Jul 5, 2022 | Starting a Business

I am starting my own business. How does investment work?

Q. Dear Zenagos, I am starting my own business, and I feel fortunate that some family members and friends have told me that they want to invest in my business. But, I realize that I don’t know the first thing about getting investors. How does investment work?
–Lucy

Congratulations! If you have people who want to invest in you and your business, things are going swimmingly! Usually, you start a company, and an investor gives you money in exchange for shares of stock (“equity”) in your company. There are laws governing who can buy stock. Anyone can buy stock in a public company that has “registered” its stock (also called “securities”) with the SEC. When a stock is registered, it can be traded on a stock exchange (like NASDAQ or the New York Stock Exchange) and bought through approved brokers. These are the big fish that you see on the news.

However, registration is an involved and expensive process. Most businesses are small fry and qualify for an exemption (under SEC Regulation D) that lets them issue stock without registering. Stocks that are unregistered are called “restricted stock” or “unregistered securities.” In order to protect the public from fishy investments, U.S. laws limit who can invest in restricted stock. Accredited Investors can usually make these kinds of investments. In some cases, non-accredited investors can, as well.

What is an “Accredited Investor”?
“Accredited Investors” are individuals (or entities) who meet certain criteria. They need to have a high income (at least $200,000 per year) and a high net worth (at least $1 million), among other things. The idea behind the law is that such people with deep pockets have a high level of financial sophistication and are able to evaluate financial risks, so the law allows them to fish in deeper water. Laws vary by state and situation, but Accredited Investors are much more likely to be eligible to invest in a private company’s stock than non-accredited investors. However, given the wealth requirements, if you need to have Accredited Investors, you’ll be fishing in a relatively small pond.

Who can invest in a small business?
The good news is that if you are going to ask for less than $10 million of investment in a 12-month period, you most likely fall under exemptions that allow you to take investment from non-accredited investors. Most of us can make do with less than $10 million (!). If you’re in that category, then most people are eligible to invest (depending on state and local laws). However, you can’t afford to assume; the smart thing to do is to develop a relationship with a local small business attorney – preferably, someone who has been referred to you – and get advice on how you should issue stock. If you take a shortcut with prefab legal documents, you could miss important details. Don’t take the bait – protect yourself by getting an attorney. The legal fees will feel like a lot, but they are worth it if they prevent you from getting into hot water later.

What else is important?
It is wise to spend some more time learning about investors before you engage with them, even if they are your family and/or friends. Do some research on the types of investors, figure out how much investment you need, and look into alternatives to investment. By putting in the time in advance, you will tip the scales in your favor.

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