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If you plan to make the rounds of venture capital firms or approach potential angel investors, you need to keep the lender’s interests firmly in mind. Simply put, these institutions or individuals want to protect their investment and generate a high return. With that in mind, here are some things to remember when structuring an investment deal:
Corporate structure: The legal structure you choose for your business will dictate your tax obligations and legal liability, as well as how you handle outside investment. Remember, if you plan to sell shares to more than 100 investors, you must set up as a C-Corp.
Preferred shares: Investment firms may insist on purchasing a special class of preferred stock with their shares. Generally, these shares are more expensive, but it gives them priority over regular shareholders. The firm may also want preferred shares to be convertible, meaning they can be converted to regular stock at any time.
Returns: Anyone putting capital into your business is going to want a dramatic return on their investment, so explain how they’ll get it. These investors want to know about an exit strategy -- by sale, IPO or buyback -- giving them a way to cash in on their investment. Be specific about the exit options; one way is to name possible buyers of your business. If this exit is a long way off, however, set up a dividends distribution schedule.
Non-monetary incentives: Will the investor be able to handpick a member of the company’s board? A VC firm or angel may want to reserve the right to purchase more equity at a later date or have a clause that automatically sells them more stock once certain revenue benchmarks are reached.
Restrictions: This protects you, the entrepreneur, from investors prematurely dumping their shares. Most investment agreements have rules stating when shares can be sold and in what quantities.
Protect your equity with non-compete clauses: All top managers should sign non-compete clauses to make sure they don’t leave your firm to immediately work for your top competitor. Investors will want to see these to make sure your company’s intellectual property is well protected. They may also insist on a clause that keeps you tied to the company.
State laws: Are there any state regulations that make your investment particularly attractive or unattractive? States have different rules regarding equity ownership, and some states don’t assess an income tax.
Future offerings: How will additional equity offerings be handled? Investors want to make sure their shares don’t get diluted as the company grows and may insist on having right of first refusal.
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