If there is a lesson to be learned from the current recession, it is the value of running a well-capitalized company. Whereas debt has spelled disaster for too many highly leveraged businesses, equity offers resilience.
The problem with raising equity from investors is that business owners worry about losing decision-making control over their companies. My response to owners of deeply troubled, equity-starved businesses is that they have already lost control of their businesses. Without some added capital to power a business turn around, their companies will likely close or enter bankruptcy. Nobody wins in this scenario.
Here are some tips to help business owners obtain a higher level of comfort, cash and control before approaching the equity markets for financing.
No. 1: Upgrade your board of directors, now. Ideally, privately-held businesses should upgrade their board of directors every four or five years to match advancing business goals. What’s important is for you to pick your team, preferably with targeted industry expertise. Skip friends and family members. “Weak” boards always get overhauled by new investors. In subtle but meaningful ways, these new members will be more loyal to the financial investors than the business founder.
No. 2: Get an employment contract. How can business founders get fired from the companies they started? It’s easy. This happens when founders lose voting control of the company’s shares and the loyalty of the company’s board of directors. One way to minimize the risk of getting fired from your own company without cause or adequate compensation is to negotiate a “reasonable” employment contract with your company’s board of directors prior to raising capital. New investors typically receive one or more board of directors’ seats as part of their funding agreements, which can change the board’s overall voting dynamic of a board. If a company’s sales and profits don’t meet projections, impatient new board members can push for management changes. Again, business owners are likely to get a better deal from board members that they invite to the board, not investors.
No. 3: Hire the qualified talent. Every time business owners put unproven staff in demanding positions, they jeopardize their equity stake. Here’s why: The longer it takes a company to meet product development schedules or bring in profitable sales, the more capital founders may have to raise to cover added operating costs. More capital infusions mean more dilution to the founder. Don’t waste time or money on so-so employees.
No. 4: Stock options. With board of directors’ approval, companies can set aside a certain number of treasury shares for an employee stock option plan. Because founders can receive annual stock option awards for good performance, stock options can help founders buy back their equity stake long after the company no longer needs investment capital.
No. 5: Explore "earn backs." To the extent business owners accept what they perceive as a “low” valuation to secure expansion funding, founders can ask investors to escrow or set aside a certain number of shares to reward exceptional performance. If management doesn’t meet agreed targets, then the lower valuation holds. If management beats projections, then the founder earns back a slice of the company’s equity pie.
No. 6: Pay attention to preferences. Most business founders get hung up on negotiating their company's current worth, or its “pre-money” valuation. I say, pay equal attention to preferred stock “liquidation preferences.”
When a company grows to a lucrative sale, preferred shareholders get paid one or two times their original investment before common stock holding founders receive a penny. Investors can also add to their percentage equity stake with annual stock dividends that accumulate year after year until the company is sold. Again, founders have to wait in the wings until investors get their liquidation preference multiple plus all accumulated stock dividends.
And lastly, here’s my best advice for maintaining control of your company. Capitalize it well and don’t hide problems from investors or board members. Collaborate as partners, not foes.
Susan Schreteris known as the “Big Voice for Small Business.” She is a 20-year veteran of the venture finance community and a university educator in entrepreneurship. She is the founder of www.takecommand.org, a community service organization that offers the largest centralized database of startup and small business funding sources in the U.S. Follow Susan on Twitter @TakeCommand.