$7,000 Mistake Sinks Company

The following is an excerpt from the book Smart Business, Stupid Business, written by Diane Kennedy of US TaxAid and Megan Hughes of Smart Business Incorporation.

There was a company that got into serious trouble by taking money from investors without following the rules. The founders were raising money through friends and family. They brought 30-40 people into the company. The investments were all relatively small, and no one investor had come in for more than $10,000.

The problem was that the investors were considered unaccredited investors under federal security laws. They didn’t meet the legal guidelines to buy stock without the company first going through the expensive process of having a private placement document prepared and having its financial statements audited. Without those two things, companies are not allowed to sell to investors who don’t meet the federal government’s accredited investor guidelines. Accredited investors are individuals with a high net worth and income, who have experience in private investments.

The company was surviving (barely) and trying to raise money to launch business operations when one of the early investors asked for his money back. He wanted to withdraw from the investment entirely. If the company had done a private placement document, he wouldn’t have been able to ask for the refund. That’s because a proper private placement document explicitly sets out the risks of private investments and states flat out that there are no refunds. But the company didn’t have a proper private placement document. The founders didn’t know they needed one, and they had simply gone around and asked people for money.

When the company couldn’t pay him fast enough, the investor made a complaint to the state’s Securities Division. In addition to the federal securities agency, each state also has a government authority that looks after investments at a state level. At the state level, there is a whole other vetting process for investors.

The state Securities Division came down on the company and its officers like a ton of bricks. Sales of unregistered securities can result in huge fines or even jail time. The company couldn’t take the strain and collapsed. One founder’s marriage broke up, and he declared bankruptcy.

The amount of the investment was about $7,000. Doesn’t seem like much, but it was enough to kill the company. The lesson to take away here is very simple: no shortcuts when it comes to raising money through equity sales!

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