Accepting Outside Investors? Here Are 5 Things to Watch Out for in Your Contract - Anthony Norman3/10/2022 As a business owner, the idea of accepting expertise and a big check from an outside investor can seem like a complete win for you and your business.
The truth of whether it’s actually a benefit for you, however, is often determined by what appears to be the boring fine print details of the contract you sign with that investor. In this article, we’ll introduce you to some of the most important contract terms to watch out for when negotiating an agreement to accept outside investments, and explain why they’re worth worrying about. 1. Structure of the investment When small business owners talk about taking on an additional investor, they typically say something nondescript like, “We’re taking on an angel investor.” What they don’t discuss are the many of ways in which that investor can actually invest. But they should, because the different ways an investor can invest in a business dramatically changes the deal you’re agreeing to. 2. Preferred versus common shares Assuming you’re considering an offer in which the investor is making a traditional equity investment (as a reminder, this is how most of the Sharks do it), the next important clause is to look at whether the shares the investor is taking are preferred or common shares. By way of background, when someone invests in your business they are actually buying shares in your business in exchange for money. They can buy common shares or preferred shares. If your investor only gets common shares, then that means you are on equal footing. So, when it comes time to make decisions, you probably each get one vote for each share of the business you own. When it comes time to get profits (or allocate losses) you each get a proportional share relative to the number of shares of the company you own. 3. Anti-dilution protection When an investor puts money into a company as an equity investment to buy shares at a particular valuation (say $100,000 at a $1,000,000), they then own a given percentage (here 10 percent) of the total shares outstanding. If, down the road, you decided to take on an additional investor, or sell new shares of the company at a discounted rate to employees or family and friends, then that investor’s total ownership percentage might fall below their 10 percent ownership. That risk of a decrease in the overall ownership percentage triggers an important term called an anti-dilution protection clause. 4. Liquidation preference When you hear of a company that sells for, say $10 million, most people assume that the founders are now multi-millionaires. Whether that’s true or not depends in no small part on how the liquidation preference clause was negotiated with outside investors. A liquidation preference is just a fancy way of describing in what order, and how the various owners of a business get paid in the event of a sale or bankruptcy. In its simplest form, in a company without any outside investors, if you owned 30 percent of the business when you sold, you’d get 30 percent of the proceeds after any outstanding bills are paid off. 5. Covenants Covenants, a legal term that just means promises, are things you promise to do (known as affirmative covenants) or promise not to do (known as negative covenants) as the manager of the business. Outside investors want covenants in the agreement as part of their investment because they’re entrusting you to take their investment and run the business in a proper way, without actually being there to check on you on a daily basis. Covenants can include all sorts of things, ranging from a high level requirement that you prepare and distribute monthly or quarterly financial forecasts for the business, to detailed requirements that you maintain certain levels of insurance protection. Any investor is going to want covenants in some form, and it’s not unreasonable that they do.
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