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Equity Investors and Your Small Business

Some small startup businesses decide that traditional business financing, like a loan from a financial institution, isn't viable. This is where equity and angel investing help. An equity investor buys a part of your business and, for better or worse, is a part owner in your enterprise with an ownership stake.

This FindLaw article describes the advantages and risks of bringing an equity investor to your startup. Do your due diligence before bringing on an equity investor.

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Reasons to Use Equity Financing

Equity financing is best when the entrepreneur may not qualify for a U.S. Small Business Administration (SBA) small business loan. For example, the owner of the new group may not be able to secure debt financing due to a poor personal or business credit score.

Sometimes, lenders for bank loans reject their applications for risky ventures. An example is a federally insured banking institution refusing to finance a cannabis business. The bank does not want to risk losing its accreditation for loaning a small business owner funds on a federally illegal business.

Private investors get intrigued by risky businesses with the potential for a high return on investment (ROI). This is where equity investors and venture capital firms can help small business borrowers.

Types of Equity Investors

Each type of equity investor has unique benefits and drawbacks.

  • Venture capitalists can be individual people or venture capital firms. They provide large sums of cash in exchange for large shareholder holdings and management say in the business as it grows.
  • Angel investors typically invest in startups to provide knowledge, connections, and cash
  • Individual private investors like a business owner's family, friends, or peers
  • Crowdfunding on online crowdfunding platform websites. These include Kickstarter or GoFundMe, where people donate small amounts of money to the company in exchange for a small item or name on a website

All these investment types are forms of equity investing. Bank loans and credit cards are debt financing.

Create a Business Plan for an Equity Investor

business plan is necessary. When pitching your business idea to venture capitalists or angel investors, there are a few areas to focus on. You may not focus on these points for traditional small business investment companies. Equity investors have unique expectations that need to be in your business plan.

An equity investor risks losing their entire investment in your company. If the business fails, the equity investor knows there is little chance of getting their money back.

Include the following in your business plan aimed to attract equity investors:

  • Offer a high percentage of company profits or other benefits to make up for the high chance of loss
  • Cap C-Suite or management salaries to ensure higher profits and quicker repayment of their investment
  • Explain your track record of creating, managing, and selling companies
  • Detail your track record of working in the industry of your proposed business idea
  • Projected timeline for the investors' return on investment (ROI)
  • The interest rate on the investors' return through profits or distributions

Although equity investors usually demand significant business profits, there's always room to negotiate. Determine your limits and boundaries ahead of time. How much of your business are you willing to give away to investors?

Equity Investors Have Substantial Rights

A contentious area between business owners and equity investors is how much control equity investors have in the company. Equity investors often exercise their rights, including voting the company's founder out.

Rights that equity investors can have include:

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

Giving an equity investor substantial rights to your company is not always negative. Often, equity investors have years of experience. Besides their monetary equity investment, they can become a source of advice and information for your startup.

Structuring Your Business For Equity Investors

There are several ways to structure your business along with your equity partners.

  • General partners. If you find equity investors for your company and don't specify a change in business structure, your business is now a general partnership. General partners have much control but are also personally liable for business debts and liabilities. Due to this, equity investors tend to avoid general partnerships.
  • Limited partners. Limited partnerships have limited personal liability for the debts and liability incurred by your business. A limited partnership must have a general partner. Most equity investors choose the startup founder as that general partner, making that person personally liable for the debts and liability. The equity investors would not be liable. Seriously consider the hazards this represents before agreeing to any such relationship.
  • Corporations. Corporations have shareholders. Shareholders who don't handle operations are generally immune from personal liability. Having you run your business may be preferable. Offer equity investors the chance to be major stockholders in the corporation. Corporations are harder to set up, subject to more laws, and involve more paperwork.
  • Limited liability companies. LLCs combine a corporation's limited liability with a partnership's tax advantages. LLCs are easier to set up and maintain than the others.

Take the time to figure out which business entity works best for you. Whatever structure you choose, finalize your agreement with the equity investor in writing.

Equity Investors and Securities

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

Find out whether you are exempt from most securities requirements. Small businesses of a certain size can offer equity investors an interest in the business without having to fill out and file complicated paperwork. But, 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 investors if you aren't exempt.

The other major component of securities laws governs what you must disclose about your business and to whom. If you are unsure, contact a securities attorney and always err on caution by disclosing items you may be uncertain about.

Hiring an Attorney to Help Your Small Business with Equity Investors

Understand your legal rights and obligations when negotiating with equity investors. Contact an experienced business law attorney to help you understand what to expect when entering a formal business relationship.

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