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.
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