The Perils of Success
I’ve noticed a pattern among entrepreneurs who come to me for advice: They are almost always concerned about the wrong thing. They worry, for example, that a plan of theirs will fail, when they should be focusing on the much larger problems they’ll face if it succeeds.
Consider a young man we’ll call Alex, who contacted me recently about plans he and two partners had for a chain of 12 restaurants selling empanadas, the Latin American stuffed pastries. The partners already had one successful restaurant. Now they wanted to franchise the concept. Toward that end, they were bringing in a restaurateur who had a chain of empanada restaurants in Argentina. He would receive 20 percent of the stock for his help.
In addition, the father of one partner had agreed to invest $300,000 in exchange for a 25 percent stake. His son was the only partner working in the restaurant. The other two, including Alex, had full-time jobs elsewhere. Accordingly, they owned less of the company, 29 percent each, than the working partner, who owned 42 percent--prior, that is, to their all being diluted by the two new shareholders. (After that, the three original partners’ share would total 55 percent.)
Alex was concerned about the deal with the restaurateur. He worried that the guy wouldn’t do what he’d promised and the partners would wind up giving away 20 percent of the company for nothing. I didn’t see that as a big problem, provided they made the stock grant conditional on achieving certain well-defined objectives within a given period of time. Alex said they had a plan that would unfold in four stages; the restaurateur would get the stock only after completing the first three. “OK,” I said, “but you need to include time limits. Then, if he doesn’t deliver, you’ll be out some time and money but nothing more.”
Then I asked Alex a question: What if the restaurateur does deliver but the company doesn’t have enough capital to finish the job? The $300,000 investment didn’t seem nearly enough to set up a chain of franchises. Granted, the company will have some additional cash flow after the partners begin selling franchises, but with legal costs, marketing costs, travel costs, administrative costs, and other costs they hadn’t anticipated, they could soon find themselves needing a lot more capital.
With a small company and few personal assets, they’d have a tough time getting a bank loan. That would mean another equity investment, which would mean further dilution. As it was, Alex’s share of the business would be down to about 16 percent after the restaurateur and the investor are given equity. The next round of capital would leave him with a much smaller percentage.
The best solution, I suggested, would be for the father to invest the $300,000 and agree in advance to loan the company whatever additional capital might be needed. He is the ideal lender, in that his son will own 23 percent of the business by then, and so together, they’ll have 48 percent, which gives them effective control. They will thus have an overwhelming interest in making sure the company doesn’t fail--which would also be good for the minority shareholders like Alex.
My point was that rather than worrying about the restaurateur’s not performing, Alex and his partners should be focusing on getting the financing they need to succeed. People can be replaced relatively easily. Coming up with capital in a pinch is much, much harder.
NORM BRODSKY | Columnist
Street Smarts columnist and senior contributing editor Norm Brodsky is a veteran entrepreneur who has founded and expanded six businesses.