Trading Equity For Cash In A New Business

Practically every new business which is created starts out with a great idea that usually needs shaping, molding and a lot of long hours and hard work if it is to become a viable and competitive member of industry. However, most business do not reach the level of industry competitor without some kind of monetary investment.

Let’s face it, after you’ve been awaken in the middle of the night, or stayed awake with a business idea that you’re convinced will change the world, only to learn next morning that you’ll need money to get the business moving. What do you do if you don’t have that ‘seed money’?

If you own a home, you’ll remortgage (refinance) it. Take it from me cause it’s what I did to start my own real estate agency in the 1980s. I was fortunate enough to have owned a home, but not everyone with a great idea for a business owns a home. So what are some other options?

Investors and Equity

Practically every economy is built upon the backs of small business and entrepreneurship practioners. Every day someone comes up with an idea that will make a great business. Every day, these same people wonder how they will come up with the cash to get the business off the ground. The classic answer is to look for investors, and this is where things can go bad.

If you’re seeking investors for your business, you are going to need to form a business entity. Corporations and LLCs (Limited Liability Companies) are the most popular, and give you the ability to trade ownership interest in exchange for cash contributions.

With a corporation, investors will buy shares in the corporation. With limited liability companies, the investors will buy membership interests. Regardless, this traditional exchange gives rise to a problem common among small business owners. They often end up giving away too much equity.

From Joy to Misery

A common mistake made by new business owners is to give away too much equity when getting initial cash contributions. This occurs because they let insecurities impact their evaluation of the business. Instead of giving away two percent of equity in exchange for $50,000, they often give away ten percent. Let’s look at an example.

An industrious person starts a business selling digital gadgets. S/he prepares a business plan and realize s/he needs $250,000 to get everything up and running. s/he has $50,000, but need to find the rest somewhere. So s/he forms a corporation with 1,000 shares and start approaching potential investors.

S/he offers 100 shares for $25,000 and finds five investors that invest $125,000 in exchange for 500 total shares. In summary, s/he now has $175,000, but has given away half the equity in the business. While s/he is not happy about this, s/he is still so excited and enthused about the business idea that s/he shrugs it off.

The business gets rolling and s/he starts selling gadgets like crazy after one year. This gives rise to a serious cash problem because s/he’s getting orders, but can’t fill them because of cash flow problems. To make a proper go of the business, s/he needs another $100,000.

Where is s/he going to get $100,000? The business is only one year old, so a bank won’t touch it. The original nvestors haven’t seen penny one back, and are unwilling to put more money in. The only option is to sell another 400 shares for $100,000. Fortunately, s/he sells the shares, raises the money and stays in business. However, there is a major problem.

In raising all of this money, s/he has now sold off ninety percent of the equity in a business S/HE started, but now s/he’s left owning 100 shares and only 10 percent of the business. This is going to severely impact this owner’s physical, emotional and overall motivational well being. Slowly but surely, s/he’s going to become very bitter. It was s/he that had the idea and s/he is doing all the work! It really isn’t fair that s/he only owns 10 percent of the business! But that’s how it is. End of example!

On second thought, this impression may come on very quickly. Regardless, the business is destined to experience major problems because the primary motivating force is no longer motivational. Unfortunately, many people with business ideas run into this problem.

If you are starting a business, guard your equity at all costs. Selling equity should be a last resort. Try to get loans or trade profit sharing in lieu of selling equity. If you must sell equity, do so only in small percentages. You do not want to be the small business person in the example above.