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Mainstream business investment advice usually tells us this: A business owner seeking investment capital should go out and look for investors, then once they’ve decided they’d like to invest, those investors set the terms of the offering.
What does this mean for the business owner over the next five to 10 years? Often, it means the owner has little to no control over what their own business looks like and that they are beholden to the terms set out by the people holding the purse strings.
If you are a business owner and this sounds unappealing to you, I have good news: Business owners can 100% set their own investment terms — defining how the investment is structured and what the relationship looks like — then go out and find the values-aligned investors who believe in their business and want to help it grow.
What’s the catch? Well, for Option B to work for you, you need to put in the work to create your own outside-the-box investment offering. That means building the knowledge, team and expertise to structure the right investment offering for your unique goals, values, plans and projections.
Fortunately, I specialize in just this kind of work, and in this article, I am going to share with you the basic information you need to know to get started on this process.
Defining “investment”
“Investment” is a vague term that simply means someone is giving someone else money with the expectation that, by some means, they will get their money back, plus some extra on top. Investments can happen in several ways: An investor could lend business money, which is called a debt investment.
They could buy a piece of the company, which is called an equity investment. Or they could buy some kind of a convertible instrument that starts as one thing and then later converts into something else. It’s important to define the terms of the investment people are making in your company.
Who should define the terms of the investment?
Given that there are so many ways to structure an investment (literally an infinite number of ways), who should decide what the investment terms will be? To be honest, I’m always surprised by how many entrepreneurs will talk to investors without having clarity about the terms they’re offering and are willing to accept.
I think it’s because business owners are often told not to worry about the terms because the investor will decide how they will invest in your business. But that’s not a very good idea because the way someone invests in your business has a huge effect on the likelihood of success of your business, the likelihood that you’re going to have a good long-term relationship with your investors and whether the entire partnership goes smoothly or goes off the rails.
I believe the investment terms should be determined by the company founders, not by an investor, because the founders know best what will be most aligned with their vision, mission and goals. This is why I work with my clients to create their own investment offerings, designed to fit exactly what is right for the company.
Related: Stop Competing on Price — Compete on Value
Debt vs. Equity
One fundamental decision to make about the type of investment you’re going to offer is whether it will be a debt or equity investment. With a debt investment, someone is lending you money you agree to pay back with interest. Pros of a debt investment include that it can be easier to document and understand; investors may perceive it as less risky as debt repayment typically takes priority over payments to equity investors; and you don’t give up any ownership of your company. Cons of a debt investment include that it can look bad on your balance sheet and therefore prevent you from getting other loans; it must be paid back to prevent a default; and payments generally can’t be delayed for too long, or there is a risk that the IRS could recharacterize it as equity.
An equity investment means an investor is purchasing an ownership interest in your company. Equity must be “priced,” meaning you and the investor agree upon a certain dollar amount per share of your company in what is known as a “priced round.” If you are not planning on a venture capital-type investment dependent on a future sale at a higher valuation than the investor bought in, the value you set is not that important.
Pros of equity investments include that equity generally doesn’t have to be repaid, and it looks good on a balance sheet. Cons of equity investing include that you are giving away some rights of your company, and equity investing can be more complicated to document and understand.
The standard venture capital investment model is a type of equity investing that, in my opinion, is not right for most businesses. Yet many lawyers and business financial consultants recommend it as a one-size-fits-all approach. With the venture capital model, an investor buys a piece of your company at a certain price with the expectation that within five to seven years, you will sell the company to a larger company for at least ten times the value. It is quite difficult for most companies to grow that fast in that short of a time, so pretty much every aspect of the company must be dedicated to rapid growth at all costs following this type of investment.
However, there are many other ways to structure an appealing equity investment offer that does not require the sale of the company for the investors to get paid.
Related: Investors Can Safeguard Their Money By Focusing on One Crucial Step
Defining terms
If you’ve ever raised money or looked into raising money, you’ve probably heard about “term sheets.” A term sheet defines the details of an investment, including the investor’s right to receive payments and the investor’s voting rights, if any. While a term sheet is not required to seek investments, it is a useful tool when raising money outside the VC model because it enables you to describe exactly what an investor will get when they invest in your business.
Once you’ve decided between equity and debt, you can describe the details in the term sheet.
You’ll want to decide whether to offer dividends for an equity investment. Dividends are a way investors can get paid without you selling your company. Dividends are paid to investors when a company becomes profitable. Once the company starts to become profitable, some of the profits are paid out to investors in the form of dividends.
Another element to consider including in an equity term sheet is a “liquidation preference.” A liquidation preference outlines what happens if you sell the company or go out of business. There are many ways to structure a liquidation preference, and you can decide what you want that to look like: What would the investors get in the case of a sale? What would you get? For example, I have some clients who don’t want to be pressured to sell their company, so they set up the liquidation preference to say that if they were ever to sell the company, the investor could only get back what they originally put in and nothing more — discouraging the investor from pressuring the founder to sell.
A third thing to consider putting into an equity term sheet is “redemption options.” This is another way someone can exit from their investment without you having to sell the company. Redemption happens when someone who has made an equity investment in your company exits from the investment by selling their stock, or equity, back to the company. Again, there are many ways to structure it so you can buy the investor out over time.
If you decide to offer debt, there are also lots of options. For example, you can structure a revenue-based debt instrument that provides for a quarterly payment to your investors that varies based on your company’s revenues.
If you decide to offer a convertible instrument, it is up to you what triggers the conversion, e.g., from debt to equity. For example, maybe the conversion happens when your business reaches a certain level of gross revenue.
These are just a few of the terms you can consider including in your term sheet and which ones you choose, and the details of the provisions will be determined by your specific situation.
Related: 6 Steps to Finding the Right Investors for Your Business
What investors want
While the technicalities of what you offer an investor are critical, values-aligned investors also typically have other considerations when determining whether to invest in your business. For example, your ideal investors will want to support the outcomes or impact your company is having, whether on your community, employees or the planet.
Investors may also be looking at the risk involved with the investment — how likely they feel they are to get their money back. If an investor knows you and believes in your capabilities and dedication to the company, they may be more likely to invest (they may be tired of investing in faceless Wall Street companies whose managers often seem to care more about short-term profits than the long-term interests of their investors and other stakeholders).
When speaking to potential investors, first make sure that they are values-aligned and passionate about your company’s mission. Once that is established, show them your customized term sheet and explain the thinking behind it. Your investors will likely be impressed that you took the time to design your investment terms based on your plans, goals and values rather than pulling a cookie-cutter document off the shelf. If you’ve taken the time to design your terms thoughtfully in a way that creates the greatest likelihood of the long-term sustainability of your company, a reasonable return for investors, and a positive impact on people and the planet, there will be investors who will enthusiastically say yes.
In conclusion
A lot more could be said about crafting an appealing values-aligned investment offering, but it all boils down to putting in the work to define what you want out of the investment and design terms that align your goals with those of your investors while being realistic about what is possible. Once you have your customized term sheet, you can begin to connect with values-aligned investors with confidence.
This story originally appeared on Entrepreneur
