NOW IS THE TIME TO PURSUE INVESTORS

October 10, 2011

For many small business owners, the thought of bringing investors into their business evokes emotions of both hope and fear. Yes, the dreams of capital to expand into new markets or finally develop the product that for years now has been stuck in R&D limbo would be great. But what price must be paid in return? Business lore is rife with stories of investors seizing control and firing the founder or suing the board of directors when dividends shrink or stagnate.

The truth, however, is that in many cases it is possible to have all the benefits of investor dollars while at the same time minimizing the risks posed by investors.

NOW IS THE TIME

As banks have tightened their lending requirements in the last couple of years, any owner of a small business who has sought a loan to keep their business from sinking has learned that the time to establish a line of credit is NOT when the line of credit is needed. That general axiom applies to seeking investors as well. Investors want to invest in businesses that are succeeding. Investors will largely avoid making investments in businesses which are currently troubled, and if an investment is offered, it is usually on terms that the business owner should refuse flatly. Right now, while your financials look good, is the time to seek out investors to help you grow your business and/or keep your business competitive.

DEFINE THE GOAL

First and foremost, decide what you would do with investment dollars, and incorporate these expenditures into your business plan. Investors will not invest in your business just so you can pay off the corporate credit cards or catch up on your delinquent accounts payable. Investors will insist their dollars be incorporated into your business such that the business will realize a return on the funds expended. In general, this means selling existing products to new clients (e.g., opening a second location), selling new products to existing clients (e.g., expanding your product line), or the best of both worlds, doing both (e.g., opening a second location and expanding your product line).

DEBT VERSUS EQUITY

It is possible to take on investors while retaining 100% control of your business through the use of debt financing. However, selling debentures to investors requires you to make regular interest payments to the investors and eventually return all the principle to the investors. This essentially makes the investors your creditors, and differs only in execution from borrowing money from a financial institution.

In most cases, it is better for a small business to sell equity interests in the business in the form of stock for corporations or membership units for limited liability companies. In this way, the investors are not creditors, but co-owners, and their interests are aligned with that of the other owners. While not all equity investors will be interested in taking an active role in the business, many will be willing to lend their business expertise by assuming a seat on the board of directors. Whether you choose to seek an actively involved investor or a more passive investor is up to you, but just be sure that the investor's role is well defined in advance.

MINIMIZE THE RISKS

There are a couple of things you can do to help reduce the risks investors pose to you and your business:

1. Convert to Delaware. In case you ever wondered why so many corporations use Delaware as their state of incorporation, the reason is Delaware's Court of Chancery, which oversees Delaware's very pro-business corporate laws. Conversion of a California business entity to a Delaware entity is a relatively simple process, and the potential benefits make such a conversion worth considering.

2. Buy D&O Insurance. Directors and Officer's insurance protects against criminal, administrative, civil, and regulatory proceedings based on actual or alleged acts, errors, omissions, misstatements, neglect, or breach of duty committed or allegedly committed by a director or officer. A nice policy to have before you bring on investors who may decide to sue if everything does not go according to the best laid plans.

3. Sell the Right Amount. If you do not raise enough capital, you will be unable to accomplish your goals. If you raise too much capital, you will not have enough places to invest the funds, leading to a smaller returns (and less enthusiastic) investors. Figure out how much you need to raise in order to accomplish your goals, and only sell enough of the business to raise that capital.

4. Read Your Documents. Read your founding documents, or have an attorney read them for you. Operating agreements, articles of incorporation, and bylaws are just a couple of the documents that spell out your rights and the rights your investors will have. Before you sell a single share, be sure you know how you will maintain positive control over the corporation even after your investors take co-ownership.

GET PREPARED

Securities laws are designed to protect investors. Thus, any discussion of seeking out investor capital would not be complete without at least a mention of the regulatory requirements a business must comply with before it starts speaking with potential investors.

Depending upon the total size of the investment offering, the financial wealth and sophistication of the investors, the investors' past personal and/or business relationships with the small business or its owners, and other factors, compliance with federal and state securities laws may not be a cost-prohibitive deal-killer. More than likely, such an investment plan will not require registration/qualification with the Securities and Exchange Commission or the California Department of Corporations, and may be accomplished through the use of exemptions and exemption notifications. With certain classes of investors, lengthy and expensive disclosure documents may not even be necessary (but are well advised even if not legally required).

Always consult an attorney before speaking to potential investors.

CONCLUSION

Taking on investors does not have to be a scary experience. Investors most likely have the money to invest because they have made wise business decisions in the past. If they wisely choose to invest in your business, make smart business decisions of your own so you may enjoy sharing in the advantages of taking on investors while minimizing the risk of doing so.

Warm Regards,

Michael J. Leonard, Esq.
Attorney at Law
San Diego Corporate Law

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