The law treats corporate shares, limited

partnership interests, and (usually) passive LLC membership interests as securities.

Federal and state securities laws regulate the issuance of these securities to investors. This means that before you sell equity to an investor, you’ll need to learn more about securities laws requirements. Fortunately,

there are generous exemptions that normally allow a small business to provide a limited number of investors an interest in the business without complicated

paperwork.

 

In order to accommodate equity financing,

two things have to happen:

1. You must convince the investor you

have a worthwhile enterprise

 

2. You must have a business entity that

can accommodate investment— that

is, you must do the paperwork with

your partnership, limited liability

company, or corporation to officially

grant ownership interests to investors.

 

Corporations are the ideal means for

making an investment. Shares can be

issued to reflect ownership interests, and

state laws provide for different level of

stock ownership— for example, nonvoting

and voting shares.

 

In general, when it comes to investment,

there is something about owning

speculative stock in a real corporation

that appeals to the adventurous capitalist

in most of us.

 

But isn’t forming a corporation a little too

pretentious for an invention? No, it isn’t.

Corporation law facilitates the formation of

very small, liberally regulated corporations

in most states, and the regulations allow for

the sale of stock or other form of financial

participation without a lot of complication

and restrictions.

 

How does one go about setting up a small corporation?

Start with a lawyer who specializes in setting

up small corporations. Call several lawyers, and

ask if they have specific experience in setting

up corporations. You don’t want a lawyer who works

mainly with large corporations. The objectives,

regulations, and advantages of large, as compared

to small, corporations are distinctly different,

and lawyers who work only or mainly with large

corporations likely will be more expensive and

may not be very dedicated to handling the “small

potatoes” corporation like yours. When preparing

to distribute shares,

deal with an attorney who is savvy about

small business setups. You should not

distribute shares in your company without

a good understanding of how this

will affect your ability to attract investors

in the future. The generous inventor who

sells too much stock to his relatives at

bargain prices will find, later on, when

he or she needs serious capital, that the

angel will not be interested.

Your corporate attorney should advise

you on this

 

You can also contact SCORE (Service

Corps of Retired Executives) through the

Small Business Administration and ask to

have free counseling from a retired investment

banker, not a regular banker. You

may even find your attorney through

SCORE. The advice should be free, but

you’ll have to pay attorney fees for setting

up your corporation. A retired attorney

should be less expensive than one in

current practice. Also contact the SBDCs

(Small Business Development Centers) in

your area.

 

Abiding by Securities Laws

 

Dividing the Pie With Strategic Partners

 

Probably the most important question that arises when granting equity to strategic partners is what percentage of the shares of the company the inventor should grant to each partner.

 

There is one simple answer to this question: As little as possible while still respecting the profit motive of the investor.

Here is my reasoning: If you give up a big chunk of stock to early partners, you almost certainly won’t be able to attract the right capital later on. Thus, when your product is ready to “roll out,” you will be severely handicapped by not having sufficient finance, and your enterprise

will remain “small potatoes,” that is, an interesting little business that could have made it big. This is especially true if your product has enough profit potential

to attract competitors that may take

 

 

Carried to its extreme, you might

believe that an offer of one percent of

your company is fair. Not so. An offer of

one percent would likely insult the intelligence

of any potential strategic partner

and kill any deal before it got beyond

the exploratory conversation. True, one

percent of General Motors would make

anyone rich beyond imagination, of

course. But your invention isn’t a Chevrolet,

and none of your potential partners

is going to wait several decades until

compounding growth makes them enormously

rich.

 

 

Ten percent of a startup company is

the kind of minimum talking figure that

might attract me if I were a designer or

patent attorney. But only if that ten percent

were in some equitable relationship

to the amount of stock you claimed for

your own, as the founder, and for the

other partners. Ideas are like flies at a

garbage dump. A raw idea is essentially

worthless until it matures into an invention

that has physical form, such as a

prototype, or at least a credible design

on paper or computer screen, and is

judged as patentable by a patent professional.

Perhaps the “idea person” is

entitled to significantly more than the

other main partners because he or she

has not only dreamed up the idea but

also is orchestrating the venture and will

act as the prime mover to its conclusion.

 

 

But if I were the only partner (let’s say,

again, the designer) with ten percent, and you

wanted to hog ninety percent, I’d probably tell you to get lost.

 

A rationale that makes some sense, at least to me, is this: The entrepreneur is both inventor and orchestrator and is entitled to at least twice the shares that any other individual partner receives, but no more than five times. (This assumes that your are engaging highly competent partners who will be an ongoing asset to your corporation.) You must ask yourself

what are the limits of resentment from the other partners, as well as what appears most enriching to you.

 

Angels (the independent investors I will discuss in Chapter 9) are somewhat unpredictable when it comes to the percentage of stock that they will demand in exchange for finance. Some angels will want 51 percent so that they can control the company and kick out any partners who are not effective (or even kick out some who are effective in order to kick in their own people). Other angels will want a substantial chunk, but not control, preferring that the control, and the burden of succeeding, remain with the entrepreneur and his or her strategic partners. Thus, it seems prudent to never yield more than a total of 49

percent except in the most desperate

circumstances. In other words, you and

all of your partners should hold at least

51 percent forever, if possible. (The

more successful you become, the less

likely you’ll be able to hold onto that 51

percent. Not necessarily a bad situation.)

 

The mechanism for “dividing the

pie” is that of issuing stock or shares.

For example, suppose you start out with

a declaration that your corporation has

100 shares. These shares represent its

total value at the time you incorporate.

The true value may be nothing or even

negative at this time, but that’s not the

point. Now, you take in three equal

partners who are each given 10 shares

in exchange for their contributions. You

hold 21 shares. The remaining 49 shares

are held “in the treasury,” which may

be only an envelope in your milk-crate

file at this time. This is an example of

the humble beginning of a corporation

that at least has defined who owns how

much.

 

I’m not saying here that this is the

best way to set it up. You need expert

advice from an attorney and perhaps an

accountant when the time comes to divide

your equity. But the principle I have

illustrated is sound. If you want me as a

partner, and I have a declaration signed

by you that says you own twice as much

as I do (plus 1 percent), I am going to

sense the fairness of this arrangement

and may be satisfied.

 

Such declaration may be a “pre-stock memorandum”— a letter addressed to me that states that when stock is formally issued, my shares will be half as much (adjusted for the 1 percent) as yours, and so on. Again, get legal advice before issuing any pre-stock memoranda.

 

Okay, that’s a reasonable starting point. Now, how much should you, personally, hold if you have done quite a bit of research and development work? Let’s say that you are so woefully lacking in “seed money” (the money it takes to get the venture to the point where you are ready to attract an angel investor) that you decide to attract the following strategic partners: designer, prototyper, patent professional, manufacturer, and marketer. That’s stretching things pretty thin, of course. But it could be done.

 

answered is which of the persons or companies performing these vital functions

should be welcomed as strategic partners, and which should be hired for pay. The easy answer is to pay them all and take in no partners, but this violates our scenario of the inventor who does not have sufficient seed money to get through the requisite steps prior to attracting serious capital from an angel.

 

Probably

the fairest way is to solicit price quotes

from each potential contributor before

proposing the idea of exchanging stock

for work. Then, divide the pie according

to the monetary equivalent portion of

each contributor.

 

How about you? Do the same thing

for yourself. Assign a value to your time

based on the skill level demanded, and

add in something for having the idea or

thinking up the invention so that you

come out with a slice of the pie that

will sound reasonable and fair to the

 

other partners. The factor by which you multiply the typical or average of the partners in order to assign your own share depends also on the level to which you have taken the development of your invention and the number of partners. For example: If you have only one partner,

let’s say a marketer, and you want 41 percent as against the marketer’s 10 percent (for a total of 51), the 41 is a much larger portion of the total than if you have three other partners, each at 10 percent, and you are only taking 21 percent.

In the latter case you, the inventor, are only taking one-fifth (plus a bit) of the whole. You appear less greedy as a one-fifth owner of your own invention.

 

 

How Much Equity Does an Angel Want?

Angels want a piece of your business—

usually represented by corporate shares.

According to Osnabrugee and Robinson

(Angel Investing: Matching Start-Up

Funds With Start-up Companies (JosseyBass)),

on average, angel investors

typically receive 21% equity in the businesses

in which they invest. However, of

course, an angel who wants to control

the business will seek a majority stake.

 

The actual amount an angel wants from your company depends on how much the investor is placing into the business and how your invention business

is valued. Typically, the investment

equals a percentage of the business value. So, if your invention business is valued at $100,000, an angel would, as a very general rule, expect to pay $25,000 for a 25% ownership interest.

 

 

Obviously, there are a few challenges here. One is to determine the appropriate

market value for your invention business— a difficult task considering the speculative nature of many inventions, especially inventions that have not yet been market-tested. Another challenge is not only to determine what the company

is worth at the time of investment,

but also to consider its value at the time when the angel plans to cash in— for example, the value of the company when it is sold in five years.

 

 

But keep in mind that the investor

is going to be looking for a return

between 20% and 50% annually. So, if

an investor puts in $250,000 for a onequarter

interest of a business valued at

$1,000,000 and expects to cash out in

five years with a 40% per year return,

your business would have to be worth

$5,400,000 in five years in order for the

angel to receive $1,350,000 (a 40% return

on $250,000 over 5 years).

 

Also, angels may want more than an ownership interest. They may want management power, a right for future financing— for example, to buy more shares at a fixed price or to prevent their ownership rights from being diluted—

and/ or some degree of control over the venture. Making these decisions may be beyond the skill of an inventor.

Seek advice when you are asked to make concessions such as creating voting

classes, ceding control or power to board members, or granting management control, particularly if you intend to keep a majority interest and control over the board.

 

 Don’t conceal, lie, or exaggerate

about the investment opportunity.

Always provide potential investors

with everything that is available

for them to make a knowledgeable

decision. When in doubt, disclose,

disclose, disclose.

 Don’t make public advertisements

of your investment opportunity.

 Don’t accept investments (or any

payment for interest in your invention)

unless the transaction is

exempt from security registration

 

requirements. If in doubt, speak with an attorney.  Do include the following notice on all solicitations, business proposals, and business plans: “Investing in this enterprise involves considerable risk and should not be done unless you are prepared to lose the complete

investment. Estimates of projected income or revenue are speculative, and this company does not presently have the capital required to meet such projections.” You can learn more information about SEC exemptions at the SEC website (www. sec. gov). A quick way to research

your state’s exemption rules is to go to the home page of your state’s securities agency, which typically posts the state’s exemptions rules and procedures. To find your state securities agency, go to your Secretary of State’s website.

 

 

 

 

 

 

 

 

source: nolo.com