Key Takeaways

  • An equity investment contract involves trading ownership in a company for funding, without repayment obligations.
  • These agreements typically include key terms like valuation, share class, investor rights, and exit strategies.
  • Equity fundraising is suitable for startups with growth potential, no collateral, or long development cycles.
  • Pros include no debt obligations and valuable investor support; cons include loss of control and potential conflicts.
  • Legal documentation and clarity on roles, responsibilities, and exit strategies are crucial to investor confidence.
  • Different types of equity investors—angel investors, venture capitalists, and strategic investors—play unique roles.
  • Understanding common clauses like liquidation preferences and anti-dilution provisions is vital.
  • Companies can benefit from working with legal counsel to customize agreements and ensure compliance.

An equity investment agreement occurs when investors agree to give money to a company in exchange for the possibility of a future return on their investment. Equity is one of the most attractive types of capital for entrepreneurs, thanks to wealthy investor partners and no repayment schedule. However, it does require the most effort to find it. Fundraising with equity means that investors offer money to your company in exchange for a stake in the business, which presumably will become more valuable as your company gains success.

How Does Equity Fundraising Work?

During the initial stage of fundraising, you'll determine a specific valuation of your company. In other words, you'll decide what your business is worth at that time. According to your company's valuation and the amount of money an investor gives to your company, they will own a percentage of stock in it. Once your company goes public or sells, they will receive back compensation in the same proportion that they invested.

For example, say the founders of Magnificent Puzzles have chosen to transform their small business into an international chain, and they are seeking $500,000 in equity investments. The company has been valued at $2 million. The venture capitalist firm Equity Excitement decides to invest $250,000, which means they will earn 12.5 percent equity in Magnificent Puzzles. In the future, when Magnificent Puzzles doubles in value, the value of Equity Excitement's initial investment will have doubled as well. Equity Excitement's investment is now worth $500,000.

Key Components of an Equity Investment Contract

A comprehensive equity investment contract outlines the expectations and protections for both the company and its investors. Typical components include:

  • Valuation: Specifies the company’s worth at the time of investment, which directly affects the percentage of ownership the investor receives.
  • Equity Stake Issued: Clarifies how much equity the investor is receiving in exchange for capital.
  • Type of Shares: Indicates the class of shares (e.g., common or preferred) and their associated rights.
  • Use of Funds: Explains how the investment capital will be used (e.g., product development, hiring, marketing).
  • Investor Rights: May include board representation, information rights, or voting rights on major business decisions.
  • Dividend Policy: Describes if and how dividends will be distributed to shareholders.
  • Exit Strategy: Outlines conditions under which the investor can exit and sell their stake, such as during an IPO or acquisition.
  • Anti-Dilution Provisions: Protects investors from losing value if new shares are issued at a lower price.
  • Liquidation Preferences: Determines the order of payouts in the event of liquidation or sale of the company.

When Does Equity Fundraising Make Sense?

Under some circumstances, equity fundraising makes the most sense. In other circumstances, it is the only realistic option for a business. A few of these situations include:

  • Your company needs a long time to establish itself. Not every company will start producing income as soon as it's launched. Some might spend a couple of years in the negative before generating income. That doesn't necessarily mean the company isn't viable. If you need a large chunk of operation cash to run your company before it begins turning a profit, equity investments are the type of capital that makes the most sense.
  • Your company has zero collateral. Lenders require borrowers to offer something of value as collateral in case they are unable to pay back their debt. If you are unable to offer a lender that security, your best fundraising option is to locate equity investors who agree to take a chance with your company. If the business fails, they will have lost their investment.
  • You can't bootstrap. Most investors expect you to launch your business before you invest, even if it's just from your garage or spare bedroom. However, some companies (a private yacht line, for example) require massive funds just to start.
  • Massive growth is imminent. Equity capital investors tend to invest in companies and industries that have the potential for huge growth and exponential returns. Your local bookshop may be successful, but it lacks the potential to become the next Fortune 500 company. However, if you intend to build the next Barnes and Noble chain and your plan and vision support that type of growth, investors may very well be interested in jumping on board.

Types of Equity Investors

Understanding the different types of equity investors can help you identify the best fit for your company's needs:

  • Angel Investors: Typically affluent individuals who invest in early-stage startups. They often bring industry expertise and mentorship.
  • Venture Capitalists (VCs): Firms that manage pooled investment funds and seek high-growth companies. They usually invest larger amounts and may seek more control.
  • Strategic Investors: Corporations or institutions that invest to gain strategic advantages, such as market access or technological synergy.
  • Crowdfunding Investors: Individuals who contribute smaller amounts through online platforms, usually in exchange for equity or rewards.

Each type of investor brings different expectations, timelines, and levels of involvement. Aligning your company’s vision with the right investor profile is key to long-term success.

Pros and Cons of Equity Investment

Like all forms of fundraising, equity investment has both advantages and disadvantages. One of the most beneficial characteristics of equity investment is that unlike regular bank financing, it does not require any regular payments. Investors look forward to a future opportunity to cash out their share of the profits. Another advantage is that equity investors (especially those known as "angel investors") can offer valuable advice and guidance that will support the growth of your business. Also, it's often easier to acquire early investments from your family and friends because they share your excitement in your success.

On the other hand, accepting investment funds from family and friends may create tension in the relationships, especially if you are unable to offer a return on their investments. Locating the right investor may also take much more time and effort than applying for a loan. Long-term business complications may also exist when you take equity investment. If you hand over a large chunk of equity in your company, you give up your exclusive control over both current and future business decisions.

Common Pitfalls to Avoid in Equity Contracts

Poorly constructed equity investment agreements can lead to long-term complications. Here are common pitfalls to avoid:

  • Lack of clarity on control and decision-making: Clearly define governance rights to prevent future disputes.
  • Overly aggressive investor protections: Terms like excessive liquidation preferences or board control can dissuade future investors or limit founder autonomy.
  • Ignoring future funding rounds: Failing to plan for how equity will be affected in later funding stages can dilute existing stakeholders significantly.
  • No exit provisions: Lack of defined exit paths may trap investors or limit flexibility for the business.

Working with an experienced attorney ensures your equity investment contract is fair, enforceable, and designed to support future growth.

How to Draft and Negotiate an Equity Investment Contract

Creating a well-structured equity investment contract involves several key steps:

  1. Engage Legal Counsel: Work with an attorney to draft an agreement that complies with state and federal laws and protects both parties' interests.
  2. Set Clear Terms: Include specific details around valuation, share classes, use of funds, and investor rights.
  3. Negotiate in Good Faith: Both parties should aim for a mutually beneficial agreement, balancing investor protection with business flexibility.
  4. Include Protective Clauses: Use standard clauses such as right of first refusal, tag-along rights, and drag-along rights to safeguard all stakeholders.
  5. Finalize with Signatures and Legal Review: Ensure the agreement is signed by all parties and reviewed for completeness and compliance.

You can find experienced startup attorneys on UpCounsel to help you draft or review an equity investment contract tailored to your business model and growth goals.

Frequently Asked Questions

1. What is an equity investment contract? It’s a legal agreement where an investor provides capital to a company in exchange for equity ownership.

2. What should be included in an equity investment contract? Key components include valuation, share class, investor rights, liquidation preferences, and exit strategies.

3. How is equity different from a loan? Unlike loans, equity investments don’t require repayment. Investors gain ownership and a share in potential future profits.

4. Do I need a lawyer to draft an equity investment agreement? Yes, legal guidance is essential to ensure compliance and to protect your interests and those of your investors.

5. Can I raise equity from friends and family? Yes, but it’s important to treat these arrangements formally with a detailed contract to avoid misunderstandings.

If you need help understanding an equity investment agreement, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.