Investment Structures in a Business Transaction

By Gary R. Pannone

July 17, 2020

The process of negotiating an investment opportunity is oftentimes intimidating for first time investors or entrepreneurs. The business jargon is confusing, while the terms and conditions vary for each investment. The non-equity investment terms will vary from lender to lender, which requires careful examination by an accountant or lawyer. The transaction’s specific terms, which include interest rate and principal amount of the loan, will depend upon how the lender evaluates the borrower’s credit history, as well as the industry in which the business is competing. The terms of the loan may include warrants or options if the borrower is a start-up, and the amount of collateral required for the lender to make the loan will depend upon the size of the loan or repayment terms. Many loans will include financial covenants such as debt service coverage ratios, which are included to provide leverage for the lender in monitoring performance.

Another non-equity form of financing is crowdfunding, which is another form of debt obligation. This type of financing provides the lender(s) with a way to assess market potential for the product or services. The entrepreneur seeking financing through this mechanism must carefully examine the fee structure, the length of the campaign, what happens if the entrepreneur doesn’t deliver the service or product or the investor does not deliver the funding.

In addition to debt financing, the investor and entrepreneur will consider equity financing in the form of common stock, convertible preferred stock or convertible notes. When considering equity ownership as the vehicle, it will be necessary to determine the total number of shares to be issued, percentage of the authorized shares to be issued and the value of each share. Equity financing also requires the entity to create bylaws while the investors and founders execute a shareholder agreement, which will outline the rights and obligations of the shareholders. The shares may have a vesting schedule that must be carefully analyzed in order to protect the investment and founders.

If convertible preferred stock is the strategy for funding a start-up, the parties to the transaction will be required to consider and resolve many issues, such as those that will impact liquidity and potential dilution or restrictions to the founders leaving during a critical path of the company. Those who purchase convertible preferred stock may also want board seats for the investors in order to monitor the founder’s performance and protect their investment.

The most flexible form of equity financing is the use of convertible notes often used with start-up companies. When using this vehicle, the parties must decide when the note may be converted from debt to equity, the conversion price or discount rate, and how the discount rate or valuation cap will affect the entrepreneur’s ownership interest if the stock price is valued higher than anticipated.

Negotiating the investment deal can be intimidating to the beginner; however, with proper guidance by counsel and an accountant, the process becomes more routine and manageable. Both sides must work toward finding an investment solution that is fair to the entrepreneur while providing a return on the investment to those financing the entrepreneur’s effort to make a product or provide a service that is scalable. For more details about investment structures in a business transaction or other business matters, please contact  PLDO Managing Principal Gary R. Pannone at 401-824-5100 or email gpannone@pldolaw.com.

Disclaimer: This blog post is for informational purposes only. This blog is not legal advice and you should not use or rely on it as such. By reading this blog or our website, no attorney-client relationship is created. We do not provide legal advice to anyone except clients of the firm who have formally engaged us in writing to do so. This blog post may be considered attorney advertising in certain jurisdictions. The jurisdictions in which we practice license lawyers in the general practice of law, but do not license or certify any lawyer as an expert or specialist in any field of practice.

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