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Equity Investors & Your Business

If you decide to forego traditional investment, such as taking out a loan from a financial institution, you may find yourself in the world of equity investors. An equity investor actually buys a portion of your business and, for better or worse, is a part owner in your enterprise. This can be a very good thing or a very bad thing, so it's important to know what you're getting yourself into.

Equity Investors Expect a Return

An equity investor is prepared to lose all of his or her investment into your company. If the business fails, the equity investor knows that there is little chance of getting any of their money back. As a result, equity investors often ask for a fairly high percentage of a company's profits or other benefits to make up for the substantial chance of loss. There's also a good chance that the investor will want salaries capped, especially in the beginning, so always consider how much of your company's hard earned profits you're willing to give away and whether you can afford to have your salary capped.

Although equity investors usually demand a significant portion of the business profits and they have considerable leverage, there's always room to negotiate. Before seriously negotiating, determine for yourself just how much you're willing to give away to investors before equity investing no longer seems attractive compared to traditional financing options for your business.

Equity Investors Have Substantial Rights

One of the most contentious points between business owners and equity investors is how much control equity investors will have in the company. Don't think of these rights as simply ceremonial or there to appease. Equity investors often exercise their rights, including voting the company's founder right out of the company. Rights that equity investors may end up with include:

  • The right to vote to elect a board of directors
  • The right to vote on all major business decisions
  • The right to be informed about all significant business decisions
  • The right to sue you or the company if they feel their rights aren't be respected

Giving an equity investor substantial rights to your company does not have to be a negative thing. Often, equity investors have years of experience and can be a significant source of advice and information.

Equity Investors & Structuring Your Business

There are several ways to structure your business along with your equity partners. Take the time to figure out which business entity works best for you:

  • General Partners : if you find equity investors for your company and don't specify a change in business structure, your business will become a general partnership by default. General partners have a good deal of control, but are also personally liable for business debts and liabilities. Accordingly, most equity investors will avoid general partnerships in order to avoid personal liability.
  • Limited Partners : as the name implies, limited partners only have limited liability for the debts and liability incurred by your business. Importantly, a limited partnership must have a general partner, which most equity investors will want to be you. This means that you would be personally liable for the debts and liability incurred by the business, but your equity investors would not. Seriously consider the hazards this represents before agreeing to any such relationship.
  • Corporations : shareholders in a corporation are shielded from personal liability for business debts, so long as they do not participate in the running of the business. For this reason, it may be preferable to have you run your business, and have the equity investors as major stockholders in the corporation. The major downside to corporations is that they are harder to set up, are subject to additional laws, and involve a lot more paperwork.
  • Limited Liability Companies : limited liability companies (LLC) have become popular because they combine the limited liability of a corporation, with the tax advantages of a partnership as well as often being less difficult to setup and maintain than a corporation.

Equity Investors & Securities

Stock from a corporation, partnership interests and LLC membership are treated as "securities" by the law. There are a host of securities laws, both state and federal, that regulate the sale and exchange of securities. No matter what kind of business organization you setup, you need to become familiar with the set of securities laws that apply to you.

For example, find out whether you are exempt from most securities requirements. Small businesses of a certain size will typically be allowed to provide equity investors with an interest in the business without having to fill out and file complicated paperwork. Be aware that if you are not exempt, complying with securities laws can cost a significant amount of money, so make sure it's worthwhile to bring in equity investorsif you aren't exempt from securities laws.

The other major component of securities laws governs what you need to disclose about your business and who you need to disclose to. If you are ever unsure, contact an attorney and always err on the side of caution by disclosing items that you may be uncertain about.

Next Steps
Contact a qualified business attorney to help you
navigate the process of starting a business.
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