Unlike a lender -- who temporarily provides you with money to operate your business -- equity investors actually buy a piece of your business. For better or worse, they become your co-owners and share in the fortunes and misfortunes of your business.
Here's a look at the pros and cons of raising money through equity investors and the different forms this equity investment can take.
As co-owners of your company, your investors will have some say in the way you run your company. They will:
- probably be able to vote to elect your board of directors
- have a legal right to be informed about all significant business events, and
- be able to sue you if they feel their rights are being compromised.
On the other hand, investors can bring helpful business experience with them that can strengthen your company.
Investors' Return on Investment
People who invest in your business often accept the risk of losing their entire investment without guarantee of repayment. To offset this risk, investors often want to receive substantial benefits if the business is successful. For example, an investor may insist on a generous percentage of the business profits and, to help assure that there are such profits, want your salary capped.
The terms are always negotiable; there's no formula for figuring out what's fair to both you and the investor. In the end, you and your investors will have to work out what you are both comfortable with.
Your Ownership Structure
If you are considering having equity investors in your business, you must determine which ownership structure will work best for you and your investors.
If you recruit people to invest in your sole proprietorship, your business will, by default, become a general partnership. This means your equity investors will be general partners, each of whom is personally liable for business debts and liabilities, whether or not he or she takes part in running the business. To learn more about general partnerships, see Partnership Basics.
Many investors will want to insulate themselves from personal liability for business debts, particularly if they're not going to actively participate in running the business. If that is the case, consider other ways to organize your business.
Because corporations offer shareholders protection against personal liability for business debts (called limited liability), a shareholder of a corporation who doesn't participate in corporate activities and decision making is virtually free from liability for corporate debt or activity.
A shareholder who helps run the company can be liable to outsiders for his or her own actions -- for example, making slanderous statements or negligently operating a piece of equipment -- but isn't personally liable for corporate debts or the actions of corporate employees.
Not everyone chooses a corporation as their business entity because organizing and running a corporation involves some initial and ongoing paperwork, as well as some fairly substantial start-up costs. For more information on forming a corporation, read How to Form a Corporation.
If you form a limited partnership and your investors become limited partners, they will have limited personal liability for business debts. A limited partner's freedom from personal liability is similar to that of a corporate shareholder, as long as the limited partner doesn't become actively involved in running the business.
Every limited partnership must have a general partner who is personally liable for the debts of the business. That will probably be you, so you should evaluate your exposure to risk before you decide to form a limited partnership.
Limited Liability Company
Another option is to form a limited liability company (LLC) and sell membership interests in the LLC to your investors. LLCs combine the limited personal liability of a corporation with the tax advantages of a partnership, and have become increasingly popular in recent years. For more information on LLCs, read LLC Basics.
Compliance With Securities Laws
The law treats corporate shares, limited partnership interests, and (usually) passive LLC membership interests as securities. Federal and state securities laws regulate the issuance of these securities to investors.
Before you sell an investor an interest in your business, learn about securities laws requirements.
Exemptions. Fortunately, there are generous exemptions that normally allow a small business to provide a limited number of investors with an interest in the business without complicated paperwork.
If you aren't exempt -- reconsider. In the rare cases in which your business won't qualify for these exemptions, you have to comply with the complex disclosure requirements of the securities laws -- such as distributing an approved prospectus to potential investors -- and register the securities. In this case, it may be too much trouble to do the deal unless a lot of money is involved.
Err on the side of disclosure. Even if you qualify for exemptions to the securities disclosure rules, investors could accuse you of providing misleading assurances. Always suggest that potential investors check with their own financial and legal advisors to evaluate the investment. The bottom line is that, although each investor will assess his or her own degree of risk, you should disclose all the relevant information to them so they can make an intelligent, informed choice.
If you are thinking about equity investors for your business, get Business Loans from Family & Friends: How to Ask, Make It Legal & Make It Work, by Asheesh Advani (Nolo). It takes you through the entire process of raising business capital -- from developing and pitching a financing plan, to signing the paperwork