When angels have too much faith.
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."
Just as important, many of YourTechOnline's shareholders, including Wandler's mother and father, simply liked being a part of the company. "They were friendly arguments," Wandler says. He emphasized that paydays are rare when people invest in private companies. Now was a chance for them to get out.
Some investors needed a lot of convincing. Ron Schlitt, a friend who invested $3,200 in 2002, had been excited by the prospect of an IPO. "My attitude was, 'Let's roll the dice and hope the sevens show up," he says. As Wandler explained his predicament, Schlitt relented. If Wandler ever takes the company public, Schlitt hopes he'll have a chance to buy into the IPO.
In retrospect, Wandler wished he had issued convertible debt rather than stock. That can make a company more attractive to potential buyers and investors, says Lori Hoberman, a New York City-based attorney and principal with law firm Fish & Richardson and a specialist in small-business finance. It works like this: Investors receive a note that converts to common stock during the next round of financing at that round's valuation. Before then, their contribution is treated as a loan that the entrepreneur can repay unilaterally (with interest at an agreed-upon rate). That means if you want to buy out your friends and family, they can't say no.
But most problems can be headed off by being honest about your company's prospects. Entrepreneurs should discuss their plans for raising additional equity and explain how that could dilute their seed investors' stakes. "Seed investors need to understand that they're probably not going to get rich," Hoberman says.
After months of cajoling, Wandler convinced about half of his shareholders to take their money back with a modest return. Now he's trying to, as he says, "realign" the expectations of the remaining shareholders as he begins negotiations with a New York City private equity firm. Though Wandler, as sole director and majority shareholder, could push the deal through, he wants his investors to support the deal, both because he feels obliged--"these people believed in me," he says--and to avoid scaring off the private equity group.
It hasn't been easy. Wandler's angels are wary of seeing their stake in the company diminished--especially now that the company seems to be on the right track. Wandler has adopted a pitch that is equal parts self-deprecation and trust me: "Look, we're not going public and that sucks," he tells his shareholders. "But this is the new direction." To secure everyone's agreement for the proposed deal, which he hopes to close this summer, he's listened to countless objections and counterproposals. Wandler doesn't begrudge his remaining investors these conversations; he blames himself for setting false expectations. "I screwed up when I sold them on the IPO," he says. "Now I tell them you can either have 20 percent of nothing or 10 percent of something."