compliance requirements or otherwise risk the cancellation and return of any funds raised. Furthermore, the corporation and it’s directors, officers and shareholders could be exposed to lawsuits for failure to meet strict corporate governance and SEC rules.

General Partnerships are Dangerous

Many new entrepreneurs start their businesses with other partners knowing that partnerships can have many advantages. In the beginning, the energy is positive and everyone feels the sky is the limit. With some naivety, the partnership pushes forward unaware of the significant legal risks and unlimited liabilities born by each partner.

A general partnership is formed when two or more people carry on together in a business for profit. General partnerships can be formed without a written agreement and do not need to file anything with the California Secretary of State. It is even possible to form a general partnership without intending to do so.

Why are General Partnerships Dangerous?

General partnerships are extremely dangerous for several reasons. The most dangerous reason is that each individual partner bears unlimited joint-and-several liability for the actions of the other partners.

For example, if one partner binds the partnership to a loan obligation or debt, the other partners become personally liable for the full amount. It is very common in a lawsuit for the plaintiff to sue the partner with the most individual assets for the full amount.

Another example, what happens if one of the partners is driving around doing business on behalf of the partnership and gets into a serious car accident? If car insurance is not sufficient to cover the damages, which is common in serious car accidents, the injured party can sue every partner personally for the full amount of damages. It does not matter that you were not driving the car.

Another example, what happens if one of the partners makes a misstatement to a client about the product or service, and the misstatement results in significant business damages to the client? What if the partner forgets to fix an important detail or the software is flawed? The client can sue each partner in his or her individual capacity and reach all of the partners’ personal assets to satisfy the damages, even if you were not the one to speak with the client or make the mistake.

What is the Solution?

There are several solutions that can protect individual partners from legal lawsuits caused by the general partnership.

One possible solution is to sign a negotiated written partnership agreement. The partnership agreement can determine how to handle legal situations that may arise. However, it is strongly recommended that the general partnership consult with a specialized business attorney to draft the general partnership agreement. Unfortunately a written partnership agreement is not the best method for protecting partners from joint-and-several liability.

The better solution is to setup a Corporation or a Limited Liability Company with the help of an experienced business attorney. Do not make the mistake of using do-it-yourself websites like Legal Zoom or a CPA. They are not attorneys and cannot give you legal advice about important legal considerations of setting up a Corporation or an LLC. If you utilize a CPA to setup your corporation or LLC, consider hiring a business attorney to handle the legal issues that will arise.

WHY SHOULD I USE A BUSINESS ATTORNEY TO SETUP A CORPORATION OR LLC?

Choosing the Right Business Entity – Corporation or LLC?

Choosing the rights business entity is one of the first important decisions that entrepreneurs must make. Many people make the mistake of using a do-it-yourself website like Legal Zoom or CPA. Using these methods is problematic because they are not attorneys and cannot give legal advice. These websites and accountants claim that you do not need an attorney’s assistance and you can save money by simply setting up the entity with them. This is a huge mistake. Yes you can setup your entity using a do-it-yourself website or a CPA but there are many legal issues that must be addressed and a boiler-plate agreement will not be sufficient.

I have even seen situations where an entrepreneur incorporated his or her own business but did not follow through with any of the corporate formalities and did not even distribute any shares. This is problematic because if the corporation or LLC is sued, the courts could view the entity as an “alter-ego” which means there is no corporation. Instead it is treated as a sole proprietorship or general partnership and all of the entrepreneur’s personal assets are at risk.

Also in situations where there are multiple business partners or investors, a do-it-yourself website or a CPA will not be able to advise the business group as to the important legal issues that may arise. Here are some common problems that I have seen:

-         How much equity ownership does each founding member receive based on their time and money invested?

-         Were the equity shares or units properly distributed?

-         Did you meet all of the compliance requirements under the California Corporations Code? Are you complying with all laws on an ongoing basis?

-         How much time will each founder spend at the business? What happens if they do not meet these expectations? What happens to their share of equity ownership? How will you split income?

-         What are each person’s responsibilities? What happens if someone does not live up to their commitments?

-         What happens if one of the founders decides to quit after six months?

An experienced business attorney can help new business startups avoid many of these problems. The time to negotiate these issues is at the beginning of a startup, not after a dispute has arisen.

Equity / Free-ride Problem / Giving Away Equity

Too often, founders bring aboard business partners and hand out equity like its Halloween candy. Other times, a group has big dreams of making it big but after a few months it becomes apparent that some of the members will not be pulling their weight. In other cases, members realize that startups are hard-work and won’t provide income for quite some time. Unable to live without a steady income, founders will leave the group and get a full-time job to pay the bills with plans of working on the startup at night or weekends or whenever time permits.

This is a major problem because the departing founders still own a percentage of the company while not providing the labor and commitment necessary to launch a successful startup. Meanwhile, the remaining founders continue to work hard to build the company knowing that if the company achieves success, they will have to share it with the departed members.

Smart entrepreneurs can avoid these types of problems with careful planning. For example, a company can vest equity to founders over time so that the longer they remain with the company, the more equity they own. A company can also institute buy-out provisions if someone leaves. However, these types of issues must be negotiated and finalized in a written agreement before a dispute arises. An experienced business attorney can assist you with this.

Buy-Sell Agreement

A common mistake made by entrepreneurs is failing to implement a buy-sell agreement for all equity stakeholders. Here are common questions that most entrepreneurs fail to address:

-          What happens if a competitor wants to buy your company and you resist but your partner says yes? If your partners accept the buy-out, and you reject it, your competitor could be your new business partner.

-          If a founder dies, what happens to his or her equity stake in the company? Does the surviving spouse become your new business partner?

-          If a founder becomes medically disabled or incapacitated and is no longer able to work, what happens to his or her equity stake? What happens to his or her voting power? Does the spouse get to vote instead?

-          What happens if a founder behaves in bad-faith resulting in termination from the company? What defines “bad faith?” What happens to the founder’s equity stake?

-          If any of the events described above happens, what is the process for buying-out the equity stake?

-          How will the purchase price or valuation of the equity stake be determined?

A well-negotiated buy-sell agreement can avoid all the problems stated above. Contact a qualified business attorney to advise you through this process. The Lloyd Lee Law Group, PC offers free initial consultations. Call today.

More than 250 fans showed up in San Carlos, CA to meet-and-greet Mike Tyson. Lloyd was responsible for handling the legal components of the event.

Basic Setup is Free – You Do Not Need to Pay for These Services

First, companies like LegalZoom and CPA firms charge you for services that you can complete for free. You can setup your own business entity without these services. Simply visit your Secretary of State’s government website for information on setting up your entity. In California, you can visit the Secretary of State’s website. You complete an application in the same manner that you complete information on LegalZoom’s website, except that it’s free.

LegalZoom also offers other fee-based services such as requesting an EIN number which is also free if you complete it on your own. For information on how to obtain an EIN for free, visit the IRS webpage.

You Need to Consult with a Real Business Attorney

Second – and I believe this is the most crucial point – these non-attorney companies cannot give legal advice because they are not licensed attorneys. Legal consultation is one of the most important components of setting up a successful new business venture. If you are going to invest money, make sure you invest in sound legal advice to ensure that your business is on solid legal ground.

Why do I Need to Consult with a Business Attorney?

I cannot stress enough the importance of consulting with a business attorney. A significant portion of my business comes from Corporations or LLC’s with two or more business partners who are now in a business dispute. When a business dispute arises – which inevitably always happens – the business owners look to their corporate governance documents for instructions on how to resolve it. What most people find is that their boiler-plate documents are not designed to handle their specific problems. The devil is in the details. Most people do not even know what is inside their corporate documents until a problem arises. This is an expensive mistake that can side-track your business for years. The time to negotiate business rights is when parties are amicable, not after a dispute arises. Investing a little money at the beginning is far more prudent than fighting a legal battle after a dispute arises.

Here are some common issues that are not usually addressed in boiler-plate documents:

-          Did you choose the proper legal structure for your business?

-          Is your entity compliant with local, state and federal laws?

-          Is your business entity legal in your industry?

-          What legal rights does each of the business partners possess?

-          Do you understand what is in your legal documents?

-          How do you resolve disputes?

-          What happens if one of a business partner quits after three months? Does he or she continue to own part of the business?

-          What happens if one business partner dies or becomes incapacitated? Does his or her spouse become your new business partner?

Again, LegalZoom and CPA firms are not allowed to tell you how to structure your company, or tell you what rights each owner should have, or what major risks you are taking. They cannot even tell you whether your company is compliant with state, federal and local laws.

If you still don’t believe me, view the Ripoff Report.

What About the Attorney Services Offered as Part of a Monthly Subscription?

When these companies include legal consultation as part of a package price, often times it is with an attorney whom you will never meet. The value of personalized professional service is eliminated. I cannot emphasize the importance of working with someone whom you know, like and trust. A good business attorney should know you and understand your business needs – it’s a real business relationship that normally lasts for many years.

Call Us Today for a Free Consultation – Affordable Flat Fees with Legal Consultation

The Lloyd Lee Law Group offers affordable flat fee rates for business formation which includes one-hour of legal consultation, state filing fees, and a customized binder with all necessary documents. Often times, entrepreneurs are not sure which entity best suits their business venture. Choosing the wrong entity can be costly and often results in higher legal costs when trying to reverse course after-the-fact. Start your business on the right foot. Call today for a free consultation with an experienced business attorney.

If you’d like more information on common problems with using Legal Zoom or CPA firms for entity formation, please continue reading below.

No observation of corporate formalities. 

Corporations and Limited Liability Companies (LLC’s) must observe certain formalities to maintain their entity status. Just because you setup a corporation does not mean you still have a corporation 18-months later. You have to follow the rules such as holding annual shareholder meetings, electing directors, and appointing officers, and adopting shareholder agreements and bylaws. Even with LLC’s, you’re required to maintain the formalities. Most people are unaware of these obligations or don’t know how to comply. Importantly, this is one of the points where lawyers would make a legal attack trying to pierce the corporate veil and reach your personal assets. Make sure this is airtight.

What happens if I don’t comply with the formalities? 

If you don’t comply with the formality requirements, then you don’t have a corporation or LLC. Creditors and litigants can pierce the corporate wall and reach all of your personal assets. This defeats the purpose of setting up the corporation in the first place, and all of your personal assets are now exposed.

Multiple Owners. 

When you have business partners or multiple shareholders, it is imperative that you speak with a competent business attorney. Here are some questions you should ask yourselves. What happens if I have a dispute with the other shareholders? What happens if the other shareholder wants to sell his shares? What happens if he dies? Does his wife become my new business partner? What happens if a rival company wants to buy my partner’s shares and she agrees? What happens if the other shareholder quits his officer position? Does he get to keep his shares while I continue working to build the company?

A well-written Shareholder Agreement, Bylaws, and Buy-Sell Agreement can resolve most disputes when they arise. However, it is important that you negotiate these terms before a dispute arises. Once a dispute arises, you’re stuck with whatever documents you have.

When you start working together with your business partners, it is inevitable that issues or disputes will arise. Everyone will immediately look to the signed corporate documents for guidance and resolution. This is why the time to negotiate your rights is BEFORE a dispute arises. Make sure you have a plan for dealing with these disputes so that it won’t derail your company’s momentum.

The only time I think it’s reasonably safe to use Legal Zoom or a CPA is when forming a limited liability company (LLC) with only one member, and even this comes with risks. In every other instance, I strongly recommend using a business attorney to handle your entity formation. I speak directly from personal experience and I see the same basic problems over and over again.

Future Investors: 

If your structure and setup are not executed properly, then investors won’t invest in your company. Clean legal foundation and meticulous corporate records are an absolute requirement for acquisition or investment.

Fast-forward to 2011. Many companies have survived the initial downturn and have been working hard to pay the bills every month. The problem is that many companies have remained at the break-even point with no revenue growth in site.

Companies are now facing the difficult question – is it worth it? In other words, is it worth it when you are barely making ends meet every month? Is it worth the long hours and stress when your business just doesn’t seem to grow and you aren’t making money?

The first important point is to review your current business model and see if there are ways to enhance revenues, reduce overhead, and realize greater profits. However, many businesses have already taken these steps. It’s the natural response.

If you’ve made the difficult decision that it’s no longer worth it to remain in business, then I would strongly recommend taking pro-active steps to wind down and dissolve your corporation. Simply burying your head in the sand and allowing your company to die a slow death will expose you to risk of future lawsuits even after your business has closed.

You should have a plan for liquidation of assets in a manner that maximizes the value of the assets while minimizing risk of future collections and lawsuits. Don’t let your company die a slow death. Don’t stick your head in the sand. Be pro-active in winding down and dissolving your company so that you can focus on moving forward with the next stage of your  life.

However, there are also many aspiring entrepreneurs who can’t seem to gain any momentum in their business start-ups. It’s called “Analysis Paralysis,” and it’s very common in first-time entrepreneurs.

Wikipedia describes “Analysis Paralysis” as:

“…over-analyzing (or over-thinking) a situation, so that a decision or action is never taken, in effect paralyzing the outcome. A decision can be treated as over-complicated, with too many detailed options, so that a choice is never made, rather than try something and change if a major problem arises. A person might be seeking the optimal or “perfect” solution upfront, and fear making any decision which could lead to erroneous results, when on the way to a better solution.”

The very essence of entrepreneurship is informed risk-taking that results in success. However, one cannot be a successful entrepreneur if he or she is unwilling to rely on his experts and make informed decisions that move the company forward.

We are always happy to help clients understand the logic behind their business decisions. Your success is our success. However, it becomes unproductive when the client continues to sit on his hands, thinking about every single detail with the paralyzing fear that he or she will make a mistake.

As any successful business person will tell you, it’s okay to make a mistake. No one becomes successful without making a mistake. After all, we’re human. It’s how you respond to mistakes that will determine the outcome of your business venture. If you believe in your vision, then surround yourself with a team of professionals and make the best informed decisions possible, and be prepared to adapt when a mistake arises!

Before bringing an investor aboard, the shareholders should carefully consider several factors before seeking outside money. For example, how much equity do you want to sell? How much ownership and control do you want to give up? How much is it worth? Can you buy it back?

One of the major problems of bringing a business partner & investor aboard is known as the “free-ride problem.” For example, let’s say you have built a new business but need an additional $250k to finance growth of your company. You find a potential investor who not only wants to invest $250k but also wants to work full-time and help the company succeed. The potential investor has expertise in the field and can add value to your company. You think it would be great to have such a qualified person join the company.

Here’s how the free-ride problem occurs. Let’s say an investor has purchased, say 40% of your company, for $250k on the condition that he will join your company as an equity stake holder and day-to-day business partner. For corporations, the investor will be a shareholder of the corporation.

Soon the investor for whatever reason disagrees with you about something. It could be anything really, from frustration about the general direction of the company to day-to-day management affairs. After a dispute, the investor quits and no longer contributes any time or labor but retains his 40% ownership in the company. The investor can now essentially get a free-ride on your continued hard-work. As the company grows in value, so does the investor’s stake. Five years later, you’ve built a multi-million dollar company and your stake-holder owns 40%, thanks to your hard work. The investor gets a “free-ride” on your hard work.

There are several contracting methods that can be used to avoid the free-ride problem. The “free-ride” problem happens quite often, especially in new business ventures when friends or colleagues start a company with a great business concept but soon disagree on the direction of the new company. It’s imperative to have options to address these types of situations so you can avoid expensive disputes. By engaging in careful contract negotiations, you can avoid many of the problems that can subsequently arise.