You’ve got a great business idea, or perhaps a great business already in action, and you want some outside funding to take you to that next level. But, where do you start? This handy dandy resource is designed to give you some preliminary information and empower you to negotiate the right deal for you and your business, so read on!
Before we start, check out the necessary foundational resource on what a “security” is here. Up to speed? Great. Now let’s talk about how you should prepare for the actual conversations you’ll be having with potential investors.
Pro-Tip: Do not pay people to find you investors unless they are registered broker/dealers!
Should You Give Your Investors Control?
Do you want your investors to have any kind of say in how the business is run? In other words, will they be involved in the day-to-day or have voting rights for running the business? If you don’t like the idea of too many cooks in the kitchen, you probably said no to both, and that’s where having a corporation comes in handy. That’s right, we usually recommend running your business with an LLC, but a corporation is better when you want to have outside investors with no voting or management rights. Why? Because of something called “preferred stock,” which is a second class of ownership that you can limit to non-voting. Why is it preferred? Because it also gets paid back on a preferred basis over the founders (who typically hold common stock), which is another reason investors prefer preferred stock. See what we did there?
How Much Equity Should You Give?
Great, we’ve established that you don’t want to give your investors voting rights or control over the company.
Note: if you do want to give rights or control, we aren’t talking about investment, we’re talking about bringing on a partner and that’s a different can of worms! Just be aware.
Next up is how much equity to give an investor for their investment money. This one is tricky and you will see all kinds of standard numbers and best practices plastered all over the internet (often times from one or two sources and just revised slightly to look original), but it isn’t that formulaic. In fact, we don’t think it’s right for attorneys to tell you how much equity to give out because it’s ultimately your business and your decision.
What we recommend, instead, is to determine for yourself what the lowest % ownership you’re willing to have in your company will be, then divvy up the remainder amongst how many investors you will have (or employees and other owners, etc.). Obviously start with offering the smallest amount to each investor, but with your absolute floor in mind, you have room for negotiation.
Keep in mind, however, that the amount the investor gets isn’t only up to you, meaning that they have the money and you will likely need to make a concession or two on what they get to receive that money. This doesn’t mean giving them a majority stake in your company, it just means being prepared to negotiate and being ready for ongoing conversations. A great [free] resource that can help you determine percentages and share allocations, without having to do the complicated math yourself, is captable.io.
Are Your Investors Accredited?
At this point, you should have established how much equity you’re going to offer to investors, what some of the rights with that equity will be (i.e. non-voting), and how much money you want for the equity. Now it’s time to determine what kind of investor(s) you’re dealing with – meaning, are they what the law calls “accredited” or not?
This is important because the law presumes that accredited investors are experienced and savvy enough to comprehend the risk of investing in your company, without you providing all kinds of disclosures, financials, etc. Why does that matter? Because if you do have to provide all kinds of disclosures and financials, it can get very costly in legal and financial reporting fees very fast.
How do you determine if your investor(s) are accredited? They can have their CPA or financial advisor send a letter certifying that they are accredited according to the SEC guidelines, they can self certify by working with your lawyer, or your lawyer will need to review their finances and taxes to confirm the status. The CPA/advisor letter is certainly the quickest and cheapest option.
To recap, accredited investors are the best because of minimal paperwork and compliance, if they are not accredited, you’re looking at some hefty legal and financial bills to compile the paperwork they’ll need in order for you to be in compliance with US securities regulations.
Family and Friends Exemption
But what about my friends and family if they aren’t accredited? Well, you’re in luck! Most states have exemptions for your friends and family because the law presumes if they’re close to you like a friend or family would be, they, too, are able to assess the risk of investing in your business. You’ll likely want to provide more paperwork to your friends and family so that they understand everything, but you won’t be under a legal obligation to provide as much as if they were an un-associated and non-accredited investor.
Wonderful, we’ve covered many of the important foundational pieces and it’s probably clear that there is no definitive roadmap for these conversations – that can be a good thing because it allows you to have a fluid conversation with your investors, in which both of you have the opportunity to structure the investment in a way that works for everyone. Speaking of, there are many different types of investment structures that are also worth discussing here.
First, traditional equity investment is where you receive cash and you give a certain number of shares (which translates to a %) of your company.
Second, there are instruments called convertible notes (variations include the KISS, the SAFE, etc.), which allow the cash you receive to be a loan until some later triggering event, at which time the investor receives a cash payout or the shares in the company that their investment cash entitles them to receive. The triggering event is typically a second round of fundraising, getting acquired, or going public.
Third, restricted stock units and phantom stock plans can be used in some situations, but are essentially only promises to grant equity if some kind of triggering event happens later on. Both the second and third options do not provide the investor with any rights because they don’t actually receive equity until the triggering event – this is good for your business, but not typically preferable for investors. You can read up more on all of these here. Remember, all of the considerations and conversations before this paragraph apply to these options, so these options are just another piece of the puzzle!
Pro-Tip: If you are giving out equity in exchange for services, it’s a bit different and you will likely be dealing with the vesting of equity over time. Vesting is the granting of equity in your company to a person/business on set intervals of time in exchange for the services they provide to your business (in other words, you can think of their time as their investment, instead of a cash investment). Vesting can trigger tax consequences if you don’t go about the valuation of your shares correctly first, which is usually done via something called a 409A valuation. These are pricey (a few thousand on average), but they can prevent very, very significant tax consequences later on.
Wrapping It Up
Approaching investor negotiations sounds scary, but if you have a well-thought out strategy, it doesn’t have to be so bad! Before you do anything, just think about the points we talked about here. Do you want to give control to your investors? How much equity are you willing to give? Are your investors accredited, or are they friends or family members? What investment structure should you use? There’s no one size fits all answer to these questions, so you do you! And if you still feel like you need some guidance on what’s right for your business, let us know. We’re happy to help.
By: Sam Mazzeo – 06/26/18
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- Vocabulary Lesson #1: What’s a Security?
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