What you must know before selling a stake in your business to outside investors.
By Elaine Pofeldt
Selling a stake in your business to outside investors can be a great way to raise capital during the early days when you are getting started. But if you don’t take the right steps from the outset, these cash infusions can also lead to disasters, like losing control of the company.
Here are some tips on protecting your interests from attorney Ed Stevenson, a Newark-based partner in the business law firm Herrick Feinstein, and chair of its emerging growth company group.
Choose angel investors who understand your field and share your goals.
“You want to have people that you trust, whom you think will have an interest in your company and your industry and who will help you build it,” says Stevenson. An ideal investor will have the connections you need to help you find additional financing and strategic partners for your business in the future.
Find out how big a role an angel wants to play.
Some angels expect to be the only investor and to provide all the cash the company needs in one round. Others will expect to you turn to other sources of financing as the company grows. Make sure you ask an angel about his or her expectations, so there are no misunderstandings later. “Look at prior transactions the angel has gone into,” adds Stevenson.
Understand how much your company is worth.
There is no perfect formula for determining a startup’s valuation, so it’s a good idea to do some research on your own before selling a percentage of the ownership to an outside investor. Knowing the value will help you to obtain a fair price. Talking to other companies in your industry that have raised capital at a similar stage of growth can give you some idea of what your company is worth, Stevenson says. “Normally, it’s just going to be a negotiation process between you and your investor,” he says.
Invest in advice from a lawyer.
Don’t take the do-it-yourself approach to drafting investment agreements, or you could face legal problems in the future. “Make sure there is compliance with securities laws,” says Stevenson. Consider the total cost of legal advice before you bring in outside investors, says Nathan McKelvey, who founded CharterAuction.com, a private jet charter flight service. When he issued preferred stock to outside investors, the cost of legal advice on both sides was close to $100,000, by the time all parties hammered out the terms, he said. His company absorbed much of those costs. “It’s a very long and expensive process,” he says.
Determine how much management control the investor will have.
Many angels expect to offer advice about growing the company—and for the entrepreneur to pay attention to it. “A lot of times, an angel is going to negotiate protective provisions, such as representation on the board of directors, and approval rights for major decisions, such as raising more capital, taking loans, and selling the company,” Stevenson says. Don’t go along with an agreement you aren’t willing to follow if you do find yourself at odds with an investor.
Consider offering stock options.
To attract talented employees, many startups issue stock options: the right to buy company stock at a set price considered attractive at the time. Even if you aren’t sure you want to go this route initially, you may change your mind later. Any contract with an angel should state whether these options will come from your ownership interest, the investors’, or a combination, says Stevenson. “It’s something that could be contentious with your investor down the road if not negotiated up front,” he says.
Keep deals with friends and family formal.
If you opt to bring in family, friends, and acquaintances as private investors, put each investment deal in writing with your attorney and strongly encourage them to review it with their own lawyers to make sure they understand it thoroughly, says Stevenson. Otherwise, you could find yourself facing difficult situations and ruined personal relationships later.