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Working with Investors: 4 Steps to Set Ground Rules

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Updated: Friday, May 18, 2012 - 17:52
Created: Wednesday, May 5, 2010 - 07:17

Now that you have successfully sold your investor on your business idea, what are legal steps you need to take to solidify your investor relationship? Do you need to sign agreements? Are there special laws and regulations you need to comply with? To avoid major disagreements and messy lawsuits, take the time to correctly set the ground rules with your investor. Follow these tips below to successfully establish your investor relationship.

1. Understand Investor Rights and Compensation

Be fully aware of your investors;s rights before you dive into the relationship. Passive investors are more than happy to let you run the show and may not exercise all their rights. Active investors are more involved. They dispense advice and want frequent updates on your business progress. Nonetheless, it is typical for investors to assert the following rights:

  • Elect one or more directors to the board of directors,
  • Receive regular business financial and operational reports,
  • Be informed of major business decisions and progress,
  • Maintain ownership of a percentage of the business in future stock issuances, and
  • Co-sell shares with the business founders.

The list above is not all-inclusive. Investors may also demand percentages of business profits in return on their investment, and may even ask to cap your salary to prevent it from cutting into their profits. While these demands work to your disadvantage, you do want to keep you and your investors happy. Therefore, negotiate to strike a balance between your needs and your investors-s needs.

2. Share Ownership- Choose the Right Business Structure

Investors are not lenders - instead of asking for repayment, they are an integral part of your business as co-owners. As you set up or change your business structure to accommodate investors, make sure you thoroughly understand your options. Go over the benefits and disadvantages of each business structure. You can consider common business incorporation types, such as partnerships, corporations, and limited liability companies, to formalize your investor relationship..

3. Comply with Federal and State Securities Law

Depending on the nature of your business and your business structure, you may or may not have to comply with federal and state securities laws. Fortunately, many small businesses qualify for exemptions. For example, the Securities Exchange Commission (SEC) exempts small corporations of 35 or fewer employees from registering a private offering. Many small LLCs that sell membership to passive investors are exempt as well.

For more information on federal securities law compliance, visit the SEC for small businesses. To comply with state laws, contact your state government agency for more information.

4. Document Your Investment Agreement

To formalize the investment relationship, you need to draw up a couple of documents, such as an equity purchase agreement and an investor rights agreement. These agreements contain information about ownership rights, legal compliance, amount of investment, financial return on investment.

If you are not familiar with investor agreements and need guidance, do not hesitate to seek legal and financial help. 

Keep in Mind

As you navigate the intricacies of investor relationships, remember that you should always try to find the best balance between you and your investor. Clear and regular communication with your investors help keep many problems and disagreements at bay. Investors are a significant part of your business, whether they actively participate or sit on the sidelines, so make sure that you're both content with the arrangements.

Have you successfully (or unsuccessfully) managed investor relationships before? Do you have other tips to share about laying the groundwork with investors? Feel free to leave comments!

Type: Community Blog