Big Love

When angels have too much faith.

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When Steve Wandler lost his job as schedule manager for a steel manufacturer in 2001, he knew it was time to get serious about the start-up he was launching on the side, YourTechOnline.com. The company, based in Kelowna, British Columbia, provides outsourced technical support for PC users. It had few customers and no employees, and was losing money rapidly. Wandler, who'd just been fired for taking customer calls in his employer's restroom, had already blown through most of a $32,500 bank loan. He desperately needed money.

He told his wife to fill out any credit card application that came to the house and began talking up the company to anyone who might be willing to cut him a check: parents, aunts and uncles, friends, even members of a computer class for senior citizens. He raised $700,000 from 25 investors, about half of them debtholders and the rest shareholders with voting rights. Many were enticed by Wandler's plan to take the company public in two years. "They thought a $10,000 investment would make them kajillionaires," he says. Wandler knew these expectations were far-fetched but didn't discourage them. Instead, he let himself dream along with his investors.

Bad idea. Amid the mad dash to raise seed capital--$1,000 here, $5,000 there--few entrepreneurs bother to consider the hazards of taking money from a gaggle of friends and relatives and giving them big promises--and voting rights--in return. A flock of investors may help an unproven company stay afloat in its early years, but those same shareholders can become deal breakers when the company tries to raise money from VCs or private equity firms. Unsophisticated investors might be surprised when told their stake will be diluted. And they might take umbrage if the company sells out for a modest sum instead of becoming the next Google (NASDAQ:GOOG).

To make matters worse, major investors often view a large bloc of shareholders as an added risk, which could lead them to reject a deal entirely. This is especially true when seed investors hold voting shares, but even nonvoting investors can scuttle a deal by threatening a lawsuit or pressuring the founder. Professional investors "have enough problems to deal with without a bunch of crazy common stockholders," says Jeffrey Sohl, director of the University of New Hampshire's Center for Venture Research. Wandler ran into trouble in 2005, when YourTechOnline had grown to 15 employees and about $500,000 in revenue, and Wandler was looking for money again. He found a large computer manufacturer interested in buying the company, but the big company was put off by the hodgepodge of small stakeholders. "When we showed them the number of people involved, they weren't interested," Wandler says. "Our investors were holding us back."

The next year, the company became cash-flow positive, and Wandler decided it was time to "clean up" for a potential deal or sale. He began trying to convince his shareholders to take their money back with interest--a case he thought would be easy to make given the company's past struggles, its modest size, and its debt, which was then about $175,000. But Wandler was the victim of his own fundraising success. "They didn't want to get out," he says. "They still believed my pitch. Their attitude was, 'You should go public, and I should be able to trade my shares on the stock market.'"

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