Deadly Legal Mistakes When raising early-stage investment capital, avoid these errors that could lead to the death of your company.

Dipankar Ganguly feels like he's been handcuffed, metaphorically speaking. Three years ago, Ganguly and a colleague set out to revolutionize breast cancer screening and detection. Using laser technology licensed from a national laboratory, his company, BioTelligent, Inc., developed a tool to detect cancerous tissue in real time without having to remove any tissue.

Like most other startup medical device companies whose products are subject to years of regulatory approval before the first unit can be sold, BioTelligent depended on outside capital to fund its operations for an indefinite period of time.

BioTelligent quickly raised more than $1 million in a "friends and family" private offering. Their strategy was to gather seed capital through private placements until they could prove that the product worked, at which point they would shop the company to venture capitalists to get the funding they needed to complete clinical trials in the U.S.

Everything was going as planned, until late 2005 when Ganguly received a letter from the California Department of Corporations. The securities regulators for the state had received a complaint from an investor, and they were requesting more information about the company's private offering. The letter was followed by series of similar letters from other state regulatory agencies and, eventually, one from the SEC.

When management further reviewed the offering, they discovered that one of the company's directors paid an employee a commission in connection with the sale of its securities--a technical oversight that didn't necessarily harm the company or its shareholders, but nevertheless violated federal securities laws.

BioTelligent self-reported the mistake to the SEC and ceased its capital-raising activities until it could finish a full internal investigation and resolve the outstanding investigations with state regulators.

"The investigations dragged on for months" says Ganguly. "It's hard enough raising investment capital for a pre-revenue company, but it's impossible with open regulatory issues." Even though the director had made what amounted to an innocuous error, no investor would touch BioTelligent. The development of the technology was at a complete stand-still.

4 Mistakes to Avoid
Unfortunately, in the sometimes desperate quest for investment capital, entrepreneurs make critical legal mistakes that can come back to haunt them. In some cases, the fallout from even the most innocent of mistakes can put a growing company out of business.

Entrepreneurs tend to get into the most trouble when management attempts to sell shares in their company to raise the seed capital needed to get things going. Generally, in these types of private stock sales, management has a tendency to cut corners, bend the rules or just take unnecessary risks, particularly if the company is undercapitalized or has already run out of cash. By becoming aware of these deadly legal mistakes you'll be more likely to keep your company going--and sleep a little better at night.

Falling into the advertising trap: These days, when you want to sell your car, sublet your apartment or find a significant other, the fastest way to get what you want is to post an ad on the internet. While online bulletin boards, listservs and newspaper ads may be appropriate for selling your personal belongings or finding a date, this kind of advertising almost always violates the law when it comes to selling securities. Both federal and state laws prohibit any kind of "general solicitation" for most kinds of private securities offerings.

Paying for help: Few things motivate someone to sell products or services like a big commission check. If you're selling shares in your company, it seems logical that you should get your company's sales staff, or outsourced services, to help you out. Pay them a significant commission, and they'll be extra motivated. It all sounds great, except that under the securities laws a company isn't permitted to pay anyone other than a licensed broker-dealer a commission or other success-based compensation in connection with the sale of its securities.

Anyone who's done some networking to find capital has likely come across "consultants" or "finders" who claim to help companies raise money. Despite what they may tell you about how they operate in the grey area of the law and how they've never had a problem before, unless they're registered securities brokers, they're violating federal law if their compensation is contingent on the successful sale of your company's securities.

Playing securities laywer: Notwithstanding all the bad jokes, it seems some entrepreneurs have a bit of lawyer-envy and have been known to play lawyer to save a buck. Unfortunately, "play-lawyers" are no match for state and federal securities laws and the regulators who enforce them. For example, when it comes to raising investment capital, many entrepreneurs have heard of Regulation D securities offerings, but most entrepreneurs have no idea that there are three kinds of offerings available under Regulation D, each with their own set of restrictions and nuances.

The reality is that federal and state securities laws are frequently obtuse. Even the best "play-lawyer" will eventually end up in hot water by overlooking the smallest of details. Always engage the assistance of a professional when selling securities in your company. You'll end up paying a fraction of the cost to do things correctly from the beginning compared to what you would end up paying later to clean up a mess because you cut corners. If you don't know any securities attorneys and can't get a referral from a colleague, try the referral service of your local bar association for a recommendation.

Selling to the wrong investors: Even though an investor may meet the income or wealth guidelines required by law it doesn't mean that it's in your best interest to sell them your company's securities. For example, in a private offering limited to accredited investors, a company can sell to anyone with more than $1 million in net assets. The problem is, back when this law was written, $1 million in net assets was a meaningful number. Now it's not uncommon for someone to have that much equity in their home.

And just because an investor meets an income or asset threshold required by law doesn't mean that they can afford to lose their investment, that they have the risk tolerance to invest in an early-stage company or that they truly understand the consequences of their decision if your company fails.

Typically, it's the investors who are inexperienced in investing in startup companies who are the most likely to complain to securities regulators or sue if they're not happy. And whether an investor's complaint has merit or not, dealing with a state investigation or lawsuit will take valuable resources away from the company and divert management's attention from building the company.

As for BioTelligent, the founding shareholders financed the company until they no longer could do so. By the end of 2006, the strain from ongoing regulatory investigations became too much, and BioTelligent filed for reorganization under Chapter 11. Management hopes it can re-emerge out of Chapter 11 sometime before the end of this year, when it will once again begin the search for angel or venture capital funding.

Stephen Furnari is a securities attorney for the New York firm Furnari Levine LLP. Learn more at FurnariLevine.com.