I really doubt it’ll be a majority stake…..
Often when meeting entrepreneurs for the first time you are faced with the inevitable question ‘how much equity will you want’? An important, emotive and understandable question even if it is challenging to answer in an initial meeting. The fear is always that you will want a majority of their business. And I agree that this should very rarely happen in early stage investing.
The reason it is hard to answer the exact question of how much equity is required in a first meeting is that it is a risk-based answer. An answer based upon stage of business, funding quantum, purposes of funds and ultimately comfort and confidence in both business plan and entrepreneur. It is typically the equity stake received that will determine all, or a good proportion, of the financial returns generated if the business is successful. The emphasis on the ‘if’.
As such if risk is lower, equity requirements should rightly be lower and if risk is higher, equity requirements should be higher. The equity portion received compensating the risk. Like odds in a horse race, each horse is priced based on likelihood of success and the outsiders come in at long-odds. If every horse in a race was 2-1 it would be imbalanced and only the favourite would ever get backed.
So again, I agree that in the early stages a majority stake request should be…. rare. In fact when I meet businesses where my instinct is that a majority stake would be required I walk away. The simple fact that the majority is required means it doesn’t work for me. The risk is too high. It is likely to be an ‘outsider’ for one reason or another and ultimately the entrepreneur’s motivation won’t be there which won’t work for any of us.
Typically a majority is required because the quantum of finance being raised is out of kilter with the stage of the business, the business growth potential is low or the entrepreneur/business plan comfort factor isn’t entirely there. In other words the valuation and potential of the company doesn’t justify the quantum of capital being raised and the boundaries of risk are being pushed too hard. As such I can always comfortably respond that if I get to the position where I am prepared to invest/introduce investment it will more than likely not be in a majority position.
If you’re being presented only with scenarios where you will get majority diluted in the early stages of funding your business I think it is good time to revisit quantum of capital and business risk. Try raising less against more defined goals that provide more demonstrable ‘de-risking’ (significant milestone achievement) in the near-term. Build in the comfort that will reassure investors that the risk is balanced against the quantum of finance.
There are only two exceptions where an inevitable minority should be the ‘norm’ early-doors:
– The absolute ‘killer’ business plan that justifies the entire external capital it will ever need on day one. A business that can truly transform a market and that can professionally define and resource its requirement to go from zero to hero succinctly with the capital it is raising. A rare beast but sometimes found.
– The cumulative effect of a series of investment rounds into a growth business pushing the entrepreneur/management into a minority position. Good businesses may get to this stage following a series of investment rounds. Here however the business justifies the investment and the entrepreneur/management should be comofratble that successive rounds justify the dilution (i.e. they own a smaller part of a much more valuable business as a result of the investment rounds). However capital will only be taken on board due to the potential and actual growth trajectory of the company.
The key when a minority position is hit for entrepreneurs/management is to make sure that that the votes held by that minority position are required to implement substantial change within the company (or more rightly to prevent substantial change taking place). To make sure the minority stake vote is required in an overall count. If the voting threshold is 75% for major approvals and the minority stake is <25% then it becomes worthy of significant consideration. A topic for another blog……