Investors for Startups: Terms of Engagement

If you ask entrepreneurs what are their major challenges in getting a new business off the ground, the three most common responses are money, money, money. There are indeed other major challenges but the primary concern of most new businesses is how to attract startup funding.

          Related article: Checklist for Starting a Business

Whether the entrepreneur is opening a small service business or introducing a new product onto the market, the challenge of funding looms large. When these small business owners face a major hurdle in attracting funding to support their new businesses, either as they are starting out or as they try to grow the business, they have at least three options: funding their business with their personal reserves; taking out a loan; attracting investors. This Rosten Law blog briefly discusses each of these options.

Self-funding for those with a big bank account.

If you can afford to finance your business, you are ahead of most entrepreneurs. Self-funding is the easiest solution for funding your startup. You and your partners simply write a check on your personal bank account and deposit it in the corporate account. Or you may want to make a cash advance from your personal credit card account, which is a very expensive way to finance your startup, but you may not have many other viable options.

Make sure that you characterize the contribution as a loan or as additional paid in capital. You and your small business lawyer should document the transaction to avoid any misunderstandings down the road, especially if you and your partners are not contributing amounts in proportion to your corporate, partnership or LLC interests. And if you are contributing appreciated property, you will want to read Rosten Law’s blog post on some of the tax ramifications for contributing property to a business.

          Related article: Traps for the Unwary: LLC Taxed as S Corp

And one word of caution: do not start transferring monies back and forth between your personal account and the business’ corporate account without the proper documentation. There are several reasons for this, not the least of which is that you may defeat the purpose of setting up a legal entity in the first place, which was to protect your personal assets. Comingling of assets may give rise to piercing the corporate veil and allow creditors to come after your personal assets.

If there are other members or stockholders in your company, you need to determine how to characterize your contribution as a loan or additional paid in capital.  Are the other members also contributing?  In your operating agreement or bylaws, you may have provisions regarding additional contributions and whether additional contributions will affect the percentage ownership share of the company.

Borrowing money from friends and relatives.

If you don’t have the big bucks to invest in your startup, then you are going to have to get money from another source, which could be family, friends, angel investors, private equity firms, banks or someone else. It is not likely that you will be able to rely on internal financing to support the growth of your company. Wouldn’t it be nice if you could generate a profit from day one and use the profit to finance the growth of your company?  It doesn’t happen very often. In the next section, we will talk about equity investment in your company, and in this section we are going to talk about debt financing, which is borrowing money.

If you are borrowing money to finance the purchase of tangible property such as equipment, you may be able to find a lender who will provide secured financing. So long as the lender has perfected its secured interest in the property, if you are unable to repay the loan, then the lender may be able to take back or sell the equipment.

What most small business owners are looking for from lenders is non-recourse debt. Unfortunately for startups, non-recourse debt is very hard to obtain. In general, there are two major kinds of borrowing. One is called non-recourse, which means that the lender is looking only to the business for repayment. If the business fails and there are no business assets, then the lender does not get repaid.  The lender will get paid off before the equity investors, those who own stock in a corporation or have membership interests in a LLC. There are not going to be many people, with the possible exception of your parents, who will lend money without the business owner putting up some kind of security.

No respectable lender is going to extend a loan to a new business without collateral.  When a lender takes a security interest in some form of property, these are known as secured loans. If the borrower does not pay back the loan, the lender can foreclose on its security, which could be equipment or accounts receivable, for example.  This link to the Small Business Administration’s site gives other examples of the kind of collateral that lenders may accept as a condition to providing a loan.

          Resource information: Borrowing Money for Your Business (Small Business Administration)

Notice that lenders will look not only to the assets of the business, but also to the assets of the owners of the business or anyone else willing to provide collateral. Most lenders to a new business will usually demand a personal guarantee from one or more of the owners of the company. Remember that banks and other lenders are trying to minimize their risk of not getting repaid.  They will extract their pound of flesh to accomplish this goal.

And keep in mind that the various loan programs through the Small Business Administration are a very good place to start, but they are going to require in most but not all cases collateral or personal guarantees on the loans available. The SBA loans require that: 1) the loan must be for a sound business purpose; 2) the owners have experience and good personal and/or business credit history; and 3) the business has the ability to pay back the loan and “reasonable to strong collateral (personal and business assets) is very important.”

You can try to apply for a microloan up to $50,000, but even then the SBA intermediary will ask for collateral or a personal guarantee, or both.  The average size of the loan under that program is around $13,000, which may not take you very far into setting up or taking your business to the next level.

Also, as a small business owner, do not neglect to pay careful attention to covenants that lenders will impose on your business as a condition of giving you the loan. The lender may require certain restrictive or protective covenants as a condition for giving you the loan. Restrictive covenants may include repayment terms, the use of collateral, and periodic reporting. Protective covenants may include maintaining a minimum level of working capital, carrying certain levels of insurance, providing financial statements or reports, and other matters. The business owner should overlook these covenants at his or her own peril. Your decision about which lender to work with may well depend on the covenants that the lender may want to impose. And if you are unsure of the implications of the covenants, you should discuss them with your business advisers and small business lawyer.

Giving up equity in your new business.

There may be no easy way to get around it.  You’ve maxed out your credit card, already borrowed money from anyone who will lend you anything, and as much as you hate to give up any ownership in your company, you have no choice if you need the money. It is not as bad as you think as some equity investors can invest not only their money or property, but also their time, energy and most importantly their expertise. This is especially true if you can attract angel investors or a private equity firm.  You may also be able to attract the interest of a venture capitalist, but for a startup, a venture capitalist would rarely be interested in investing at the startup phase.

The first hurdle is to find anyone who is willing to invest. That is no small achievement in any market.  The next challenge assuming that you find an investor is what terms you need to address. In this section of this article, I will discuss what are some of the major terms that you may want to consider as you invite investors to the table. And as in all negotiations, you will of course keep in mind that the bargaining positions are somewhat skewed; they have the money and they have numerous opportunities where they can place their investment.

Corporations are better vehicles to attract outside investors than limited liability companies. If you are looking to attract outside investors, you are more likely to be able to gain their attention if your new business is a corporation rather than a limited liability company. And if you remember our discussion on S corporations, you will recall that they only allow one class of stock, which will not be an attractive option to an investor. A S corporation may not issue both a class of common stock and a class of preferred stock. Outside investors will generally want preferred stock, under which they usually are entitled to a fixed dividend before dividends are issued to the common shareholders. They usually also require conversion and anti-dilution rights. That means that generally you are in a better position to attract an outside investor if you have a C corporation. But a friendly investor you know may be willing to invest in your limited liability company taxed as a partnership. Your small business lawyer can craft an operating agreement for the LLC.

          Related article: Starting a LLC: Tax as a Corporation or Partnership

Kind of investment: The prospective investor may be contributing cash or property to the new business. Or someone may be contributing his or her services. As a new business owner, you need to determine exactly what the investor is contributing. A cash investment is usually what the new business owner wants and needs, but you may sometimes want to give up equity in your company for the services of an expert. Although this may not seem like a typical “investment,” an expert’s services may be no less vital to the growth and development of the company.

Debt vs. equity: This may seem elementary but you need to know if the investor is lending money to the company or is investing in the company in exchange for equity. The repayment of a loan is not included as a distribution. The investor may request a hybrid of debt and equity such as through preferred stock. The investor wants to get paid first before other equity holders in the event of a liquidation and as discussed above wants a fixed dividend.

Securities Considerations: Remember that unless your offer to sell securities like stock to outside investors meets one of the exemptions in the Securities Act of 1933, you must register the securities with the Securities and Exchange Commission (SEC) and your company will become a public company with all of the attendant rules and regulations.  No, your small mom and pop restaurant does not want to go public. There are several well-known exemptions such as seed capital, private placements and accredited investors, but if you have any questions as you get into this thicket of legal issues, you may want to consult with a corporate lawyer.

New forms of investments: Depending on your product or service, you should not overlook new forms of attracting startup money mainly through crowdfunding.  There are two relatively new forms of investments. The first is through reward sites, the most heralded of which is kickstarter.com. You get money from many contributors who receive in exchange for their investment a reward. The obvious reason to structure contributions in this matter was to overcome some of the constraints of the securities laws.

The other major new innovation is equity crowdfunding, which was only recently allowed when the SEC issued new rules to implement the Jumpstart Our Business Startups Act (JOBS) Act. These rules allow smaller investors to gain a small equity stake in startups and small businesses.  According to JOBS Act crowdfunding, your company is limited to raising $1 million in any 12-month period from non-accredited investors. Investors making less than $100,000 per year can invest the greater of $2,000 or 5% of their annual income. Investors making $100,000 or more per year can invest up to 10% of their annual income. You have to engage an intermediary that is registered with the SEC.

Allocations: Back to the traditional forms of attracting investment, your investor will be concerned on how the investment is allocated. When the investor is contributing cash, then how the contribution is allocated is relatively straightforward. But if the investor is contributing an asset that can be depreciated or amortized and has a low tax basis, the business owner and the investor will discuss how the built-in gain will be allocated for tax purposes.

        Related article: Traps for the Unwary: LLC Taxed as S Corp

Distributions frequency: The owners will have to agree with the investors with what frequency distributions will be made. Also they need to decide whether there should be distributions should be required to cover tax liabilities.

Management and control: You will have to negotiate with outside investors how much control you will have to give up to protect the investor’s minority shareholder or minority ownership interests. What decisions that may affect the business are you willing to allow minority investors to have a say on Will certain decisions require unanimous consent? Your corporation has a board and are you willing to allow your investor to sit on the board or appoint a representative? There are many issues that may implicate the interests of the minority shareholder and a sophisticated investor will want to be protected.

Duties of investors: Then you also need to decide the extent to which the investor will have access to proprietary or confidential information. Certainly the investor will want to have access to the financial records of the business. Should the investor have access to other proprietary information such as specific proprietary processes? If your business is the owner of valuable intellectual property, you should consider whether the investor should be required to sign a noncompetition agreement

Transferability: Remember that stock in a corporation is generally freely transferable absent a shareholders’ agreement or some limitation in the bylaws. Operating agreements for LLCs typically contain numerous restrictions on transferability. You will have to discuss with and decide with your outside investors if they are willing to accept restrictions if they want to transfer their stock or membership interests.

These are just some of the many issues that you will have to grapple with when you decide to take on investors for your new business. Growing a business is an exciting venture and if you have the right advisers and investors to help you along the way it will be a much easier path.