Accepting Outside Investors? Here Are 5 Things to Watch Out for in Your Contract

As a business owner, the idea of accepting expertise and a big check from an outside investor can seem like a complete win for you and your business.

The truth of whether it’s actually a benefit for you, however, is often determined by what appears to be the boring fine print details of the contract you sign with that investor.

1. Structure of the investment

When small business owners talk about taking on an additional investor, they typically say something nondescript like, “We’re taking on an angel investor.” What they don’t discuss are the many of ways in which that investor can actually invest. But they should, because the different ways an investor can invest in a business dramatically changes the deal you’re agreeing to.

Perhaps the best way to explain it is by a reference to something most of us are already familiar with—the ever popular television show, Shark Tank.

If you’re an avid Shark Tank viewer, you’ll notice that there are two types of investor sharks: Mr. Wonderful, and pretty much everybody else. All the other sharks typically make a traditional equity investment; for example they’ll invest $100,000 at a $1,000,000 business valuation, and take 10 percent of the business. That’s called a traditional equity investment.

Mr. Wonderful, by contrast typically makes his investment in the form of Debt Securities With Warrants. What this means, is that he gets paid not as a portion of the profit, but as a portion of the overall revenue, regardless of the profit. If you watch the show closely, Mr. Wonderful often doesn’t even discuss his ownership percentage, and never focuses on it, because it’s really irrelevant to the overall deal as he typically structures it.

As a small business owner, the difference to you between an equity investor and a debt security investor is that the equity investor only gets paid if you’re actually making a profit, whereas with the Debt Security with Warrants investor, you’re paying that investor back monthly no matter what, regardless of whether your business is actually profitable.

Needless to say, if all else is equal, a traditional equity investment is better for you, the small business owner. So, if you’re going to take a Debt Security with Warrants investment, make sure the terms—the amount of money they’re giving you relative to the amount and terms that you’re paying it back on—are significantly better such that it’s worthwhile to you.

2. Preferred versus common shares

Assuming you’re considering an offer in which the investor is making a traditional equity investment (as a reminder, this is how most of the Sharks do it), the next important clause is to look at whether the shares the investor is taking are preferred or common shares.

By way of background, when someone invests in your business they are actually buying shares in your business in exchange for money. They can buy common shares or preferred shares.

If your investor only gets common shares, then that means you are on equal footing. So, when it comes time to make decisions, you probably each get one vote for each share of the business you own. When it comes time to get profits (or allocate losses) you each get a proportional share relative to the number of shares of the company you own.

By contrast, if your investor is getting preferred shares, the investor is probably exercising a disproportionate level of control and taking a larger share of revenue than you might otherwise think if you were just comparing the number of shares each party owned. That’s because preferred shares operate under a completely separate set of rules (which will be defined in the investment documents) than your shares.

So, for instance, they might get 10 votes per share whereas you get one, or they might get $20 in profit until their initial investment is paid back to every $1 you get. They generally also get additional rights that common shareholders don’t get, such as anti-dilution protection, and liquidation preference (discussed further below).

In sum, if you see that they are getting preferred shares from their investment, that doesn’t necessarily mean you’re getting a bad deal, in fact most investments are done this way, it just means that they are going to be operating under a completely different set of rules than you will be as a common shareholder. So you need to make sure you understand what they’re getting, and what you’re giving up in terms of control and profits.

3. Anti-dilution protection

When an investor puts money into a company as an equity investment to buy shares at a particular valuation (say $100,000 at a $1,000,000), they then own a given percentage (here 10 percent) of the total shares outstanding.

If, down the road, you decided to take on an additional investor, or sell new shares of the company at a discounted rate to employees or family and friends, then that investor’s total ownership percentage might fall below their 10 percent ownership. That risk of a decrease in the overall ownership percentage triggers an important term called an anti-dilution protection clause.

Almost every outside investor is going to request an “anti-dilution protection” clause be included in some form. As the small business owner, the goal is just to understand how to negotiate the clause to serve you best.

The version of “anti-dilution protection” that most benefits outside investors is commonly called a “full ratchet.” Under this scenario, the outside investors are able to buy additional shares of the company whenever they’re under the threat of having their ownership percentage diluted at whatever the lowest price that shares were ever offered at.

That means that if you offered limited additional shares to employees or family, or a small number of shares to a high profile investor at a big discount just to get them on board, you’d have to offer the same discounted pricing to the original investor. They would, presumably, always buy at that discounted price because they’d be acquiring additional shares at a below market value which would, effectively, water down your ownership relative to theirs.

As a middle ground on the “anti-dilution clause” you should be pushing for what’s called a “partial ratchet.” Under this scenario, the outside investor would get to buy additional shares according to a weighted formula that is generally closer to the actual market price of the shares.

So, if for example, the market value of the shares were $10 per share, and you had offered them to employees at $5 per share to encourage employees to become invested in your company, a “partial ratchet” as part of an “anti-dilution protection” clause might allow the outside investor to buy their additional shares at $7.50, thus hurting you, the founder, less.

4. Liquidation preference

When you hear of a company that sells for, say $10 million, most people assume that the founders are now multi-millionaires. Whether that’s true or not depends in no small part on how the liquidation preference clause was negotiated with outside investors.

A liquidation preference is just a fancy way of describing in what order, and how the various owners of a business get paid in the event of a sale or bankruptcy. In its simplest form, in a company without any outside investors, if you owned 30 percent of the business when you sold, you’d get 30 percent of the proceeds after any outstanding bills are paid off.

If there’s a liquidation preference clause, however, you’ll need to look at the formula in the clause to see how people get paid off. For instance, if the outside investor has added a “double dip” or “triple dip” requirement into the “liquidation preference” paragraph, they’ll get paid two or three times their original investment before the common shareholders (you) get anything.

So, for example, if an investor put in $3 million, had a “triple dip” clause, and the business sold for $10 million, they’d get $9 million first, leaving only $1 million for you and the other common investors.

This is done to ensure that the outside investor gets a return early, and acts as a discouragement to you selling the business for anything short of a huge valuation because you, the founder, only start making money once the valuation exceeds $9 million.

5. Covenants

Covenants, a legal term that just means promises, are things you promise to do (known as affirmative covenants) or promise not to do (known as negative covenants) as the manager of the business.

Outside investors want covenants in the agreement as part of their investment because they’re entrusting you to take their investment and run the business in a proper way, without actually being there to check on you on a daily basis.

Covenants can include all sorts of things, ranging from a high level requirement that you prepare and distribute monthly or quarterly financial forecasts for the business, to detailed requirements that you maintain certain levels of insurance protection. Any investor is going to want covenants in some form, and it’s not unreasonable that they do.

What you want to do is make sure that you aren’t signing anything that you can’t actually follow through on, even if it sounds reasonable.

For example, a common request is that you covenant that you won’t violate any regulation or law in running your business. Sometimes, however, there are so many regulations or laws that you may not know that you’re violating something, so you can compromise and have that covenant changed to agree instead that you won’t knowingly violate any regulation or law.

Another concern to watch out for with covenants is that they don’t unduly restrict you running your business on a day to day basis. For example, having to go to the investor for approval before signing any new contract or making a new hire is going to be a big hassle and will probably hurt your ability to jump on new opportunities as a business. By contrast, having to ask their permission before giving yourself a raise or distributing significant amounts of money is probably a reasonable request.

What’s the takeaway?

Taking on an outside investor may seem like the sort of five minute negotiation you see on the Shark Tank, but in truth there are dozens of important legal clauses that you need to understand and negotiate before you can sign a deal.

When negotiating, you won’t get all of these clauses completely in your favor, nor should you. But understanding the implications of the clauses, instead of just glossing over them and signing whatever is put in front of you, can literally be the difference between a business sale that leaves you a multi-millionaire and one that leaves you looking for another job.

Disclaimer: The purpose of this article is to promote awareness of legal and other issues that may affect business owners, and is not intended to provide either legal or professional advice. Business owners should consult directly with a properly qualified professional or with an attorney admitted to practice in their jurisdiction for appropriate legal or professional advice.