June 22, 2016
How to divide equity in a business between a founder and investor fairly
By Achim Neumann
Often, an entrepreneur will have an idea that can transform an industry, but they lack the financial capital to make it happen. On the other side of the coin, there are no shortage of people searching for profitable opportunities in which to invest their extra cash.
Without the qualities that each party brings to the table, a business cannot happen. The real issue is this: how can one divide ownership of a business fairly between a founder and an investor? In this article, we will address the issues surrounding this thorny problem…
Founders should retain the lion’s share of equity
Despite the assistance that venture capitalists provide a startup, the vast majority of the hard work will be done by the founder. In light of this, it would be a mistake to give away too much power and ownership of the business to a third party.
This isn’t to say that external investors aren’t important, but the founders should be careful to insert language in any agreement that protects their interests in the years that lie ahead.
No matter what happens, the founder should always have a majority equity stake, plenty of stock options, and a parachute clause to protect them financially from termination by an executive board.
Try to solicit convertible loans or debt financing from investors instead
When a founder is seeking out financial assistance from investors, the first approach should be to attempt to solicit convertible loans or debt financing rather than offering equity.
This tends to work more often than not, as both of these financing vehicles are more attractive to investors rather than having ownership in a company.
This is mostly due to tax issues surrounding equity stakes, which can result in a more substantial tax bill compared to the previously mentioned alternatives.
Hash out equity stakes before any money is accepted
If equity stakes are offered to a potential investor, it is important that a concise agreement is agreed upon before any form of financing is accepted from an investor.
Most founders and investors have a great deal of separation when it comes to the financial worth of a business, as the entrepreneur behind it tends to have an inflated idea of the value that it brings to the marketplace.
These days, startups can have a practical value that is close to zero before any real money is made, so if any cash offer is made by an investor, it should be seriously considered: just be sure to hash out a contract that makes ownership stakes and other benefits clear before receiving financial assistance from a VC.
Avoid investors that draft agreements that are legalese-heavy
While there are investors out there that want to help entrepreneurs grow their businesses, there are plenty more that are only in it for themselves.
The latter crowd drafts agreements that are heavy on legal terms which benefit them disproportionately, all in the hope that their potential victim won’t read the fine print.
Watch out for language that seeks to take veto and anti-dilution rights away from the entrepreneur, among other tricks.
About A Neumann & Associates, LLC
A Neumann & Associates, LLC is a professional mergers & acquisitions and business brokerage firm having assisted business owners and buyers in the business valuation and business transfer process through its affiliations for the past 30 years. With an A+ Better Business Bureau rating, the company has senior trusted professionals with a deep knowledge based in multiple field offices along the East Coast and has performed hundreds of business valuations in its history. The firm’s competitive transaction fees are based on successfully completing transactions. For more information, please contact A Neumann & Associates at 732-872-6777 or firstname.lastname@example.org