Blueprint for Wealth
Wayne M. Zell, Esq.
What Investors Really Want
If you are looking for outside investment to help grow your business or to invest in a start-up, you may want to focus on the following criteria investors typically use in making an early-stage investment.
1. Get a Return of Investment. If all else fails, investors want to receive a return of their investment before the founders of the company get their initial investment back. This means that you may structure the investment as debt (i.e., where creditors get paid before the shareholders) or as some form of preferred equity. It does not mean that the founders cannot take reasonable compensation, they can. But the investors may try to impose constraints on how much compensation the founders receive. It does mean that you cannot use an S corporation, if the investment is structured as preferred stock, because S corp’s can have only one class of stock. Most institutional investors prefer Delaware C corporations to avail themselves of the more friendly business climate in Delaware, to avoid unrelated business income tax on earnings that would be generated from a limited liability company and for securities and labor law reasons.
2. Make a Return on Investment. In addition to getting their money back, investors want a reasonable return on the investment. If structured as debt, the investment return is the interest rate paid by the borrower that reflects the relative risk of the investment. If the debt is secured by a pledge of property or other collateral, the interest rate may be lower than if the debt is unsecured. Conversely, if the debt is unsecured, the interest rate may be significantly higher. A preferred stock investment, which is even more risky than debt, may carry an annual return (in the form of accrued dividends) of 8-15 percent or higher, because of the risk inherent in the investment. Most investors demand the ability to convert their debt or preferred equity into common stock (in addition to receiving a return of their original investment plus some agreed upon return), so they can participate in the growth of the company. Another way to partake of the growth is to grant warrants to purchase common stock at a low entry price.
3. Have an Exit Strategy. The market for initial public offerings of stock has cooled dramatically in recent years. Instead, investors hope that the company can be sold to reap a multiple of the original investment. To protect themselves from having to wait too long, many investors demand the right to require the company to repurchase their shares after a period of time, say five years. The repurchase price may be based on a current market valuation or a multiple of the original investment, ensuring that the investor does not have to wait for the founders to sell the company.
4. Protect Against Dilution. Investors may want the right to make later investments in the company on the same terms and conditions as new investors. This right, known as a participation right, is carefully negotiated at the time of the original investment. In addition to the participation right, investors may want protection from the company selling stock at a price below what the investors paid for their shares. This “anti-dilution” protection is customary in convertible debt and preferred stock investments as well as in investments involving warrants.
5. Give The Right to Say No. Some investors, particularly venture capitalists, expect to participate in the management of the company. This may be in the form of taking one or more seats on the company’s board of directors. Other investors may be satisfied in having the ability to prevent the company from taking certain actions without the consent of the investors. These actions may include changing the capital structure of the company, changing the business model, adopting budgets, issuing new shares, selling or merging the business with another company, and other corporate events, where the investors may feel the need to have a veto right over the company’s proposed actions. These criteria are mere guidelines; they are not set in stone. You should consult with an experienced, transactional attorney before investing or taking investment dollars.