Selling Equity in Your Business: Key Concerns and Documents You’ll Need
Selling equity in your business can be an effective way to raise capital, attract investors, and scale operations. But this move comes with significant legal and financial considerations. In this blog, we’ll cover the key concerns to keep in mind and the documents required to successfully sell equity in your company. We’ll also outline when you’ll need each document and explain the differences between selling equity in corporations versus limited liability companies (LLCs).
Key Concerns When Selling Equity
Loss of Control Selling equity means giving up some control of your business. Depending on how much equity you sell, investors may gain voting power and decision-making authority, which can affect your ability to make unilateral decisions. It’s essential to establish clear terms upfront regarding what control the new equity holders will have.
Valuation One of the most important steps in selling equity is determining the value of your business. Your business’s valuation dictates the price of the equity you are selling. Underestimating your company’s value could lead to selling more equity than needed, while overestimating could turn potential investors away.
Dilution Every time you sell equity, the ownership stakes of existing shareholders (or members in an LLC) are diluted. This means you, as a founder, will own a smaller portion of the business after the sale. It’s important to weigh the benefits of raising capital against the long-term impact of dilution on your control and financial upside.
Investor Rights Investors often expect certain rights in exchange for their capital. These could include voting rights, rights to dividends, or control over important business decisions. Clearly define these rights in your agreements to prevent future disputes.
Exit Strategy Investors want to know how they will eventually exit their investment. Whether you’re planning for an IPO, selling the business, or buying back their shares in the future, you need to have a clear exit strategy in place. Without one, potential investors may hesitate to commit.
Key Documents Needed When Selling Equity: Timing and Differences Between Corporations and LLCs
Selling equity requires several key documents to ensure the transaction is clear, legally binding, and protects the interests of both the business owner and the investor. Below are the primary documents you’ll need, along with distinctions between corporations and LLCs.
1. Term Sheet
When You’ll Need It:
The term sheet is typically the first step after you’ve discussed terms with potential investors. It outlines the fundamental points of the equity sale, including valuation, amount of equity sold, and any special investor rights. While it’s non-binding, it sets the stage for the binding agreements that follow.
Corporation vs. LLC:
In corporations, the term sheet may define whether the shares sold are common or preferred, and address any related voting rights or dividend structures.
In LLCs, the term sheet will outline the percentage of membership interest being sold and specify profit-sharing arrangements, which are often more flexible than in corporations.
2. Shareholder Agreement (Corporations) / Operating Agreement (LLCs)
When You’ll Need It:
After the sale, a shareholder agreement (for corporations) or an operating agreement (for LLCs) governs the relationship between shareholders or members. This document outlines voting rights, profit sharing, and what happens if an investor wants to sell their equity. It’s essential to finalize this document once the equity sale is confirmed but before closing.
Corporation vs. LLC:
Corporations: The shareholder agreement addresses governance issues, including voting power, board seats, and the process for transferring shares.
LLCs: The operating agreement covers the roles and responsibilities of members and often focuses on how profits will be distributed and how the business will be managed.
3. Subscription Agreement
When You’ll Need It:
You’ll use a subscription agreement when an investor commits to purchasing equity in your business. This legally binding document specifies the amount of equity, the purchase price, and any warranties from both parties. You’ll need this document ready during the closing stages of the equity sale.
Corporation vs. LLC:
In corporations, the subscription agreement covers the purchase of shares (e.g., common or preferred).
In LLCs, it covers the sale of membership interests, which represent ownership rather than stock.
4. Stock Purchase Agreement (Corporations) / Membership Interest Purchase Agreement (LLCs)
When You’ll Need It:
This document is essential for formalizing the equity sale. It sets the terms for the sale, including price, number of shares or membership interests, and any conditions to closing. You’ll use this agreement during the closing process to finalize the transaction.
Corporation vs. LLC:
For corporations, the stock purchase agreement governs the sale of shares and outlines terms about transfer, ownership, and investor rights.
For LLCs, the membership interest purchase agreement serves the same function but focuses on transferring a percentage of ownership rather than stock shares.
5. Cap Table
When You’ll Need It:
The cap table is necessary both before and after the equity sale. It tracks ownership percentages and ensures transparency regarding equity distribution and dilution. It’s critical to update the cap table after the sale to reflect changes in ownership.
Corporation vs. LLC:
In corporations, the cap table shows the number of shares held by each shareholder, including common and preferred stock, and any options or convertible securities.
In LLCs, the cap table shows the membership interest percentages and details profit-sharing allocations if they differ from ownership.
6. Amended Articles of Incorporation (Corporations) / Amended Articles of Organization (LLCs)
When You’ll Need It:
After the equity sale, if your ownership structure or share classes change, you may need to file amendments with the state. This is necessary once the equity sale closes and any structural changes take effect.
Corporation vs. LLC:
Corporations: Amended Articles of Incorporation are needed if new classes of stock (e.g., preferred stock) are issued or if significant changes to governance occur.
LLCs: Amended Articles of Organization may be required if there are changes to the ownership structure or management roles, especially after bringing in new members.
7. Investor Rights Agreement (Corporations) / Membership Agreement (LLCs)
When You’ll Need It:
This document is necessary when investors are granted special rights beyond standard equity ownership. It’s typically drafted after the term sheet and before the final deal closes.
Corporation vs. LLC:
Corporations: An investor rights agreement grants specific privileges, like board seats, voting rights, or first refusal on future equity sales.
LLCs: A membership agreement defines similar rights but often focuses more on profit-sharing and governance since LLCs tend to have more flexible structures.
Additional Considerations: Corporations vs. LLCs
Corporations typically involve more complexity when selling equity. The process often includes managing share classes, stock options, and extensive governance structures. Venture capital and institutional investors frequently invest in corporations because of the clearer structures around share ownership and rights.
LLCs offer more flexibility, especially regarding profit distributions and management. However, selling membership interests often requires updates to the operating agreement and detailed documentation about how profits and losses will be shared among members.
Final Thoughts
Selling equity in your business is a big decision that requires careful consideration. Whether you’re operating a corporation or an LLC, it’s important to be prepared with the right documents and a clear strategy. The right approach can help you raise capital, bring in new partners, and maintain control over your business's future.
If you’re looking to sell equity in your company, StartSmart Counsel is here to help. We can guide you through each step of the process, from drafting essential agreements to negotiating investor terms. Contact us today to schedule a consultation and ensure you’re ready to sell equity while protecting your business.
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