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
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.