Legal Aspects of Using Other People's Money

With the economy showing signs of recovery, many established restaurateurs are looking to grow their businesses. Customer counts are building and weaker competitors have fallen by the wayside. There is no shortage of good ideas, but after climbing out of a trough in the business cycle, cash is tight.

Meanwhile, investors are looking for ways to put their money back to work. The real estate market is still soft in most regions. And while the Dow Jones Industrial Average is above 11,000 as of this writing, the timing of the stock markets is tricky. Many private investors are looking for nontraditional investment vehicles (i.e., outside the stock markets) with which to diversify their holdings.

In an ideal world, independent restaurateurs with winning concepts and proven management skills would hook up with investors who are willing to bet on those ideas. When this marriage between Business Savvy and Other People's Money works, it has all the romance of a great love story, with all parties increasing their wealth.

That said, these relationships are not without risk, financially and legally. If you are considering funding through private sources -- be they private equity firms, friends, relatives or strangers who believe in your ideas -- you need to understand the mechanics and pitfalls that can create aggravation and liability if these deals go sour.

This article will explore various types of other people's money, briefly touching on bank lending and venture capital, with a focus on raising private equity funds from friends, family and outside investors.

A Few Words on Institutional Lenders

You may already realize that banks have never really been keen on making loans to small-business startups, especially restaurants, given the real and perceived risk of failure. This posture changes once the operator has established a successful concept and seeks financing to expand. In that case, lenders see a steady cash flow stream and can get their hands on collateral to secure debt going forward.

The beauty of institutional financing is that the bank is just a bank. It only cares about being repaid. Unlike private equity sources, it doesn't want to be a partner in the business, or otherwise get involved in how you run your restaurant.

In this economy, not surprisingly, bank lending to small businesses has dropped significantly in 2008 and 2009, compared with prior years. The mortgage-lending meltdown of 2008, coupled with the bankruptcy of CIT Group (a leading lender to the restaurant industry), caused access to institutional loan capital to virtually dry up last year.

Though government stimuli have opened the taps a bit, most notably via Small Business Administration lending, various reports published during the first quarter of 2010 suggest lending this year will be slow to come back online, and will not reach pre-2009 levels. Moreover, SBA loans only comprise a small percentage of total business lending.

Whether you use an SBA program or more conventional lending, the odds of obtaining no-money-down small-business loans have diminished. At the very least, lenders expect operators to have "skin in the game," and place their own money at risk. And in the case of traditional (non-SBA) lending, banks routinely expect transactions to be collateralized with either liquid or fixed assets, backed with cash flow projections and guarantor support sufficient to meet bank approval. In other words, the lenders want security in the case of default, either in the ability to take possession of assets that can be sold or another party to assume the debt.

Therefore, while bank lending is still an option, it is most likely not a viable option for many operators looking to expand who cannot either come up with the cash requirements of the SBA program or the collateral requirements of more traditional lenders.

Private Equity Sources

Particularly in this economy, private funding is a more realistic avenue for financing your business. Here are the common sources of such funding and their respective terminology.

Venture capital (VC)

VC or "private equity" firms provide capital and management in return for ownership in a company (often a rather large bit of ownership in the company). They typically invest in more established companies with unique products, such as technology or medical devices, expect a high rate of return and often acquire companies with the goal of ultimately "taking them public."

The University of New Hampshire's Center for Venture Research analyzes venture and "angel investor" (more on them later) funding. The center also maintains a "Capital Locator," the purpose of which is "to assist entrepreneurs in their networking process of finding early-stage capital." While traditional venture capital is not often an option for restaurant startups, it certainly could be a viable growth vehicle as companies expand and become more established or for the unique concept that can be rolled out in a large scale, either regionally or across the nation.

Friends and family

Friends and family (as opposed to outside investors) are often the first, best choice when seeking funding for growth, whether in the form of debt or equity. The intangible costs of securing funding from friends and family, however, can be extremely high. Family members are often eager to volunteer financial assistance, but they can have unrealistic expectations about factors like their role, their voice or their right to payback. Perhaps most importantly, business/family relationships are almost always affected when you either make money or lose money. Both success and failure can create unexpected reactions in family members.

My experience has been that when you seek funds from these sources, it is advisable to treat the transaction as if you were not dealing with friends and family. Though many operators do not feel that they need to spend time documenting transactions with family as thoroughly as they would if they were dealing with strangers (and often feel that presenting a comprehensive set of legal documents will offend the friend or family member), it does not take much to convince those people that such documents protect everyone involved, and show your level of commitment to the project by doing things properly. Simply put, the eventual success (or failure) of your venture can have a way of causing amnesia in anyone without proper documentation, even family members.

Loans from family members should be properly papered with loan agreements, promissory notes and, if applicable, agreements securing collateral. These documents should set out the payment terms, including the interest rate, payback period and monthly payment.

Investment by family members should use the same documentation you would require of anyone else, including a Private Placement Memorandum, Subscription Agreement, and Company Agreement, discussed more fully below.

Outside investors

The phrase "angel investor," like "silent partner," is often a misnomer. Raising money from and then dealing with investors can be daunting, and more often than not they prove themselves to be neither "angels," nor "silent." Thus, this article will use the term "outside investors" to mean anyone investing in the project (including friends and family) other than the concept creator.

Any time a business raises equity from outside investors (whether the business exists as a corporation, partnership or LLC), the transaction involves the offering and sale of "securities" (as in the Securities and Exchange Commission [SEC]). Even though your company is not publicly traded, you must comply with both state and federal laws governing the sale of securities, including the filing of "Form D" with the SEC.

Without going into the technicalities of myriad 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. For example, Rule 506 of Regulation D to the act allows a company to raise an unlimited amount of money so long as it complies with the following conditions:

• No general solicitation or advertising of the offering.
• Sale to an unlimited number of "accredited investors," and up to 35 other investors, so long as those 35 (either alone, or with a representative) are "sophisticated" investors.
• Compliance with the anti-fraud provisions of the act (full disclosure).
• Availability to answer questions by prospective purchasers.
• Financial statements certified by an independent public accountant.
• Securities must be "restricted" -- that is, they cannot be resold for at least a year.

A Private Placement Memorandum (PPM) containing a description of the business, the terms of the investment, and disclosures of various risks should be given to potential investors prior to their investment in the offering to ensure compliance with applicable securities laws.

Restaurateurs, whether they start a new concept or expand an existing one, routinely make grave mistakes when raising money from outside investors. These mistakes, which are most often the result of either unfamiliarity with the process or intentionally doing the project "on the cheap," are easily overcome. Unfortunately, most of these mistakes occur in drafting the PPM. Failure to make adequate disclosures to investors or to meet state and federal filing deadlines can subject the investment to rescission and, in certain circumstances, allegations of securities fraud, so doing it properly is extremely important.

Pitfalls to Avoid

Before embarking down the path of obtaining funding from private parties, whether a private equity firm, friends and family, or angel investors, make sure you are supported by both a CPA and attorney with experience in private equity funding. There are many traps and pitfalls along the way that can be overcome with the right team.

One of the most common mistakes restaurateurs make in raising private equity is believing that providing investors with a "business plan" is enough. Downloading a business plan template from the Internet or hiring a consultant to assemble a business plan can be a useful tool for the business, but it is by no means the end of your responsibility to outside investors. The PPM should consist of a narrative about the business, executive summaries, financial terms of the offering (including a pro forma showing revenue forecasts and projected rates of return), risk factors particular to the industry and other applicable information.

Businesses seeking investment funds often try to accelerate the process by paying a "finder's fee" to people who are not registered securities brokers. Such a payment, however, can subject the finder to liability and put your offering at risk.

Drafting an Effective Private Placement Memorandum

Matthew Mabel, president of Dallas-based hospitality and management consulting firm Surrender Inc., has been serving growing restaurant companies since 1991. Mabel says that prior to assembling the investor materials, the restaurateur should ask himself a few questions: "Why is it going to work, why is it going to last and how does what you are about to do carry on from what you have already achieved? If you can't answer those questions, you should not be expanding, let alone raising money from outsiders," Mabel says.

Narrative

The narrative is the storytelling portion of the PPM. The operator can tell about its history, successes, management and plans for growth.

To construct a good narrative, Mabel suggests you tell the story in a way that anyone can understand it, and remember that prospective investors may not be familiar with the inner workings of the restaurant industry. "All they know about is breakfast, lunch and dinner," he says. "Put your thoughts together about the uniqueness of your concept: how it responds to national dining trends and tastes along with customer traffic trends in your market."

Financial projections

"We like to illustrate three levels of revenue," Mabel says. "First, we establish 'Intermediate' and 'Superior' levels, starting with guest counts and PPA, which are mapped out by meal period, day of the week, and even time of year, and follow that with fixed and variable expense assumptions. Then we produce a third level, 'Breakeven,' by working backward in the same process from a zero bottom line. In that case we end up with guest count and PPA."

While the Superior level will put a big smile on everyone's face, Mabel says, "We do not make the Superior level a 'blue sky' or project the most volume the restaurant could ever do. No investor or operator should count on that. We want our clients to be happy when they hit a stand-up double. Not disappointed if they miss the home run."

Risk factors

Risk factors commonly found in private placement memoranda include those reminding investors that there is no guarantee projected returns will actually be realized, and that the company is subject to general economic conditions, which could be adverse and cause the loss of all the invested funds.

Risk factors more specific to the restaurant industry, however, include (by way of example) those associated with the service of alcohol, the highly competitive nature of the industry (i.e., competition for labor, customers and market share within a trade area) and the possibility of government regulation (e.g., changes to immigration laws), all of which could affect the business' profitability.

Must-haves

There are a few items that are essential to include in a PPM. First, take great care to describe the amount of ownership, voting power and profit/loss allocation that investors will receive in exchange for their investment, since you will want to ensure your control of the company's operations.

Remember to declare the contents of the memorandum confidential, and ensure that memoranda are returned to you from those who choose not to invest. It is unwise to have profit projections floating out in the marketplace for competitors and/or copycats to see.

If you or your company is the sole owner of the concept and you seek outside investment for the first time, you may want to take steps to ensure that trademarks and other intellectual property are properly protected and remain subject to your control. Keeping the intellectual property in a separate entity from the operating entity (and the investors) is one way to accomplish this.

Finally, in a PPM for a new venture or an expansion in an existing company by issuance of a new class of ownership, such as preferred shares, the concept creator may want to include language that will allow for the buyout of outside investors according to a predetermined formula. This allows the restaurateur the ability to buy back the outstanding interests or sell the company to a third party (most often after the investors have recouped an amount equal to their initial investment) without fighting investors over the value of intangibles such as goodwill.

Selling the PPM

The thought of selling interests without a registered securities broker can be intimidating. In reality, however, not many brokers will take the time to work on small private equity offerings (most restaurateurs do not want to pay the fees required when they do).

As for selling these securities, the "No. 1 most important thing we have identified for success is that the operator has confidence and truly believes he is offering prospective investors an opportunity to get involved in a deal that is both realistic and going to be profitable," Mabel says.

"For your first raise," Mabel says, "the best sources of capital for growth are your friends, family, and a category that may surprise you: your customers. These are people who know you, have seen what you can do, and believe in your concept and abilities. We tell our clients to write down a list of everyone they know who might be a prospect, and prioritize them from most to least likely." Mabel also says, "Meet people at your existing restaurant or on the site of your new development. Investors like to taste, smell and feel what they are investing in, as well as evaluate locations, to satisfy and comfort themselves that they are doing the right thing. Asking people to simply give you money will not get you very far. But offer people an opportunity to get involved in a select number of units in your new venture, and you'll have their attention."

Financial planners can also be a good resource for pointing investors your way (and there is always the chance they will invest, themselves), by looking over a roster of clients that might include people interested in exploring private placements of securities.

As for the timing of funding and the use of investor money, few investors want to provide the first dollars into a new project. It is therefore common for the restaurateur to escrow a large portion of the invested funds until a certain threshold is met (e.g., 70 percent of the funds needed).

This achieves a few objectives, most notably it provides investors with the peace of mind to know that their funds will not be spent while there is still significant risk that the company may not raise all the required funds, and it allows the company the ability to repay the investors' money in the event the placement is canceled for some reason.

Conclusion

There are various avenues for acquiring funds for expansion; private equity is often the one that best meets restaurateurs' needs. While there are many requirements to properly assembling and selling an effective PPM, diligently meeting those will ensure that the concept can move forward to see profitable growth, whether through friends, family or other outside investors.

No Harm In Asking? Think Again!

By Larry S. Green, Esq.

Raising money from investors is easy. All you have to 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 even want to ask for, other people's money as capital invested to finance your business, you cross the great divide that separates those who invest money and time in themselves from those who finance 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 to them a greater return on their investment than what they would receive if they simply lent money.

The seemingly innocent acts 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 a fairly 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 "Black Friday," the October 1929 stock market debacle. 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 fairly 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.

Editor's Note: Legal Articles are 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.