Investing in a small business can be rewarding but also risky. When structuring an investment in a small business, there are several key factors to consider in order to protect your interests as an investor. First, you need to understand the capital needs of the business and negotiate an investment amount and valuation accordingly. It’s also crucial to define your rights through a shareholder’s agreement spelling out voting rights, information rights, exit strategy, and other terms. You’ll want representation on the board of directors proportionate to your stake. It’s wise to tie founder and management compensation to milestones and vesting schedules. Lastly, you must conduct thorough due diligence on the team, product, market, financials, and legal structure. With the right deal structure and protections, investing in a promising small business can lead to excellent returns.
Assess the capital needs and negotiate investment amount
The first step is to understand how much capital the business needs and what milestones that investment will help achieve. This will inform the valuation and amount you are willing to invest. Founders may ask for more than truly needed, so scrutinize financials and projections carefully. Negotiate an investment level that meets the business’s near-term needs while leaving room for additional rounds. Structure the deal to Close when mutually agreed milestones are met.
Define shareholder rights and voting control
To protect your interests as an investor, the shareholder’s agreement should spell out information rights, voting rights, board seats, liquidation preferences, pro rata rights, drag-along/tag-along rights, and other terms. Information rights allow access to financials and other documents. Negotiate voting rights and board seats proportional to your stake. Liquidation preferences provide downside protection. Overall, the agreement outlines rights, processes, and recourse if things go sideways.
Tie founder/management compensation to milestones
Founder and management compensation should be structured to align incentives with the investor’s interests in seeing the business succeed. vesting schedules, whereby founders earn their stock over 3-4 years, ensure continued commitment. Tying significant portions of compensation – bonuses, exits, etc. – to milestones prevents excess payouts before value is created.
Conduct due diligence on all aspects of the business
To make a sound investment, scrutinize all aspects of the business through a due diligence process. Verify financials and projections. Vet the team for skills, experience, and character. Assess the product or service’s competitive advantages. Size up the market and growth potential. Inspect legal documents and cap table. Identify risks and make contingencies. Utilize legal, financial, and industry experts. Don’t rely solely on information provided by the company.
Key steps in structuring an investment include sizing the amount based on capital needs, negotiating investor rights, linking pay to milestones, and due diligence. Taking these precautions when investing in a small business provides downside protection in case of problems and aligns incentives to drive growth and returns.