Why (& How) to Guard Your Startup With an Equity Investor
Blog Post (with free questionnaire)
Today I want to detail out the issue of trading equity for services. When a business or startup decides to explore this, the formal term is inviting an “equity investor” to join the team. Many new businesses who are cash strapped think about this as a trade for services. For instance, exchanging website design services for 1% of equity in the company instead of paying cash for the web design. As with any decision in this game, it needs to be weighed carefully and strategically.
Many entrepreneurs I’ve worked with have faced this common scenario. The problem lies with how startups think about equity.
See if this sounds familiar: You’re in the initial stages of your startup. You’re short on cash, and in need of services. Equity is the only valuable trade-off you can afford.
Or is it?
And at what cost are you letting go of this valuable piece of your business?
Let’s dive in.
The Motive Behind Asking for Investor Equity
First, consider what’s driving you to consider doling out equity. Are you cash-strapped? In need of services with no payment options? Once you uncover the motive behind the temptation to trade equity, you can look for other alternatives.
When a business brings on an equity investor, they are really bringing a new team member into the business. This person will be in a position to have say in decision making in various aspects of the business. That is, unless it is contractually written up that 1% equity does not equal 1% control.
More Than Just a Trade – You Give Away Control
When you consider this trade of services for equity, ask yourself if you want to consider this person’s input in company decisions going forward. This equity investor will also be able to share in the profits when the company does well. Will it drive you crazy to give 1% profits away 10 years from now to a web designer or business plan writer who helped you one time a decade ago?
Plus, if there are issues with the equity investor, such as them not contributing enough time or not being aligned to the company vision, then separating them from the business requires contractual changes.
Simply considering the legal aspect of what it means to give away equity in a company is an expensive task, likely more expensive than just paying that service provider for the services rendered.
Take some time and effort to look elsewhere for cash. There’s no shortage of funding options. So don’t let that be the reason you start weakening and watering down your control or raking up legal fees.
…This Could Look Bad.
Any startup or existing business thinking about approaching an investor for funding needs to remember optics. A business that has equity investors who do not bring tangible value to the business are a red flag to many seasoned investors. It implies the owner is careless and undisciplined with their own business. It raises questions about the entrepreneur’s ability to make sound decisions and handle financial situations smartly.
Consequences if You Need a Big Investor
If it looks like a business owner is doling out equity (usually obvious if there are several 1% shareholders in the business who do not work daily in the business), then an investor may back away from becoming yet another equity investor in a business that is saturated in shareholders already. They want their money to equal power and weight in business decisions, which is less possible when there are several shareholders already.
This means that if you gave out small amounts of equity, and now need a large investment (say $1MM), then it will be HARDER to find an investor since you’ve given out little bits of equity carelessly.
Examining the Risks
Treat a potential equity owner for the big decision it is. Think of what’s at stake, both operationally and financially.
You’re giving up part ownership of your company. Do you understand the ramifications?
Consider. Think of the implications of a service provider turned equity owner. How likely will they now be to meet deadlines? Budgets? Contribute long-term?
Consider. What does it look like when you pitch to investors, and don’t have much share in your own company? How much control and input can you really offer them? So what remains to appeal to investors? Remember: You look a lot more attractive with fewer equity owners.
What is the value of that equity you’re giving away? To fully appreciate the potential, you need to look at what your equity could represent in the future, rather than today. Any percentage of a prosperous business will yield quite large payouts. Believe in your company today. Believe it will be a thriving success, and you will treat your equity with the value it deserves.
Blood, Sweat, and Grit
When you believe in your startup, you invest more. More of your time, your resources, your personal sweat. You also require more. More of your partners. You require from them a similar determination and hard work. If they expect to reap the benefits of the success story, they must be involved in writing it, one piece at a time. Require more – require everything – of would-be equity owners, because that’s what you’re putting in yourself.
Wondering about when it’s ok to trade equity for services?