Hey, Entrepreneurs: This is NOT the Way to Solicit Money from Investors!

Getting money for your hot start-up idea the wrong way can get you into hot water. Do some research before you take money from friends or other potential investors.

Someone pushes a red button that is labeled "No!"
(Image credit: Getty Images)

“Mr. Beaver, I am being sued in small claims court by several investors in my revolutionary Food Truck App that enables you to know when a food truck is in your area,” a flustered “Colin” explained during our phone call.

“No one else has anything like this. I told several friends about it and my need to finance development and sale of the app to food truck owners. So, they each gave me $2,500. I began work on the project, got behind, was unable to finish it and the money is gone. They all want their investment returned. What should I do?”

Does this sound at all familiar? Has a friend approached you with a similar request?

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I asked Colin if he had set up a corporation, an LLC or partnership. Did he have any formal business structure at all? Were there any written agreements specifying what these investors would be receiving?

His answers were “no” to each question. “I didn’t think about that stuff. I just quit my job with an IT company and used their money to develop the app and live off of.” He admitted to never seeking legal advice before asking for money.

How to Get Yourself in Trouble Looking for Investors

To Bakersfield, California, attorney Chris Hamilton, whose law practice concentrates on transactions and business formation, “Colin’s situation is not unique. Stories of millionaires who got their start working in a garage have led to a belief that success in the world of technology does not depend on prudent business practices. Unfortunately, that is not the case.

“Dennis, no matter how great your idea, the worst thing you can do is to start accepting money from investors – especially family or friends — without first clearly outlining the nature of the investment and the potential risks. You must seriously consider the damage a failed investment will do to friendships and family relations.”

With that theme as a background, Hamilton offers these time-tested methods of getting yourself into hot water.

1. Failing to do your own due diligence regarding your proposed busines

Consequences: If you do not understand the market you are entering, your idea may be destined to fail. Also, some investors may claim you misrepresented the quality or nature of the investment. Before you seek investors, you should know:

(A) Who is my competition?

(B) What is my business advantage, and is my business idea really viable?

2. Failing to consider the appropriate format for your business

Consequences: This can result in personal liability from your business, an unnecessarily complicated management structure, inability to attract investors, or a tax disadvantage. You absolutely must be able to answer these questions:

(A) Should I incorporate, form an LLC or some sort of partnership?

(B) Who are my proposed investors?

(C) Will my business make money through the sale of goods or by offering services?

3. Failing to vet your potential investors and establish clear terms of investment

Consequences: You may end up taking money from an investor who cannot afford the amount or type of investment you need. Further, you may end up with co-owners when you only sought a loan; or, alternately, a loan that must be repaid before you are able to repay it. Ask yourself:

(A) Is an equity investment — for example, selling shares — preferred to a loan for the business?

(B) Do I have enough verified financial information about potential investors to satisfy state and federal securities laws?

(C) Have I clearly identified in writing the terms of the proposed investment that acknowledge the risks and establish expectations?

4. Failing to consider how much money your business needs

Consequences: You may doom yourself and your investors to the loss of their investment. It is critical to:

(A) Prepare a realistic proposed budget that forecasts initial and future capital as well as operational costs to give the business the best chance of success.

(B) Give yourself a buffer for unexpected costs.

5. Failing to obtain legal advice regarding your proposed business before you begin soliciting investments

Items 2-4 are best addressed with the assistance of counsel. An experienced business attorney should:

(A) Discuss and formalize your investment needs.

(B) Help you establish appropriate documents to gather necessary investor information; establish investor expectations; clearly define investor rights and obligations.

(C) Advise whether your proposed fundraising will require state or federal registration or is exempt from such registration and assist with appropriate filings.

Concluding our interview, Hamilton points out, “Colin clearly failed numbers 1, 3 and 4 above. He claimed his idea was original, but it was stale, as food truck apps have been around since 2009! He did not establish the terms of the investment, investor expectations nor did he raise enough capital to succeed.”

My advice to Colin was simple; “Pay these people back their money and hope that no one goes to the police.”

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

H. Dennis Beaver, Esq.
Attorney at Law, Author of "You and the Law"

After attending Loyola University School of Law, H. Dennis Beaver joined California's Kern County District Attorney's Office, where he established a Consumer Fraud section. He is in the general practice of law and writes a syndicated newspaper column, "You and the Law (opens in new tab)." Through his column he offers readers in need of down-to-earth advice his help free of charge. "I know it sounds corny, but I just love to be able to use my education and experience to help, simply to help. When a reader contacts me, it is a gift."