Many small businesses operate under the false assumption that
outside investors look forward to the day when they may ultimately
be able to wrest control of the enterprise away from the founding
team. They expect that all the options and convertible preferred
stock will one day leave the founders with a minority equity stake
in the firm and a pink slip in their mailboxes.
Nothing could be further from the truth. Capital providers
aren't looking for fledgling businesses they believe can be
taken over through funding deals that somehow "foreclose"
on the owners over time. Sound investors are actually looking for
three things:
1. Tremendous opportunity for sustainable sales growth and
profitability over time
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2. Risk that can be clearly identified and effectively addressed
through strategies
3. Personnel who can deliver tangible results through management
expertise.
Let's call these points: opportunity, the
plan, and the people. Most, if not all, capital
providers simply want to secure reasonable assurances that these
three facets will be organized, clarified and implemented through
the business plan and funding process. In time, the "big
three" will be realized as operations commence and the venture
moves forward.
What reasons would support the idea that investors don't
have any interest in taking over the entrepreneur's business?
First, the entrepreneur probably has special expertise that
can't be easily replicated. Second, the founders may personally
hold patents, licensing agreements or copyrights. Third, the owners
are ready to run the company on a full-time basis while investors
may have little (if any) substantive time to devote to managing a
business. Fourth, the entrepreneur may have partnerships or company
alliances in place with suppliers, distributors and subcontractors
that are uniquely linked to the new venture's product or
service. Finally, the founders may have assembled all--or most--of
the management team. These individuals probably have allegiance to
the owners, creating the possibility that they would leave the firm
if investors tried to take control under adverse circumstances.
Investors agree to the deal when the opportunity, plan and
people are in place, or nearly ready to go. They'll want to
structure the funding deal in a way that provides various hedges
against the impacts of adverse risk. The entrepreneur can't
fault the capital providers for wanting to build in several layers
of assurances and provisions to address potential misfires on the
part of the founding team. For example, two investors might be
offered a 20 percent equity stake in a startup company in exchange
for $600,000 (the post-deal value of the firm is agreed to be $3
million). But under such an agreement, the funding partners have
only a one-fifth voting interest in the firm. Their stake may
entitle them to two of the 10 director seats on the board, but the
reality is that the founders maintain a controlling interest (80
percent of the voting common) with eight seats.
This is a very risky position for an investor, because the
entrepreneurs can function virtually uncontested in dictating
company policies and are free to implement management strategies
that may not be conducive to the long-term health of the
enterprise. If the capital providers can bring to the bargaining
table several "value added" people, capabilities,
supplier contacts, initial buyers or manufacturing referrals, the
entrepreneurs should be willing to recognize these as tangible
justification for increased input and decision-making
responsibility on the part of the investors.
There may be one or two vital people missing from the management
mix, and the investors have referrals that will make a great fit in
that company function. The funding deal may stipulate that certain
individuals be hired and given latitude to work with their industry
contacts in shoring up a crucial component of the manufacturing or
marketing plan. This is not to say that the entrepreneur simply
takes a back seat to everything that investors request. But
investors are fundamentally another layer of new partners for the
enterprise. They want you to be wildly successful in your business,
but they also want to find ways to minimize specific, identifiable
risks that challenge the venture's long-term viability.
That doesn't mean you have to initially offer a 60 percent
equity stake to potential investors. But don't be afraid to
share the company's decision-making votes with the capital
providers who bring the crucial funds to make your business plan a
reality. If you find investors you feel you can work well with over
the long term, it might come down to this: Do you want a 90 percent
stake in a firm that never quite makes it or a 45 percent stake in
a business that may be worth several million dollars when it's
acquired in five years?
David Newton is professor of entrepreneurial finance at
Westmont College in Santa Barbara, California. He is the
contributing editor on growth capital for Industry Week Growing
Companies and a moderator on small-cap stocks for eRaider.com. His
books include Entrepreneurial Ethics(Kendall-Hunt)
and How To Be a Small-Cap Investor(McGraw-Hill), named November 1999 book-of-the-month by
Money magazine and a 1999 Top 10 book by Forbes. His latest book
is How To Be an Internet-Stock Investor
(McGraw-Hill). He has written or contributed to more than 80
articles for publications including Entrepreneur, Your
Money, Business Week and Solutions, and has been a
consultant to emerging, fast-growth entrepreneurial ventures since
1984.
The opinions expressed in this column are
those of the author, not of Entrepreneur.com. All answers are
intended to be general in nature, without regard to specific
geographical areas or circumstances, and should only be relied upon
after consulting an appropriate expert, such as an attorney or
accountant.