Entrepreneurs: how much equity capital you should have
Unless an entrepreneur has decided to go through the journey of entrepreneurship all alone from the beginning till the end, a question has to be asked - how much control should I have over the enterprise? When there is a need to get in a partner, the same question may have to be asked again and again.
Running an enterprise requires lots of resources such as money, talent, human networks etc. More often than not, a person will not have all the required resources to start and continue running the enterprise. Partner(s) may have to be brought in for monetary or other types of resources. Negotiation kicks in on how much equity should be allocated to the partner(s). Valuation of the enterprise and the resources to be injected by the partner(s) has to be done. The parties involved usually have different perception of the values and deadlocks have to be resolved before the final agreement is inked.
Throughout the negotiation process, the entrepreneur should bear the following in mind:
- If a different class of shares is to be created, this means the class rights will be different. These rights usually involve voting, veto power on certain financial matters, board seats, appointment of key executives, dividend, distribution of assets etc. Different voting rights may give more power to the new class shareholders and may create a dominant force in shareholder meetings. This could, among other things, lead to the kicking out of the founder from the board of directors. Senior executives may also have to be re-shuffled. When the board structure changes, decision making process will be different. The entrepreneur will not be the only person making the decision.
The new shareholders may be entitled to different dividend rate and priority in receiving dividend. In the event of dissolution, they may also be entitled to receive return on equity capital first.
If there are subsequently several rounds of capital raising, the equity and management control of the entrepreneur will be further diluted. The entrepreneur should psychologically be prepared for all these.
- If a time table on some key financial milestones is set, realistic assessment whether these figures are achievable must be made. It is advisable to err on the side of caution. Consultation with financial experts may be beneficial before saying ‘yes’ or ‘no’.
- If the enterprise is facing a life and death situation e.g. liquidity crunch, loss of significant orders / revenue etc. not much time may be left to conclude a deal. The other parties might have sensed this situation too. Stronger effort will be used to put down the value of the enterprise. Can / should the entrepreneur swallow this to save the enterprise for the time being? Again, a practical assessment on the chance of survival after getting the resources should be estimated to decide whether to give it a go.
When all odds are against the enterprise, exit to take a break should be considered. Save the resources and prepare for a comeback!
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