As a business owner, the idea of accepting expertise and a big check from an outside investor can seem like a complete win for you and your business. The truth of whether it’s actually a benefit for you, however, is often determined by what appears to be the boring fine print details of the contract you sign with that investor. In this article, we’ll introduce you to some of the most important things to watch out for when negotiating an agreement to accept outside investments.
Structure of the investment
When small business owners talk about taking on an additional investor, they typically say something like, “We’re taking on an angel investor.” What they don’t discuss are the many of ways in which that investor can actually invest. But they should, because the different ways an investor can invest in a business dramatically changes the deal you’re agreeing to. As a small business owner, the difference to you between an equity investor and a debt security investor is that the equity investor only gets paid if you’re actually making a profit, whereas, with the Debt Security with Warrants investor, you’re paying that investor back monthly no matter what, regardless of whether your business is actually profitable.
Preferred versus common shares
Assuming you’re considering an offer in which the investor is making a traditional equity investment, the next important clause is to look at whether the shares the investor is taking are preferred or common shares. By way of background, when someone invests in your business they are actually buying shares in your business in exchange for money. They can buy common shares or preferred shares. If your investor only gets common shares, then that means you are on equal footing. So, when it comes time to make decisions, you probably each get one vote for each share of the business you own. When it comes time to get profits (or allocate losses) you each get a proportional share relative to the number of shares of the company you own. By contrast, if your investor is getting preferred shares, the investor is probably exercising a disproportionate level of control and taking a larger share of revenue than you might otherwise think if you were just comparing the number of shares each party owned.
When an investor puts money into a company as an equity investment to buy shares at a particular valuation (say $100,000 at a $1,000,000), they then own a given percentage (here 10 per cent) of the total shares outstanding.
If down the road, you decided to take on an additional investor or sell new shares of the company at a discounted rate to employees or family and friends, then that investor’s total ownership percentage might fall below their 10 per cent ownership. That risk of a decrease in the overall ownership percentage triggers an important term called an anti-dilution protection clause. Almost every outside investor is going to request an “anti-dilution protection” clause be included in some form. As the small business owner, the goal is just to understand how to negotiate the clause to serve you best. The version of “anti-dilution protection” that most benefits outside investors is commonly called a “full ratchet.” Under this scenario, the outside investors are able to buy additional shares of the company whenever they’re under the threat of having their ownership percentage diluted at whatever the lowest price that shares were ever offered at.
When you hear of a company that sells for, say $10 million, most people assume that the founders are now multi-millionaires. Whether that’s true or not depends in no small part on how the liquidation preference clause was negotiated with outside investors. A liquidation preference is just a fancy way of describing in what order, and how the various owners of a business get paid in the event of a sale or bankruptcy.
Covenants, a legal term that just means promises, are things you promise to do (known as affirmative covenants) or promise not to do (known as negative covenants) as the manager of the business. Outside investors want covenants in the agreement as part of their investment because they’re entrusting you to take their investment and run the business in a proper way, without actually being there to check on you on a daily basis. Covenants can include all sorts of things, ranging from a high-level requirement that you prepare and distribute monthly or quarterly financial forecasts for the business, to detailed requirements that you maintain certain levels of insurance protection. Any investor is going to want covenants in some form, and it’s not unreasonable that they do.
By Damilola Faustino
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