The ABCs of Equity Financing
In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors offer some tips for business owners who are hoping to attract equity funding for their startup.
Equity financing for your business can come from various sources, including venture capital firms and private investors. Whichever source you choose, there are some basics you should understand before you try to get equity capital to fund your startup. An investor’s “share in your company” comes in various forms. If your company is incorporated, the investor might bargain for shares of stock. Or an investor who wants to be involved in the management of the company could come in as a partner.
Keeping control of your company can be more difficult when you're working with outside investors who provide equity financing. Before seeking outside investment, make the most of your own resources to build the company. The more value you can add before you go to the well, the better. If all you bring to the table is a good idea and some talent, an investor may not be willing to provide a large chunk of capital without receiving a controlling share of the ownership in return. As a result, you could end up losing control of the business you started.
Don’t assume the first investor to express interest in your business is a godsend. Even someone who seems to share your vision for the company may be bad news. It pays to know your investor. An investor who doesn’t understand your business may pull the plug at the wrong time—and destroy the company.
Because equity financing involves trading partial ownership interest for capital, the more capital a company takes in from equity investors, the more diluted the founder’s control. The question is: How much management are you willing to give up?
Don’t overlook the importance of voting control in the company. Investors may be willing to accept a majority of the preferred (nonvoting) stock rather than common (voting) stock. Another possibility is to give the investor a majority of the profits by granting dividends to the preferred stockholders first. Or, holders of nonvoting stock can get liquidation preference, meaning they’re first in line to recover their investment if the company goes under.
Even if they’re willing to accept a minority position, financiers generally insist on contract provisions that permit them to make management changes under certain conditions. These might include covenants permitting the investor to take control of the company if the corporation fails to meet a certain income level or makes changes without the investor’s permission.
Investors may ask that their preferred stock be redeemable either for common stock or for cash a specified number of years later. That gives the entrepreneur a chance to buy the company back if possible but also may allow the investor to convert to common stock and gain control of the company.
Some experts contend that retaining voting control isn't important. In a typical high-growth company, the founder only owns 10 percent of the business by the time it goes public. That’s not necessarily bad, because 10 percent of $100 million is better than 100 percent of nothing. The key is how valuable the founder is to the success of the company. If you can’t easily be replaced, then you have a lot of leverage even though you may not control the business. But keep in mind, you might think you’re really valuable—but you might not be in the eyes of your investors.
If you're good enough, the investors may decide their best choice is to let you run the company yourself. So try not to get hung up on the precise percentage of ownership: If it’s a successful business, most people will leave you alone even if they own 80 percent. To protect yourself, however, you should always seek financial and legal advice before involving outside investors in your business.
When most people think of equity financing, they think of venture capital. Once seen as a plentiful source of financing for startup businesses, venture capital—like most kinds of capital—is no longer so easy to come by. Yes, there are venture capital firms out there. Quite a few, actually. There are websites you can go to, like Entrepreneur.com’s Top 100 Venture Capital Firms—a directory of venture capital firms—and you may find some luck. And luck is exactly what you need to convince venture capitalists to invest in your business. If you think we’re trying to discourage you, we are. Money can be found for investing in your company, but the era of the venture capitalist happily handing out forklifts of money is over—especially for startups.
Venture capital is most likely to be given to an established company with an already proven track record. If you're a startup, your product or service must be better than the wheel, sliced bread, and the PC—with an extremely convincing plan that will make the investor a lot of money. And even that might not be good enough.