Recently I have been receiving numerous thoughtful questions for my weekly podcast. At present, I am receiving far more questions than I can answer in the podcast format in a timely manner. The editorial management of Allbusiness suggested that I try and answer some of the questions here in my blog which I think is a great idea.
We received a question from a listener asking about investing in a small private company. Her question specifically concerned what sort of percentage of ownership she should receive for her investment. In her situation, she is contemplating investing $40,000 into a small business and has been told she will receive a 40% share of the company. Her concern is whether her percentage of ownership is reasonable.
I am going to try to answer her question the best I can, but I am also going to raise other issues that she should be concerned with. I am not an attorney and am not giving legal advice, nor am I registered by the National Association of Securities Dealers (NASD) to give investment advice. Anyone contemplating investment into a private company should seek appropriate counsel of an attorney or NASD registered representative.
Investing in a small business is extremely risky. The investor should be prepared to loose everything invested when they make the investment. I am not suggesting that any particular investment is bad, but I am suggesting that any money invested should be discretionary funds. Think about how much money you would be willing to loose if you went to
Understand your risks as a 40% owner. You may face risks associated with the activities of the company. For example, if the company is sued by a customer, you as a 40% owner should understand that you will likely be personally named in the lawsuit as well as the company and other owners. Other common risks are that all IRS trust taxes (payroll) are paid current. As an officer, director or owner (usually greater than 20%), you will be held personally liable for any payroll taxes not remitted to the IRS in a timely manner. So as an owner, you should always see proof that the IRS 941 tax forms are filed on time and that payments are made.
Personal Guarantees. Nearly all lenders will require personal guarantees of shareholders greater than 20% so if you become a 40% shareholder of this business and the business needs to borrow money, you will likely be asked to sign an unlimited personal guarantee. You will likely be jointly and severally liable for all obligations for which you guaranteed.
Corporate Structure. The legal structure of the entity should matter to a potential investor. There are tax consequences depending on the type entity. A sole proprietorship should be avoided because all funds can be co-mingled with the sole owner’s.
Documentation. The company should have a set of bylaws or operating agreement. The company should be in good corporate standing with the secretary of state of the state the company is chartered in. There should be a written agreement between the investor and the company being invested in. The written agreement should specify all of the expectations of both the investor and the company invested in. This would include use of invested funds, voting rights of the investor, etc. In many cases, state and federal securities rules and regulations require the investor to be “accredited.” Make sure there is a stock certificate issued in the investor’s name, which represents the ownership interest.
Valuation. An investor and the company being invested in should agree on the pre-money and post money valuation of the company. An investor should completely understand these terms before investing. There are a number of ways to determine pre-money and post money valuations and their formulas can be found numerous places on the Internet. The percentage of ownership is determined by the valuation and the impact of the dollars invested.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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EXTRA: If you have questions for Sam regarding business financing, the credit market, and similar issues, please send an e-mail. Your questions will be recorded and Sam will answer the best ones in his Ask the Expert podcast show.