Every investor has her personal requirements and every deal is different. The important thing is that both parties understand the risks and think it is a good deal. Here are some suggestions that have worked well for others in situations where the potential investors weren’t well acquainted with the entrepreneur. Obviously, if your investors are family members, close friends or people who wish to support your business for political or personal reasons, they may be willing to accept a lower rate of return.

Should You Guarantee a Return?

Very few investment proposals offer the investor any guarantees. Nevertheless, some equity investors want a guaranteed return in addition to a share of the profits. If you guarantee a return, you will pay back the original investment plus a profit on the investment, even if the deal goes sour. Doing this is great if the project makes the profit you think it will. But it’s a risk for you since you’ll have to get the money to pay off the investor from some other source if your business fails. If you are willing to guarantee the repayment and the profits, you may be able to get an investor to accept the return of her investment plus a reasonable profit of 20% or 30% on her investment, within a year or two time frame. Most entrepreneurs with the ability and assets to offer a guarantee can secure financing at a lower cost from more conventional sources.

Perhaps they can pledge their assets for a straight bank loan or sell their assets and obtain money that way. If you are starting a new business and do not plan to guarantee the return of the investment, you’ll almost always need to offer investors a high possible return. If you don’t put up any money, investors may expect as much as 75% of the profits. You, the promoter, may get as little as 25% of the profits plus a reasonable salary for your work to make the project go. Of course, it is rare that a person who starts a business doesn’t invest at least some of his own money, so the investors’ percentage would normally be adjusted downward. Another alternative for a start-up business where investors bear the entire risk of loss is for the founder to work in the business on a daily basis and receive a small wage as a project expense. The first profits are used to pay back all the money advanced. Profits are split on an agreed percentage. If the investor puts up all the money, this might be 50/50; if the investor puts up less, his share should also be less. Sometimes these profit splits terminate after a specific number of years, and sometimes they continue indefinitely.

Occasionally, the parties agree on a formula to establish a price for which one party may buy out the other party in the future. If you’re expanding an established business, the returns can be adjusted toward normal bank loan rates if the expansion appears conservative. Investment profits will have to be considerably higher than bank rates if the project appears risky. The main thing that increases risk for an established business is changing its normal course of business. For example, an established employee leasing company that plans to expand its receivables in the face of increasing demand is more conservative than the same company that plans to open a new office in another state. It’s a higher risk if the same company plans to enter a completely new line of business, such as management consulting.

b. Legal Forms of Owning Equity Investments An equity investor chooses among three options in sharing ownership in your small business. These are the only options available, even if the consideration for the ownership share is something other than cash, such as labor, materials and so forth:

•General partnerships. A general partner joins you in owning the business. He shares in your profits and losses in proportion to his partnership share. General partnerships work best when all partners work full-time in the business. Equity investors normally prefer not to become general partners, because they don’t want day-to-day involvement in your business. Also, by law, if the partnership loses money, the investing general partner must pay back part or all of the losses. Everybody has heard stories of partnerships that went sour, with dire consequences. These were usually general partnerships. If you are interested in forming a partnership, limited or general, or learning more about them, see The Partnership Article, by Denis Clifford and Ralph Warner (Nolo).

•Limited partnerships. This arrangement is a form of business organization under which you as governed by state and federal regulations. What are the advantages of a limited partnership to you as the entrepreneur? First, investors are more likely to invest in your project when their liability is limited to their investment. Second, you’ll be the sole boss of your business—no one else will have a say in the details of its operations. The major disadvantage of this form of ownership is that the general partner, normally you, is personally liable for all the partnership debts and lawsuits. That’s why most businesses form as corporations, which limit the personal liability of all owners.

•Corporations. One of the most popular methods of selling equity investments is to form a corporation and sell shares of stock. The shareholders’ potential losses are typically limited to the purchase price of their shares. A corporation is a legal entity that is separate from you. You form a corporation by paying fees and filing forms at a state office. A corporation lets you keep management control of the business; as long as you retain 51% of the shares of stock, you can call the shots. How much people are willing to pay for your stock depends mostly on what they think of your prospects. If you have a firm, exclusive contract to sell a popular, new type of computer peripheral and only need money to build a showroom, potential buyers will probably find you. However, if you’re trying to build a factory to mass produce a new and relatively untried type of pooper scooper, you will almost certainly have more difficulty. If you conduct business in a legal and ethical manner, the corporation can shield you and your shareholders from personal liability for business losses. However, officers and directors of a corporation can be held personally liable for any corporate acts that break the law or breach their duty to the shareholders to act responsibly.

Warning

Lenders and landlords normally require that corporate officers personally guarantee any loans or leases that the corporation enters into until it has a several-year track record and a strong financial position. So, you can expect to be held personally responsible for company debts even though you form a corporation and are protected from routine business losses.

Corporations and Red Tape Corporations bring several complications—but most entrepreneurs consider the costs and inconvenience a small price to pay for the ability to raise the capital they need. I only summarize a few issues here:

•Recordkeeping in corporations. Keeping your shareholders informed and your corporation in good standing means that you have to perform certain legal acts and pay various taxes and fees. It’s more complicated and expensive than doing business as a sole proprietor.

•Taxes and corporations. You can take money out of your corporation in only two ways: salaries rates.

•Selling shares in your corporation. Both federal and state regulatory authorities have many rules and regulations governing sales of corporate shares or limited partnership interests. The bottom line of all these regulations is this: You can’t take any money into your venture until you comply with the appropriate rules. These rules try to protect investors from crooks and con artists and also try to make it relatively easy to raise money for legitimate ventures. Before selling any security, or soliciting for the sale of any security, make sure you have complied with the appropriate regulations. (See Section F8, below, for a short discussion.)

3. Loans and Equity Investments Compared To raise money for your new business, you must decide whether you prefer to borrow money or sell part of your project to an equity investor. Often, you may not have many options. The person with money to lend or invest will obviously have a lot to say about it. But you should know the trade-offs you normally make by preferring one to the other:

•Loan advantages. The lender has no profit participation or management say in your business. Your only obligation is to repay the loan on time. Interest payments (not principal payments) are a deductible business expense. Loans from close friends or relatives can have flexible repayment terms.

•Loan disadvantages. You may have to make loan repayments when your need for cash is greatest, such as during your business’ start-up or expansion. Also, you may have to assign a security interest in your property to obtain a loan, thereby placing personal assets at risk. Under most circumstances you can be sued personally for any unpaid balance of the loan, even if it’s unsecured.

•Equity investment advantages. You can be flexible about repayment requirements. Investors sometimes are partners and often offer valuable advice and assistance. If your business loses money or goes broke, you probably won’t have to repay your investors.

•Equity investment disadvantages. Equity investors require a larger share of the profits. Your shareholders and partners have a legal right to be informed about all significant business events and a right to ethical management; they can sue you if they feel their rights are compromised. Loans are better for businesses if the cash flow allows for realistic repayment schedules and the loans can be obtained without jeopardizing personal assets. Equity investments are often the best way to finance start-up ventures because of the flexible repayment schedules. If you don’t already know an accountant specializing in small business affairs, you will be wise to find one. Your personal tax situation, the tax situation of the people who may invest and the tax status of the type of business you plan to open are all likely to influence your choice.