If you have a company that needs investment, you have a lot of options for the type of investment to create. Depending on the situation, you may also want to consider loans or other ways to finance your company beyond investments. This article will discuss the different types and define what they mean. Later articles will discuss the finer details of each investment type in greater detail.
For the purpose of this article, we used stocks, and briefly describe the situation for LLCs. If you have a complicated investment plan or plan on bringing in or removing owners often, it is far simpler to do this with a corporation. Corporations have stock, and stock is clearly understood under the law as far as how to transfer it and what it is when owned or traded. There are also many statutes in the Internal Revenue Code that make stock ownership, for investors, very beneficial.
Investment Agreements, generally, are any transaction that gives a person or business an ownership interest, either now or in the future, in your company in exchange for anything of value.
The most common types of Investment Agreements, in no particular order, are these:
- Stock Purchase Agreement
- Nonstatutory Stock Option Agreement
- Statutory Stock Option Agreement
- Convertible Debt Agreement
- Restricted Stock Agreement
- Deferred Compensation
- Royalty, Commission, or Percent of Revenue
Stock Purchase Agreement
The Stock Purchase Agreement is the simplest of the various types of Investment Agreements. This is generally an exchange of money for stock, much like you would do when purchasing stock from the stock market, but because the company is no publicly traded, there is a lot more paperwork.
Nonstatutory Stock Option Agreement
Nonstatutory Stock Option Agreements, sometimes called Nonqualified Stock Option Agreements, are the default if you want to give stock options to an investor or worker in your company. A stock option is the ability to purchase stock later at a price set at the beginning. The idea is that as the value of the company rises, the more profit you can get instantaneously when you exercise your stock options. Most stock options have restrictions that make them become exercisable over time, called vesting.
For example, let’s say Alphie is given 1,000 stock options in XYZ, Inc which is to vest over 20 months with an exercise price of $10 each. If, after 10 months, the value of the stock is now $100 each, Alphie may want to exercise half his stock options (which are all that vested so far), so that he can sell them at a profit of $90 each. That’s a $45,000 profit for Alphie.
Nonstatutory Stock Options have a less beneficial tax treatment than the Statutory Stock Options, but there are also no formal requirements to be able to issue these Nonstatutory Stock Options.
Statutory Stock Option Agreement
Statutory Stock Options, also called Incentive Stock Options or Qualified Stock Options, are a special type of stock options regulated under the Internal Revenue Code. This type of stock option plan comes with very beneficial tax treatment, but comes with strict requirements that yield higher up front cost for the company. The most notable restrictions are that these can only be granted to employees of the company and that the exercise price cannot be lower than the market value per share. They also have restrictions on when they must be exercised and when they cannot be sold. Because of the strict requirements, the IRS requires that the market price be determined by a third party in order to defend the valuation.
Statutory Stock Options are not available to LLCs.
Convertible Debt Agreement
Convertible Debt is an interesting instrument where an investor loans money to a company and can later either be repaid or convert the debt into an ownership interest in the company. What determines whether or not the debt is converted to ownership interest or gets repaid is determined by the agreement that is drafted between the two parties. Among the different types of investment agreements, this one tends to be able to be the most creative in terms of how the investor receives her return on investment.
For example, let’s say Diane gave $250,000 to company XYZ, Inc in exchange for a Convertible Debt note that will either be repaid in 2 years with 50% gain or converted to 250,000 shares. The note would also likely contain provisions that protect Diane in case XYZ, Inc brings in other investors or issues additional stock, thereby increasing the shares her note would convert into to the same value of shares.
Restricted Stock Agreement
The Restricted Stock Agreement is generally going to actually be one of the earlier examples, but with some provision that limits the investor’s ability to claim ownership (or allow the company to reclaim ownership) of the equity interest based on the occurrence of some event or events. For example, usually those who contribute time and effort into a company will have Restricted Stock Agreements because they’re expected to contribute time and effort over a period of time. If they fail to contribute for the full time, the individual will no longer be eligible to own that stock.
This can work with stocks or LLC ownership interest and it can work with straight equity, stock options, or the various ways you can issue LLC ownership interest.
Deferred Compensation isn’t a type of investment, as the recipients don’t receive any ownership from specifically the Deferred Compensation. They may be entitled to ownership through one of the other types of agreements; however, it was worth noting that many times those employees who are first in agree to receive bonuses or larger salaries later for the work they put in now. In their minds, this is an investment in the future of the company and they will be entitled to this future compensation when the company grows.
Royalty, Commission, or Percent of Revenue
Many times, investors don’t want to own the company. They want to own the profits on the company or product of the company. To receive these, there are Royalty Agreements, called many things like Commission Agreements or Profits Interests. How these work is that an investor gives money in exchange for a certain percentage or dollar amount over a period of time.
For example, imagine that Susan gives XYZ, Inc. $1,000,000 in exchange for $5 per widget sold by XYZ, Inc for the first 20 years. Susan, in this scenario, assumes XYZ, Inc will sell enough widgets to make her investment more than worthwhile; however, she didn’t want to own any stock in XYZ, Inc.
There are no rules that state the limitation on number of years or amount the investor can take. An investor can negotiate 99% of profits indefinitely if the owner agrees to it.
All of these different types of Investment Agreements have their different uses and many can be combined to form the right type of Agreement for the particular situation they’re being employed. This is an area, however, that can yield very high penalties if done incorrectly, and the best advice we can give (and the only advice we can give over a blog) is to speak to an attorney and a CPA before employing any of these strategies. One wrong step can cost you hundreds of thousands, if not millions, of dollars because you’re being watched by the SEC and IRS simultaneously here.
If you have any questions on types of Investor Agreements or would like to discuss creating your stock plan, please contact us at firstname.lastname@example.org or by calling 919-912-9640.