What Small Businesses Should Know About Writing an Investor Agreement

Whether you need to overcome financial obstacles, expand, or you want added business expertise, the right investor(s) can fulfill your needs. However, you need an agreement in place to outline your goals and the compensation investors can expect. Learn how to write an investor agreement and then speak with a legal professional to execute the contract.

Investor agreement: What it is and why you need one

Investment agreements are legal contracts between an investor and a company. The investor supplies funds with the intent of receiving a return. In turn, the company protects the individual's financial investment in the business. The Securities Act of 1933 governs investment contracts.

According to the U.S. Securities and Exchange Commission (SEC), a valid investment contract must meet the following criteria laid out by the Howey test:

• It is an investment of money.
• There is an expectation of profits.
• The acquisition is in a common venture.
• Any profit comes from the efforts of others.

A well-executed agreement can help secure the investor's interests and safeguard your company. According to Global Negotiator, "the purpose is twofold": It will ensure you meet your financial goals while protecting investor funds without jeopardizing your enterprise. The SEC provides a sample investment agreement, giving you an idea of what one looks like.

[Read more: Business Investors: A Guide to Knowing When and How to Find One]

How to negotiate terms with investors

Negotiating agreement terms takes a little effort and a lot of foresight. You need a deep understanding of your company's needs, the dynamics of the market, and how you’ll work together. The first place to start is to get an accurate valuation of your company.

"A well-supported valuation gives you the leverage to discuss equity stakes and investment terms with confidence," wrote Visible VC. "This knowledge prevents undervaluation and helps you articulate your business's potential effectively, ensuring that investment terms are fair and reflective of your startup's true value."

As with any business negotiation, take time to research market benchmarks. Learn what other companies have received from investors, or speak to multiple investment parties to get better terms. Keep in mind that negotiations are also about building relationships: It’s beneficial to be prepared, but you don't want to alienate someone with whom you could be partnering for many years.

Types of investors

An investor can be a person or a business. For example, a family member could contribute some of their savings to your company in exchange for shares, or a corporation could invest funds in a joint venture where the corporation itself is the investor.

Five common investor types include:

• Personal investors, like friends and family.
• Peer-to-peer lenders, such as group lending or crowdsourcing.
• Banks, which act as a source of capital for established companies.
• Angel investors, who invest in startups or new entrepreneurs.
• Venture capitalists, including well-off investors and investment banks.

Enterprises typically use investor funds to launch a new business, scale operations, upgrade equipment, or hire new staff. However, each circumstance varies, so UpCounsel suggests seeking legal guidance before contacting investors.

Investor agreement formats

Although some elements may overlap in investment agreements, the structure may differ depending on the type of investment. Seek the counsel of financial and legal advisers to select the correct format.

The Orlando Law Group lists the most common types of investor agreements as:

• A stock purchase agreement.
• A stock option contract.
• A restricted stock agreement.
• Royalty, commission, or a percentage of revenue.
• A convertible debt agreement.
• Deferred compensation.

[Read more: 3 Investors Demystify Why Some Startups Win Funding Windfalls]

What to include in an investor agreement

A well-executed agreement should include the basics, such as names and addresses, the amount and purpose of the investment, and each party's signature. In addition, when drafting an investor agreement, the Kumar Law Firm advises being concise and not leaving any room for ambiguity.

"The terms of the investment should be clearly laid out in the agreement," the firm advised.

Although each investment agreement differs, most should include:

• Fundamental terms: Describe the amount, the transfer date of the investment, and the tender, such as cash, certified check, or tangible assets. Also, record the allotments of funding, when the contract commences and expires, and if the investor gets voting rights.
• Terms of the return on investment (ROI): Determine if and when the investor will receive an ROI. Stipulate what kind of ROI, namely a lump sum payment, an agreed-upon interest rate paid annually, or a figure based on the project's profitability.
• Other details: Include restrictions regarding the investor's rights, a strategy for solving disputes, and the consequences for violating the contract. Additionally, the Kumar Law Firm recommended addressing what happens to the funds if the company is dissolved or files for bankruptcy.

How to manage investor relations after agreement signing

Once your contract is official, it's time to shift into investor relationship management. Your investors want regular updates on your progress toward the goals they've agreed to fund. Investor relations can quickly become a core business activity depending on how much you raise, how many investors you recruit, and any compliance regulations that may apply.

Your financial investors will ask for regular financial reports quarterly or annually. Fulfill those obligations at a minimum. Certain investors, such as angel investors, may also take a more active role in mentoring you and your leadership team.

Ultimately, the best approach is to build strong, transparent relationships with your investors, updating them regularly.

"How investors perceive you as a business manager is as important as any financial metric," wrote Fora Financial. "Actively building relationships helps you control that perception."

Clauses that affect founder control, dilution, and future fundraising

Many small business owners worry that bringing on investors diminishes their authority to run the business independently. The term sheet, a nonbinding form outlining an investment's basic terms and conditions, will specify if there are clauses that impact your business ownership.

Two clauses —  liquidation preferences and participation rights — determine who gets paid — and how much — in any exit scenario. A one time (1x) liquidation preference means investors recoup their full investment before founders or employees see any proceeds, while a two time preference doubles that threshold. In a modest exit, this can leave founders with very little.

Participation rights also allow investors to take an additional pro rata share of the remaining proceeds — effectively letting them double-dip. A more equitable arrangement for a business owner and investor is a 1x liquidation preference paired with nonparticipating stock, in which investors choose between their preference or their pro rata share rather than claiming both.

Anti-dilution clauses protect investors in down rounds by adjusting their ownership stake upward. Watch for super pro rata rights, which allow early investors to grow (not merely maintain) their stake in future rounds. These rights can crowd out new investors or give existing ones undue leverage.

When to use a lawyer, and how to prepare for legal review

Always have a legal expert review all documents before signing with an investor.

Hire a legal expert before signing any term sheet, since many of its clauses determine how money is paid out, how ownership is protected, and who controls key decisions.

Involving an attorney is especially critical when a deal could affect your ownership stake or your ability to raise money down the road. If your investor is a venture capital firm or experienced angel, assume they have seen hundreds of these agreements and the terms favor them. Founders who do not hire legal counsel are, in effect, negotiating blind.

“Seemingly minor clauses in SAFE notes, convertible notes, or venture capital term sheets can significantly dilute founder ownership or shift control to investors if not negotiated properly,” wrote Grellas Shah LLP. “A startup lawyer provides essential guidance by: Reviewing fundraising documents for unfavorable clauses; Negotiating fair terms that protect the founder’s interests; Ensuring compliance with securities laws and investor regulations; [and] Structuring equity agreements to maintain control over company decisions.”

Before meeting with a lawyer, gather documentation that lists who owns what in your company, including existing loans or agreements that could convert into ownership stakes later. List your non-negotiables, such as how many board seats investors will receive or what it would take to force a company sale. Finally, if possible, speak with another small business owner who had a similar experience. Firsthand insight into what terms are standard versus aggressive in your market can be a valuable starting point.

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