When you start a business, you own it. You can sell or share equity in the business to grow. You may be trading equity for cash from investors or giving equity to people you need to grow the company. However, there are many mistakes you can make when you’re giving others a stake and say in how you run the business. Here are three things you should consider before giving up equity in your business.
Too many founders undervalue their business. They then give away a 5% stake to investors for a small sum that becomes worth a fortune when the business is profitable. In other cases, they trade equity for a discount on loans or instead of paying someone a market rate for their services. It may feel like you’re getting your website or app for free when a 15% stake isn’t worth much. However, this is a waste of money and limits your future options, especially if the person you hired didn’t deliver amazing service.
Do a cost-benefit analysis. How are you going to use the money? And what is the return on that investment? Don’t give away equity if you can get a reasonable interest rate on a loan. Suppose you have to trade equity for cash. Know what the equity is worth before you offer investors an equity stake in your business.
Different valuation methods can be used to determine what your business is currently worth. Whichever one you use, you should at a minimum use it to properly value the equity stake you’re considering giving away. However, there are valid reasons why you may want to treat equity as the limited resource it is.
If you own your business, you get to make all of the decisions. If there are several partners, your partnership agreement should outline how decisions are made and by whom. When you sell equity, you’re bringing in another partner who also has a right to say how things will be done, so determine how this affects decision-making.
You can offer investors preferred shares or common shares. If they buy common shares, then their vote is proportional to their equity stake. If they have preferred shares, they can exercise a disproportionate level of control and will probably get a larger share of the revenue than their equity stake would suggest.
Many startups sell equity because they have no money to fund their startup or their initial growth. Many investors will provide funding in exchange for equity. They generally want to see a return on their investment, often by selling the equity stake when the business has become successful.
Know the financial details of your business before you court investors. They’ll want to know your turnover, your growth forecast, and other key details about the business. You should also have a good plan for repaying them. Then you don’t have to worry about them selling their equity stake to an unknown third party to get their money back. On the other hand, if you have these numbers, you could argue for paying them a share of the profits without giving them equity.
When you give away equity, you’re giving up money and control. Make sure it is a fair trade before you commit to giving away part of your most valuable asset – your startup.