If you have a business that will be taking others money in exchange for shares for your profits, you have many different types of options. The purpose of this article is to make you aware of some of these options, allowing you to make a more informed decision.
If you have a complicated company structure that allows bringing on and getting rid of investors often, you should take advantage of the structure of a Corporation. Corporations have stock and the rules governing stocks is understood well plus offer various benefits to investors.
What is an investor agreement?
Investor agreements generally cover any transaction that gives other people or businesses ownership interest in the company. This could be interest now or into the future and could be in exchange for anything of value such as cash, labor, an asset, and more. Some common types of investors agreements are:
- Stock Purchase Agreement
- Statutory Stock Option Agreement
- Restricted Stock Agreement
- Royalty, Commission, or Percent of Revenue
- Nonstatutory Stock Option Agreement
- Convertible Debt Agreement
- Deferred Compensation
Stock Purchase Agreement
A stock purchase agreement is one of the more simple options for investment agreements. Generally, money is given in exchange for stock, much like you would do when purchasing stock from the stock market, but because the company is not publicly traded, the paperwork is more complicated. If you are considering this type of strategy, you should meet with an attorney who understands not only the transactional and drafting side but the actual real world business situations that apply.
You will want to consider some other support documents in addition to the stock purchase agreement such as articles of organization filed with the secretary of state for which the company exists or will exist under. You will want to make sure that there is an actual existing legal entity. Additionally, the founder should have an operating agreement on how the company will be run, how many actual shares will be issued, types of stock issued, powers each shareholder has, death and incapacitation of a shareholder, and much more.
Statutory Stock Option Agreement
Statutory stock options are often referred to as Incentive Stock Options or Qualified Stock Options. These are special types of stock options are regulated by the Internal Revenue Code. Statutory stock options have tax benefits but some with strict requirements that cost the company more up front. One of the restrictions is that these options can only be granted to employees of the company and that the offered price can’t be smaller than the market value per share. Incentive stock options are restricted in that they must be exercised and have rules for when they can/can’t be sold. The IRS requires that the price for these stocks be evaluated by a third party in order to have a legitimate valuation. It should be noted that these type of stock options are NOT available to LLC’s.
Restricted Stock Agreement
This type of stock agreement consists of provisions that limit the investor’s ability to take ownership of the equity interest (or allow the business to claim ownership) based on a particular event or events taking place. An example would be an employee who receives restricted stock options based on them contributing time and effort to the company. If they fail to perform their duties based on the time and effort requirements set in this type of agreement, the individual will no longer be eligible to own that stock. This type of stock agreement can apply to stocks or LLC ownership interest and can work with straight equity, stock options, or the various ways you can issue LLC ownership interest.
Royalty, Commission, or Percent of Revenue
In a lot of situations, investors only want to own the rights to profits of the company or product of the company. For an investor to be entitled to such distributions, a royalty agreement, also known as Commission Agreements or Profits Interests, can be created. In this type of agreement, an investor would give money up in exchange for a certain percentage or dollar amount that vests over a period of time.
An example would be in Jane wants to give $50,000 to ABC (company) in exchange for $10 per widget sold by ABC for the first 5 years. Jane is assuming that by giving the company $50,000, they will sell more than enough widgets to make her investment plus more back. In this situation, she doesn’t own any part of the company but rather has a contract to receive a portion of each widget sold by the business. It should be noted that there are no rules stating a limitation on the number of years or percentage of profits/ amount of interest per product the investor can take. Thus, Jane above could take 99% of profits forever if the owner agrees to it.
Nonstatutory Stock Option Agreement
A nonstatutory stock option is also referred to as Nonqualified Stock Options. These options are good if you want to give stock options to an investor or worker in your company. A stock option is the ability to purchase the stock at a later date for a price set at the beginning. As the company’s value rises (ideally), you can get instantaneous profits when you exercise such stock options. Most stock options have restrictions which make them exercisable over time. This if referred to as vesting. These options have a less beneficial tax treatment than the statutory stock options mentioned above.
An example would be if John is given 10,000 options in ABC (company) which is to vest over 24 months with an exercise price of $10 per option. If after 12 months, the value of the stock is now $200 each, John could exercise half his stock options (which have vested up to this date), so he can sell them at a profit of $190 per option. For John, he would make $950,000 profit.
Convertible Debt Agreement
Convertible debt allows an investor to loan money to a company and then later either be repaid or convert the debt into their own ownership interest of the company. This creative agreement is drafted according to the intentions of the parties. The terms of the contract will determine whether or not the debt is converted to ownership or gets repaid.
An example would be if Dexter gives $100,000 to ABC (company) in exchange for a convertible debt note that will either be repaid in 1 year with 50% gain or converted into 100,000 shares of the company’s stock. In the provisions of the note, there would be protections for Dexter in case ABC brings on other investors or issues additional stock (essentially preventing dilution before the notes convert accordingly) and allow her shares to convert into the adjusted value of the shares.
Deferred compensation results, not in ownership, but rather allows the recipient to ownership through one of the other types of agreements. An example would be employees who agree to receive bonuses or larger salaries later for the work they put in now. Basically, the investment of time for them is an investment for the sake of the company which will vest later through a deferred compensation agreement.
All of the different investment agreements discussed herein have different situations where they apply. They can be combined to satisfy the requirements of the specific situation between the investor and the owner of the company. If you are considering taking someone else’s money or investing money in a company, you should see a CPA and an attorney to help advise you through the process. Not doing so could cost you, hundreds of thousands or even millions of dollars, as well as subject you to jail time because the SEC and IRS are watching carefully.