Article

A Startup Restaurateur's Guide To Raising Private Equity Funding

Raising Capital, whether for a new concept, a second unit, or a multi-unit growth spurt, is not a task to be undertaken lightly. As Gordon Gekko famously said in the movie "Wall Street"; "A fool and his money are lucky enough to get together in the first place."

You might not see yourself in the same light as a Wall Street tycoon, but always be aware that the sale of securities (taking investment money to run a venture and pay profits) is highly regulated, and can be mired with legal and logistical pitfalls.

While it is never advisable to raise investment capital without first speaking to both an attorney experienced in private offerings and a certified public accountant, there are a few tips and tricks that may help you strategize how your company should raise funds.

The Rules and Why They Matter

Without going into the myriad details of the various state and federal securities laws, under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption to registration. Ideally you will sell securities to "accredited" or "sophisticated" investors.

To be accredited, one must meet one of several criteria indicating financial wherewithal, the most common of which are (a) a net worth of $1,000,000 (not including the investor's primary residence), or (b) gross income in the past two years (and an anticipation that the income will be the same in the current year) of $200k for individuals or $300k for married couples.

You should not sell securities to unsophisticated investors. One can imagine why – the government is tasked with protecting investors from being hoodwinked by unscrupulous sellers of securities, and unsophisticated investors are simply more likely to be taken advantage of.

One of the documents included in the private placement memorandum is an Investor Questionnaire, which potential investors must complete so the company has a signed document establishing the investor's status as accredited or sophisticated.

The various exemptions to registration determine the maximum amount of capital that can be raised, the number of unaccredited (but sophisticated) investors from whom investment can be sought, and the type of disclosures that must be made to the investors.

To take advantage of these exemptions under federal securities regulations, you must file "Form D" with the Securities and Exchange Commission. To further complicate matters, each state has its own securities rules, laws and filing requirements with which you must abide if you offer or sell securities within those states. Again, you need a lawyer who is experienced in these transactions to guide the process.

Form and Structure Your Entity

There are two elements to business entity structure that you should keep in mind: (a) legal structure and (b) tax structure.

The legal structure is comprised of the business entity type(s) you select (corporation, limited liability company ("LLC"), limited partnership ("LP"), etc.) as well as the foundational documents that lay out how you intend for your business to run.

No matter which type of entity you choose, it is important that, at the very least, your foundational documents clearly specify who will control decision-making, how much capital (cash or otherwise) each owner or investor has contributed, and any special agreements regarding the allocation of profits and losses to certain owners.

Treat Friends and Family as if They Were Strangers

A common misconception is that approaching friends and family to invest in your company does not trigger federal or state securities laws. Unfortunately, this is incorrect and could put you at risk of violating securities laws.

While founders often fail to properly document transactions with friends and family (possibly out of fear that handing them a large set of legal documents will be seen as offensive), the reality is that your friends and family want to know that the company is following proper procedures and appreciate that such documents protect both them and the company.

To maintain control over how the business is run, those seeking investment would be wise to ensure that the entity structure is set in place well in advance of considering how much and from whom to seek investment. Concept creators want to remain in control of their businesses.

Tax structure predominantly consists of how the entity is to be taxed. While the purpose of this article is not to delve into the wide world of taxation, at a basic level, one must understand that there are two types of entity taxation: corporate and pass-through.

Corporate taxation (when a company is taxed as a C- corporation" or "C-Corp") requires the entity to file annual corporate tax returns with the IRS and most state taxing authorities, and requires the owners (shareholders) to pay tax when profits are distributed.

C-corporations must also be strictly run. For one, there are several formalities to which you need to adhere to maintain the liability protection of the corporation; e.g., you must have annual board of director and shareholder meetings. In addition, it is difficult to allocate profits and losses in ratios different from one's percentage ownership in the company. Independent restaurant companies seeking investors should probably shy away from C-corporations, in most instances.

Pass-through taxation occurs when an entity does not pay corporate tax, and the profits and losses of the company are passed through to its owner's LLC members, partners in a limited partnership, etc. LLCs and partnerships may elect to be taxed as corporations, but there are very few reasons they would make that choice.

As a business looking for investors, you should also be aware of the limitations of electing S-Corporation (S-Corp") tax status for your entity, as it can significantly impede your ability to accept investment. For one, S-Corp tax status limits an entity to having only one class of investors. This prevents founders from being able to provide investors with different voting or distribution rights that would otherwise be desirable in structuring investor payback mechanisms. Additionally, S-Corp. tax status limits from whom businesses may take investment. The IRS restricts S-Corp. companies from having shareholders that are entities (as opposed to individuals). As many large investors use entity investment vehicles, S-Corp election is not typically the ideal tax status for a company seeking investment.

Selection of entity is a critical decision when creating a business and is one of the first orders of business. The decision is best approached with the assistance of both an accountant and an attorney. Although secretary of state websites make the process to create an LLC look simple, e.g. filling out forms, paying a fee, etc., there are numerous issues to consider based on your goals and prospective investors.

Protect Your Intellectual Property

Restaurant investment is often sought on a per-unit basis. When raising equity for the first unit, it is imperative that the concept creator clarify for investors whether they are investing in the ground floor of the concept (including all its future growth), or just a specific unit or two.

Make Sure Investors Provide Proper Information to You

Once investors come on board, you must do more than just take checks to the bank. Ensure you receive a signed Investor Questionnaire. You must be able to confirm investors' accredited or sophisticated status before you deposit their money. Moreover, ensure investors promptly return their signed agreements to ensure accurate recordkeeping.

Additionally, investors need to know what they will receive for contributing capital to the company. Naturally, describing anticipated return on investment is essential. However, accelerated profit distributions, preferred returns, investor discounts, etc. can all be ways to entice investors to participate in your project.

Failure to clarify can lead to expensive litigation down the road when the concept creator seeks to open additional units with a different investor mix or bank debt, and the initial investors find themselves excluded from being able to invest in, or profit from, future units.

The simple way to accomplish this is to create a company to own the concept's brand DNA (the logo, trademarks, recipes, trade secrets, etc.) that is separate from the operating entity. Investors learn of this arrangement (and that they are investing in a restaurant unit, not the entire concept) when they receive an offering memorandum specifically informing them that they have no ownership in the concept itself.

Make Sure the Equity Structure Matches Founder and Investor Expectations

A large part of structuring your legal entity in preparation for investment involves ensuring that you have built an equity structure that matches the founders' desires for the business moving forward.

Equity may be separated into two types of interest that may be conveyed to an investor at different rates – voting interest and financial interest. Unless otherwise stated in the company's governing documents, an investor's voting and financial interests are treated the same. Once you think about these interests separately, however, you can get creative with investment deals.

Pro rata split. This is the most common form of business equity structure and involves simply splitting the equity amongst the members of a business based on their investment.

Founders whose contribution to the business primarily involves day-to-day management, operations, or other forms of sweat equity, can find it difficult to value the intangible contributions made to the company when juxtaposed with specific dollar amounts from investors.

Even more undesirable in this scenario is the fact that without multiple classes of profit distribution, investors who want to be paid back quickly will demand large percentages of equity, which can lead to a loss of control for the concept creator.

Separate different deals into different classes. As pro rata splits are not ideal for many founders, oftentimes businesses will structure the entity so that investors are separated into different classes from the founders. This functionally allows founders the opportunity of structuring different investment deals for different forms of investment and for different stages of development.

One increasingly common scenario involves creating a class of ownership for investors where they receive an accelerated allocation of profits and losses until they recoup their investment, but own a non-controlling interest in the company. Forms of accelerated return can take many forms, such as:

Example: In exchange for a $100,000 investment in a limited liability company (a common entity choice for independent startup restaurants), Jules the Investor is given ownership in Class A, which provides her 20% of the business's voting rights and 20% of its financial rights with an accelerated return of 80% until she receives a 100% return on investment. After she recoups her initial investment, she will receive 20% of the distributions going forward.

As a result, Jules is given 80% of distributions until she recoups 100% of the $100,000 investment she made in the business. Once she receives 100% of her investment, she will receive 20% of distributions moving forward. This arrangement assures Jules that she will recoup her initial investment in the short term, after which she agrees to a 20% pro rata share of profits and losses and 20% voting rights.

This is just one example of the numerous creative ways in which a founder may build investment packages that meet the needs of investors without compromising the founder's control. Profit-sharing ratios are often used in limited liability companies, which are partnership-type entities. Regarding the designation of "classes", each member of an LLC has some ownership stake in the company. While all members have economic rights in the company, the classes designate their voting rights, if any.

The scenarios can range widely depending on the members' initial investments, the value of member sweat equity, how much control of the organization they want to maintain, and their long-term financial goals. Ideally, the members will structure ownership interests with the counsel of a CPA and an experienced business finance and formation attorney, who can suggest the pros and cons of various approaches.

Additional Considerations

There are other considerations, beyond dollar amounts and profit splits, that should be considered when deciding on an investment structure. First, one must clearly define the terms in the investment offering to avoid ambiguity in interpreting the setup. Second, if the company is a tenant on a lease, then consult any applicable change of control or assignment clauses in the lease contract so the company does not inadvertently breach its lease by adding owners to the company.

Finally, the many documents that make up the offering should fit together seamlessly. Do not rely on internet forms or downloaded business plans to take investment capital. The documents only get the company part of the way down the road, as state and federal regulatory filings are required to effectively complete a private offering.

Have a Substantive Disclosure Document and Provide It to EVERY Investor

As mentioned above, the offering must include specific disclosures to potential investors. You will work with your attorney to build this document so it is not misleading. There are a few points that every substantive disclosure document will provide:

The 'ask' and the 'return'. You should clearly tell potential investors how much money you will permit them to invest, and how much equity you are willing to exchange for that investment. It is also a good idea to include a minimum investment amount that you are willing to accept for participation in the business or project. Small denominations of investment can lead to many investors, and investors often purchase only one unit in an offering, so try to price units accordingly.

Additionally, investors need to know what they will receive for contributing capital to the company. Naturally, describing anticipated return on investment is essential. However, accelerated profit distributions, preferred returns, investor discounts, etc. can all be ways to entice investors to participate in your project.

Investment proceeds. Investors must be told how their money will be spent. Ideally, numbers related to your budget should be verified and checked by a CPA to ensure they are both reasonable and not misleading. Project budget information should include a breakdown of all costs associated with the project as well as whether anyone linked to the business or project will be given a fee, payment or salary from the proceeds.

A Well-used Process

Raising funds via a private equity offering can be one of the most flexible and practical ways to grow a restaurant concept. Startup concepts often have limited access to institutional lending; however, even as the restaurant grows and gains the confidence of bank loan officers, debt financing increases the risk of the business.

Equity investors receive their profits though distributions and dividends when the business becomes profitable. Loans need to be paid on schedule, regardless of whether the business is generating sufficient operating cash flow. Even large, publicly traded restaurant companies have a mix of equity and debt financing.

Though the requirements of raising money through private equity financing might seem daunting, the process has been well-used to grow many startup concepts into multi-unit maturity. Again, team up with a good accountant and attorney at the beginning, and you can save yourself numerous headaches as you work with investors.

Editor's Note: This article is for your general information only. Legal advice must be tailored to the circumstances of each case, and laws are constantly changing. Federal laws, the laws of each state, and often each municipality, vary and each may have its own procedures and time limitations that must be followed. Confer with a lawyer in your state to assess your legal rights in a particular situation.

Know Your Objectives and Strategy

What are your project and business objectives and how do you plan to achieve them? Investors want to see the strategy you are implementing to achieve returns on their investment. It is important to describe how you developed your budget (including the assumptions you made), foreseeable variables that can impact the budget or returns, a multi-year pro forma, and the anticipated time until investors will recoup their capital. Additionally, the following factors (and others) are often disclosed:

• Information about the company and project
• Founders' background
• Financial background of company
• Company details
• Entity
• Management
• Treatment of Intellectual Property
• Copies of relevant entity formation documents and agreements
• Desired real estate/demographic criteria of possible restaurant location
• Warranties and Disclaimers
• Private Offering not registered under the Securities Act of 1933
• Investor Suitability
• Limited Rights to Participate (if applicable)
• Limits to how interests can be resold
• Tax Issues
• Risk Factors
• What risks are there that could impact your company's performance?
• On what factors and assumptions are your numbers dependent?
• What specific external factors typically impact companies in your industry or location?

No Harm in Asking? Think Again!

Raising money from investors is easy. All you must do is ask for it, explain how it will be used, give the investor part of the company, and promise a fair return within a reasonable time, right? Wrong. Dangerously wrong.

When you use, or ask for, other people's money as capital investment to finance your business, you cross the great divide that separates those who invest money and time in themselves, from those who invest in business ventures not to own and operate them, but rather to obtain a return on their invested capital. In exchange for their money, investors, unlike creditors such as banks that earn a fixed return (interest) on money lent, expect a piece of the action – ownership of some part of (an equity position in) the company, since that likely will yield a greater return on their investment than what they would receive if they simply lent money.

The seemingly innocent act of accepting or even asking for other people's money in exchange for a piece of your company (for example, offering shares of stock in a corporation or a membership interested in a limited liability company – both of which are securities) in exchange for startup or seed money, trigger federal and state securities regulations designed to protect unwary investors from unscrupulous profiteers.

In general, unless an exemption applies, every security issued must comply with securities registration laws (often an expensive and cumbersome process).

Exemptions often key on factors such as a limited number of investors; residence of all investors in a single state; investor sophistication (as measured by wealth and income, with the upper end termed accredited); a pre-existing relationship between the investor and the company or its principals; the absence of any advertising or promotional information; and a commitment from the acquirer that the stock purchase is for his or her own account and is not being made as a securities dealer, with an eye to further distribution. State regulations often are referred to as "Blue Sky Laws" because that is all that some disreputable companies delivered to their investors in exchange for their hard-earned and often forever-lost cash.

Many of the reforms that continue to govern today (federal securities acts of 1933 and 1934) were created in the aftermath of the October 29, 1929 crash of the U.S. stock market.

Consistent with former U.S. Supreme Court Justice Louis Brandeis's admonition that "sunlight is said to be the best of disinfectants", by calling for specific disclosures and warnings, these rules partially level the playing field to help neophytes participate alongside more experienced investors.

Regulation does not mean that raising money is taboo; just that anyone not an expert in the area should retain an attorney who specializes in securities laws to guide them through the process, whether by way of registration, qualification, or exemption. Depending on the complexity of the financing structure, the entire process can be straightforward and involve minimal filing requirements, or incredibly complex, requiring extensive disclosures such as those found in a prospectus or private placement memorandum.

The failure to comply with securities laws can have dramatic consequences, so take care to obtain legal advice applicable to the securities being issued or transferred and the company (issuer) issuing or acquiring them.

Securities-Based Crowdfunding

Securities-based crowdfunding is possible, primarily through the 2012 Jumpstart Our Business Startups Act (or JOBS Act). When the JOBS Act was adopted with bi-partisan Congressional support in 2012, there was great hope that the law would significantly change the way small businesses and start-ups raised start-up capital. Among other innovations, in one of the biggest changes to securities law since 1933, the JOBS Act intended to make it possible for small businesses and start-ups to solicit investors directly - in person and on the Web - to make investments in their companies.

Congress expected change to occur immediately. Congressman Patrick McHenry (R-NC), one of the JOBS Act's sponsors, said that crowdfunding utilized online technology to increase small business access to new sources of financing. Social networks were not just for keeping up with friends – they could become marketplaces for everyday investors and entrepreneurs.

In particular, the JOBS Act created three types of crowdfunding:

• Crowdfunding to accredited investors under Rule 506(c)
• Crowdfunding for up to $50 million each year under new Regulation A+ and,
• Crowdfunding to both accredited and non-accredited investors in small offerings under Title III.

For more information on the JOBS act, please visit: https://www.sec.gov/spotlight/jobs-act.shtml