Investor financing is a unique way to fund a business as it involves giving up ownership rather than taking out a loan that needs to be repaid. This means that investors will contribute money to fund the business and, in exchange, receive a certain percentage of ownership of the company. The investors are not repaid the money they contribute but instead receive income from the business and may sell their share in the future if they wish. This type of financing can be a good option if you are comfortable bringing on other owners, but it does mean giving up some control of the business.
Characteristics | Values |
---|---|
Investor financing | Involves ownership of the business rather than a loan |
Investor's contribution | Money to fund the business |
Investor's gain | Percentage of ownership of the company |
Investor's risk | Could lose their investment if the business doesn't work out |
Investor financing pros | Doesn't have to be repaid like a loan; doesn't impact your credit; investors may have skills and ideas to improve the business |
Investor financing cons | Must give up your share of ownership; may lose control of the business; brings other owners' personalities and priorities into the business |
What You'll Learn
Investor financing pros and cons
Pros
- No repayment necessary: Investor financing does not have to be repaid like a loan.
- No impact on credit: It does not impact your credit score.
- Access to expertise and connections: Investors often bring valuable resources, such as connections and expertise, in addition to capital. They may have experience in your industry, serving as mentors or advisors.
- No collateral: There is no collateral involved, so you don't risk losing your business if you can't make repayments.
- Access to funding: It can be a good source of capital, which is necessary for business growth and keeping operations running.
- No restrictions on funding use: Investors do not impose restrictions on how the capital is used. The business can use the funds for any purpose.
- No personal assets at risk: Equity financing does not require collateral from the borrower. The business owner does not have to put personal assets at risk.
Cons
- Loss of ownership and control: The biggest disadvantage of investor financing is the loss of ownership and control over the business. Investors will likely want a say in how the business is run, especially if they are venture capitalists or angel investors.
- Less profit: Investors expect a return on their investment, which means a smaller share of profits for the business owner.
- Potential conflict: Bringing on investors can lead to conflict if there are differences in opinion or conflicting visions for the company's future.
- Pressure to perform: There may be added pressure to turn a higher profit and grow quickly to meet investor expectations.
- Dilution of ownership: Equity financing can dilute the ownership of the company by giving new shareholders a portion of the company's stock.
- Costly: Equity financing can be expensive, as shares typically need to be offered at a discount to attract investors.
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Fiduciary responsibilities
When an investor provides funding, they are putting their trust in the business to manage their money and put their interests above their own. This creates a fiduciary relationship, which comes with certain responsibilities.
Duty of Obedience
This duty requires adhering to corporate bylaws, superiors' instructions, and the law. It helps prevent fraud, which can be detrimental to a company's success. The duty of obedience demands obeying the law when following instructions that necessitate illegal action.
Duty of Information
This duty involves disclosing necessary information and being truthful to investors. It requires being open and honest with shareholders (candor) and refusing to share confidential information when necessary (confidentiality). Greenwashing, or misleading customers about a product's environmental impact, is an example of breaching this duty.
Duty of Loyalty
This duty requires acting in shareholders' best interests and avoiding potential conflicts of interest, which occur when directly benefiting from actions taken on behalf of the company. Conflicts of interest to avoid include self-dealing and insider trading, both of which can have legal consequences.
Duty of Care
This duty involves evaluating the potential outcomes of decisions before taking action. It requires understanding the difference between risk and negligence when founding and scaling a business. Breaching the duty of care can lead to legal challenges, depending on the degree of negligence.
Additional Considerations
Fiduciaries should also strive to create an ethical corporate culture and promote ethical behaviour within their organisation to maintain investors' trust and increase the chances of long-term success.
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Financial advisor fee structures
Financial advisors can charge for their services in several ways, and it's important to understand how they are compensated. Here is an overview of the most common fee structures:
Assets Under Management (AUM)
This is a percentage-based fee calculated as a proportion of the total assets of a client's account. The rate typically decreases as the asset level increases, so those with more assets will pay a lower percentage. The average AUM fee is around 1% per year, but this can range from 0.25% to 1.18% or more, depending on the advisor and the size of the account.
Hourly or Flat Fee
Advisors may charge a set hourly rate, typically between $120 and $400 per hour, for their services. Alternatively, they may charge a flat fee for a specific service, such as creating a financial plan, which can range from $1,000 to $7,500.
Commission-Based
Commission-based advisors receive compensation from the sale of financial products that they recommend to their clients. The client does not pay this fee directly; instead, it is paid by the company offering the product. This structure can create a conflict of interest, as advisors may be incentivised to recommend products that benefit them financially rather than those that are in the client's best interests.
Performance-Based
Advisors using this structure charge an additional fee if their service outperforms a specified benchmark.
Robo-Advisors
Robo-advisors are automated software platforms that provide investment advice and management. They typically charge lower fees than traditional advisors, usually around 0.25% to 0.50% of assets under management. While they offer a more affordable option, they may not be suitable for those with complex financial situations or large portfolios, as they provide less personalised advice and human interaction.
It is important to note that fee structures can vary among financial advisors, and some may combine different structures. When choosing a financial advisor, it is essential to understand their compensation structure and ensure that their services align with your financial goals and needs.
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Financial advisor credentials
Financial advisors help clients with their money and future goals, offering guidance and expertise on the intricacies of managing money, from retirement and estate planning to real estate and investment opportunities.
There are almost 250 different financial advisor and professional designation certifications available. Here are some of the most common certifications and what they mean:
Certified Financial Planner (CFP)
CFPs typically offer fee-based financial planning services and have a holistic, all-encompassing approach to financial planning. They must complete an accredited certification program, pass a six-hour exam, and accrue either 6,000 hours of professional experience or 4,000 hours of apprenticeship experience. They must also commit to a fiduciary standard, meaning their financial advice must always put the customer's interests first.
Chartered Financial Analyst (CFA)
CFAs specialize in advanced investment analysis and generally offer strong portfolio management skills. They must pass three progressively more challenging exams, acquire relevant work experience, obtain several letters of professional reference, and apply to join the CFA Institute. The CFA is considered a prestigious credential, especially for those working in the areas of investment research and portfolio management.
Chartered Financial Consultant (ChFC)
The ChFC is offered by the American College for Financial Services and was originally developed as an alternative to the CFP certification. It requires additional coursework beyond the CFP's program, but unlike CFPs, ChFCs are not required to pass a final comprehensive exam.
Certified Public Accountant (CPA)
CPAs fill a wide range of financial roles, from managing and preparing financial records to tax-related documents for companies and individuals. They must satisfy state and national requirements, including a minimum education threshold, work experience, and a four-part exam.
Retirement Income Certified Professional (RICP)
A RICP focuses on retirement financial planning, including Social Security, employer-sponsored retirement plans, and planning for long-term needs. It is issued by the American College of Financial Services and requires relevant work experience, completion of a course of study, and passing a final exam.
Certified Private Wealth Advisor (CPWA)
The CPWA is aimed at wealth managers who work with high-net-worth individuals, focusing on tax strategies, asset protection, and wealth transfer. Candidates must have five years of experience in financial services or serving high-net-worth clients, as well as complete a course of study and pass an exam.
Chartered Life Underwriter (CLU)
A CLU is a financial professional specializing in life insurance planning. They must have at least three years of relevant experience and complete certification courses on life insurance, estate planning, and elective courses on topics such as income taxation and retirement planning.
Registered Investment Advisor (RIA)
This is not an individual credential but refers to a type of financial company that provides advice to clients. RIAs have a fiduciary duty, meaning they are legally obligated to act in their clients' best financial interests.
Investment Advisor Representative (IAR)
IARs are employees of RIAs and typically hold one or more of the certifications mentioned above. They are certified via exams administered by FINRA, which is authorized by the federal government to oversee US broker-dealers.
Certified Financial Fiduciary (CFF)
The CFF is an additional qualification that advisors can obtain to signal their commitment to the highest standard of fiduciary duty. It is administered by the National Association of Certified Financial Fiduciaries (NACFF), which conducts rigorous requirements, including passing an exam, agreeing to a code of conduct, and undergoing a background check.
Personal Financial Specialist (PFS)
The PFS is credentialed by the American Institute of Certified Public Accountants (AICPA). This designation is for CPAs who want to specialize in all aspects of financial and wealth management, including estate planning, retirement planning, investing, and insurance. It requires 3,000 hours of work experience, rigorous continuing education, and adherence to high ethical standards.
In addition to these credentials, financial advisors typically need a bachelor's degree, preferably in a related field such as finance, accounting, business, or economics. A master's degree, such as an MBA, can also enhance a financial advisor's resume and qualifications.
While not always required, internships and entry-level roles are valuable for gaining experience in the financial industry and building a strong foundation for a career as a financial advisor.
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Financial advisor suitability
When it comes to financial advisors, there are two main standards: the fiduciary standard and the suitability standard. These standards are important to understand when selecting an investment advisor, as they dictate the ethical guidelines that advisors must follow when managing clients' money.
Fiduciary Standard
The fiduciary standard, established as part of the Investment Advisors Act of 1940, requires advisors to put their clients' interests above their own. Fiduciaries must provide advice that is the result of thorough and accurate analysis and must execute it in a cost-effective manner. They must also avoid conflicts of interest and disclose any potential conflicts to their clients. Registered Investment Advisors (RIAs) are legally required to follow this standard.
Suitability Standard
The suitability standard, also known as the suitability rule, is followed by broker-dealers. This standard is not as strict as the fiduciary standard, as advisors only need to provide advice that is suitable for a client's financial needs, objectives, and circumstances. They are not required to give the best advice, and they can recommend investments that pay higher commissions as long as they align with the client's goals. Advisors following the suitability standard have their loyalty to the company that employs them, rather than directly to the client.
Finding the Right Financial Advisor
When selecting a financial advisor, it is important to understand which standard they adhere to. A good way to find out is simply to ask the advisor. Fiduciary advisors will be open and willing to put their standard in writing. If an advisor is not forthcoming about the standard they follow, or if they follow the suitability rule, it may be wise to reconsider the relationship.
It is also important to note that financial advisors can offer personalized advice tailored to an individual's goals and circumstances. This comprehensive approach can help clients feel more confident in their financial decisions. Additionally, seeking advice from financial services professionals, such as financial advisors, bankers, accountants, and attorneys, can provide valuable insights and guidance.
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Frequently asked questions
Financial advisors are personal finance experts who give financial advice and manage your money. Some are fiduciaries, meaning they are legally required to act in your best financial interest.
Investor financing can be beneficial as it doesn't have to be repaid like a loan and doesn't impact your credit score. Additionally, investors may bring valuable skills, ideas, and connections to improve the business. However, a significant con is that it involves giving up ownership and control of the business, which may result in running the business for investors' interests rather than your own.
It is essential to ask about their fiduciary status, compensation structure, consistency of fiduciary duty, financial planning approach, available services, client profile, account minimums, conflicts of interest, required information, and meeting frequency.
Financial advisors become particularly helpful when your financial life becomes complex, such as when you get married, have children, get divorced, manage multiple debts, receive an unexpected windfall, or make end-of-life financial decisions.