Equity Investments as a Source of Funding

Learn about the advantages and disadvantages of bringing investors into your company.

Unlike a lender, who provides you with funds to operate your business temporarily, equity investors purchase a portion of your company. For better or worse, they become your co-owners and share in the fortunes and misfortunes of your business.

Here are the benefits and drawbacks of raising funds from equity investors, as well as the many forms of equity investment available

Investors' Rights

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

Investors in your company frequently incur the risk of losing their entire investment with no certainty of reimbursement. To mitigate this risk, investors frequently want big rewards if the company succeeds. For example, an investor may demand a large share of the company's profits and, in order to ensure that profits are made, may want your compensation capped.

There's no formula for determining what's fair to both you and the investor; terms are always flexible. Finally, you and your investors must decide what you are both comfortable with.

Your Ownership Structure

If you're thinking about bringing in equity investors, you'll need to figure out which ownership structure is appropriate for you and your investors.

General Partnership

If you get other people to invest in your sole proprietorship, it will automatically turn into a general partnership. This means that your stock investors will be general partners, and each of them will be individually liable for the company's obligations and liabilities, whether or not they participate in its management. 

Many investors will wish to protect themselves from personal liability for business debts, especially if they aren't going to be involved in the day-to-day operations. If this is the case, you should think about various ways to arrange your company.

Corporation

Because companies provide shareholders with limited responsibility protection for business obligations (known as limited liability), a shareholder who does not engage in corporate activities or decision-making is practically immune from liability for corporate debt or action.

A shareholder who helps operate the firm can be held accountable to third parties for his or her own acts, such as making defamatory statements or recklessly operating equipment, but not for corporate debts or the activities of corporate personnel.

Not everyone picks a corporation as their company entity because it entails a lot of paperwork in the beginning and ongoing, as well as some significant start-up expenditures. Read How to Form a Corporation for further information on how to form a corporation.

Limited Partnership

Your investors will have limited personal liability for business obligations if you form a limited partnership and make them limited partners. As long as the limited partner does not get actively involved in the firm, the limited partner's personal liability is identical to that of a corporate shareholder.

Every limited partnership must have at least one general partner who is personally responsible for the company's debts. That will almost certainly be you, so consider your risk tolerance before forming a limited partnership.

Limited Liability Company

Forming a limited liability company (LLC) and selling membership interests in the LLC to your investors is another possibility. LLCs have grown in popularity in recent years because they combine the restricted personal liability of a corporation with the tax advantages of a partnership. Read LLC Basics for further information on limited liability companies.

Compliance With Securities Laws

Corporate shares, limited partnership interests, and (typically) passive LLC membership interests are all considered securities under the law. The issuing of these securities to investors is governed by federal and state securities regulations.

Learn about the obligations of securities laws before selling an investor a stake in your company.

Exemptions. Fortunately, there are a number of generous exclusions that allow a small corporation to offer a limited number of investors with an interest in the company without having to go through a lot of red tape.

If you aren't exempt, think about it. If your company doesn't qualify for these exemptions, you'll have to follow the securities laws' complicated disclosure requirements, such as publishing an approved prospectus to potential investors, and register the securities. In this situation, unless a large sum of money is involved, it may be too difficult to complete the transaction.

On the side of disclosure, there was an error. Investors may accuse you of offering misleading assurances, even if you qualify for exemptions from the securities disclosure regulations. To analyze an investment, potential investors should always consult their own financial and legal counsel. The main line is that, while each investor will estimate their own level of risk, you should provide them with all essential facts so they can make an informed decision.

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