Q: We are looking to expand our business and have an investor lined up. He asked me to present him with various options for dealing with his investment. I am not sure what to do. Should we offer him shares of stock in the corporation, profit sharing, or what? Frederick S., Washington D.C.
A: When a business wants to bring in a new investor, there are several ways to do the deal depending upon the legal structure of the business.
If the business is a sole proprietorship or a partnership, the money could be considered a loan that you will pay back by an agreed-to time and at an agreed-to interest rate. Alternatively, you could say that the investor is buying a part of the business and will get a percentage of the profits every month. This is something to be negotiated.
When a company is a corporation (either an S or a C), the two basic methods for raising revenue are the sale of debt and the sale of equity.
The sale of debt is, essentially, a deal whereby the invested money is considered a loan. These are called “debt securities.” Some investors like debt securities because they take precedence over equity securities. That is, in a risky startup, if something were to go wrong, your investors’ loan (his debt securities) are legally protected and given higher legal priority than your ownership interest.
The other reason you might consider his investment as a debt security relates to taxes. If you were to simply sell this investor stock (called a sale of securities, see below), when he is repaid, it would be likely considered a dividend. When your business pays someone a dividend, it is not deductible on the business’ taxes. However, if you structure the deal as a sale of debt (a loan), your repayments are considered interest payments and thus are deductible on the business’ taxes. By structuring the deal as a loan your business would pay fewer taxes.
The second method for structuring the deal is to simply sell your investor’s shares of the corporation. This is called a sale of equity or a sale of securities. Many investors like this option because it gives them an actual ownership interest in the business. The sale of common stock to an investor carries with it the right to participate in earnings, and a right to vote on the board of directors. This is the most common type of financing arrangement.
How much stock they should get is impossible to say. It depends upon the size of your business and the amount of money he is investing. Also how much authority you want him to have, etc. You would need to discuss this with your lawyer.
If you own a Limited Liability Company (an LLC), things are a bit different. LLCs do not have “shares” of stock as a corporation does. Instead, its owners are called members and you sell membership shares.
If you want to sell your investor shares of your LLC, you are certainly free to do so. However if you do, it may change the structure of your LLC. There are two types of LLCs. Most are “member managed:” that is, the owners, the members, manage and run the business. The other management structure is called “manager managed” – this means that the owners have managers who help run the business. The non-managing owners (presumably your new investor) would simply share in LLC profits.
The important to understand is that in a manager-managed LLC only the named managers get to vote on management decisions and act as agents of the LLC. Your investor would be like a shareholder in the corporation except that he wouldn’t have a right to help pick a board of directors, nor could he sit on the board. Why? Because LLCs don’t have boards of directors.
Whatever method you choose, you should be sure to speak with your lawyer and accountant.
Whether you are selling shares in a corporation or an LLC, the sale of a partial interest in either is considered a sale of a “security” and therefore, of potential interest to the Securities and Exchange Commission (SEC.)
The thing to know is that when ownership interests are considered securities, you must qualify for an exemption from the state and federal securities laws, otherwise, you must register the sale of your securities with the SEC and your state. Fortunately, most small businesses usually qualify for securities law exemptions. In your case, there is something called a “private offerings” exemption that applies to the unadvertised sale to a small number of people (35 or fewer.) There are several
other exemptions as well. Check out sec.gov.