Looking For Investors? Beware!

Many have made fortunes on the adult Internet, usually as a result of tenacity and a good business concept. But in order to parlay one of these ingenious business concepts into a flow of revenue, you need to prime the pump.

Although Web-based businesses are not particularly capital-intensive, investments must be made in corporate start-up (legal and filing fees), site creation (purchasing or developing content, all requiring money), setting up bank accounts and merchant processing, and, finally, eating operating costs until money starts to fill the pipeline — probably a month or two of operating before you see your first dollar.

So where does the money come from? If you do not have a ton of money in your piggy bank, maybe an investor or two is the answer. But avoiding legal traps for the unwary in dealing with investors is not easy.

An example of the most common scenario is two partners who bring different talents to the table. For example, one might have the artistic and technical ability to make a website hum, while the other has business experience and acumen. They get together and form a corporation or LLC; each gets a half interest in the entity. Maybe the business guy puts in $10,000 and the art/technical guy puts in $5,000, along with his work to date in developing the concept, which the partners agree is worth another $5,000.

Thus, the corporation/LLC has a $20,000 start, $5,000 of which has been spent on the so-called "sweat equity" of the art/technical partner. Then, the $15,000 left in the bank is spent to formalize the corporation (including the all-important restrictions on sale and buy-sell agreements) and get the project launched. Hopefully, before the rest of the money dries up, income will start flowing.

So, suppose you have a business concept and enough time on your hands to execute it, but no money to get it rolling. Then you meet a guy in a bar who, after hearing about it, is dazzled and expresses an interest in investing in it. He doesn't want to be bothered with the day-to-day operation of the business; he just wants a return on his investment. Beware — you are about to walk into a minefield!

During the 1920s, the largely unregulated American stock market spiraled. People were speculating heavily on stocks continuing to rise, often making investments with 70 percent borrowed money. Everything was booming — until Thursday, October 24, 1929, when the market fell significantly; and the following Monday and Tuesday, when the bottom dropped out.

As the Great Depression continued, there was a growing awareness that an unregulated investment market was among the prime factors that gave rise to spiraling market prices and the ensuing crash. With the advice of Joseph Kennedy, who had made a fortune through all of this, Congress enacted the Securities Act of 1933 (the "Truth in Securities Act") and the Exchange Act of 1934. And, in response to the widely held public belief that the market crash had caused the Depression, state politicians became involved, as well; so the states embraced regulation of securities.

Generally, securities regulations do not require that anyone get a license to sell a security. Rather, the focus is on accurate disclosure so that investors, with the help of their advisers and the press, can make intelligent decisions on the value of an offered security. Publicly traded securities do require registration, but that is only a disclosure; no permission is required. If you are going to go to Wall Street to raise millions of dollars, you will have a team of attorneys and accountants preparing your offerings and complying with the securities laws. But what must you do to deal with the guy in the bar?

The scope of coverage of securities laws apply all the way from the multi-million dollar IPO to the guy you met in the bar. A security is generally defined as a transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. So if the guy in the bar simply wants to put in $25,000 to purchase 40 percent of the stock in your company, and then go home and wait for checks to come in, you have sold him a security. You are the promoter.

Most violations of federal or state securities laws are felonies. So how can you have the guy in the bar help finance your business without winding up in the hoosegow?

You can; but you need to be careful. To avoid problems, you need to be sure he is really involved in the operation of the business. He should be a corporate director or LLC manager and an officer. He does not need to participate in decisions such as whether to buy a Dell or an HP, but he does need to participate in deciding whether to buy a computer and what the rough budget for it will be. You need to meet with him regularly to discuss business strategy, and he needs to be on top of what is going on.

Now, be conscious of the fact that the purpose of this column is not to give legal advice. Rather, it is to program your legal radar to know when you need to consult an attorney. And any time a legal relationship is formed, a lawyer needs to be consulted. In the example of the guy in the bar, you probably need one for each of you.

Suppose that the guy in the bar insists that he really does not want to be bothered with the operation of the business. Rather, he thinks it is a brilliant idea and just wants a piece of the profits. Is it possible to do that? Yes, but the place to start is with a lawyer -- not the author of this column or any of the other adult-entertainment attorneys that write industry columns or speak at Internext.

The lawyer you need is one whose practice revolves around this type of investment transaction and one who has solid professional liability insurance in case things fall apart. That lawyer will prepare the appropriate disclosure memoranda and guide you through the treacherous waters of selling securities. And unless you are talking about at least a six-figure investment, the legal costs are prohibitive. The alternative, of course, is just borrowing the money from the guy with a straight-up and probably high-interest loan.

In decades of representing adult businesses, I have seen a remarkable number of clients who think they have their business financed, but are alarmed to discover that they are about to commit felonies. It is much easier for a lawyer to prevent you from doing something that will get you sent to jail than to get you out.

Clyde DeWitt is a Los Angeles and Las Vegas attorney whose practice has been focused on adult entertainment since 1980. He can be reached through AVN Online's offices, or at ClydeDeWitt@Earthlink.net.

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This article originally appeared in the February issue of AVN Online. To subscribe, visit AVNMediaNetwork.com/subscribe.