Equity investors buy a piece of your business. They become co-owners and share in the fortunes andmisfortunes of your business. Like you, they can make or lose a bundle. Generally, if your business doesbadly or flops, you're under no obligation to pay them back their money. However, some equity investorswould like to have their cake and eat it, too; they want you to guarantee some return on their investmenteven if the business does poorly. Unless you're really desperate for the cash, avoid an investor who wantsa guarantee. It's simply too risky a proposition for someone starting or running a small business.
Because equity investors are co-owners of the business, they may be exposed to personal liability for allbusiness debts unless your business is a corporation, limited partnership, or limited liability company. Ifyou recruit equity investors for what has been your sole proprietorship, your business will now be treatedas a general partnership. This means your equity investors will be considered to be general partners,whether or not they take part in running the business. And as far as people outside the business areconcerned -- people who are owed money or who have a judgment against the business -- general partnersare all personally liable for the debts of the partnership.
Equity investors often want to limit their losses to what they put into the business. An investor who puts$10,000 into a business may be prepared to lose the $10,000 but no more. In short, the investor doesn'twant to put the rest of his or her assets at risk. The investor will want to avoid being -- or being treated as-- a general partner.
Fortunately, there are three common ways toorganize your business so that you can offer an investor protection from losses beyond the money beinginvested.
Encourage investors to determine their own degree of risk. As mentioned, an investor in a businessorganized as a corporation, limited partnership, or limited liability company usually stands to lose no morethan his or her investment. However, state laws must be followed carefully to achieve this result. Toavoid having investors accuse you of giving misleading assurances, recommend that they check with theirown financial and legal advisers to evaluate if their investment exposes them to the possibility of incurringadditional losses.
Return on Investment
Someone who invests in your business may be willing to face the loss of the entire investment and notinsist that you guarantee repayment. But to offset the risk of losing the invested money, the investor maywant to receive substantial benefits if the business is successful. For example, an investor may insist on agenerous percentage of the business profits and, to help assure that there are such profits, may seek to put acap on your salary. The terms are always negotiable -- there's no formula for figuring out what's fair toboth you and the investor.
Here are just a few possibilities:
Compliance with Securities Regulations
The law treats corporate shares and limited partnership interests as securities. Issuing these securities toinvestors is regulated by federal and state law. In some cases, an investor's interest in a limited liabilitycompany may also come under these laws.
This means that before selling an investor an interest in your business, you'll need to learn more about therequirements of the securities laws. Fortunately, there are generous exemptions that normally allow asmall business to provide a limited number of investors an interest in the business without complicatedpaperwork. Chances are good that your business will be able to qualify for these exemptions. In the rarecases in which the exemptions won't work for your small business and you have to meet the complexrequirements of the securities laws -- such as distributing an approved prospectus to potential investors --it's probably too much trouble to do the deal unless a great deal of money is involved.
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