All businesses need money to operate. Money to pay the rent, to pay employees, to buy furniture and equipment and to pay for supplies. A business can get this money from various sources – the owner’s personal savings, "bootstrapping" (using the profits from sales to grow the business), borrowing money from a bank, from an angel investor (usually wealthy individuals with an interest in the business sector) or from institutional investors.
For successful companies looking to expand their business, issuing shares to investors in return for cash is a very common method of raising finance. This funding (known as equity finance or equity investment, as opposed to debt finance from a lender) is attractive because it is unsecured, usually committed for a considerable length of time, and (unlike bank loans) strengthens the balance sheet of the company.
However the legal implications of this type of finance are not always the top priority for directors. Before an investment is concluded, there are a number of important rules which apply to companies seeking equity investment. Many small companies simply ignore the legal rules and procedures, or just do not realise that they exist. Sometimes the founders and directors of a company believe that they can raise money from friends and relatives without any restriction. Although they might have got away with it at the time, there are often consequences further down the line when institutional investors or potential buyers express an interest in the company and carry out due diligence checks. The problems that they sometimes find can easily derail a business opportunity.
The general rule (in section 113 of the Corporations Act 2001) is that a private (Pty Ltd) company cannot raise money from the general public. It can only raise funds by offering to issue its shares to existing shareholders or employees or to certain classes of investor. These classes of investor include high net worth individuals, professional investors, listed companies, and small scale personal offers to investors (no more than 20 investors and no more than $2 million in any 12 month period).
A public company (usually a company with 50 or more non-employee shareholders) can raise finance by offering to issue its shares to the general public, providing that it complies with certain disclosure obligations (generally by issuing a prospectus or offer information statement).
In addition to the general rules on raising capital, there are also restrictions on publicising investment opportunities. For example, an advertisement of an offer to the public must have a statement that the terms of the offer are contained in the prospectus and that any application for shares must be made on the application form in the prospectus. And promoters are not allowed to offer shares to the public by unsolicited telephone calls or meetings.
Where a company wants to circulate documents (for example a business plan or prospectus) to the public, the directors must take into account that it is an offence to include misleading statements or to engage in misleading or deceptive conduct. Care should be taken to ensure that these documents are correct as investors are relying on the information contained in them. If the information turns out to be incorrect, an investor may have a claim against the company and/or the directors personally.
There are also rules restricting directors from recommending an investment in their company. For example, in order to make a recommendation to buy shares in a particular company, the recommender may be required to hold an Australian Financial Services Licence.
Once these initial legal issues have been dealt with, there are a number of more practical issues which an investor may wish to raise in relation to a new investment. The biggest issues are usually reaching agreement on the percentage of the company which the investor gets in return for the money it invests, and the amount of control over the company that an investor is entitled to.
Other issues include whether shareholder consent should be required for important matters, such as changing the nature of the business or approving any borrowing, and whether there should be restrictions on the transfer of shares.
The legal process relating to an equity investment begins with an initial review of the proposal by an investor, meetings with the management team to review the business plan, and due diligence enquiries. This process is a bit more involved today than it used to be in the technology boom of the 90s, when valuations for internet companies were sometimes just plucked from the air. These days, most investors will instruct lawyers to check that the company has complied with all its legal obligations. The due diligence process is followed by the drafting and negotiation of legal documents, which set out the agreed position reached on the practical issues mentioned above.
Although the legal formalities can sometimes seem protracted (and expensive), they ensure that the company is fully compliant, in good shape to concentrate on its business going forward, and will be "investment ready" when funding is needed.
1. Copyright 2006, Swaab Attorneys. All rights reserved. All material contained in this article is the intellectual property of Swaab Attorneys and cannot be reproduced, copied, published, quoted or disseminated without the prior permission of Swaab Attorneys.
2. This article is intended to give an overview of the legal issues involved in raising finance. It is not intended to be fully comprehensive or to be a substitute for legal advice.
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