In our five-part series on Starting Your Business, we have discussed considerations to be made when selecting your entity type, establishing governance structures in your business, and issuing equity to owners and employees. In the final blog in this series, we will now explore issuing equity to investors.
For small and closely held businesses, bringing on investors can be a valuable way to finance growth, scale operations, and fund new projects. Equity investment, however, introduces complexities, especially when dealing with different types of investors and business structures. Whether a business operates as an LLC or a corporation, the decision to issue equity requires an understanding of SEC regulations, investor obligations, and structuring options that align with the company’s long-term vision.
This blog explores essential considerations for issuing equity to investors, including SEC compliance, obligations to various investor types, and key distinctions between LLCs and corporations in equity offerings.
Why Issue Equity?
For businesses looking to grow without taking on debt, issuing equity can provide the necessary capital while sharing the risk with investors. In exchange for a percentage of ownership, investors provide funding, strategic advice, and potentially valuable connections. Equity investors, particularly those who take an active role in the business, often have an interest in helping the company succeed beyond simply recouping their investment.
Equity issuances to investors, however, involve regulatory requirements and obligations to each type of investor that need to be managed carefully.
Types of Equity Investors and Their Obligations
Understanding the types of investors a business may attract is crucial to structuring the equity offering and managing expectations. The following are common investor types in small or closely held businesses:
In-Kind Investors:
Overview: In-kind investors provide goods or services instead of cash in exchange for equity. This may include a skilled advisor, consultant, or partner who offers services critical to business growth.
Obligations: The business must clarify and document the value of the in-kind contribution, ensuring fair valuation to avoid tax implications or shareholder disputes. Additionally, agreements should specify performance expectations or minimum service levels to ensure the investor’s contributions align with business goals.
Angel Investors:
Overview: Angel investors are typically individuals or small groups who provide early-stage funding in exchange for equity. They may bring industry expertise or a network to help the business grow.
Obligations: Angel investors often seek updates on business performance and may have a seat on the board. Businesses should be prepared to provide regular financial and operational updates, particularly if angels have specific milestones they expect the company to meet.
Venture Capital (VC) Investors:
Overview: VC investors are professional investment firms that fund businesses with high growth potential in exchange for significant ownership. Venture capital usually involves larger investments and aims for high returns.
Obligations: VC investors typically require a substantial role in company governance, such as board seats, veto rights on major decisions, or an exit strategy within a set timeframe. Companies working with VCs should be prepared for intensive oversight and decision-making influence by investors.
Managing obligations to different investor types means customizing communications, financial reporting, and strategic involvement to suit each party’s needs while balancing business objectives.
LLC vs. Corporation: Structuring Equity Issuances
The legal structure of a business—whether as an LLC or a corporation—impacts how equity can be issued to investors.
Issuing Equity in an LLC:
Membership Interests: In an LLC, equity is typically structured as membership interests, which can be given in units or percentages. Membership interest comes with profit-sharing rights, and sometimes voting rights, depending on the operating agreement.
Profits Interests: Many LLCs issue “profits interests” to investors, which entitle the investor to a share of future profits without any claim to the current assets of the company. This can be tax-efficient, as it avoids certain income taxes on the initial grant.
Considerations for LLCs: LLCs must update their operating agreements when issuing equity to new investors, outlining rights and responsibilities. LLCs should also carefully structure distributions, as members will pay taxes on income regardless of actual cash distribution. Furthermore, for LLCs with more than a few investors, the pass-through tax structure may become complex.
Issuing Equity in a Corporation:
Common and Preferred Stock: Corporations offer both common and preferred stock, providing flexibility in structuring ownership tiers. Preferred shares, often offered to angel and venture investors, include dividend preferences, liquidation preferences, and voting rights.
Convertible Instruments: Corporations often issue convertible notes or SAFEs (Simple Agreement for Future Equity) to investors, allowing them to convert these instruments to stock at a later funding round or specified event.
Considerations for Corporations: Corporations are typically better suited for equity fundraising because of their straightforward stock issuance and ability to offer more investor rights. They are also more attractive to VCs, who prefer the structure and predictability of stock over LLC membership interests. C-corporations can also avoid the double taxation issue if structured carefully, but companies should plan for potential corporate tax obligations if they choose this structure.
SEC Compliance and Registration Requirements
When offering equity to investors, even small and closely held businesses must comply with SEC and potentially state regulations. Here are the primary SEC considerations:
Securities Act of 1933 and Securities Registration:
Any offer or sale of stock or equity interests constitutes a securities transaction under the Securities Act of 1933 and may require registration with the SEC. However, private companies often rely on certain exemptions to avoid public registration, including Regulation D and Rule 506(b) or 506(c), which allow private placements.
Regulation D, Rule 506: Under this exemption, companies can raise unlimited capital from accredited investors without SEC registration, but general advertising is limited. Rule 506(c) allows broader advertising, but all investors must be verified as accredited.
Rule 504: For businesses raising less than $10 million within 12 months, Rule 504 may provide a more accessible exemption, though offerings are subject to individual state registration requirements.
Disclosure Requirements and Reporting:
Even when exempt from registration, companies must provide certain disclosures to investors to avoid potential liabilities for fraudulent or misleading information. This includes financial statements, business risks, and information on the business model and competitive environment.
SEC rules require private companies that exceed certain thresholds (500 non-accredited or 2,000 total shareholders) to begin reporting similar to public companies. For this reason, closely held businesses often work with legal advisors to manage ownership numbers carefully.
State Securities Laws (Blue Sky Laws):
Equity issuances must comply with state-level securities laws, known as Blue Sky laws. These vary by state but often require companies to file notice or seek exemptions at the state level. Working with legal counsel familiar with both federal and state requirements can ensure compliance.
Steps for Structuring Equity Issuances
Choose the Right Structure for Your Business:
For businesses seeking broad investor appeal and scalability, a corporation may be preferable. LLCs, on the other hand, offer flexibility and tax benefits for a limited number of investors, though they may be less attractive to certain investor types.
Develop an Investor Rights Agreement:
Draft a clear agreement outlining voting rights, board representation, information rights, and buy-back provisions. Investors, particularly angels and VCs, will expect clear documentation of their rights and role.
Prepare for Disclosure Obligations:
Even under exemption, providing detailed disclosures about business risks, financials, and company performance builds investor confidence and minimizes liability risks.
Seek Legal and Tax Guidance:
Issuing equity to investors has significant legal and tax implications. Legal counsel can help navigate regulatory requirements, draft agreements, and establish buy-back provisions. Tax professionals can advise on structuring for tax efficiency, particularly regarding distributions and deductions.
Conclusion
Issuing equity to investors allows small and closely held businesses to raise capital and bring in strategic partners. However, structuring the offering requires careful consideration of SEC regulations, investor expectations, and the company’s legal structure. By working with knowledgeable advisors, business owners can create an equity issuance strategy that aligns with company goals, provides transparency, and fosters positive investor relationships. Whether as an LLC or corporation, businesses that thoughtfully manage these factors can create a solid foundation for future growth and investment success.
Contact Skufca Law at (704) 376-3030 today to learn more about issuing equity to investors and other questions related to starting or funding the operations and growth of a business.