I frequently receive calls from clients asking for my thoughts regarding the process of bringing an equity investor into their company. I always remind clients that bringing in equity investors is often like getting married without the wedding, and like any newlywed, you want to make sure that everyone has the same goals and plans for the company to avoid any marital discord.
First I ask my client to identify and outline the roles that the equity investor would or would not play in your company. For instance:
- Will the equity investor be a silent partner who receives only cash and has no or little voting rights or management control?
- Will the equity investor have a minority position but have veto rights on certain actions? If so, what actions?
- Does your company’s current legal and/or tax structure restrict your ability to bring in such equity investment without creating an adverse tax situation for you or the investor? For instance, is your entity taxed under sub-chapter S while you want to provide preferred equity interests?
- Is the investor already, or will the investor become, an employee or consultant of your company?
- What consideration, if any, will the investor provide? You may need to address certain tax concerns for those who are contributing “sweat equity.”
At this stage, it is also important to consider whether the sale or issuance of additional equity securities of your company would require registration under any state or federal securities laws or “blue sky” laws.
Then, like any good pre-marital counselor, I begin to ask harder questions that address how the parties would operate or exit the business, such as:
- What happens in the event of the death, disability, divorce, retirement, or bankruptcy of the equity investor?
- If the investor is also an employee or consultant, how would you negotiate a divorce of all ties rather than give your former employee continuing access to potentially confidential information?
- Could a former employee and equity owner’s subsequent employment at another company create an unacceptable conflict of interest with the company or its customers (for instance working for a competitor while holding equity in the company), and would such conflict prevent the company from operating?
- Could you live with the investor’s heir or other successor’ becoming an equity investor in your company? If not, how and when should we structure the right to remove and part ways with the successor?
- Would any of the events sketched above have an impact on business operations?
- How might an operating agreement or buy-sell agreement help you to navigate through any divorce with the equity investor- is it clear or do you need to modify any existing documents to take this into account?
- If you do contemplate an exit- on what terms, will payments be deferred, and if so, for how long?
These questions are just the tip of the iceberg in examining not only how equity investors will come into your company, but also what rights and control they will have as owners and what exit strategies (and rights on exit) might come into play upon their exit. Nevertheless, answering these preliminary questions is an important first step in preparing to launch a successful new marriage with an equity investor.
DISCLAIMER: Opinions and conclusions in this post are solely those of the author unless otherwise indicated. This article is for general information purposes and is not intended to be and should not be taken as legal advice on any particular matter. It is not intended to and does not create any attorney-client relationship. Since legal advice must vary with individual circumstances, do not act or refrain from acting on the basis of this article without consulting professional legal counsel. If you would like additional information on the subject matter of this article, please feel free to contact the author. IRS CIRCULAR 230 NOTICE: Any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding federal tax penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.