Who Gets What in the Equity Pie?
Over the last few weeks, we’ve spent a lot of time working through the ideas of using stock certificates and LLC Certificates as equity shares in a small business, and we’re continuing on that tack today. If you’re just joining in, the ideas we’ve been working on are that a.) our small business is doing really well, b.) loans from the bank or family don’t really solve the growth issues quickly, and c.) equity investors offer real value by bringing expertise to our business from the first day.
So how do we figure out how much of the business to sell? Well, that’s impossible to answer well without understanding each specific case, but generally you have to understand that investors’ best weapon, as they look at a deal, is the simple word “no.” As in “No, I don’t want to do this deal.”
We need to consider the “why” for the investor as well. Is it about recouping the investment and profiting or about growing the business long-term and profiting? Drilling down into this thought process, here are some very general rules as you consider whipping out those stock certificates!
- Naïve people with money, like friends and family, are often terrible partners even when they wrote big checks for small pieces (say 1-10%). We’ve covered how bad it would be at Thanksgiving if your mother-in-law was an investor, but really, their return is going to most likely be very little, even below a similar investment at regular interest rates. The unforeseen circumstance comes much later for you, though, because you end up with unsophisticated investors who get in the way of real growth prospects later by clogging up progress as you attract professional investors at the next level of capitalization.
- Investment by outsiders is for scalable, defensible, high-profile startups with proven management teams. Obviously, the management part of a primary investment round is important, and this is exactly where you should be looking in your own business systems for partners. As you look to scale, you also need to understand what your ultimate exit strategy is and to be committed to it. If you don’t like these criteria, rewrite your business plan to need less investment.
- Serious investors will want to have enough clout to make sure you don’t decide later that you don’t want to sell the company. That doesn’t mean that every investor is going to want more than 50 percent, but the most experienced investors or partners will almost always want to see that the outside investors combine to hold more than 50 percent. They don’t make money when you do. They know that investment will only be recouped when you sell the company.
- Don’t give equity to anybody you don’t want permanently involved in your business. Those 1 percent-5 percent-10 percent pieces that startup entrepreneurs give out to friends and family? Those are going to drive you crazy later. As you grow and prosper, you’ll need those shares for employees. If the business is struggling those people will be bugging you over the long term, pressuring you to give them money where there is none.
- Remember the math of equity and valuation: You calculate how much money investors give for how much ownership by managing valuation, meaning how much you say your company is worth. So if you want to give 10 percent equity for $250,000, you’re saying your company is worth $2.5 million. This is often a huge issue in small businesses, so understand your companies’ value and the investor’s viewpoint as well.
In the end, the equity valuation at the smaller level really is driven by one thing – better management of a business to grow due to capitalization. That management piece is extremely critical for the continued growth, so next week, we’re going to look at where exactly that management needs to come in – before you start sending folks cigars and stock certificates!