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July 14, 2004
Just Because Someone Wants to Invest is not Reason to Take the Money
If someone is ready to invest in your business you should take the money. Right? Not necessarily! As flattering as it may seem, and as many times as you may hear about the advantages of using other people’s money, taking on equity investors should be done with great caution.
Dilution of Ownership
Each new equity investor reduces your share of ownership, which is known as dilution (think of that glass of ice tea as the ice melts). The argument is that with the additional money, you will create a bigger pie for all to share. Well, maybe. Investors will talk of very high expectations for their rates of returns. Venture capitalists often look for deals that can create 70-100% annualized returns. This is because they recognize that your business is a huge risk for their investment. Failure of any given deal is always a real possibility. Just because they are willing to invest does not mean that they assume that your deal is a safe bet. That is why they want a seat on the board for each investor and to maintain the rights to take over the company (which they often do). So, a bigger pie is not a “given” when it comes to adding more equity shareholders in your business. You may just have less of the same pie, or even less of a smaller pie. Remember, these investors expect you to grow quickly, which increases the overall risk of your business.
The Risk of Sharks
Some investors are best described as predatory. They are looking for deals, not partners they want to be in business with. Although it is not true of most investors, there are a certain number who intend on taking over your company at the first opportunity. The language in the contracts they insist on, give them quite a bit of power to put in “new management” if performance criteria are not met. And they will do it the first time you give them a chance. Again, most investors are not sharks, but there are a few circling out there, and they can always smell blood in the water.
Dynamics of Adding on New Partners
You and your partners have been through all of the excitement and stress of getting things up and going. Hopefully you have chosen each other with a great deal of forethought. Take on an investor and those dynamics change forever. It is like a nice stable family that suddenly has a long lost relative who moves in to stay. There are new relationships that have to be established, rules change, the culture can even begin to change, and certainly the dynamics between the original founders will never be the same. You always have to consider “that person who now sleeps in the bedroom down the hall” in every decision.
There are instances when equity investment makes sense. Start-ups that take a great deal of time to reach cash flow and require large capital investments often have no choice but to bring on investors. Some expansions, especially rapid ones, may need such funding. But, just because you can raise equity does not necessarily mean you should. Be flattered when investors come calling, but think it all through very carefully. If you can reach your goals with your own money, a little more debt, or through slower organic growth it may be a better option for many businesses.
Posted July 14, 2004 06:21 AM
Comments
Posted by: Elizabeth Adams at July 15, 2004 08:52 AM
I think this information is good advice for all entrepreneurs. Starting a business is hard work, and it would be easy to take on any money that comes through the door. New business owners need to remember to be picky when it comes to the business in all aspects. When my father started his dental practice here, he went to a bank for a loan. The only way they would give him money was to have my grandmother co-sign the loan. He wanted to go into business by himself. He went to another bank and got a loan under his own name, and he is doing well today. Since he was picky with certain money decisions, it has kept him in full control of his business. I think this is valuable information to keep in mind.
I will keep in mind in the future to take every investor on its own and spend plenty of time thinking about the consequences of certain investors.
Posted by: Elizabeth Adams at July 15, 2004 08:52 AM
This article does a great job of summarizing everything we learned in class about venture capitalists and some of the problems or warnings areas we should be aware of. Your point is well made regarding the rejection of money/investors in not so good situations. It takes lots of self discipline to reject financing money for a new venture. Just think how excited everyone is when they get to the point in the start-up process that money has been offered. That is where education comes in to play. If we, as entrepreneurs, have been taught what to look for and be aware of by our entrepreneurial predecessors, it will make the process much smoother. How could it not? Going into business with "bad" partners is the beginning of a disasterous future!
Posted by: Raven Teeples at August 5, 2004 03:33 PM
at Belmont University in Nashville, Tennessee. He consults with a variety of businesses on start-up and growth related issues, and with larger corporations on re-establishing entrepreneurial cultures within their organizations. Dr. Cornwall's current research interests include entrepreneurial finance and entrepreneurial ethics. He has authored or co-authored four books.
