Trading equity in their business for investment is a fact of life for most entrepreneurs. Unfortunately, sometimes they can get the raw end of the deal
Getting the equity deal right can have huge long-term ramifications for an enterprise’s future. Give away too much and an entrepreneur can end up seeing their returns dwindle away to almost nothing. Which is why we approached a venture capital firm, an angel investor and an entrepreneur to ask, how can we make equity deals just a little more equitable?
From an investment perspective, it is worth recognising that an investor is being asked to take on a high level of risk. “Investing in early-stage businesses is really risky,” says George Whitehead, venture partner manager at VC firm Octopus Investments. “When a company comes and it’s got a management team that hasn’t worked together for very long, a product that isn’t proven, a technology that doesn’t work yet, no revenue and no customers, you look at the business and it’s risk on top of risk on top of risk.”
But an investor isn’t just putting their money in a position of risk. They’re also bringing a whole wealth of support to the table. Around 18 months after he first founded online contact-lens retailer Lenstore, Mitesh Patel began to look for angel investment in his enterprise. But he was clear it was about more than just getting a cash injection – he also needed a great advisor, which he found in Keith Potts, angel investor and co-founder of Evenbase. “There was very much that dual purpose in bringing Keith on board,” Patel explains. “I was really looking for an internet entrepreneur and internet superstar if you like, who had been through the entire lifecycle of what I was hoping to go through.”
Obviously then, a large part of the equity deal recognises the value an investor is contributing. However, this doesn’t mean that sometimes investors don’t make demands above and beyond the value they’re contributing and end up damaging the business as a result. “One of the things that has happened in the past I think is angels and VCs have been too greedy, taking up too much in shares,” comments Whitehead. And while it may not occur to an investor, this can be cutting off their nose to spite their face.
Equity distribution reflects what all parties are bringing to the business and if an investor strips too much equity away from an entrepreneur, it can be catastrophic as they are effectively stripping out the incentive the founder has to really grow the business. In his early days as an angel, Potts recalls a situation where he and his colleagues over-asked for equity. “This guy signed up to it but there wasn’t the passion there; he became a minority stakeholder of something he created,” he says.
If an entrepreneur ends up feeling demotivated because they don’t stand to gain enough from their work, this minimises the end profit for all involved, meaning it becomes self-defeating. This is something that Potts was adamant he wanted to avoid in his dealings with Lenstore. “Mitesh is the guy running the business day-to-day, building the business, building the relationships and it’s really the case that the more equity he can have, the more incentive he has,” he says.
Additionally, founders and investors aren’t the only people involved in driving a business forward. If too much equity is removed early on, the chances of bringing in major executive talent diminishes. “In my experience, the really top-tier people won’t go to work for start-up companies unless they have a piece of the action,” says Whitehead. As few early-stage enterprises can afford to pay competitive salaries, the hires they make are going to expect to be compensated for their hard work in growing the business. “Having a puny share option scheme is just going to mean you’ll find it very hard to recruit A-grade people,” he says.
Good advice when making equity deals can really pay dividends. As one of Lenstore’s principle investors, Potts has always had a stake in protecting both the company’s interests and those of its founder. One of the most significant contributions he has made to the company came when the firm was trying to attract other investors during its seed round and one of the parties involved was placing excessive conditions on his investment. “Keith very discretely advised me that I didn’t have to sign up to all of the conditions that the investor wanted,” says Patel.
Potts recommended the entrepreneur simply walk away, saying they could make do without the additional investment. “All it would have done really is that it would have meant Mitesh sold out more equity than he had to,” he explains. “It wasn’t needed and the other investor was coming up with some quite unpalatable conditions for his investments.” This has had huge ramifications for the founder’s share and means he will be much better off if and when he decides to exit. Patel says: “The truth is that advice from Keith has saved me about £1m worth of equity.”
But how does an entrepreneur work out what is reasonable? In part, keep looking toward the exit. “Have a good idea of how companies that are in your sector and space have been valued at exit,” comments Whitehead. This makes it much easier to calculate growth targets at each investment stage and work out exactly how much equity each party needs to profit from their hard work. He concludes: “This is how you will genuinely make money for everyone involved.”