4 Things to Consider Before Bringing in Outside Capital
When we tally the requirements for entrepreneurship, we love to talk about grit and passion and vision and work ethic. While all of these qualities do help, your business isn’t going to go anywhere without funding.
If you’re looking to fund your small business (and bootstrapping isn’t cutting it for you), there are two main ways to raise outside capital: debt financing and equity investment.
Business owners who aren’t ready to relinquish control turn to debt financing. Lenders don’t expect to have a say in your business; they just expect you to make your payments. Then, once you’ve repaid your debt, your liability is over and you get to keep all the profits. This option can be far cheaper in the long run, but it can also be a burden on startups who are burning cash to initiate growth.
Sometimes, however, debt financing isn’t an option. Because of the high failure rate of small businesses, some debt investors won’t even give you the chance to lose their money.
In this case, equity investment is a viable option—albeit the only option—for startups. There are great advantages to raising capital this way as far as cash flow and potential for growth. However, there are some major downsides as well.
If you are considering bringing in outside capital through equity financing, think about these four losses first.
Loss of Equity
The most obvious downside of equity financing is the dilution to your ownership.
By definition, equity financing involves raising capital from investors in exchange for ownership rights (or shares). Every time you bring on a new investor, you increase the amount of cash on hand and decrease your financial hold on your business.
While these funds can be critical to daily operations, the cost is diluting your stake in your own business.
At first, this exchange may be well worth it. However, some owners make the mistake of raising and spending so often that their stake in the business approaches negligible. Even if the business itself is growing, this obsessive approach to capital damages your hold on it.
Of course, if the equity you receive allows you to significantly increase your value, you may be better off with 10% than 100%. Just be cautious, and be a competent negotiator. Remember, if you choose to issue “preferred stock” (which you almost certainly will in any standard equity raise), investors get their money out first. That means if you don’t end up selling for more than the amount invested in your company, you won’t end up with a single penny when your business is acquired.
Loss of Control
Dishing out shares means more than just dishing out money—you’re also distributing control. By piecing up the decision-making power for your business, you are opening yourself up to potential conflict or being outspoken.
Equity partners almost always gain the right to influence the direction of your business when they invest. This influence could come in the form of board seats, veto rights, or simply a voice in your ear. When you take on investors or venture capital firms, make sure you’re compatible. As this is going to be a long-term relationship, look for similar goals, working styles and a shared vision. If you and your financing partners don’t see eye-to-eye, there will be stormy waters.
Distributing equity between lots of investors can also make things difficult. With too many captains, decision-making becomes complicated, even stalled. While funding can improve growth, the loss of executive authority could actually impede growth strategies.
In worst case scenarios, small business owners lose control of board seats or are replaced completely.
Loss of Profitability
One thing entrepreneurs and investors tend to agree on is the goal of rapid growth. If you can build a profitable business, quickly and efficiently, everyone will end up happy and the risks of outside capital become moot.
Unfortunately, that’s not how it works in practice (at least, not very often). Typically, business owners seek out equity funding because they cannot yet turn a significant profit on their own. They raise capital in order to operate unprofitably for some time—and they need to start hustling to figure out how to make their business profitable and how to scale in order to meet the high demands of return-seeking investors. Then, even when profits come, there’s a chance they’ll have to pay up first, leaving themselves and their business with nothing.
While outside capital can increase your potential to bring in cash, it’s important to remember a basic finance principle: cash in the bank doesn’t mean positive cash flow. In other words, just because you have a lot of funding, doesn’t mean you’re profitable or even that your business is succeeding.
Loss of Lifestyle
Many entrepreneurs found their company with the goal of creating a lifestyle business—to be their own boss, take a generous salary, run their little kingdom. Unfortunately, in the moment you take on outside capital, you are putting your kingdom at risk.
Once you take on investors, you’ve got someone (or multiple someones) looking over your shoulder at all times. The freedom you enjoyed in making strategic decisions, personal compensation, or even vacation time, is usually unrecoverable once this additional accountability enters the picture. Your personal feelings of obligation, as well as intense investor oversight, can whisk away the “lifestyle” aspect of your business.
For the most part, while you have equity investors on your capitalization table, your personal goal of providing a great quality of life shifts to a business goal of growing big enough to provide a return to your investors.
Think about it
Equity financing isn’t all bad. In fact, over the last few years, terms have grown more favorable to entrepreneurs and safer investment options have opened up.
Just take your time and think about your decision. Don’t follow the herd. Find what’s best for you at this stage in your business. Calculate how much money you really need. Weigh the alternatives, like business incubators or working capital solutions. Consult a business lawyer. Make sure you’re ready to deliver results to investors.
Almost every business has to bring in outside money at some point. Just don’t hand out equity like lollipops.
Guest post by author Jaren Nichols, Chief Operating Officer at ZipBooks, free accounting software for small businesses. Jaren was previously a Product Manager at Google and holds an MBA from Harvard Business School.