Raising Equity Capital
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Businesses grow in one of two ways: either from funds generated internally or through raising outside capital. Internally generated funds are the best way from the standpoint of maintaining control, but this method can be extremely slow. The other way is to raise money from outside equity investors; i.e., individuals who invest for an ownership stake that hopefully will increase significantly in value.
From the entrepreneur’s perspective, there are two main caveats that they should be aware of before entering into an agreement with an outside investor.
First, you need a written contract, preferably drafted by an attorney, that clearly states the investors are investing as equity stakeholders and that they are not lending the business money. If the business fails, this precludes them from claiming that they are creditors of the firm and that you owe them the invested money.
Second, if your business is a startup or developmental stage enterprise, you are probably going to have to surrender a majority percentage of the equity to obtain substantial capital. As majority owners, the equity investors, in the future, can fire you after you have built a successful business for them. It happens all the time. While terminating your employment would not end your ownership interest, you would probably spend years in court fighting for a buyout. Therefore, your agreement with your investors should state that, should they choose to terminate your employment, upon termination, you will be bought out according to a predetermined formula.
Finally, small companies that cannot pay market salaries, or choose not to, often ask employees to work for less in return for equity in the business. This is a good way for the employee to get screwed if he or she does not know what they are doing. “Sue, we cannot pay you the $100k that the job is worth, but we can pay you $60k”. The $40k difference will be considered an equity investment on Sue’s part, and after five years she will own 10% of the business. Now, five years later, the company is sold for $5 million. Sue asks: “Where is my $500,000”? What are you talking about, the boss asks, you are an employee. Be careful. The business world is a vipers nest of thieves and whores. Now all Sue can do is tell it to the judge. Of course, as a mid-level employee she probably does not have $100k to pay in legal fees to pursue her claim in court, so she is screwed. There is a joke in the legal world: how much justice can you afford?