The Impact of Equity on Personal Wealth
You can't start a company until you decide how to finance it, and the financing decisions you make along the way will forever affect how you approach your business. Should you dig deep into your pockets, take a second mortgage on your house, visit generous relatives and fill out as many credit card applications as you can get your hands on? If you do, you're funding it through cash flow and personal debt. That's a good choice if your priority is to remain king of your company, doing whatever you want, whenever you want, and not answering to anyone but yourself.
But, suppose you're staring at a huge opportunity that you just can't pursue through these traditional methods of financing? an idea that requires large quantities of capital coupled with rapid growth in order to reach fruition. Big ideas are rarely grown to a large scale through the incremental growth path of the traditional small business. Many of today's hottest public companies that are less than 10 years old reached their present size via multiple rounds of private equity financing? with entrepreneurs selling pieces of their business along the way.
In 1988 I started TriNet, a human-resources outsourcer, with an initial investment of $5,000. For the next two years, financing was more about survival than growth. Our unproven business model was not generating the sales needed to keep the doors open. Personal debt like credit cards, a second mortgage, and family loans kept us afloat until we sold our first piece of the company in a private placement, raising $50,000 from angel investors.
Now, with year 2000 revenues of more than $34 million? and an Internet-based delivery platform poising us for even more rapid growth? TriNet's ability to generate revenue is no longer an uncertainty. Equity financing, as much as sales, gave us the resources we needed. Since that $50,000 placement more than 10 years ago, we've done four other rounds of financing that have included both corporate and professional venture investors. As a result, those investors now own almost 60 percent of the company's equity.
Understand the Tradeoffs
Growth supported only by cash flow and debt means fewer choices for your business when it comes to expanding rapidly, without the support of immediate profitability. As anyone who's brought a popular business idea to market can tell you, true hyper-growth consumes more cash to build than short-term profitability can readily support? even if there is overwhelming demand for your product or service. And, professional investors can provide you with more than just ready cash. Their guidance on building a scalable business, proximity to other financing sources, and access to top-tier service providers and business development relationships can all add up to significant advantages.
As you would expect, there's a price for taking this "smart money"? including things like giving up seats on your board of directors, accepting terms that give professional investors control over key decisions in your capital structure and, possibly, handing over a significant chunk of the company itself. It helps to understand that equity investment is a tradeoff for the investor as well as yourself. You're asking investors to take a risk and buy shares with no guarantee for payback.
Conventional wisdom notwithstanding, the loss of some degree of control isn't likely to be your biggest pain point. The greatest trial for many newbie entrepreneurs accepting equity financing comes in the form of deferring their own short-term wealth in favor of realizing a return to investors and option-holding employees.
Take a Long View of the Good Life
Accepting equity financing forever alters your entrepreneurial journey, because you no longer have the luxury of thinking about yourself as the primary recipient of the company's financial success. Professional investors can liquify their equity investment in a company in only one of two ways: either the business conducts an initial public offering or it merges with another company. Therefore, you must make the strategic decisions necessary to guide your company down a path to investor liquidity? even if doing so conflicts with your short-term personal financial goals.
As a small business reaches a stable level of profitability, it is not unusual for entrepreneurs to see opportunities for their business to pay certain personal lifestyle expenses. From financing a condo in a resort area to driving a company-paid luxury car, owner perks can assume many forms? including the ability to draw a much higher-than-market salary in exchange for your talents. With the endgame of either an IPO or a merger or acquisition on the horizon, though, you will have to view your business through a markedly different prism.
Professional investors will not tolerate extravagant behavior in how their capital is put to use. They're looking for partners who will use the equity investment to build a long-term business, one that scales for enterprise-level service. The last thing an investor wants to see is a CEO who leverages equity financing for personal gain, taking money out of the business that should be reinvested for growth.
Let Compensation Reflect Commitment
In my own case, instead of seeing a big jump in TriNet's company bank account as a means for a trip to Paris or a way to build a dream home, I become excited about the new technologies and delivery capabilities that outside financing or earnings will buy as money is plowed right back into the business. I seek to improve my company's internal efficiencies, rather than focusing on ways to maximize my personal bank statement. Essentially, I accept a limit on personal wealth, in relative terms, in order to make the right decisions that will scale my business.
For instance, from Day One, TriNet has been a C-corporation. Almost any company that receives financing from professional investors has to be, because that status allows it to issue preferred stock? which investors demand as part of the deal. It also means that the compensation I take out of the company must be reported as salary on a W-2 form. Since that creates a double taxation effect, many small, closely-held companies avoid C status. But doing it that way shows an entrepreneur's commitment to building value for investors, rather than draining resources from the company.
Since building an enterprise-level company often means deferring personal financial goals, it requires that pride, as well as comfort, be sacrificed on the altar of an impending liquidity event. Sounds like fun, doesn't it? But in the long term, if your company succeeds in growing to be much more than a small business, the commensurate financial rewards will appear? although even those must be seen as secondary to the ability to create long-term success.
Taste the Value of Your Slice
The reality of equity financing hit me back in 1994, at a Young Entrepreneurs Organization program for high-growth businesses. One of the speakers was Mitch Kritzman, founder and CEO of PowerSoft, a publicly traded company. Kritzman had endured many rounds of outside equity financing in order to bring his company to IPO. Each round had reduced his stake, so that by the time he took it public, he only owned 10 percent of the business! How could he give up such a large stake of equity to other people and relinquish control over his own company?
Kritzman's response put things in perspective: "Don't worry so much about the percentage of the company you own? giving up ownership doesn't mean you're about to be fired. Entrepreneurs will still retain control of their companies as long as they're successful at what they're doing. No professional investor would remove an effective CEO, and an ineffective CEO has no right to lead the company in the first place."
Okay, fine, but the audience still wanted to know about the financial return. Hadn't this entrepreneur sacrificed the fruits of his labors by giving up so much equity? But when someone asked finally about the current value of the company, it turned out that the founder's 10 percent stake was worth more than $60 million. Mitch replied calmly, "It's not how much of the pie you own. It's the value of your slice that matters." It was clear to all of us that he didn't simply mean money.
© 2001 Kauffman Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation, 4801 Rockhill Road, Kansas City, MO 64110.All rights reserved.
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