How to avoid legal, practical pitfalls of raising capital

Steven Reed

Opening and operating a restaurant is a capital-intensive process. When starting, capital is required for the purchase and lease of equipment and supplies, securing a location through lease or purchase of real property, hiring and training employees and funding the operations until the restaurant gains traction. Even then, due to seasonality or other causes, additional capital infusions may be required.

Capital structures vary widely. What may work best for one restaurant may be completely wrong for another, depending on the resources available, the management team, and other factors. Different capital structures include:

• bootstrapping (completely financed by the founder(s);

• debt financing (either through traditional bank financing or other investors);

• equity financing (through the sale of stock in a corporation or membership interests in a limited liability company); or

• a combination of all or some of the above.

For many businesses, however, the first two structures may be impractical, either because of the risk preferences of the founders or due to unavailability of funds from founders or lenders.

Many companies, consequently, pursue equity financing as a means for raising needed capital; however, there are legal and practical pitfalls that business owners should be aware of prior to jumping into the process of raising capital through the sale of equity interests. Below are brief descriptions of a few of these legal and practical pitfalls, several of which involve complex legal issues.

1. Aligning expectations 

When disputes arise between business owners and investors, they often reflect, in part, to misalignment of expectations. For example, a founder may expect that all profits from the business in the first several years, if any, will go toward opening a second location. Investors may be expecting profits to be distributed. Prudent founders take time to learn who their potential investors are to ensure that the expectations of the potential investors and the company’s management team are aligned. 

2. Options and capital calls

The contractual provisions governing the relationship between the company and the investors are important. For example, during the slow season or when expanding, additional money infusions may be necessary. Provisions can be put in place that require the equity owners to put additional capital into the business. It is important that all parties understand the obligation under such a provision and what the consequence will be if a party fails to contribute capital. Another important contractual provision is a “right of first refusal.” Before an investor sells their equity investment to a third party, the company may want to require the investor to first offer the interest to the company. This provision can enable the company to limit who their equity holders are.

3. Securities laws

Too often founders fail to realize that, no matter how small an investment, a company is selling a security when it sells equity (or debt) in exchange for capital (either money or other property). Whenever a company sells a security, it must comply with applicable federal and state securities laws. Generally speaking, all securities being sold by a company must be registered with the Securities and Exchange Commission and applicable state securities regulatory agencies, unless an applicable exemption applies. For many reasons, including the cost of a securities offering, small businesses typically try to rely on an exemption from registration.

One of the most common exemptions is found in Rule 506(b) of Regulation D, which allows a company to raise an unlimited amount of money from individuals who (i) the company has a pre-existing, substantive relationship with, and (ii) meet a certain wealth threshold.

Recent legislative actions have created additional opportunities for small businesses seeking to raise capital. For example, many states, including Arizona, have also adopted crowdfunding laws, where companies can raise small amounts of money from many in-state investors, regardless of the wealth status of the investors, subject to certain restrictions and limitations.

Numerous avenues exist for restaurant owners to raise capital; however, it is imperative that any small business seek the advice of competent advisors before undertaking any such effort.

Steven Reed is an associate with Jennings, Strouss & Salmon’s corporate, securities and finance group. He focuses on advising businesses and investors in a broad range of transactions and relationships.