[Originally published in the Winter 2016 issue of Artisan Spirit – available here.]
In my article last quarter, I discussed some common mistakes made by early-stage entrepreneurs and how to avoid them. One of those mistakes — not taking advantage of potential funding opportunities — forms the springboard for this installment. Specifically, in this article I will explore some typical (and some not-so-typical) avenues for funding your spirits business, as well as legal issues that may arise during the process. With that in mind, let’s consider some ways to fund your shiny new business.
Be Independently Wealthy. There is an old adage to the effect that the easiest way to make a small fortune is to start with a large one. There is a lot of truth in this, unfortunately, in that it tends to be much easier to spend cash than it is to generate it. But the fact remains that if you’ve got access to ample capital at the outset, your business is more likely to succeed than if cash is scarce.
Even if you are independently wealthy — or maybe especially if you are — the truth underlying the joke means that you may not want to personally fund all of the business’ needs. Sure, by personally funding it you’ll have the opportunity to make all the decisions and retain absolute control over your brand. But you will also have all the risk associated with the venture. And while you may be pretty confident that your new signature-brand, spaghetti-squash-infused whiskey is going to be the next big thing in bars across the country, what if it isn’t? Do you want to bear all the risk? And maybe more importantly, isn’t it possible that you’d benefit from getting others involved in a way that might just stop you from taking delivery of all those gourds?
Having someone else kick in some of the capital can be helpful not only by keeping your fortune from dwindling too quickly but also for the side benefit of making sure that you’re tempering your passion a bit by considering the views of others. This is particularly important if you’re thinking that the way you’ll fund your business is by funneling all your life’s savings into the endeavor. If you’re putting all your eggs in this particular basket, you owe it to yourself to make sure you’re not blind to significant problems in your business plan. Having other people invested in your business (both emotionally and monetarily) can make that happen. Also, don’t underestimate the benefits that others may bring to the table in terms of their industry contacts or expertise. After all, your ultimate objective is to make the business a success and there is certainly nothing wrong with leveraging others’ talents (along with their financial strength) in service of that goal.
Lean Heavily on Credit Cards. It seems that not a day goes by without our family receiving an invitation to apply for a new credit card. In fact, at my house we’ve had at least one credit card application arrive addressed to one of our sons (who at the time was in third grade). I await the day when the post office delivers an application addressed to one of our dogs. The number and variety of credit cards available to U.S. consumers and businesses is staggering and seems unlikely to decrease any time soon.
Setting aside policy questions and concerns about the broader economy, the availability of easy credit has been a tremendous benefit to many small businesses. But it does not come without potential complications. First among those is the question of personal liability. In most cases, the thoughtful entrepreneur will not have started a business in her own name. Rather, she will have formed a corporation or limited liability company and will want to operate the business through that structure so that she can avoid personal liability for obligations of the business. But of course the banks issuing credit cards rightfully want to be repaid. As a result, the fine print in the credit card agreement for a credit card issued nominally in the name of a small business will often provide that the individual holding the card (e.g., the owner of the business) is ultimately liable for repayment of any obligations incurred on the card. In essence, the business owner using a “corporate” card is providing the issuing bank with a personal guaranty. Again, this is not necessarily a bad thing, but the entrepreneur needs to be aware of this fact so that there are no surprises when it comes time to pay the bill.
As a secondary matter, the entrepreneur using credit cards to finance the new or growing business should simply be aware that the cost of easy credit is expensive credit. Most commonly, the interest rates associated with these cards (absent a teaser or introductory rate) will be quite high. The savvy entrepreneur uses this type of credit wisely and sparingly, and will most commonly want to keep from carrying a balance if at all possible.
Tap Friends and Family for Cash. Your parents gave you life. Is it really that much to ask that they also help give life to your business? Possibly. In all seriousness, soliciting funds from friends and family is one of the most common ways to gather initial startup financing. In many respects, it is also one of the riskiest. Before we get to the risks, however, remember that owners of significant equity stakes in spirits businesses may require vetting with the TTB and state liquor authorities. So before you accept capital from friends and family — or any other party — in exchange for a stake in the business, make sure you’re prepared to address those requirements.
Assuming you’re ready to call up cousins and hit them up for cash, let us consider the potential legal risks. When entrepreneurs solicit funds from friends and family, they rarely take the time to appropriately document the transactions that follow. This makes intuitive sense, in that the entrepreneur who thinks her mother is likely to bring legal action against her for breach of fiduciary duty is unlikely to solicit funds from her mother in the first instance. But the slim possibility of future legal action between the parties is not the only consideration. Instead, the entrepreneur should be thinking about how the transaction will impact future efforts to obtain investment in the business from third parties and even how the transaction may impact the value of the business in connection with a future sale. By failing to observe traditional corporate and legal formalities associated with taking in the investment (even if it is coming from friends and family) the entrepreneur is giving a prospective future investor or purchaser a reason to discount the value of the business. For this reason, the decision to eschew corporate formality in a friends and family deal can be a false economy. By cutting corners and saving costs at this stage the entrepreneur risks a reduction in future value.
Of course, legal risks aren’t the only consideration when tapping friends and family for capital. The savvy entrepreneur will also think through the potential ramifications of the investment on her relationships with these folks. Business can be difficult and many relationships have been soured as a result of disagreements in the boardroom. Before you call up your in-laws in an effort to raise the cash needed to buy that new bottling machine, consider the potential change to Thanksgiving dinner conversation if your business struggles. You should not take investment from anyone with whom your relationship isn’t strong enough to survive the failure of your business and the loss of their money. At least not if you hope to continue that relationship.
Court a Few Outside Investors. Assuming you’ve already solicited friends and family and they’re now screening your calls, you might next consider raising business capital from outside investors. But before you start dialing for dollars, you need to be aware of some meaningful legal considerations. [Note: These restrictions aren’t limited to soliciting investment from unrelated third parties, and technically also apply to soliciting friends and family for investment, but entrepreneurs often begin to focus on these legal requirements once soliciting true third parties (and I’ve yet to see an entrepreneur sued by her mother for securities fraud).]
First, you need to understand the concept of a security. Under state and federal law, a “security” can be a share of stock, a promissory note, a warrant or any number of other items. A security can also be found in an “investment contract,” which is a catch-all concept intended to cover essentially any situation in which one party gives value to another party, with an expectation of profit to result primarily from the efforts of that second party. Using this investment contract analysis, items as disparate as orange groves, chinchillas and emus have been determined to be securities. Critically, the determination that something is a security means that there is an entire body of state and federal law applicable to the sale of that item.
An entrepreneur who wants to sell shares in her distillery corporation is offering a security. Similarly, the entrepreneur who wants to sell membership interests in her distillery limited liability company is also offering a security, assuming that the buyer will not be helping to run the business. And the entrepreneur who offers to sell a particularly special bottle of hooch by assuring the buyers that the bottle will increase in value may also be offering a security.
What does it mean if you’re offering a security? Well, under U.S. laws every sale of a security is either (i) registered; (ii) exempt from registration; or (iii) illegal. The first option tends to be prohibitively expensive in the context of small offerings. The third option also tends to be rather expensive. That leaves us with the middle path and the need to structure an offering so that it complies with the requirements for an exemption from registration. Luckily, several exemptions are readily available.
The most commonly used exemption from registration is found in Securities and Exchange Commission Regulation D, Rule 506. Under Rule 506, an issuer of securities can avoid registration for an offering of any dollar amount (i.e., an offering of a potentially unlimited size) so long as two basic conditions are met. First, the company must conduct the offering without engaging in a general solicitation. That means that the company is prohibited from advertising the offering or soliciting investors with whom it has no prior relationship. Second, the company must sell only to investors who are “accredited” for purposes of U.S. securities laws. For individual investors, being accredited means having a net worth (excluding any equity in the investor’s personal residence) of at least $1 million, or having individual income of at least $200,000 (or joint income with the investor’s spouse) in each of the last two years — with an expectation of continued income at or above that threshold. Of course, if you’re a connoisseur of governmental regulations (and if you’re in the hooch business you probably are), you’re probably scratching your head at the idea that any regulation could be so simple. Your suspicions would be right — there are additional requirements that may apply and prohibitions that come into play. So with any potential offering the prudent entrepreneur will want to be sure that she obtains competent legal advice about these requirements — as well as any additional legal requirements that may apply based on the domicile of the business or state of residence of the investors.
Court a Lot of Outside Investors. In light of the legal challenges (and potential control concerns) that follow from selling securities to raise capital, in recent years a number of alternative approaches to raising capital have hit the market. Broadly described as crowdfunding, these avenues allow the entrepreneur to solicit relatively small amounts of funding from a large number of funding sources. At the time of this article, the two most frequently used platforms for crowdfunding are Kickstarter and Indiegogo, each of which has been involved in raising millions of dollars for new and developing ventures.
In most cases, the folks providing funding aren’t investors, they’re customers. That is a distinction with a difference, because most crowdfunding sites try to avoid the application of state and federal securities laws to the transactions they facilitate. Avoiding securities laws means that the individuals putting in cash can’t have a reasonable expectation of profit or an increase in the value of whatever they receive in exchange for their contribution. So a traditional crowdfunding launch from a hooch company may promise contributors goods or services (e.g., shot glasses or distillery tours) in exchange for the donation — but not stock or something that would constitute the investment contract discussed above. Kickstarter’s rules prohibit offering alcohol as a crowdfunding perk — but Indiegogo lets participants go a step farther and offer contributors vouchers that can be redeemed for spirits. So, in essence, an Indiegogo campaign can be used to pre-sell spirits not yet in the bottle.
Of course, a company might want to be able to solicit and receive equity investment from a large group of far-flung investors — even individuals who may not qualify as accredited investors — each contributing a small amount of the capital needed by the business. If that is your idea of a perfect situation, then you’re in luck. With the passage of the Jumpstart Our Business Startups (JOBS) Act of 2012, Congress attempted to put this in motion. The JOBS Act contemplates that businesses will be able to solicit investment in just this fashion. At the same time, however, JOBS Act equity crowdfunding will require a company soliciting and receiving investment to jump through some significant administrative hoops, so this isn’t to be undertaken without study. While a full discussion of the nature and extent of the administrative requirements would require several pages, hooch companies considering this path should, as an initial matter, be aware that an equity crowdfunding offering may only be conducted with the assistance of either a registered broker-dealer or through a registered funding portal. In addition, completion of an equity crowdfunding offering will subject the business to periodic financial reporting obligations with the Securities and Exchange Commission on a go-forward basis.
Ultimately, only time will tell if equity crowdfunding will become a viable option for entrepreneurs seeking capital for their ventures. For smaller offerings, the requirements may simply be too onerous to justify the use of this mechanism. But with the change in the law many industry participants are bullish that this is the wave of the future. In fact, as of the time of this writing Indiegogo is launching its own equity crowdfunding platform. If it succeeds in making equity crowdfunding as accessible as Kickstarter and Indiegogo have with respect to reward-based crowdfunding (i.e., non-equity crowdfunding), this may soon become part of the standard playbook for entrepreneurs seeking capital.
Meet a few Bankers. Startup ventures are typically frustrated when they try to obtain bank financing. But slightly more established ventures frequently benefit from strong relationships with bankers. In the context of spirits — where stock often needs to be stored and aged for several years prior to sale — this benefit can be particularly strong when the business is able to collateralize the barrels as they age. Of course, asset-based lending of this type will not be available to every distillery stocking away whiskey for the future. Most (but not all) banks will want to see that the spirits being aged will have a ready market once bottled. So the best terms will be available to those producers with recognizable brands and a track record of sales. Of course if a producer has a recognizable brand and a track record of sales, you might argue that it has no real need of the banker’s services. There is some truth to that, but being able to use the aging spirit to secure good terms for working capital or a revolving line of credit can be a tremendous benefit.
This is obviously not an exhaustive list of the means of funding your shiny new hooch business. But these approaches give you a fighting chance of meeting your business’ needs for capital. With some luck, appropriate funding, and by avoiding as much as possible the mistakes commonly made by entrepreneurs and discussed in the last article, you stand a decent chance of building value in your business and in your brand. With that value comes opportunity not only to become the next king or queen of the spirits world, but also the chance to expand, acquire other spirits brands, or harvest the value by selling your business to an acquirer.
HoochLaw 