Taking on Investors? Here’s What You Need to Know Legally

Starting and growing a business often requires capital, and at some point, you might consider bringing in investors to help take your business to the next level. Whether you're seeking funds from angel investors, venture capitalists, or even friends and family, it’s crucial to understand the legal implications before signing any agreements. Taking on investors can impact your ownership, decision-making power, and long-term business trajectory. Here’s what you need to know to protect yourself and your business.

1. Know What Type of Investment You’re Offering

Investors typically provide funding in exchange for one of two things:

✅ Equity (Ownership in Your Business)

• When an investor receives equity, they become a part-owner of your company.      This means they may share in profits and have a say in business decisions,      depending on the type of equity they receive.
• While equity investments provide funding without requiring repayment like a loan, they can also dilute your control over the company, especially if investors demand voting rights or seats on your board.
• Recommendation: Carefully consider whether you’re willing to give up a portion of your business and what level of control investors should have.

✅ Debt (Loans with Repayment Terms)

• Some investors prefer to act as lenders rather than business partners. In this      case, they provide funding with the expectation of repayment, usually with interest.
• Debt financing allows you to retain full ownership of your business but requires you to make scheduled payments, which can strain cash flow.
• Recommendation: If you opt for debt financing, ensure your business can sustain the repayment terms without jeopardizing operations.

Some investors may offer convertible notes, which start as loans but convert into equity if not repaid within a certain timeframe. These can be beneficial for early-stage businesses that need immediate funding but don’t want to give up equity right away.

2. Choose the Right Business Structure

Your business entity plays a crucial role in determining whether and how you can accept investments. Some structures are more investor-friendly than others:

✅ Sole Proprietorships and LLCs

• Sole proprietorships do not allow for outside investment, as there is no legal distinction between the owner and the business.
• LLCs are more flexible but can be tricky when bringing in investors because ownership interests are not as easily transferable as shares in a corporation.
• Recommendation: If you operate as a sole proprietorship and are seeking investment, you’ll likely need to restructure your business.

✅ S Corporations

• S Corps allow only 100 shareholders and prohibit ownership by non-U.S. resident or entities, which may limit your ability to take on investors.
• However, they offer tax benefits, as profits and losses pass through to shareholders' personal tax returns, avoiding corporate taxation.
• Recommendation: If you plan to take on only a small number of U.S.-based investors, an S Corp might be a good choice, but it has limitations on scalability.

✅ C Corporations

• C Corps are the preferred structure for attracting investors, particularly venture capitalists.
• They allow for multiple classes of stock, making it easier to offer different rights and privileges to different investors.
• The downside is double taxation, meaning the business pays corporate tax, and shareholders pay tax on dividends.
• Recommendation: If you're serious about raising funds from multiple investors, forming a C Corp may be the best option.

3. Have a Solid Investment Agreement

A handshake deal won’t cut it when money and ownership are involved. A properly drafted investment agreement protects both you and your investors by clearly outlining:

✅ Investment Amount & Terms

• The agreement should specify how much money is being invested and whether it      is in exchange for equity, debt, or a convertible note.
• If it’s a loan, repayment terms, interest rates, and due dates should be clearly defined.

✅ Investor Rights & Decision-Making Authority

• Some investors may demand voting rights, board seats, or veto power over certain decisions.
• If you don’t define these terms upfront, you could end up with investors who have more control over your company than you expected.
• Recommendation: Limit investor control unless you specifically want a more hands-on partner.

✅ Exit Strategies

• Investors need a way to cash out, whether through selling their shares, receiving dividends, or participating in a future buyout.
• Having an exit plan prevents disputes when an investor wants to withdraw their funds.

✅ Dispute Resolution

• Clearly outline what happens if disagreements arise. Mediation and arbitration clauses can help resolve conflicts without costly litigation.

A poorly drafted investment agreement can lead to major legal headaches down the road. Always have an attorney review or draft investment contracts to ensure you’re protected.

4. Understand Securities Laws

Once you take money from an investor, you might be subject to federal and state securities laws that regulate how businesses raise funds.

✅ SEC Regulations

• If you're raising capital, your business may need to register the investment with the Securities and Exchange Commission (SEC).
• Small businesses may qualify for exemptions, such as Regulation D, which allows certain private fundraising without full SEC registration.

✅ State “Blue Sky” Laws

• In addition to federal laws, each state has its own securities laws regulating investments.
• If you’re taking money from investors in different states, you may need to comply with multiple sets of laws.

✅ Why It Matters:

• Failing to follow securities laws can result in hefty fines, legal action, or even criminal liability.
• Recommendation: Work with an attorney to ensure you’re raising funds legally and      qualifying for applicable exemptions.

5. Be Transparent About Risks

Investors need to be fully informed about the potential risks of your business. Transparency prevents misunderstandings and legal disputes.

✅ Private Placement Memorandum (PPM)

• A PPM is a legal document that outlines your business’s financial health, potential risks, and investor rights.
• While not always legally required, providing a PPM can help protect you from fraud allegations if things don’t go as planned.

✅ Financial Disclosures

• Investors will likely want to see financial statements, revenue projections, and      business plans before investing.
• Inflating numbers or failing to disclose liabilities can lead to legal trouble.

✅ Why It Matters:

• Misleading an investor, even unintentionally, can result in lawsuits or loss of trust.
• Recommendation: Be upfront about the risks and challenges your business faces.

6. Plan for the Long Term

Taking on investors isn’t just about securing money—it’s about forming a long-term partnership.

✅ Control & Decision-Making Power

• Some investors are hands-off, while others want to be actively involved in operations.
• Make sure you’re comfortable with the level of influence your investors will have.

✅ Investor Expectations

• Investors may expect rapid growth, profitability, or an eventual sale of the company.
• If your goals don’t align, conflicts may arise down the road.

✅ Why It Matters:

• An investor who pressures you to grow too quickly or take on unnecessary risks could harm your business.
• Recommendation: Choose investors who align with your vision, not just those offering the most money.

Final Thoughts

Taking on investors can be a game-changer for your business, but it comes with legal responsibilities and long-term consequences. Before moving forward, consult with a business attorney to ensure you’re structuring the investment correctly and protecting yourself from future conflicts.

If you’re considering bringing on investors and need legal guidance, schedule a consultation today to ensure you’re making the right legal moves for your business!

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This article is a service of Dolev Law, a Personal Family Lawyer® Firm. We don’t just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That's why we offer a Life & Legacy Planning Session,Ⓡ during which you will get more financially organized than you’ve ever been before and make all the best choices for the people you love. You can begin by calling our office today to schedule a Life & Legacy Planning Session.

The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer® firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own separate from this educational material.