Accepting Outside Investors? 5 Things to Watch Out for in Your Contract

As a business owner, accepting expertise and a big check from an outside investor may seem like a win for you and your business.

However, the truth of whether it’s truly beneficial depends on the contract you sign with that investor.

1. Structure of the investment

When small business owners consider an additional investor, they often mention an angel investor. However, they fail to discuss the various ways in which an investor can invest, which significantly affects the deal.

If you’re familiar with the TV show Shark Tank, you’ll notice two types of investor sharks: Mr. Wonderful and everyone else. While the other sharks typically make a traditional equity investment, Mr. Wonderful invests using Debt Securities With Warrants. This means he gets paid a portion of the overall revenue, regardless of the profit.

As a small business owner, the difference between an equity investor and a debt security investor is that the equity investor only gets paid if the business is profitable, whereas the debt security investor gets paid regardless.

If you’re considering a debt security investment, ensure that the terms are significantly better for you.

2. Preferred versus common shares

When someone invests in your business, they buy either common shares or preferred shares.

If the investor only gets common shares, you both have equal footing in decision-making and profit allocation based on the number of shares owned.

However, if the investor receives preferred shares, they have more control and a larger share of revenue, as preferred shares have different rules than common shares.

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For instance, they may have more votes per share or a higher profit share until their initial investment is paid back. They may also have additional rights like anti-dilution protection and liquidation preference.

It’s important to understand what the investor is getting and what you’re giving up in terms of control and profits.

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