Preparing For Your First Investor

Cliff Ennico
Mon, 15 May 2023 21:00:00 -0700
Lifestyle

"We set up a limited liability company last year for a tech business. There are three of us; one of us acts as 'managing member' and the other two vote only on important decisions. We have never had a written agreement for our business.

A wealthy individual has indicated an interest in investing in us, and our accountant is telling us we need to 'clean up our act' and adopt a more formal agreement before we let this person invest in our business. Do we really have to, and if so, what exactly must we do to 'clean up our act'?"
Updated: Tue May 16, 2023

"We set up a limited liability company last year for a tech business. There are three of us; one of us acts as 'managing member' and the other two vote only on important decisions. We have never had a written agreement for our business.

A wealthy individual has indicated an interest in investing in us, and our accountant is telling us we need to 'clean up our act' and adopt a more formal agreement before we let this person invest in our business. Do we really have to, and if so, what exactly must we do to 'clean up our act'?"

Yes, you have to. Investors are not looking to join families or communes. They are looking to get a return on their investment over time, and they want to know exactly where they stand. You will need to hire an attorney and put together a formal operating agreement (similar to a partnership agreement) for your LLC.

Here are some of the provisions I would put into that agreement:

A "Board of Managers": When investors come on board, it's time to separate the "worker bees" from the "money bees" in the organization. Your agreement should establish a "board of managers" (similar to the board of directors for a corporation) and give the board nearly dictatorial powers to run the business. The members (owners, like shareholders in a corporation) should do as little as possible.

Your managing member can be the sole manager for starters, but it might be better to have all three of you as managers. The reality here is that the three of you are running the business as partners, and you want to preserve that. You always want to have an odd number of board members so there are no "tie votes" that have to be broken and could lead to "deadlock."

Three Classes of Equity: Right now, you have only one class of LLC membership interest. That will have to change before you bring an investor on board.

Your LLC should have at least three classes of equity: a class of voting preferred equity, a class of voting common equity and a class of nonvoting common equity (known as "profits interests").

If your company liquidates, dissolves or goes out of business at some point, the holders of preferred equity get their money back before anyone else does. This is the class of equity your investor probably will want. DO NOT specify the terms of preferred equity in the agreement — leave that to be negotiated between your investor and the board of managers.

The three of you would hold voting common equity (similar to common stock in a corporation). If your company goes out of business, the three of you would split whatever is left over after the preferred equity investors get what's coming to them.

The nonvoting common equity is for "worker bees" you bring on board in the future. Once you have an investor in your company, the company has a value, so anybody you give equity to in the future must either (a) contribute cash for their equity or (b) pay taxes on the value of the equity at the time they receive it. For example, if your investor puts $100,000 into your company, and the next day you hire a programmer and give her 2% of the company as a "sweat equity" incentive, she will have a $2,000 tax liability at the end of the year.

"Profits Interest" Language: To avoid this result, the nonvoting common equity must be treated as a "profits interest" for tax purposes. This means the holder pays taxes only on any increase in the company's value from the date she acquires it, not her entire percentage interest in the company. Make sure your lawyer puts language in the agreement saying that all nonvoting common equity will be treated as "profits interests."

"Tag-Along" and "Drag-Along" Rights: If your investor owns less than 50% of the company, you will need these provisions in your agreement. A "tag-along" clause says that if the majority owners of the company (you) decide to sell their equity at some point, they must give the minority owners (your investor) the chance to sell their equity at the same price. A "drag-along" clause is similar except that the minority owners MUST sell their equity at the same price.

A "Pre-Emptive Rights" Clause (Maybe): If after bringing your investor on board you decide to issue equity to another investor (or launch a venture capital round if you are really successful), a "pre-emptive right" allows your investor to buy additional equity in your company at the same price you offer subsequent investors in an amount sufficient to maintain his percentage ownership in the company.

Putting this clause in the agreement will make your investor happy, but subsequent investors may not like it. I would leave it out unless your investor makes it a "deal point" in the negotiations.