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[capitalminute] Negotiating Equity
August 05, 2004
brought to you monthly by Mike Elia
Financial & Marketing Consultant, Author
"Business Plan Secrets Revealed!”
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This issue of The Capital Minute is a special report that includes three tips for negotiating a larger share of equity ownership in your business when you are raising money for your business venture.
How to Negotiate Equity Ownership When Raising Money for Your Business
Addressing the risks associated with your business in your business plan helps investors assess their investment risk. However, the relative personal economic risk you take to back your plan tells them how serious you are about making your plan work.
In fact, how much of your company you eventually get to keep or have to give up raising money for your business depends on how well you mitigate your investors' downside risk.
Here are three ways to help a potential investor feel less exposed to downside risks, especially the loss of their investment, and better your position to negotiate a larger share of equity ownership.
1) Show them the money
How much "real" money you have already invested or will invest in your business gives investors comfort that you won’t walk away when times get tough.
By real money, I mean hard cash – not forgone pay or other perceived economic sacrifices on your part. With no monetary investment in your business, there’s nothing to keep you from walking away when the going gets rough. You could easily walk away from everything, leaving your investors holding the bag with no business and no way of getting their initial investment back. Let alone any return. That's why investors like to see the entrepreneur with some economic skin in the game.
If you haven’t invested any real money yet, then how much will you invest and where will it come from? When you take a second mortgage on your house or sign a personal note with a bank to invest real money in your venture, you send a strong message to investors. You are telling them that you are willing to put your blood and sweet into the business. That you are willing to risk taking a personal hit if the venture fails. Investors need to know that you cannot walk away from the venture without suffering an economic loss. This is the true test of having “skin in game.”
2) Provide collateral support
Sometimes you have a great idea but don’t have cash available to invest. In this case, what collateral are you willing to pledge as security to potential investors?
When you buy a car or home you often have to make a down payment. Title or ownership doesn’t pass to you until you pay off your loan. A business is similar. However, business investments are more risky. There usually are no hard assets – like machinery and equipment or real estate - in the business to ensure investors recoup at least a portion of their investment if the business fails.
Thus, the objective here is to find a way to reduce the downside risk of the investor and increase your opportunity to hold a larger equity position in your company. Your willingness to provide investors with collateral shows a large commitment on your part. It is a way to put “skin in the game” when you don't have real cash to put in yourself.
3) Offer them a piece of the action
When you have no cash or collateral to offer investors, you have to ask yourself: What percentage of my business am I willing to offer a potential investor for investing in my business?
This is a tough, emotional decision for owners and entrepreneurs. Some owners and entrepreneurs are willing to give up more than what’s necessary to get funding. When this happens deals usually come together quickly. But most entrepreneurs are too tightfisted when it comes to the percentage of ownership they are willing to part with. They forget that without these funds it will be difficult to launch and sustain their business. They argue that if the business hits its future projections, the investor stands to make a huge return on investment.
The problem with this argument is the entrepreneur is valuing the venture based on “when” the business achieves its future earnings; rather than “if” the business achieves its future earnings. When you value a business this way you are not considering the risks that can prevent the business from achieving its projections on schedule. The higher these risks, the higher the percentage of equity ownership investors will have to receive and the less available to the entrepreneur.
From an investor’s perspective, you must look at the value of the business today and who loses economically if it fails. When investors put up all the money for a small portion of the equity and the business fails, they lose their entire investment and the entrepreneur loses little. If the business performs as planned the potential returns to investors pale in comparison to what the owner would receive for little or no monetary investment risk. This is just not an equitable distribution of the potential return when you consider the risk investors are taking on.
Unfortunately, there’s no hard-and-fast formula for setting equity ownership. It will be a matter for negotiation between you and your investors. The more you can mitigate their downside risks, the better position you’ll be in to keep a larger share of the equity ownership in your company.
Investors think about risk. If they believe the downside risk of investing in your business plan is small, then you stand a good chance of getting a large monetary investment and keeping a large portion of your equity ownership in the company. How well your business plan addresses your investors’ downside risks and how much “skin” you put in the game will determine the comfort level of your investors. More importantly, it will determine how much of your company you eventually get to keep or have to give up when you raise money for your business.
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