Preferred Notes and Profit Participation Versus Equity

Financing for small companies is always a challenge. Among the many dilemmas faced by entrepreneurs is the prospect of allocating equity to investors. With a brand new baby business, many feel their only choice is to throw the baby with the bath water out to whomever will give them money. This often means disproportionate partnership interests being given to relatively small investors. Worse still, the entrepreneur has not planned for the future, resulting in a "crowding" out of potential future investors.

It is here that the entrepreneur must distinguish between "equity" and "profit participation." When an investor is given equity, for better or for worse, that investor has rights that only someone with an ownership stake can get. For example, they may get voting rights at one end of the spectrum, or full blown managerial rights at the other end. This can be a very difficult scenario, especially for the entrepreneur who gave multiple small investors such rights. Consider the difficulty encountered with dealing with such investors if the company needs emergency cash infusions, or worse, the company needs to fold.

Instead of giving away partnership interests which entail equity or actual ownership, an entrepreneur may consider extending preferred notes to such small investors. With a preferred note, the entrepreneur can give an investor a return on his investment in the form of interest, without making them a partner. Moreover, since the note is preferred, you can give the investor a modicum of security by agreeing to subordinate other debts to theirs. Secondly, the note purchase agreement can provide the investor with a profit participation as opposed to equity. This essentially means that if the company makes money, the investor will get some percentage of that. On the other hand, that's the extent of the investor's right--they do not get any managerial rights or percentage of any losses. In addition, the notes can be made part of a series, whereby a group of investors sign on to the same purchase agreement and receive roughly the same note. This is critical to avoid a patchwork of rights and obligations.

One should not rush to give friends, family, or investors significant stakes in your company without real sums of money in return. Consider notes instead of an equity stake. So now when the investor that wants the moon and the stars approaches you with money that you can't afford to turn down, you may be able to counter with just the moon.