Is there a formula or some kind of rule of thumb by which business owners should abide in terms of their own personal investment into their company, relative to outside funds invested by others? The simple answer is that there is no basic measure for gauging an owner's equity stake compared to investors' equity in the firm. But there are two very important concepts about business financing that do apply to the general topic of owners' equity.
First, in virtually every funding deal that I've ever been involved in as a business partner, consultant, investor or advisor, the outside investors required that the founding team have a vested financial stake in the enterprise. The rationale is that the owners need to demonstrate a solid financial commitment to the business plan, and having their own money at risk--alongside the outside capital providers--provides a tangible assurance to outside investors that the entrepreneur believes strongly in the merits of the company's business model and strategy. I always tell my clients and students to think about this logically. Would you want to invest in a business knowing that the founding entrepreneur does not have any of his or her own money also invested? Of course not!
When term sheet proposals are being circulated along with a company's executive summary, investors always focus their initial attention on four major areas:
- What is the product or service concept, and how is it differentiated from the competition?
- How large is the potential market for this product or service?
- Who on the management team will drive the business strategy forward?
- What do the business model and the financial structure look like? This fourth area examines the way the company makes money, as well as the debt-equity arrangement that capitalizes the assets that will be employed to achieve success with that model.
When outside investors see that the company founders have already invested significant time into the business, that's well-received. But sweat-equity alone is not enough to persuade investors to fund the deal. In addition to plenty of hours invested working in the business, the owners must also be equity investors with money at risk--otherwise, capital providers view the level of commitment as being less than desirable.
The second important concept is the form of the founders' capital commitment to the company. Some entrepreneurs will provide a loan to their new venture, and it may even be secured by fixed assets purchased with those funds. This is less positive than if the founding team has stock in the firm.
The time frame for the company to pay off a loan can also be a concern to outside investors. If the owners have a provision to pay themselves back within a year or 18 months, the priority of payment sends a signal to outside capital providers that the owners want to be sure to cover their own personal financial positions first, and this can cause concern. Outside investors would much rather see the owners in a side-by-side position with them, where everyone has an equity stake and no one is getting priority of payments from operating cash flow.
In summary, equity stakes for the founders always look better than short-term and/or secured loans to the company. When outside investors do co-invest with the entrepreneur, the deal will go much more smoothly if owners and founders are equity investors and they're both in the same class of securities. For example, outside capital providers will frown on the situation where the founders have preferred stock, while investors have lower-priority common stock.
The best way to put these two concepts together is to understand the perceived risk of the venture. Investors will always look for ways to mitigate certain risk exposure in order to reduce the potential for capital loss. Some companies pursue financing strategies that are entirely based on using "other people's money" to grow the firm. That makes sense when additional funds needed for expansion come in from outside investors, as long as those are in addition to the founders' initial capital invested. But when working with outside funding sources, be sure they understand clearly your commitment to the venture--and the reduced risk perception--by bearing some of the company risks through your own equity investment. There are so many other line items to be negotiated in doing a funding deal that the question of an owner's equity participation should not be one of them.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 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.