Issuing shares can provide capital without the fixed repayment schedule associated with a conventional loan. But stock is not free money. A financing can change who owns the company, who controls important decisions, and how the proceeds of a future sale are distributed. Founders should model those consequences before agreeing to a valuation or accepting a check.

Understand what the investor is buying

Equity financing typically gives investors an ownership interest rather than a contractual right to repayment of principal. The economics depend on the class of shares and the rights attached to them. Common stock and preferred stock can differ in voting power, liquidation preferences, dividend treatment, conversion rights, and protective provisions.

The relevant question is not just how many shares the investor receives. It is what those shares entitle the investor to do and receive under the charter, financing documents, and applicable law.

Calculate dilution on a fully diluted basis

Suppose a founder owns 100% of a corporation before a financing. If new shares represent 20% of the company immediately after closing, the founder's percentage generally falls to 80%, before considering any other changes. But the actual calculation may also include outstanding options, warrants, convertible instruments, and a proposed increase to the employee option pool.

A pre-money valuation and a post-money valuation are not interchangeable. Founders should review a pro forma capitalization table that shows ownership before and after the financing, including assumptions about conversions and option reserves. The model should also show what happens in a later round, not just at the first closing.

Separate economic rights from control rights

An investor can hold a minority of the shares while negotiating meaningful influence. Common provisions include board appointment rights, consent requirements for major expenditures or new debt, information rights, preemptive or participation rights, and restrictions on future stock issuances.

A founder may remain the largest shareholder yet need investor approval to sell the business, amend governing documents, or raise additional capital. Consider how each proposed veto affects day-to-day operations and future transactions.

Match the documents to the actual transaction

Depending on the structure, the closing package may include a stock purchase or subscription agreement, board and shareholder approvals, amended charter documents, investor-rights agreements, voting agreements, and updated stock ledgers. Representations and warranties should be reviewed for accuracy, and any conditions to closing should be realistic.

A clean capitalization table and properly documented prior issuances make later diligence easier. Informal promises of ownership, undocumented advisory grants, or missing approvals can become expensive problems when the next investor requests records.

Address securities laws before approaching investors

Issuing shares generally implicates federal and state securities requirements. A private company may rely on an available registration exemption, but that analysis must be done before the offering is conducted. The exemption can depend on who is solicited, how the company markets the offering, the investors' qualifications, disclosures, and applicable filings.

A private offering does not eliminate antifraud obligations. Business plans, revenue claims, risk disclosures, and cap-table statements must be evaluated for accuracy. Securities counsel should assess the relevant federal exemption and state notice or qualification requirements.

Compare the cost of equity with borrowing

Debt may preserve ownership but impose repayment, collateral, covenants, and default risk. Equity may ease near-term cash demands while sharing future upside and decision-making authority. The better fit depends on the company's cash flow, growth prospects, valuation, and tolerance for restrictions.

For example, a company with predictable receivables might reasonably compare a secured credit facility with a minority equity round. A pre-revenue technology company may have fewer conventional borrowing options and different investor expectations.

Prepare for the next financing and eventual exit

Review transfer restrictions, drag-along provisions, rights of first refusal, liquidation preferences, and investor consent rights with an eye toward a later sale or financing. A provision that seems unimportant when the company is raising its first $500,000 can become decisive during a much larger transaction.

Planning a stock financing? Alex Nahai Law can help founders and companies evaluate governance, investment documentation, capitalization issues, and securities-law considerations before terms become binding.

General information only; not legal advice. Reading this article does not create an attorney-client relationship.