So You Want Investors – Are You Sure?

by | January 6, 2016

When talking with clients about their annual goals, cash flow and fundraising is a common theme. Many are looking for growth capital and are keen to bring on investors. To them, investors = money and money is good. But there are many factors to consider when thinking about investors for your business.

1. What kind of investor and what drives them? Investors come in all shapes and sizes and are all universally involved to make a return on their investment. However, there are categories of investors, each with particular expectations of their role and return. “Friends and Family” tend to be smaller amounts of money with fewer restrictions to the company. These are folks that are helping you get started and not requiring a lot from you. “Angels” are typically individuals or groups of individuals who are investing their own money because they believe in the founders and the concept. They are certainly looking for a return but often are willing to stay invested longer term, not looking for a quick return. Their investment amount varies but is usually on the smaller end, under $1M. “Venture Capitalists” are the big swingers. They have “funds” created by their own investors and, therefore, have significant funds to invest. They are also seeking a relatively quick return for their portfolio – they are accountable to another party for their success in the investment. This is business, not personal; although some amazing personal relationships develop between founders and their investors.

2. What role will the investor play? As you move along the spectrum from Friends and Family to Venture Capitalists, you typically also increase the involvement and control the investor has. This makes sense – the more money they have invested and the more accountable they are to others, the more information and control they will desire. Usually, investors do not have a majority ownership, so they don’t control everything; however, Venture Capitalists and sometimes Angels require one or more Board seats. Sitting on the Board of Directors gives them a say in appointing or terminating the officers of the company and making other strategic decisions. A Voting Agreement that requires all shares to be voted in a particular way for certain types of decisions. Again, for these investors, they are doing what is necessary to protect their investment. Regardless of the type of investor, you will be required to act more formally than you might otherwise (which is generally a good thing anyway). You must share financial information and have annual meetings to share strategy, plans, and finances with investors. If they are on the Board, you’ll need to formalize your meetings. You’ll be a better CEO for it! However, if the company’s not performing to expectations, you will be held accountable; and depending on their level of control and your negotiated agreements, you may be replaced.

3. What legal hoops are necessary? The stock or units of ownership of your company are called “securities” and the sale of securities is highly regulated in the US both by the federal government and the individual states. In taking on investors, you must comply with both federal and state law for every state where you have an investor as well as your company’s home state. This means the “registration” of the securities or more commonly filings related to the exemption from registration because your “offering” is a “private placement”. Overall, this means ensuring that your sale is properly documented and risks fully disclosed to investors. In addition to these compliance issues, you will need to negotiate and document the “deal” with the investors. The deal includes not only the amount of ownership being transferred and the valuation or price but also the control, governance, and transfer terms. These are typically in documents such as a Shareholder Agreement, Voting Agreement, Co-Sale Agreement, and Investor Rights Agreement. In addition, as a founder, you want to be sure your ownership and role in the company are protected in an Employment Agreement. And you wonder why this process can be so expensive…

Bottom line is that investors, especially sophisticated investors, are there for their own return and they’ll create structures that help them be successful. However, their presence dramatically affects your own performance. In good times, I think it ups a CEO’s game, holding them accountable and keeping them on track. In tough times, it creates significant pressure to perform and to change tact away from what a founder or CEO really desires or believes in. This pressure can have a positive impact on some but it can also break the relationship and sometimes even the company. If, as a founder, you understand the dynamics when going into your negotiations, you can have upfront discussions and make an informed decision about whether a particular investor will be the right partner to grow your company or whether another source of capital would better suit your business’ needs.