The golden rules of equity investment
To launch the company John realised that he needed at least a $100,000 capital in order to invest in machinery and initial staffing costs. His cash flow projection showed that he was unlikely to start making inroads into that debt for at least a year. The banks were prepared to lend, but that came at a cost. If he opted for that route John knew that it would be a very hard year and would involve a dramatic change to his way of life.
However John knew some friends who might be prepared to invest, but was that going to be the best option in the long term?
The advantages of equity investment
Equity investment is an attractive option for many prospective business owners who need a large injection of capital to get their businesses up and running. Effectively it costs nothing in the short term. The investors are paid back through the profit the company generates and will ultimately realise their investment when their shares are sold. That relieves the pressure on cash flow in those early days of trading when the bank or lender would otherwise require the business to service the loan. As a result there is a greater potential for rapid growth. But there is a downside.The downside
The downside is that you are giving away part of your company. This means that not only are you giving away part of your profit, but you are also giving away control, depending on how much equity you are giving away to your potential investors. This causes problems for a seedling company with no trading record. Any astute investor is not going to invest a great deal of money without acquiring a significant shareholding in return. The more money you are asking for the greater shareholding the investor will want. Give more than 50% and you have given away control of your company. Even giving away 25% or more denies you the ability to make certain important decisions about your company.When giving away control causes problems
Loss of control only becomes an issue when there is a disagreement about the direction the company should take, a major decision that used to be acted upon. Your position on the Board of Directors will count for nothing if the other shareholders have directors in place who can out-vote you around the boardroom table. If you don’t have a sufficient shareholding you can’t rectify that position by appointing directors sympathetic to your standpoint.It’s no longer your company
All of a sudden you realise that it is not your company anymore. You become a minority and the vision you had at the outset for your company starts to vanish before your eyes. It is at that point you realise that loan finance may have been the better option, even though more costly at the outset.However that is not to say equity investment doesn’t work, but if you are considering that route here are a few golden rules to follow.
The golden rules of equity investment
The first golden rule is to treat your equity investors as business partners: because that is what they are. Even if they describe themselves as silent partners, beware. They may be silent when the company is being run how they think it should, but if you want to go in a different direction that doesn’t suit them you can expect them to be vocal.So, as with any business partner, choose wisely. Don’t seek equity investment from anyone you wouldn’t go into business with – you could regret it later.
Finally, always have a shareholder’s agreement. With a shareholders agreement it is possible to retain a degree of control despite giving away some of the company’s shareholding. For example you can retain a mix of directors on the Board which doesn’t disadvantage you, and attach different rights to different classes of shares.
John’s case
John was able to raise enough equity investment to fund his $100,000 capital injection required. The problem was that with no trading history he couldn’t put forward a viable argument as to why he should retain more than 50% of shares in the company. Ultimately his investors wanted too much, so John turned his back to the banks. This was going to cost him more in the short term, but if he could get through the first year he would be much better off in the long run.© Michael Smyth. Would you like to use this article in your newsletter, on your website or in your magazine? If so, I would be happy to give you permission. Simply click here to find out how you can use this article
| Do you have a shareholders agreement that will protect you if you fall out with your business partners? If not then I can prepare one for you. Simply drop me an email michael@approachablelawyer.com or give me a call (09 358 2725). |