Investors help your startup grow fast. They provide not only capital, but also advice for your startup. However, there’s a danger that you may give too much control to an equity investor, allowing them to take your business in a direction that doesn’t align with your goals.
This article explains what to watch out for when you bring on an equity investor and the legal safeguards that can keep you in control of your business.
Types of Investors
Investors can include anyone from your family and friends through to wealthy investors (also known as ‘angel investors’) and institutional investors (such as venture capital firms). You may choose to raise capital through debt, equity and hybrid fundraising:
- Debt — you obtain a loan from the bank or other institutional lenders.
- Equity — you offer shares in exchange for a percentage of your company.
- Hybrid — you issue a convertible note or Simple Agreement For Equity (SAFE) to investors that provides an immediate capital injection. These instruments convert to equity at a trigger event. For example, at a time-based milestone such as the passing of 12 months or at a financing milestone such as the raising of a qualified round.
Investors can also be defined as ‘passive’ or ‘active’. Passive investors provide funds but do not make day-to-day business decisions. Active investors — typically equity investors — do make decisions and may also provide industry know-how and a valuable network. But you must be careful that you share the same business goals. They may wish to push your business to grow faster than you are comfortable with.
Investors May Control the Company
Investors can have control over the company if they hold a significant amount of shares, a seat on the board, or both. Often, shareholders with a significant shareholding in the company (for example, 20% or more) may have the right to vote on key business decisions.
Furthermore, if you appoint an investor to your board of directors, they will have decision-making power in relation to board decisions. Each director typically has one vote each when voting on matters, which generally relate to the day-to-day operation and management of the business.
An equity investor may be content to invest their money and entrust operations to the business. However, some investors want to be very hands-on, especially when decisions may affect their interests.
Consider Your Goals
The right investor can be a strong ally by making introductions, providing industry know-how and guidance but an investor can also be divisive and inhibit growth.
For example, imagine that you’re considering whether to bring an investor on board who has aggressive growth plans. You require funding to continue and grow your hospitality business. You’ve have been offered money and would like to get back to running your business, instead of spending time searching for funding. However, you have two reservations:
- You and the investor are at odds at what rate to grow the business; and
- You want to expand to a maximum of three venues in the next two years, but your investor wants to immediately open five locations
What would you decide? We’ve had clients in this exact situation. Some have decided to take capital despite different goals and temperaments to their investors. Others choose to walk away and pursue capital raising options that are more consistent with their goals and timeframes.
While it’s unlikely that you and your investor will agree on everything, it’s worth considering what your ‘dealbreaker’ points are. Once you know what is essential, you will be able to negotiate on other points. However, be wary if your starting position is so far apart that a middle ground is hard to find.
A Shareholders Agreement Influences Investor Control
A shareholders agreement governs relations between a company and its shareholders. A shareholders agreement covers practical matters such as how to issue shares and how to resolve disputes. Because equity investors will hold shares, the shareholders agreement helps manage how much control they have over business decisions. For example, the shareholders agreement may give an investor the right to appoint a director. This would give the investor more decision-making power inside the business.
The shareholders agreement may also have a list of ‘critical business decisions’ that require a vote by the shareholders. The required vote to pass the resolution may be a majority (50%), special majority (75%) or unanimous (100%) decision. Critical business decisions may include issuing new shares, borrowing money and changing the nature of the business (for example, the services or products on offer).
The list of critical business decisions and the required majority will influence how much control an equity investor wields in the business. For example, if critical business decisions require unanimous votes, you will need to find common ground on every decision. Therefore, it’s a good idea to pay careful attention to how many directors that investors have been allowed to appoint, and what critical business decisions require their votes.
Investors can be a timely source of money to grow your business. However, an investor’s goals may be at odds with your goals and cause difficulty in the running of your business.
One way to limit how much control an equity investor has over your business is to draft a shareholders agreement. If you would like to get a shareholders agreement drafted or reviewed, call LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
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