Investing Your Own Money in Your Business Don't let outside investors think for a second that you're unwilling to take on some financial risk.
By David Newton •
Opinions expressed by Entrepreneur contributors are their own.
Is there a formula or some kind of rule of thumb by whichbusiness owners should abide in terms of their own personalinvestment into their company, relative to outside funds investedby others? The simple answer is that there is no basic measure forgauging an owner's equity stake compared to investors'equity in the firm. But there are two very important concepts aboutbusiness financing that do apply to the general topic ofowners' equity.
First, in virtually every funding deal that I've ever beeninvolved in as a business partner, consultant, investor or advisor,the outside investors required that the founding team have a vestedfinancial stake in the enterprise. The rationale is that the ownersneed to demonstrate a solid financial commitment to the businessplan, and having their own money at risk--alongside the outsidecapital providers--provides a tangible assurance to outsideinvestors that the entrepreneur believes strongly in the merits ofthe company's business model and strategy. I always tell myclients and students to think about this logically. Would you wantto invest in a business knowing that the founding entrepreneur doesnot have any of his or her own money also invested? Of coursenot!
When term sheet proposals are being circulated along with acompany's executive summary, investors always focus theirinitial attention on four major areas:
- What is the product or service concept, and how is itdifferentiated from the competition?
- How large is the potential market for this product orservice?
- Who on the management team will drive the business strategyforward?
- What do the business model and the financial structure looklike? This fourth area examines the way the company makes money, aswell as the debt-equity arrangement that capitalizes the assetsthat will be employed to achieve success with that model.
When outside investors see that the company founders havealready invested significant time into the business, that'swell-received. But sweat-equity alone is not enough to persuadeinvestors to fund the deal. In addition to plenty of hours investedworking in the business, the owners must also be equity investorswith money at risk--otherwise, capital providers view the level ofcommitment as being less than desirable.
The second important concept is the form of the founders'capital commitment to the company. Some entrepreneurs will providea loan to their new venture, and it may even be secured by fixedassets purchased with those funds. This is less positive than ifthe founding team has stock in the firm.
The time frame for the company to pay off a loan can also be aconcern to outside investors. If the owners have a provision to paythemselves back within a year or 18 months, the priority of paymentsends a signal to outside capital providers that the owners want tobe sure to cover their own personal financial positions first, andthis can cause concern. Outside investors would much rather see theowners in a side-by-side position with them, where everyone has anequity stake and no one is getting priority of payments fromoperating cash flow.
In summary, equity stakes for the founders always look betterthan short-term and/or secured loans to the company. When outsideinvestors do co-invest with the entrepreneur, the deal will go muchmore smoothly if owners and founders are equity investors andthey're both in the same class of securities. For example,outside capital providers will frown on the situation where thefounders have preferred stock, while investors have lower-prioritycommon stock.
The best way to put these two concepts together is to understandthe perceived risk of the venture. Investors will always look forways to mitigate certain risk exposure in order to reduce thepotential for capital loss. Some companies pursue financingstrategies that are entirely based on using "otherpeople's money" to grow the firm. That makes sense whenadditional funds needed for expansion come in from outsideinvestors, as long as those are in addition to the founders'initial capital invested. But when working with outside fundingsources, be sure they understand clearly your commitment to theventure--and the reduced risk perception--by bearing some of thecompany risks through your own equity investment. There are so manyother line items to be negotiated in doing a funding deal that thequestion of an owner's equity participation should not be oneof them.
David Newton is a professor of entrepreneurial finance andhead of the entrepreneurship program, which he founded in 1990, atWestmont College in Santa Barbara, California. The author of fourbooks on both entrepreneurship and finance investments, David wasformerly a contributing editor on growth capital for IndustryWeek Growing Companies magazine and has contributed to suchpublications as Entrepreneur, Your Money,Success, Red Herring, Business Week, Inc.and Solutions. He's also consulted to nearly 100emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are thoseof the author, not of Entrepreneur.com. All answers are intended tobe general in nature, without regard to specific geographical areasor circumstances, and should only be relied upon after consultingan appropriate expert, such as an attorney oraccountant.
